6 dividend decision

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Dividend Decisions



Dividend Decisions 2

Dividend Decisions

Dividend Policy determines the proportion of totalearnings is to be paid as dividends and the

proportion to be retained in the business for

reinvestment purposes.

Dividend decision links the Investment decisionwith the Financing Decision.

Higher dividends means lower Retained

earnings, which in turn means more reliance on

external funds.




Forms of Dividends

Cash Dividend: Companies mostly pay dividends in

cash. ± Regular, special, and interim dividends

± Have liquidity issues.

Stock Dividend (Bonus Shares): Issue of shares free of cost to the existing shareholders of the company.

± Represents the capitalisation 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 shareand a 1:1 bonus.




Forms of Dividends

Why Bonus shares:

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 thestock.

Indicates bright future prospects.

Stock Splits: The par value of the shares is reduced, thereby

increasing the no. of shares outstanding. (Not a form of Dividend)

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




Forms of Dividends

Share Repurchase: Purchase by the company of its own

equity shares. ± rewarding the shareholders as the repurchase is at a

price higher than the current market price, besidesmode of capital restructuring.

Modes of Share Repurchase:

± Open Market Repurchase (India)

± Tender Offer (India)

± Dutch Auction




Procedural Aspects of Dividends

Board Resolution: Board of Directors at their board

meeting adopt a resolution to pay dividends. Shareholders¶ approval: Board¶s resolution has to be

approved by the shareholders at the Annual GeneralMeeting.

Record date: Upon approval of the resolution, theCompany fixes a ³Record date´ ± to freeze theshareholders 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

to receive dividends

Announcement

date

Ex-Dividend Record

Date

Payment

date

Company approves

DividendCompany closes books and

records owners of stockDividend is paid

to shareholders



7

Dividend Decisions - Overview of Theories

Dividends are ³Bad´

Middle-of

-the-road

(MM Theory)

Dividend

Policy

Dividends are ³Good´

7Dividend Decisions




Dividends are ³bad´

Dividends create tax disadvantage for investors who

receive them as dividends are taxed heavily than capitalgains.

Accordingly, dividends should reduce the returns to

shareholders after personal taxes.

Shareholders would respond by reducing the stock pricesof firms of such firms relative to firms that do not pay

dividends.

Consequently, firms would be better off by either retain

the money they would have paid as dividends or repurchasing stock.




Measuring the Dividend Tax disadvantage

Tax rates on dividends are generally greater than on

capital gains.

Measure the price change on the ex-dividend date and

compare it with the actual dividend paid.

B B B cgCF P (P P)t! A A A cg oCF P (P P)t D(1 t )!

B B cg A A cg oP (P P)t P (P P)t D(1 t ) !

oB A

cg

(1 t )P P

D (1 t )

!

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

between tax on dividends and capital gains.

If PB-P A = D, investor is indifferent between dividends and Capital Gains

If PB-P A < D, investor is taxed more heavily on dividends

If PB-P A > D, investor is taxed more heavily on Capital Gains

Sell before Ex-dividend Sell after Ex-dividend




Implications of Dividend Tax disadvantage

Firms with an investor base composed primarily of

individuals should typically have lower dividends ascompared 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 ³Good´

Despite the tax disadvantage of dividends, firms continue

to pay dividends.

Some dubious reasons for paying dividends are:

o Bird-in-hand fallacy: C ertain dividends are better than

uncertain capital gains.

The choice is, however, between dividends today andan almost equal amount in price appreciation today.

o Temporary excess cash: Return excess cash arising

due to extra-ordinary year or sale of assets might appear

reasonable. But if the firm expects shortfall in the near future, it is

better to retain the excess cash now than to return it

now and raise funds later, as there is cost of issuing

bonds/ equity.




Some good reasons for paying dividends

Although the dividends have tax disadvantages, esp. for

individuals, they are preferred due to:

1. Investors like dividends:

Self-Control: Individuals lack self-control. They rely on

external regulations to control their actions. Hence in order

to conserve their savings, investors would like to limit theamount at their disposal in the form of Dividend such that

the principal amount is left untouched.

Clientele Effect - Over a period, shareholders tend to invest

in firms whose dividend policies match their preferences.

High tax investors prefer companies which pay low or nodividends, while low tax investors prefer high dividend

paying firms. Pettit (1977) regressed dividend yields on characteristics of investor base ± age, income,

diff tax rates etc.

Safer companies had older and poor investors paid more dividends than companies with

rich and younger investors.





2. Dividends as Information Signal: H ow 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 sends positive signal as it indicatesimproved capacity to generate higher cash flows in the future





3. Dividends reduce managerial discretion:

Accumulated cash left to the discretion of managers may

be wasted in poor projects.

Forcing firms to pay dividends is a way to discipline

managers in project selection and to reduce the cash

available for discretionary use.

Firms with separation of ownership and management,

should pay larger dividends than firms with substantial

insider ownership.




Modigliani & Miller (MM) Theory

Assume an unlevered firm which has:

± post-tax EBIT of Rs 100 Mn that grows @5%pa

± Shares outstanding:105 Mn shares

± cost of capital : 10%.

± Reinvestment requirement: Rs. 50 Mn (grows @ 5%. pa)

Value of Firm = Cash flow / k-g

(100-50)*(1.05)/(10%-5%) = Rs.1050 Mn

Price per share = Rs 1050 Mn /105 Mn = Rs 10/-

Based on its cash flow, firm could pay dividend of Rs 50 Mn

Dividend per share = Rs 50 Mn/ 105 Mn = 0.476

Total value per Share = Rs 10 + Rs 0.476 = Rs 10.476.




MM Theory

Scenario ± I : Company doubles the dividend:

± Dividend to be paid is Rs 100 Mn instead of Rs 50Mn. ± Firm would have to raise additional Rs 50 Mn for dividend pay out.

± Assume the firm issues new shares (at no floatation costs)

Value of Firm = (50)*(1.05)/(10%-5%) = Rs1050 Mn

Existing shareholders will receive a much larger dividendDividend per share = Rs 100 Mn/ 105 Mn = Rs 0.953

After issue of new shares, old shareholders are owningRs.1000 Mn, out of the total firm value of Rs. 1050 Mn.

Price per share = Rs 1000 Mn /105 Mn = Rs 9.523 Total value per Share = Rs 9.523 + Rs 0.953 = Rs 10.476.

Firm value remains unaffected by the dividend policy.




MM Theory

Scenario ± II : Company stops paying the dividend:

± The firms decides not to pay dividend and retain the residual cash of Rs 50 Mn.

Value of Firm = Cash flow/k-g + Cash Balance

(50)*(1.05)/(10%-5%) + 50 = Rs1100 Mn

Value per share = Rs 1100 Mn /105 Mn = Rs 10.476

Increase in stock price is offset by the loss of cash flowfrom dividends. When the firm pays more, the pricedecreases but is exactly offset by the increase in dividends

per share.

Firm value remains unaffected by the dividend policy.




MM Theory

Value of the firm depends upon the earning power of the

firm¶s 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

Crux of the MM hypothesis: The effect of dividendspayments on shareholders¶ wealth is offset exactly by theimpact of other means of financing. Hence, Dividenddecision is a residual decision.




Dividend policy when dividends are irrelevant

The assumptions needed to arrive at the dividend

irrelevance proposition are too restrictive and we may betempted to reject it.

But the theory does contain valuable message.

± 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.




Quantum vs. Stability

Two aspects of Dividend Policy are: ±Quantum of Dividends

±Stability or Fluctuating Dividends

Dividend payout may be ³ H igh´ or ³Low´ and the

payout be ³Stable´ or ³Fluctuating´ .




Factors affecting ³Quantum of Dividend´

1.Funds Requirements: Payout depends upon funds

requirements in the foreseeable future, assessed thru¶

financial forecasts.

± Firms with large investment projects, hence huge

requirements of funds, keep D/P low.

± On the other hand, firms with limited investment

avenues, have high D/P ratio. E.g. Bombay Dyeing.

2. Liquidity: For paying dividends, firm needs Cash

(Liquidity). Hence, liquidity status has an impact on the D/Pdecision. A ³profitable´ & ³rapidly expanding´ firm may not

have the necessary funds to pay dividends due to liquidity

constraints.

21Dividend Decisions




3. Access to External Funds: Firms which has access to

external sources, may feel less constrained in its dividend

decision. Dividend decisions would be independent of the

Investment decision & Liquidity position. Such firms may

pay liberal dividends.

4. Shareholder Preference: Preference of shareholders

may influence the D/P. If Shareholders prefer dividends

instead of Capital Gains, Co. may be inclined to pay liberaldividends and vice versa. The ³clientele effect´ appears to

work in such cases.






5. Control: External equity (except for Rights Issue) dilutes

the control over the company. Internal financing helps in

maintaining the control. Management & Shareholders are

averse to external financing & hence firms rely on retained

earnings.

6. Difference in Cost of External Equity & Retained

Earnings: Cost of External Equity is higher than the cost

of Internal Equity (Retained earnings) ± due to Issue Cost

& Under pricing. Magnitude of the differential has abearing on the proportion of external Equity & Retained

Earnings. And therefore on the D/P.




Factors affecting ³Stability of Dividends´

Stability of dividends is considered a desirable policy by the

Management.

Stable Dividend Payout Ratio Policy: % age of

Dividend paid out remains constant. Dividends ,therefore,

fluctuate with the Earnings. Such policy transfer the

variability of earnings to dividends. Not very popular.

Earnings

/Dividends

Time

Earnings

Dividends




B. Factors affecting ³Stability of Dividends´

Stable Dividend Policy: Rupee level of dividends

remains stable or gradually increases (generally).Generally this policy is followed.

Dividend

Earnings

/Dividends

Time

Earnings




Why firms follow Stable Dividend Policy?

Firms tend to follow a Stable or gradually rising

Dividend Policy.

1. For many investors, dividend income is utilised to

meet a portion of their living expenses. As these

expenses are stable or gradually increasing,investors prefer stable or gradually increasing

dividend inflow. If dividends are fluctuating widely,

investors may be forced to either sell their

investments or reinvest the surplus funds. Bothinvolve transaction costs & inconvenience.




Why firms follow Stable Dividend Policy?

2.Dividend decision provides a Signal to the investors

regarding the future prospects of the Company.

Increasing dividends means improved earnings prospects,

and so on.

Dividends, therefore, resolves uncertainty in the minds of

the investors. If the firm varies the Dividends frequently

based on short term influences, its dividend decision shall

lack the ³uncertainty ± resolution power ́.

Hence, firms maintain a stable dividends and change only

gradually corresponding to long-term changes inprospects.




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 ³changes´ in

dividends rather than ³absolute´ dividends;

3. Dividends tend to follow earnings, but dividends follow

a smoother path than earnings;

4. Dividends are sticky as managers are reluctant tochange Dividends which may have to be reversed

later.




Lintner¶s Model

Lintner expressed Corporate Dividend Behaviour in the

form of a Model:Dt = cr EPSt +(1-c)Dt-1

where,

Dt = Dividend per Share for year ³t´

c = adjustment rater = target payout rate

EPSt = Earnings per Share for year t

Dt-1= Dividend per Share for year ³t-1´

Lintner¶s Model shows that current Dividend dependsupon: (a) Current earnings, and (b) Previous year¶sdividends

Lintner¶s Model is supported by empirical researchconducted in India also.




Lintner¶s Model

Calculate the DPStfrom the following data for XYZ

Ltd :

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

Dt = (0.45 * 0.6*Rs 25 ) + ((1-0.45)*Rs14)= 6.75 + 7.70 = Rs 14.45

³c´

the adjustment factor shall be small for conservative companies and large for

aggressive companies.




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 policy varies across countries ± Difference in stage of growth

± Difference in tax treatment

± Difference in corporate control

6 dividend decision

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