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    Dividend PolicyDividend Policy

    Topic 3

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    Dividend is Financing orDividend is Financing or

    Investment Decision?Investment Decision?

    Dividend decision is part of Financing

    decision, because the earnings available

    may be retained in the business for Re-investment. If the funds are not required,

    they may distributed as dividends.

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    Affects:Affects:

    Dividend policy of the firm affect both the

    long-term financing and wealth of the

    shareholders. Therefore, the firm

    distribute;- reasonable amount as dividend to its

    members,

    - retain the rest for its growth & survival.

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    Do investors prefer high or lowDo investors prefer high or low

    payouts? There are threepayouts? There are threetheories:theories:

    Dividends are irrelevant: Investorsdont care about payout.

    Bird-in-the-hand: Investors prefer ahigh payout.

    Tax preference: Investors prefer alow payout, hence growth.

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    Dividend Irrelevance TheoryDividend Irrelevance Theory

    Investors are indifferent betweendividends and retention-generated capitalgains. If they want cash, they can sell

    stock. If they dont want cash, they canuse dividends to buy stock.

    Modigliani-Miller support irrelevance.

    Theory is based on unrealisticassumptions (no taxes or brokeragecosts), hence may not be true. Needempirical test.

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    BirdBird--inin--thethe--Hand TheoryHand Theory

    Investors think dividends are less

    risky than potential future capital

    gains, hence they like dividends. If so, investors would value high

    payout firms more highly, i.e., a high

    payout would result in a high stockprice.

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    Tax Preference TheoryTax Preference Theory

    Low payouts mean higher capital

    gains. Capital gains taxes are

    deferred. This could cause investors to prefer

    firms with low payouts, i.e., a high

    payout results in a low stock price.

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    Implications of 3 Theories forImplications of 3 Theories forManagersManagers

    Theory Implication

    Irrelevance Any payout OK

    Bird-in-the-hand Set high payout

    Tax preference Set low payout

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    Which theory is most correct?Which theory is most correct?

    Empirical testing has not been ableto determine which theory, if any, is

    correct. Thus, managers use judgment whensetting policy.

    Analysis is used, but it must beapplied with judgment.

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    Dividend Decision:Dividend Decision:

    Acc. to one school of thoughtdividend decision does not affect the

    shareholders wealth.

    A

    cc. to another school of thought,dividend decision affect the

    shareholders wealth.

    Based on these two thoughts, it can be

    classified into two theories.

    1. Irrelevance Theory

    2. Relevance Theory

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    1. The Irrelevance Theory1. The Irrelevance Theory

    Modigliani & Miller (MM) approach:Acc. to this dividend policy has no affect on the

    market price of the share and value of thefirm, is determined by the earning capacityof the firm.

    Assumptions:

    - There are perfect capital market

    - Investors are rational

    - No taxes or no difference in the tax rate todividends and capital gains.

    - No risk or uncertainty in future.

    - Investment and dividend decisions areindependent.

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    MM argument:MM argument:

    If a co. retains earnings instead of giving it out as dividends, the

    shareholder enjoys capital

    appreciation equal to the amount of

    earnings retained.

    If it distributes earnings by way of

    dividend - the shareholder enjoys

    dividends instead of appreciation in

    the retained earnings.

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    Criticisms of MM position:Criticisms of MM position:

    Uncertainty and Fluctuations

    Offering of additional equity at lower

    prices Higher dividend Greatervolume of under priced equity issue Greater dilution of control

    Issue cost

    Transaction cost

    Differential rates of taxes

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    (n+m) P(n+m) P11 (I(I E)E)npnpoo == ----------------------------------------------

    1 + K1 + Kee

    I - (E nD1) m = no. of sharesm = -------------- issued

    p1 I = New Invt. required

    E = EarningsP1= p0 (1+ke) D1 P1 = Mkt. price per share at

    the endKe = cost of equity n = no. of shares at

    the beginning

    D1 = dividend paid at the endnp0 = Value of the firm (present)

    Illustration: Refer worksheet case 4

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    1. Walters approach:1. Walters approach:

    Acc. to this dividend decisions are

    relevant and affect the value of the

    firm. It is significant based on Return on

    Investment (R) and Cost of Capital (K).

    He has made three different firm;

    (a)Growth firm : R > K

    (b)Normal firm : R = K

    (c) Declining firm : R < K

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    Assumptions :Assumptions :

    The investment of the firm are financed

    through retained earnings only and the

    firm does not use external funds.

    Investment decision is dependent on the

    dividend decision. The IRR and K of the firm are constant.

    Earnings and dividends do not change

    while determining the value. The firm has very long life.

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    D r (ED r (E D) / KD) / KeeP =P = ---------- ++ ------------------------------------

    KKee KKee

    P = Mkt. price per share

    D = Dividend per sharer = Internal rate of return

    E = EPS

    Ke =Cost of equity capital

    Illustrn.: pp 547

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    Criticism.Criticism.

    Firms depends on external funds aswell as retained earnings;

    IRR & cost of capital does not remainconstant.

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    (b) Gordons Approach(b) Gordons Approach

    Acc. to him dividends are relevant and itaffects firm value.

    Assumptions:

    - The firm is an all equity firm;- No external financing is available;

    - The IRR & cost of capital is constant;

    - The cost of capital is greater than growthrate i.e, rate of return on investment of allequity firm.

    - The firm has perpetual life.

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    Implications..Implications..

    When r > k, the share price increasesas the dividend payout ratio decrease;

    W

    hen r = k, share price remainunchanged, dividend payout is variant

    When r < k, the share price increases,as the dividend payout increases.

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    Gordons Revised model:Gordons Revised model:

    Considered risk & return even when r=k dividendpolicy affects the value of shares on account of

    uncertainty of future;

    Investors are risk averse and avoid risk;

    They prefer near dividends rather than futuredividends;

    Bird-in-hand argument the value of rupee of

    dividend income is more than the value of rupee of

    capital gain. uncertainty, the cost of capital cannot be constant

    and so firm should high payout ratio.

    Illustration : Refer worksheet

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    Dividend Policy:Dividend Policy:

    1. Stable dividend policy: Acc. to this,the percentage of earnings paid out

    as dividends remains constant. Sothat, dividends fluctuate in line withearnings.

    Earnings

    Time

    Dividend

    Earnings

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    2. Steadily changing dividend:2. Steadily changing dividend:

    As per this policy, the rupee levelof dividends remains stable or

    gradually increase or decreases.Earnings

    Time

    Dividend

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    Dividend policies in practice:Dividend policies in practice:

    Nature of Industry Dividend practices

    Electrical 10% (Govt. expects)

    Chemical Depends on earning position

    Tea No fixed (may be 30-50%)

    Toothpaste Both dividends and bonus

    shares usually high

    Aluminium When performance is good

    more dividend or vice versa

    Pharmaceuticals Around 30% or maintain min.

    18% dividend every year

    Textiles No fixed, depends on profit

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    End