dividend decesion

34
DIVIDEND DECESION A STRATEGIC PERSPECTIVE

Upload: prashant-mittal

Post on 26-Mar-2015

77 views

Category:

Documents


0 download

TRANSCRIPT

Page 1: DIVIDEND DECESION

DIVIDEND DECESION

A STRATEGIC PERSPECTIVE

Page 2: DIVIDEND DECESION

MEANING OF DIVIDENED

The term “Dividend” refers to that part of after tax profit which is distributed to owners (shareholders) of the company. The undistributed part of profit is known as Retained Earnings.

Page 3: DIVIDEND DECESION

MEANING OF DIVIDEND POLICYThe dividend policy of a company refers to the

views and policies of the management with respect to distribution of dividends. The dividend policy of a company should aim at shareholder – wealth maximization.

Page 4: DIVIDEND DECESION

Factors influencing dividend policy Age of company Past dividend rates Liquidity of company Stability of earning Expectation of share holder Legal restrictions

Page 5: DIVIDEND DECESION

ESSENCE OF DIVIDEND POLICYIf the company is confident of creating more than

market returns then only it should retain higher profits and pay less as dividends, as shareholders can expect higher share prices based on higher RoI of the company.

However if the company is not confident of generating more than market returns, it should payout more dividends .

Page 6: DIVIDEND DECESION

REASONS FOR PAYOUT

Payout is done because of two reasons: The shareholder prefer early receipt of cash

(liquidity preference theory). The shareholders can invest this cash to

generate more returns (since market rate of interest is higher than returns generated by company).

Page 7: DIVIDEND DECESION

GRAHAM MODEL

Based on his observations of stock over the years, Benjamin Graham developed a stock valuation model that allows for future growth. Graham observed that the average no-growth stock sold at 8.5 times earnings, and that price-earnings

where G is the rate of earnings growth, stated as a percentage.

P/E = 8.5 + 2GP/E = 8.5 + 2G

Page 8: DIVIDEND DECESION

SHORTCOMINGS OF MODELThe original formulation was made at a time when

there was very little inflation, and growth could be assumed to be real growth; the AAA corporate bond interest rate prevailing at the time was 4.4%. In later years, the formula was adjusted for higher current interest rates that contained an inflationary component:

P/E = [8.5 + 2G] × 4.4/Y

where Y is the current yield on AAA corporate bonds.

Page 9: DIVIDEND DECESION

EXAMPLE

As an example, at a 6% bond yield and an assumed annual earnings growth rate of 10%, the P/E multiplier would be:

P/E = [8.5 + 2(10)] × 4.4/6       = 28.5 × 0.73       = 20.9

Page 10: DIVIDEND DECESION

INTERPRETATION OF MODELThe Graham and Dodd P/E Matrix uses this

valuation formula to show the price-earnings ratio that results from a given bond yield at a given rate of earnings growth. You will be able see from the table that changes in interest rates will have a dramatic effect on price-earnings ratios for any given earnings growth rate.

Page 11: DIVIDEND DECESION

Graham & Dodd P/E Matrix

Bond Yield

Expected 5-Year Annual Growth Rate:

0% 5% 10% 15% 20% 25% 30% 35% 40%

1% 37.4 81.4 125.4 169.4 213.4 257.4 301.4 345.1 389.4

2% 18.7 40.7 62.7 84.7 106.7 128.7 150.7 172.7 194.7

3% 12.5 27.1 41.8 56.5 71.1 85.8 100.5 115.1 129.8

4% 9.4 20.4 31.4 42.4 53.4 64.4 75.4 86.4 97.4

5% 7.5 16.3 25.1 33.9 42.7 51.5 60.3 69.1 77.9

6% 6.2 13.6 20.9 28.2 35.6 42.9 50.2 57.6 64.9

7% 5.3 11.6 17.9 24.2 30.5 36.8 43.1 49.3 55.6

8% 4.7 10.2 15.7 21.2 26.7 32.2 37.7 43.2 48.7

9% 4.2 9.0 13.9 18.8 23.7 28.6 33.5 38.4 43.3

10% 3.7 8.1 12.5 16.9 21.3 25.7 30.1 34.5 38.9

11% 3.4 7.4 11.4 15.4 19.4 23.4 27.4 31.4 35.4

12% 3.1 6.8 10.5 14.1 17.8 21.5 25.1 28.8 32.5

13% 2.9 6.3 9.6 13.0 16.4 19.8 23.2 26.6 30.0

14% 2.7 5.8 9.0 12.1 15.2 18.4 21.5 24.7 27.8

15% 2.5 5.4 8.4 11.3 14.2 17.2 20.1 23.0 26.0

16% 2.3 5.1 7.8 10.6 13.3 16.1 18.8 21.6 24.3

17% 2.2 4.8 7.4 10.0 12.6 15.1 17.7 20.3 22.9

18% 2.1 4.5 7.0 9.4 11.9 14.3 16.7 19.2 21.6

19% 2.0 4.3 6.6 8.9 11.2 13.5 15.9 18.2 20.5

20% 1.9 4.1 6.3 8.5 10.7 12.9 15.1 17.3 19.5

Page 12: DIVIDEND DECESION

LINTER’S MODEL

In the 1950’s, Lintner conducted a classic series of interviews with corporate managers about their dividend policy. He then proceeded to formulate a seemingly logical model of how companies decide on dividend payments. The findings of Lintner’s survey can be summarised in four “stylised facts”, as interpreted by Marsh and Merton

Page 13: DIVIDEND DECESION

Firms have long-term target dividend payout ratios. Managers focus more on dividend changes than on

absolute levels. Dividend changes follow shifts in long-term,

sustainable earnings. This trend implies that managers tend to “smooth” dividends so that changes in transitory earnings are unlikely to affect dividend payments over the short term.

Managers are reluctant to make changes to dividends that might have to be reversed. They are particularly concerned about having to rescind a dividend increase.

Page 14: DIVIDEND DECESION

ESSENCE OF MODEL

The essence of Lintner’s dividend model is that, if a firm persisted with its target payout ratio, then the dividend payment in the ensuing year (Div1) would equal a constant proportion of earnings per share (EPS1), or

Div1 = target ratio * EPS1

Page 15: DIVIDEND DECESION

If a firm adhered to its target payout ratio, it would change its dividend whenever its earnings changed. However, the managers in Lintner’s (1956) survey were reluctant to do this. They believe that shareholders prefer a steady progression in dividends. If, for instance, circumstances appeared to warrant a large increase in their company’s dividend, they would move only partially towards their target dividend. Their dividend changes appear to conform to the following model:

Div1 – Div0 = adjustment rate * target change = adjustment rate * [(target ratio * EPS1) - Div0]

This equation can be rewritten in a summarised form as:D1 – D0 = a*(TE1 – D0) = aTE1 – aD0 (2) where a = adjustment rate; T = target rate; D1 = current dividend; E1 = current earnings; and D0 = previous dividend.

Page 16: DIVIDEND DECESION

WALTER MODEL

Prof. James E. Walter devised an easy and simple formula to show how dividend can be used to maximize the wealth position of shareholders.

He considered dividend as one of the important factor determining the market valuation.

Page 17: DIVIDEND DECESION

According to Walter, in the long run share prices reflect present value of future stream of dividends. Retained earnings influence stock prices only through their effects on further dividends.

Page 18: DIVIDEND DECESION

ASSUMPTIONS OF THE MODEL Internal financing 100% payout or retention Constant RoI and cost of capital Infinite time

Page 19: DIVIDEND DECESION

According to Walter model

P = Market price per shareE = Earning per shareD = Dividend per shareKc = Cost of capitalRoI = Return on investment

P= [D+(E-D)*RoI/Kc]/KcP= [D+(E-D)*RoI/Kc]/Kc

Page 20: DIVIDEND DECESION

EXAMPLE

r = 0.15, 0.10, 0.08K = 0.10Eps = Rs.10Dps = 40%

P = (4 / 0.1) + (0.15 / 0.1) (10 – 4) = Rs.130 0.1P = (4 / 0.1) + (0.1 / 0.1) (10 – 4) = Rs.100 0.1P = (4 / 0.1) + (0.08 / 0.1) (10 – 4) = Rs.88 0.1

Page 21: DIVIDEND DECESION

SHORT COMINGS OF THE MODELThe model considers internal rate of return (IRR),

market capitalization rate Kc and dividend payout ratio in determination of share price. However it ignores the various other factors determining share price .it fails to accurately calculate prices of companies that resort to external sources of finance.

Further the assumption of constant return and constant cost of capital are unrealastic.

Page 22: DIVIDEND DECESION

If the internal rate of return of retained earning is higher than the market capitalization rate, value of ordinary share would be high even if dividends are low. However, if the RoI within the business is lower than what market expects, the value of shares would be low. In such case shareholders would expect higher dividends.

INTERPRETATION OF WALTER MODEL

If RoI > Kc Price would be high even if dividend is low.

Page 23: DIVIDEND DECESION

GORDON’S MODEL

According to Gordon’s Model the market value of a share is equal to an infinite stream of dividends received by shareholders.

The formula is:

Po = DIV1/K-GOR

Po= EPS1 (1-b)/K-br

Page 24: DIVIDEND DECESION

Here

EPS = Earning per share

r = Rate of return

b = Retention Ratio

g = Growth rate

k = Cost of capital

Page 25: DIVIDEND DECESION

EXAMPLE

r = 0.15, 0.10, 0.08K = 0.10Eps = Rs.10

b = 60%

P = 10(1-0.6) / 0.10 (0.15 * 0.60) = Rs. 400P = 10(1-0.6) / 0.10 (0.10 * 0.60) = Rs. 100P = 10(1-0.6) / 0.10 (0.08 * 0.60) = Rs. 77

Page 26: DIVIDEND DECESION

Assumptions of Gordon’s Model All equity funds No external financing Constant return Perpetual earning No taxes Constant Retention Cost of capital greater than growth rate

Page 27: DIVIDEND DECESION

Interpretation of Gordon’s ModelAccording to Gordon’ s model dividend policy is

irrelevant where r=k, when all assumptions are held valid. as per this theory dividend policy does affect value of share even when r=k. This view is based on the assumption that under conditions of uncertainty investor tends to discount distant dividend at higher rate than they discount near dividends.

Page 28: DIVIDEND DECESION

The implication of dividend policy as per Gordon’s model for growth firms, normal firms and declining firms are as follow:

The market value of share increases with retention ratio for firms with growth opportunities i.e. r>k.

The value of share increases with payout ratio (1-b) for declining firms i.e. r<k.

The market value of share is not affected by dividend policy when r=k.

Page 29: DIVIDEND DECESION

MM HYPOTHESIS

According to Modigilani and Miller under a perfect market situation, the dividend policy of a firm is irrelevant, as it does not affect value of the firm.

Page 30: DIVIDEND DECESION

ASSUMPTIONS OF MM HYPOTHESIS Perfect capital market No taxes No risk

Page 31: DIVIDEND DECESION

Interpretation of MM HypothesisUnder the MM theory r will be equal to k and identical

for all shares. As a result the price of each share will adjust so that rate of return and capital gains will be equal to k on each share.

Thus minimum rate of return may be calculated as follows:

r = Dividends + Capital Gains

Share price

Page 32: DIVIDEND DECESION

Shortcoming of MM HypothesisThe assumptions of theory are not valid under

practice. The following are the situations where MM Hypothesis may go wrong:

Uncertainty and shareholder preference Transaction cost Tax differentials

Page 33: DIVIDEND DECESION

BONUS ISSUE

Bonus share: In place of or in addition to cash dividend a company may offer additional shares.

Example: The company may decide to give 1 additional share to holder of every 2 share.

You own 100 shares@100 each (Rs 1200) After bonus issue you have 150 shares @Rs.

8 each (Rs. 1200)

Page 34: DIVIDEND DECESION

SHARE SPLIT

Change in number of share outstanding 3 for 2 split You owned 100 shares @ 12 each (Rs1200) After split you have 150 share @ 8 each (Rs

1200) Same impact as bonus issue