Dividend Policy

Presented By:-Hemangi

Dividend Policy :-

It is the decision about how much of earnings to pay out as dividends versus retaining and reinvesting earnings in the firm.

Dividend policy: the decision to pay dividends versus retaining funds to reinvest in the firm

Three elements of dividend Policy:- Dollars of dividends to be paid out in the near

future. Target payout ratio: Long-run policy regarding

the average percentage of earnings to be paid out to stockholders.

Should we announce our dividend policy and then stick with it?

Important Dates

Declaration Date of the firm Ex-dividend Date Date of Record Date of Payment

Three elements of Theories:-

Irrelevant: Investors do not care what payout is set.

Investors prefer a high payout. Investors prefer a low payout in order to get

growth and capital gains.

Irrelevance Theory:-

Investors are indifferent between dividends and retention-generated capital gains. If they want cash, they can sell stock. If they don’t want cash, they can use dividends to buy stock.

Modigliani-Miller support irrelevance but their theory is based on unrealistic assumptions (no taxes or brokerage costs), and hence may not be true.

Illustration:-

A firm can either pay out dividends of $10,000 per year for each of the next two years or can pay $9,000 this year, reinvest the other $1,000 into the firm and then pay $11,120 next year. Investors require a 12% return. Market Value with constant dividend = $16,900.51 Market Value with reinvestment = $16,900.51

If the company will earn the required return, then it doesn’t matter when it pays the dividends

High payout:-

A high payout is desirable Desire for current income

Individuals in low tax brackets Groups that are prohibited from spending principal Uncertainty resolution

Taxes Dividend exclusion for corporations Tax-exempt investors

Low Payout:-

A low payout is desirable. Upper income individuals Flotation costs – low payouts can decrease the

amount of capital that needs to be raised, thereby lowering flotation costs

Dividend restrictions – debt contracts might limit the percentage of income that can be paid out as dividends

Implications of these theories..

Theory ImplicationIrrelevance Any payout okayBird in the Hand Set high payoutTax preference Set low payout

Cliental Effect

Different groups of investors, or clienteles, prefer different policies, e.g. retirees need dividends.

A firm’s past dividend policy deter-mines its current clientele of investors.

Clientele effects impede changing policy. Taxes and brokerage costs hurt investors who switch companies.

Cliental effect…

Some investors prefer low dividend payouts and will buy stock in those companies that offer low dividend payouts

Some investors prefer high dividend payouts and will buy stock in those companies that offer high dividend payouts

Steps in setting up a dividend policy:- Identify target capital structure. Forecast capital needs over planning horizon,

often 5 years. Estimate annual debt and equity needs. Set long-run target payout ratio based on the

relevant model.

Traditional model

According to this model founded by Graham and Dodd, the market price of the shares will increase when a company declares a dividend rather than when it does not.

Quantitatively P=m (D+E/3) Where: P is the market price per share M is a multiplier D is the dividend per share E is the earning per share

Walter model :- According to this model founded by James Walter, the

dividend policy of a company has an impact on the share valuation.

Quantitatively P=(D+(E-D) r/k)/k Where: P, D, E have the same connotations as above and r is the

internal rate of return on the investments and k is the cost of capital.

The impact of dividend payment on the share price is studied by comparing the rate of return with the cost of capital.

When r>k, the price per share increases as the payout ratio decreases (optimal payout ratio is nil)

When r=k, the price per share does not vary with the changes in the payout ratio (optimal payout ratio does not exist)

When r<k, the price per share increases as the payout ratio increases (optimal payout ratio is 100%)

Gordon model: According to this model founded by Myron Gordon, the

dividend policy of the company has an impact on share valuation.

Quantitatively P= Y (1-b)/(k-br) Where P is the price per share Y is the earnings per share b is the retention ratio 1-b is the payout ratio br is the growth rate r is the return on investment k is the rate of return required by shareholders

On comparing r and k, the relationship between market price and the payout ratio is exactly the same as compared to the Walter model.

MM model :- According to this model, as founded by Miller and

Modiliani, the market price of the share does not depend on the dividend payout, i.e. the dividend policy is irrelevant. This model explains the irrelevance of the dividend policy in the following manner:

When profits are used to declare dividends, the market price increases. But at the same time there is a fall in the reserves for reinvestment. Hence for expansion, the company raises additional capital by issuing new shares. Increase in the overall number of shares, will lead to a fall in the market price per share. Hence the shareholders would be indifferent towards the dividend policy.

Other dividend policy in practice:- Residual dividend policy Compromise dividend policy Constant growth dividend policy Constant payout ratio

Residual Dividend Policy

Determine capital budget Determine target capital structure Finance investments with a combination of debt

and equity in line with the target capital structure Remember that retained earnings are equity If additional equity is needed, issue new shares

If there are excess earnings, then pay the remainder out in dividends

Compromise Dividend Policy

Goals, ranked in order of importance Avoid cutting back on positive NPV projects to pay a

dividend Avoid dividend cuts Avoid the need to issue equity Maintain a target debt/equity ratio Maintain a target dividend payout ratio

Companies want to accept positive NPV projects, while avoiding negative signals