DIVIDEND POLICYCHAPTER 18

LEARNING OBJECTIVES

Explain the objectives of dividend policy in practice Understand the factors that influence a firm’s

dividend policy Focus on the importance of the stability of dividend. Discuss the significance and implications of bonus

shares and stock splits and the share buyback Explain Lintner's model of corporate behaviour of

dividends

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OBJECTIVES OF DIVIDEND POLICY Firm’s Need for Funds Shareholders’ Need for Income

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PRACTICAL CONSIDERATIONS IN DIVIDEND POLICY Firm’s Investment Opportunities and Financial Needs Shareholders’ Expectations Constraints on Paying Dividends

Legal restrictions Liquidity Financial condition and borrowing capacity Access to the capital market Restrictions in loan agreements Inflation Control

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STABILITY OF DIVIDENDS

Constant Dividend per Share or Dividend Rate. Constant Payout. Constant Dividend per Share Plus Extra

Dividend.

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Constant dividend per share policy

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Dividend policy of constant payout ratio

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Significance of Stability of Dividends

Resolutions of investors uncertainty. Investors’ desire for current income. Institutional Investors’ Requirement. Raising Additional Finances.

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TARGET PAYOUT AND DIVIDEND SMOOTHING: LINTNER’S MODEL OF CORPORATE DIVIDEND BEHAVIOUR

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FORMS OF DIVIDENDS

Cash Dividends Bonus Shares (Stock Dividend)

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Advantages of Bonus Shares To shareholders:

Tax benefit Indication of higher future profits Future dividends may increase Psychological value

To company: Conservation of cash Only means to pay dividend under financial difficulty

and contractual restrictions More attractive share price

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Limitations of Bonus Shares Shareholders’ wealth remains unaffected Costly to administer Problem of adjusting EPS and P/E ratio

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Conditions for the Issue of Bonus Shares Residual reserve criterion Profitability criterion

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Share split

A share split is a method to increase the number of outstanding shares through a proportional reduction in the par value of the share. A share split affects only the par value and the number of outstanding shares; the shareholders’ total funds remain unaltered.

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Example

The following is the capital structure of Walchand Sons & Company:

Walchand Company split their shares two-for-one. The capitalization of the company after the split is as follows:

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Bonus Share vs. Share Split The bonus issue and the share split are similar except

for the difference in their accounting treatment. In the case of bonus shares, the balance of the

reserves and surpluses account decreases due to a transfer to the paid-up capital and the share premium accounts. The par value per share remains unaffected.

With a share split, the balance of the equity accounts does not change, but the par value per share changes.

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Reasons for Share Split

To make trading in shares attractive To signal the possibility of higher profits in the

future To give higher dividends to shareholders

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Reverse Split

Under the situation of falling price of a company’s share, the company may want to reduce the number of outstanding shares to prop up the market price per share.

The reduction of the number of outstanding shares by increasing per share par value is known as a reverse split.

The reverse split is generally an indication of financial difficulty, and is, therefore, intended to increase the market price per share.

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BUYBACK OF SHARES

The buyback of shares is the repurchase of its own shares by a company.

As a result of the Companies Act (Amendment) 1999, a company in India can now buyback its own shares.

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In India the following conditions apply in case of the buyback shares: A company buying back its shares will not issue fresh capital,

except bonus issue, for the next 12 months. The company will state the amount to be used for the buyback

of shares and seek prior approval of shareholders. The buyback of shares can be affected only by utilizing the

free reserves, viz., reserves not specifically earmarked for some purpose.

The company will not borrow funds to buy back shares. The shares bought under the buyback schemes will be

extinguished and they cannot be reissued.

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Methods of Shares Buyback First, a company can buy its shares through

authorized brokers on the open market.

Second, the company can make a tender offer, which will specify the purchase price, the total amount and the period within which shares will be bought back.

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Effects of the Shares Buyback It is believed that the buyback will be financially

beneficial for the company, the buying shareholders and the remaining shareholders.

Increase in the company’s debt-equity ratio due to reduced equity capital.

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Advantages of the BuybackReturn of surplus cash to shareholdersIncrease in the share valueIncrease in the temporarily undervalued share priceAchieving the target capital structureConsolidating controlTax savings by companiesProtection against hostile takeovers

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Drawbacks of the BuybackNot an effective defence against takeoverShareholders do not like the buybackLoss to the remaining shareholdersSignal of low growth opportunities

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