1 dividend decision

1Dividend Decision

Dividend Decision 2

Dividend Decision

Dividend Policy determines the proportion of total earnings is

to be paid as dividends and the proportion to be retained in

the business for reinvestment purposes.

Dividend decision links the Investment decision with the

Financing Decision.

We need to analyze the trade-off between high dividends and

low dividends, given the Investment & Financing decisions.

2Dividend Decision 3

Measuring Dividends Dividend Per Share (DPS):

Dividend Yield:

Dividend Payout ratio:

Amount of Dividend per Share =

Current Market Price per Share

Amount of Dividend per Share=

Earnings per Share

5.50= =10%

55.00

5.50= = 50%

11.00

Total Dividend =

No. of Equity Shares outstanding

Rs. 10 Lacs= =Rs 10 per share

1 Lac shares

Dividend Decision 4

Forms of Dividends

1. Cash Dividend: Companies mostly pay dividends in cash. Regular, special, and interim dividends

Have liquidity issues.

2. Stock Dividend (Bonus Shares): Issue of shares free of cost to the

existing shareholders of the company.

Represents the capitalization of reserves.

Proportionate shareholding remains the same, while shareholding of

each shareholder increases.

In India, bonus shares cannot be issued in lieu of cash dividends.

RIL recently declared a cash dividend of Rs. 13 per share and a 1:1 bonus.

Equity Capital Before Bonus

Paid-up Equity

(100 shares of Rs. 10/- each)

Rs. 1,000/-

Reserves Rs. 5,000/-

Total Equity Capital Rs. 6,000/-

Equity Capital After 1:1 Bonus

Paid-up Equity


Rs. 2,000/-




Forms of Dividends

Bonus Debentures: HLL issued (1:1) debentures on bonus (free) basis (2001).

3. Share Repurchase: The company buys its own shares from its own shareholders.

rewarding the shareholders as the repurchase is at a price higher than the current market price

Also a mode of capital restructuring

Modes of Share Repurchase in India:

1. Tender Offer (Fixed Price Tender Offer)

2. Open Market Repurchase thru Book Building Process

(Reverse Book Building/ Dutch Auction)

3. Open Market Repurchase thru Stock Exchange

Tender Offer Method

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Firm fixes the no. of shares, buyback price & time period during which it will buyback the securities.

Shareholders intending the sell their shares are required to tender them to the company.

In case the offer is oversubscribed, the firms buys on pro-ratabasis.

4Open Market Method Thru Book Building

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Also called Dutch Auction method or Reverse Book Building process.

Firm announces the no. of shares, range of buyback prices & time period during which it will buyback the securities.

Firm, thereafter, invites bids from shareholders - no. of shares and price ,within the price band, at which the investors are willing to sell.

Based on the bids received, the final price is decided (usually the highest price at which the target no. of shares is achieved).

Open Market Method Thru Book Building

8

Current Market Price Rs 530/-

Price Band Rs 540 560/-

Target No. of Shares 2,00,000

Investor Bid Price

No. of

Shares

A 550 10000

B 555 2000

C 540 50000

D 545 7500

E 550 24000

F 540 80000

G 550 6000

H 555 85000

I 540 4500

J 545 2500

K 550 1000

L 560 4500

M 545 9500

N 550 5000

O 560 10000

Total Bids Received for 301500

Bid Price No. of Shares Cum.

540 134500 134500

545 19500 154000

550 46000 200000

555 87000 287000

560 14500 301500

301500

5Open Market Method Thru Stock Exchange

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Firm authorizes a stock broker to buy the securities from the shareholders.

Company buys securities thru that broker to effect the buyback programme.

Dividend Decision 10

Procedural Aspects of Dividends

Board Resolution: Board of Directors at their board meeting adopt a resolution to pay dividends.

Shareholders approval: Boards resolution has to be approved by the shareholders at the Annual General Meeting.

Record date: Upon approval of the resolution, the Company fixes a Record date to freeze the shareholders to whom dividends has to be paid.

Dividend payment: Once the dividend is declared, dividend warrants must be posted within 30 days.

Stock has to be bought

by this date for

investor (buyer) to

receive dividends

Announcement date Ex-Dividend Record date Payment date

Company approves

DividendCompany closes

books and

records owners

of stock

Dividend is paid

to shareholders

2-3 weeks 2-3 days 3-4 weeks


Stock Splits

Stock Splits: The par value of the shares is reduced, thereby increasing the no. of shares outstanding. (Not a form of Dividend)

If a company declares 50% stock split, a shareholder holding 2 shares would hold 3 shares (3:2 split) after the split.

100% stock split means 2:1 split.

Brings the market price within a popular price range.

A share of Rs 1000/- is less affordable than Rs 100/- share.

Increases the no.of shares, hence the liquidity of the stock.

Indicates bright future prospects.

Equity Capital Before Stock Split

Paid-up Equity


Rs. 1,000/-



Equity Capital After 10 : 1 Split

Paid-up Equity

(1000 shares of Re. 1/- each)

Rs. 1,000/-




Impact of Stock Dividends on Market Price

Stock Dividend: If a company declares 10% stock dividends, a

shareholder would get 1 new share for every 10 shares held.

Reverse Split: 1:10 reverse split means every 10 shares are

replaced by 1 new share.

Before After

Market Value of Assets (Rs. Mn) 400 400

No. of Equity Shares outstanding (in Mn) 10 11

Share Price (Rs. Per Share) 40 36.36


Impact of Stock Dividends/ Stock Splits

The stock of Country Inn Hotels is currently trading at Rs. 20 per share.

What would happen to the stock price, if the company announces:

a. Stock dividend of 20%

b. 3:2 Stock Split

c. 1:3 Reverse Stock Spilt.

a. Stock dividend of 20% : 1 new share for 5 held

Market Value of 5 Shares before stock dividend: 5*20 = 100

No. of Shares after Stock Dividend: 5+1 = 6

Market Value per share after Stock Dividend: 100/6 = Rs.16.67

b. 3:2 Stock Split : Shareholder holds 3 shares instead of 2 shares

Market Value of 2 Shares before stock spilt: 2*20 = 40

No. of Shares after Stock Spilt: 3

Market Value per share after Stock spilt: 40/3 = Rs.13.33

c. 1:3 Reverse Stock Split : Shareholder holds 1 share instead of 3 shares

Market Value of 3 Shares before Reverse Stock Spilt: 3*20 = 60

No. of Shares after Reverse Stock Spilt: 1

Market Value per share after Reverse Stock spilt: 60/1 = Rs.60.00


Empirical evidence of Dividend Policy

Dividends tend to follow earnings

As dividends are paid out of earnings.

Dividends are sticky

Reluctance of firms to raise dividends until they feel confident

of maintaining it and to cut dividends unless absolutely

required.

Dividends follow a smoother path than earnings

A firms dividend policy tends to follows the life cycle of the firm

Firms in high growth stage pay low / no dividends, while stable

firms with large cash balances and fewer projects pay out

higher dividends.


Dividend Decision - Overview of Theories

Dividends do not have any impact on stock prices:

MM Dividend Irrelevance Theory

Dividends have an impact on stock prices:

Under Market Imperfections

Dividends are Bad

Dividends are Good

Under Perfect Markets

Walters Model

Gordons Model

Dividends do not have any impact

on stock prices

(MM Dividend Irrelevance Theory)


Dividends in MMs world of Perfect Capital Markets

Modigliani & Miller (MM) hypothesized irrelevance of Dividends under assumptions of Perfect Capital Markets.

Consider an unlevered company which expects to generate free cash flows of Rs 48 Mn each year. The firm has Rs 20 Mn of excess cash, 10 Mn equity shares outstanding & cost of capital of 12%.

The value of the firm, today, would be the present value of the future cash flows (till perpetuity) + excess cash:

0

FCF 48V = + cash = + 20 = Rs.420 Mn

k 0.12


Dividends in MMs world of Perfect Capital Markets

The company has 3 options:

Pay Cash dividend out of excess cash

Repurchase equity instead of paying Dividends

Pay higher Dividends (& Raise additional cash to pay)

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1. Pay Dividend out of excess Cash

The company may decide to distribute Rs 20 Mn excess cash as dividends amongst its 10 Mn shares i.e. pay Rs. 2 per share as dividends.

In future, as the company would generate Rs 48 Mn of free cash flows each year, it may expect to pay dividend of Rs. 4.80 per share each year.

Fair price is the present value of future dividends.

Price Before ex-dividend would be:

Price After ex-dividend would be (buyer will not get the current dividend):

The stock price will fall on ex-dividend date by the amount of

dividend.

cumP = Current Dividend + PV of Future Dividends

4.80= 2 + = 2 + 40 = Rs. 42/-

0.12

exP = PV of Future Dividends

4.80= = Rs. 40/-

0.12


1. Pay Dividend out of excess Cash

The price falls when dividend is paid, as such payment reduces the market value of the firms assets.

Thus, in perfect capital markets, when dividend is paid, the share price drops by the amount of dividends when the stock begins to trade ex-dividend.

But the companys shareholder does not incur a loss.

Before dividends, the market price was Rs. 42/- while after the dividend payout , the market price is Rs. 40/- and has Rs 2/- in cash as well.

Cum-Dividend Ex-Dividend

Cash (Rs. Mn) 20 0

Market Value of other assets (Rs. Mn) 400 400

Total Assets (Rs. Mn) 420 400

No. of Shares (Mn) 10 10

Market Price per share (Rs. per share) 42 40

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2. Repurchase equity (instead of Dividend)

Now, assume the company does not pay dividends but instead repurchases its equity in the open market.

How will repurchase affect the share price?

With initial price of Rs. 42/- per share, the firm would be able to buy 0.476 Mn shares (Rs. 20 Mn/Rs. 42 ) out of 10 Mn shares.

Although the market value of assets fall, but the no. of shares outstanding also falls, the two changes offset each other, so there is no impact on the market value of the firms equity shares.

Before Repurchase After Repurchase

Cash (Rs. Mn) 20 0

Market Value of other assets (Rs. Mn) 400 400

Total Assets (Rs. Mn) 420 400

No. of Shares (Mn) 10 10-0.476 = 9.524

Market Price per share (Rs. per share) 42 42



In the future, the company expects to generate Rs. 48 Mn in free cash flows, which can be used to distribute as dividends over 9.524 Mn shares (10 Mn 0. 476 Mn) i.e. Rs. 5.04 per share each year.

Thus, the market price after repurchase would be:

By not paying dividends today and repurchasing shares instead, the company is able to increase the dividend per share in the future.

Increase in future dividends compensates the shareholders for loss of dividends today.

Thus, in perfect capital markets, an open market repurchase has no effect on the stock price price is same as Cum-dividend price if dividend was paid instead.

rep

5.04P = = Rs. 42/-

0.12

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Investors wealth also does not change.

Assume an investor holding 2000 shares and does not sell the shares, the wealth remains the same in either of the options

The only difference is the distribution between cash and stock holdings.

Thus, investors would prefer between cash and stock holding depending on whether they requires cash or not.

If Co. pays Dividend of Rs. 2/- If Co. Repurchases Shares

Share Value Rs. 40 * 2000 = Rs 80,000/- Rs. 42 * 2000 = Rs 84,000/-

Cash Rs. 2 * 2000 = Rs 4000/- Nil

Total Wealth Rs 84,000/- Rs 84,000/-



Case 1: If the firm repurchases stock and the investor needs cash, he would sell the shares.

Investor would sell 95 shares (Rs. 4000 / Rs. 42 per share) to raise Rs. 4000/- in cash.

Investor would be left with 1905 shares(2000-95) valued at Rs. 80,000/- (@Rs.42/- per share)

Thus, in case of repurchase, by selling the shares, an investor can create a homemade dividend

Case 2: If the firm pays dividend but the investor does not require cash, the investor can buy more shares out of the dividends received.

Investor would buy 100 additional shares (Rs. 4000 / Rs 40 per share)out of the dividend of Rs. 4000 received.

Investors shareholding would be 2100 shares(2000 +100) valued at Rs. 84,000/- (@Rs.40/- per share)

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Investors position would be:

By reinvesting the dividends or selling shares, investor can create any combination of cash & stock.

Hence, the investor is indifferent between the two modes of rewards (returning cash).

Thus, in perfect capital markets, investors are indifferent between the firm distributing funds by dividends or share repurchase. By reinvesting dividends or selling shares they can replicate either payout methods on their own.

If Co. pays Dividend

(Buy 100 shares)

If Co. Repurchases shares

(Sell 95 shares)

Stock 2100 @ Rs. 40 = Rs 84,000/- 1905 @ Rs. 42 Rs 80,000/-

Cash - 95 @ Rs. 42 4000

Total Rs 84,000/- Rs 84,000/-


3. Raise cash and pay high Dividend

Now assume the company wants to pay larger dividend (higher

than Rs 2 per share)

Instead of paying Rs 48 Mn in dividends from next year onwards

(as assumed earlier), it wants to pay Rs 48 Mn now, but the

company has only Rs 20 Mn of excess cash.

Hence, the company needs to generate Rs 28 Mn in cash.

Option 1: Give up +ve NPV projects worth Rs 28 Mn. This would

lower the value of firm.

Option 2:Raise cash by selling equity. At Rs 42 per share, the firm can raise Rs 28 Mn by selling 0.67 Mn shares

No. of shares outstanding now would be 10.67 Mn & dividend per share

would be Rs. 4.50 per share. (Rs 48 Mn / 10.67 Mn shares)

Under the new policy, the cum-dividend price would be:

Thus, increasing dividends also has no effect on stock price.

cum

4.50P = 4.50 + = 4.50 + 37.50 = Rs. 42/-

0.12

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Modigliani Miller Dividend Irrelevance

If the company lowers current dividends and repurchases shares, it will have fewer shares, and so will be able to pay higher dividends in the future.

If the company pays higher current dividends by issuing equity, it will have more equity and hence lower free cash flows and hence would be able to pay lower dividends in the future.

MM Dividend Irrelevance: In perfect capital market, holding the investment policy fixed, the firms choice of a dividend policy does not effect the firms stock price, and therefore is irrelevant.

Dividend Policy Initial Price Year 0 Year 1 Year 2 .

1.Pay Dividends out of Excess Cash Rs. 42/- 2.00 4.80 4.80 .

2. Repurchase Shares Rs. 42/- 0.00 5.04 5.04 ...

3. Increase Dividends & raise cash Rs 42/- 4.50 4.50 4.50 .


MM Theory

Value of the firm depends upon the earning power of the firms assets or its Investment policy.

The manner in which the earnings are split between Dividends & Retained earnings does not effect the value of the firm.

Assumptions of MM Hypothesis:

Perfect Capital Markets Investors are rational.

No flotation costs

No taxes

No change in the given Investment policy

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Dividend policy when dividends are irrelevant

The assumptions needed to arrive at the dividend irrelevance

proposition are too restrictive and we may be tempted to

reject it.

But the theory does contain valuable implications:

A firm that has invested in bad project, cannot hope to

increase its value by paying higher dividends.

A firm with great investments may be able to sustain its

value even if it does not pay any dividends.

Dividends have an impact

on stock prices

- Under Perfect Market conditions

(Walters & Gordon Model)

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Dividend Relevance: Walters Model

As per Walters Model, the market value of equity is the sum of

Present Value of :

(a) Infinite stream of constant dividends, and

(b) Infinite stream of returns from retained earnings.

Present Value of infinite

stream of constant

Dividends

Present Value of infinite

stream of returns from

retained earnings

r( E - D )

D kP = +k k

where,

P = Market Price per share

D = Dividend per share

E = Earnings per share

r = firms average rate of return

k = firms cost of capital


Walters Model (Contd.)

Basic

DataEPS Rs 20 Rs 20 Rs 20

r 18% 14% 10%

k 14% 14% 14%

Payout (%) Case I

r > k

Case II

r = k

Case III

r < k

0% Rs 184 Rs 143 Rs 102

25% Rs 173 Rs 143 Rs 112

50% Rs 163 Rs 143 Rs 122

75% Rs 153 Rs 143 Rs 133

100% Rs 143 Rs 143 Rs 143

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Walters Model - Implications

Case I (r > k): Firm is able to earn more than what the shareholders can earn on their own.

Such firm should retain all of its profits i.e. Dividend payout ratio (D/P) should be Zero, at which the Market Price shall be maximum.

Case III (r < k): Firm does not have projects which can earn as much as the minimum hurdle rate (k).

Such firm should distribute all its profits (D/P = 100%) for market Price to be maximum.

Case II (r=k): Firm earns at a rate equal to the minimum hurdle rate (k).

Such firm is indifferent.


Walters Model - Illustration

Excel Industries has reported an EPS of Rs. 10/-. It earns @ 15% on itsassets while its cost of capital is 12.5%. If Walters model is used,what shout be the optimum dividend payout policy? What would bethe stock price at this policy. What would be the impact on stockprice, is the dividend payout policy is changed?

EPS = Rs. 10/- ; r=15%; k = 12.5%

As r>k, the optimum dividend policy as per Walters model wouldbe to retain 100% of the earnings

At D/P = 0%, the stock price would be:

If the payout is 30% (instead of 0%), the stock price would be:

0 . 1 5( 1 0 - 0 )

0 0 .1 2 5P = + = R s . 9 6 / -0 . 1 2 5 0 . 1 2 5

0 . 1 5( 1 0 - 3 )

3 0 . 1 2 5P = + = 2 4 + 6 7 . 2 0 = R s . 9 1 . 2 00 .1 2 5 0 . 1 2 5

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Dividend Relevance: Gordons Model

Using the Dividend Discounting Model, Gordons

valuation model states:

where:

P0 = Price per share at T0E1 = Earnings per share at T1b = retention ratio

k = firms cost of capital

r = firms rate of return on investments

10

E (1 - b )P =

k - b r


Gordons Model (Contd.)

Basic Data EPS Rs 20 Rs 20 Rs 20

r 18% 14% 10%

k 14% 14% 14%

Retention

Ratio (b)

Payout

Ratio(1-b)

Case I

r > k

Case II

r = k

Case III

r < k

75% 25% Rs 1000 Rs 143 Rs 77

50% 50% Rs 200 Rs 143 Rs 111

25% 75% Rs 158 Rs 143 Rs 130

0% 100% Rs 143 Rs 143 Rs 143

If r > k, price increases as dividend payout decreases

If r < k, price increases as dividend payout increases

If r = k, price remains unchanged

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Walters Model - Illustration

Excel Industries has reported an EPS of Rs. 10/-. Its cost of capital is10% and retention ratio is 40%. Determine the price per share as perWalters model and Gordon Model if the company earns @ 15%;10% or 5%.

g Walters Model Gordon Model

0.40*0.15 = 6% 120 150

0.40*0.10 = 4% 100 100

0.40*0.05 =2% 80 75

EPS = Rs. 10/- ; r=15%; 10%; 5%; k = 10%; b = 40% :DPS = (1-b)EPS =6

10

E (1 - b )P (G o r d o n ) =

k - b r0

r( E - D )

D kP ( W a l t e r ) = +k k

Dividends have an impact

on stock prices

Under Imperfect Market conditions

(Bad vs. Good)

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Dividends are bad

Shareholders are taxed on:

Dividend income when they receive it, and

Capital Gains, when they sell shares.

Typically, the tax on Dividends is higher than the tax on Capital

Gains.

This creates a tax disadvantage for investors who receive

dividends.

Accordingly, dividends should reduce the returns to shareholders

after personal taxes.

Shareholders would respond by reducing the stock prices of firms

paying dividends relative to firms that do not pay dividends.

Hence, firms would be better off by either retain the money they

would have paid as dividends or repurchasing stock.


Taxes in India

Companies pay tax @ 30% (plus Surcharge & Education Cess) on the

profits earned by them (subject to MAT).

Dividend received is Income for the investors

It is exempt in the hands of the Investors but is subject to Dividend

Distribution Tax (DDT) @ 15% + 10% Surcharge + 3% Education cess

(= 16.995%) to be deducted by the company on payment of dividends.

Individuals are taxed at: 0%, 10%, 20%, 30% (plus Surcharge & EC),

depending upon the income level.

Tax on Capital Gains on Shares:

Short Term Capital Gains (< 12 months): 15%

Long Term Capital Gains (> 12 months): 0% (if STT is paid)

In India, tax on Dividends paid by investor @ 0%, while tax on Capital

Gains is @ 0% or 15%.

This therefore creates tax advantage for Dividends instead of

disadvantage as in most other countries.

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Measuring the Dividend Tax disadvantage

To measure the tax disadvantage of dividends, we may compare

the change in stock prices on the ex-dividend date and compare it

with the actual dividend paid.

On Ex-dividend date, the stock price would drop to reflect the loss

of dividend to those buying stock after that date.

B B B cgCF = P - (P - P)t A A A cg dCF = P - (P - P)t + D(1-t )

B B cg A A cg dP -(P -P)t = P -(P -P)t +D(1-t )

dB A

cg

(1-t )P -P=

D (1-t )

For investor to be indifferent between selling before or after ex-

dividend date, the price drop must reflect the investors tax differential

between tax on dividends and capital gains.

Sell before Ex-dividend Sell after Ex-dividend

d cg

B A

cg

(t -t )P -P =D 1 -

(1-t )

Or

Effective Dividend Tax Rate


Dividend Tax disadvantage

Price drop on the ex-dividend date should reflect the tax

differential between tax on dividends and capital gains.

If PB- PA = D, marginal investor is indifferent between dividends

and Capital Gains

If PB- PA < D, marginal investor is taxed more heavily on dividends

If PB- PA > D, marginal investor is taxed more heavily on Capital

Gains

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Consider an Investor who plans to hold a stock. If the tax rate on

dividends is 39% and on capital gains is 20%, what is the effective

dividend tax rate?

d cg*

d

cg

(t -t ) (0.39 - 0.20) 0.19 t = = = =23.75%

(1-t ) (1- 0.20) 0.80

This indicates a significant tax disadvantage for dividends.

Each Rs 100 of dividends is worth only Rs. 76.25 of Capital Gains.



You purchased 1000 shares of Sesa 5 years ago @ Rs 50 per share.

The company is now considering to repurchase shares @ Rs 70 per

share under a fixed price tender offer. Alternatively, the company

may pay a dividend of Rs 70 per share. If capital gains are taxed @

15%, then at what rate should the dividends be taxed so that you

are indifferent between the two options?

To be indifferent between the two options:

Tax on Dividends = Tax on Capital Gains

Capital Gains (per share) = 70 - 50 = Rs. 20/-

Tax on Capital Gains (per share) = 15% of 20 = Rs 3/-

Dividend per share = Rs 70/-

3 = 70*td or td = 3/70 = 4.29%

If dividends are taxed at a rate higher than 4.29%, repurchase

would be preferred.

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Dividend Capture/Arbitrage/Stripping

ABC Ltd has been paying dividend of Rs. 5/- per share for the past

10 years. The stock price falls by about Rs. 4/- on ex-dividend date. It

is expected that this trend would continue in the future as well. The

stock price before ex-dividend is Rs. 50/- per share.

Ignoring taxes and transaction costs, can you benefit from such a

situation?

Buy the stock before ex-dividend @ Rs. 50/-.

Receive dividend of Rs 5/-

Sell the stock after ex-dividend @ Rs. 46/- (50 4)

Outflow: 50

Inflow: 46 + 5

Net Cash flow: Inflow Outflow = 51 - 50 = Re. 1 per share



Now consider an Investor in India who plans to hold a stock for less

than a year. Tax rate on dividends is 0% and on Short term capital

gains is 15%, what is the effective dividend tax rate?

d cg*

d

cg

(t -t ) (0 - 0.15) -0.15t = = = = -17.65%

(1-t ) (1- 0.15) 0.85

This indicates a significant tax disadvantage for STCG

Each Rs 100 of dividends is worth Rs. 117.65 of STCG.

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Implications of Dividend Tax disadvantage

In general (not in India):

Firms with an investor base composed primarily of individuals

should typically have lower dividends as compared to firms with

tax-exempt institutional investors.

Higher the income level (and hence the tax rate) of investors,

lower should be the dividend payout by the firm.


Dividends are Good

Although the dividends have tax disadvantages, they are

preferred due to:

1. Some Investors like dividends

2. Dividends as Informational signals

3. Dividends reduce managerial discretion

4. Dividends as a tool for changing the Financing mix (over time)

In fact, firms continue to pay dividends in spite of their tax

disadvantage is often referred to as The Dividend Puzzle

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Some Investors like dividends

Clientele Effect: Over a period, shareholders tend to invest in

firms whose dividend policies match their preferences. Generally, tax on Dividends is higher than on Capital Gains.

Also, capital gains tax is payable only when an investor sells the shares

This creates tax disadvantage for dividends.

Hence, High tax investors prefer companies which pay low or no

dividends, while low tax investors prefer high dividend paying

firms.

Implications: Firms get investors they deserve

Firms will find it difficult to change an established dividend policy , even if

the change is justified.

Pettit (1977) regressed dividend yields on characteristics of

investor base age, income, tax rates etc.

Safer companies had older , poor investors , and paid more

dividends than companies with rich and younger investors.


Dividends as Information Signal

How do firms convey information credibly to financial markets?

Signaling theory suggests that firms need to take actions that

cannot be easily imitated by firms without good projects. say

by increasing dividends

Increasing dividends send positive signals as it indicates

improved capacity to generate higher cash flows in the future

Decreasing dividends send negative signals because firms are

reluctant to reduce dividends. Markets view such action as an

indication of long-term financial problem being faced by the

firm.

Empirical evidence also supports the Signaling theory.

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Dividends reduce managerial discretion

Managers have more information / do not share complete

information about the company with the shareholders

Information asymmetry.

This leads to Agency problems conflict of interest between

managers & shareholders.

To reduce Agency problems :

Shareholders monitor the actions of managers Agency costs

Force firms to pay dividends thereby reduce the cash

available for discretionary use & discipline managers in

project selection

Implication :

Firms with clear separation of ownership and management,

would pay larger dividends than firms with substantial insider

ownership.


Dividends as a tool to change Financing mix

Firms may use dividend policy as a tool to change the

financing mix also.

Increasing dividends increases leverage over time, while

decreasing dividends reduces leverage.

Why bond prices fall on announcement of large dividends?

Payment of large dividends takes away cash from the firm

which could have been used to pay interest or redemption.

Hence, bondholders try to protect themselves by imposing

restrictions on how much a firm may pay as dividends.

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Cash Dividends vs. Stock Repurchases

Sustainability & stability of Excess Cash flows: Repurchase and

increase in Dividends is triggered by excess cash flows.

If excess cash flows are one time / temporary, co. should go

for repurchase.(or pay Special Dividend)

If excess cash flows are predictable and stable, co. may

increase the dividend.(sends a stronger signal)

Predictability of Future Investment requirements: Firms with

uncertain investment plans, should return excess cash by

repurchasing shares (due to flexibility)

Undervaluation of shares:

Remaining shareholders gain if repurchase at lower than

intrinsic value (IV =100/-; MP=45; RP = 50)

Repurchase would send the signal of stock being

undervalued, hence would react positively.


Cash Dividends vs. Stock Repurchases

Shareholders tax preference:

If shareholders are taxed more on dividends, then better to

go for repurchase, otherwise increase dividends

Management compensation:

Managers are compensated by issue of Stock options of the

firm(ESOPs).

When a company pays dividends, stock price falls, while in

case of repurchases, stock price usually increases

Value of Stock Option is linked to stock price.

Hence, managers with substantial stock options would like to

repurchase stock rather than increase dividends.

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Corporate Dividend Behaviour

Do firms follow a pattern regarding Dividends?

Lintner provided an answer, based on a survey of Corporate

Dividend Behaviour. Findings of the survey suggests:

1. Firms set long-run target payout ratios;

2. Management is more concerned with the changes in

dividends rather than absolute dividends;

3. Dividends tend to follow earnings, but dividends follow a

smoother path than earnings;

4. Dividends are sticky as managers are reluctant to change

Dividends which may have to be reversed later.


Lintners Model Lintner expressed Corporate Dividend Behaviour in the form of

a Model:

Dt = cr EPSt +(1-c)Dt-1where,

Dt = Dividend per Share for year t

c = adjustment rate

r = target payout rate

EPSt = Earnings per Share for year t

Dt-1= Dividend per Share for year t-1

Lintners Model shows that current Dividend depends upon:

(a) Current earnings, and

(b) Previous years dividends

Lintners Model is supported by empirical research conducted in India also.

29


Lintners Model

Calculate the DPSt from the following data for XYZ Ltd,

using the Lintners Model:

EPSt = Rs 25/- ; Dt-1= Rs 14/- ; c = 0.45 & r = 60%.

Dt = cr EPSt +(1-c)Dt-1

Dt = (0.45 * 0.6*Rs 25 ) + ((1-0.45)*Rs14)

= 6.75 + 7.70 = Rs 14.45

c the adjustment factor shall be small for

conservative companies and large for aggressive

companies.

1 dividend decision

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