dividend theory & policy

DIVIDEND THEORY &

POLICY

– In the absence of dividends, corporate earnings accrue to the benefit of shareholders as retained earnings and are automatically reinvested in the firm.

– When a cash dividend is declared, those funds leave the firm permanently and irreversibly.

– Distribution of earnings as dividends may starve the company of funds required for growth and expansion, and this may cause the firm to seek additional external capital.

Corporate Profits After Tax Retained Earnings

Dividends

Dividends a Financing Decision

Factors determining dividend policy of a firm

1. Dividend Payout (D/P) Ratio2. Stability of Dividends3. Legal, contractual & internal

restrictions4. Owners’ considerations5. Clientele effect6. Capital market considerations7. Inflation

Dividend Payout (D/P) Ratio1. D/P Ratio indicates the percentage earnings

distributed to shareholders in cash, calculated dividing the cash dividend per share by its earnings per share

2. Optimum dividend policy should strike a balance between current dividends & future growth which maximizes price of firm’s share

3. In practice, investors in general have a clear-cut preference for dividends because of uncertainty & imperfect capital markets.

4. Thus a low D/P ratio may cause a decline in share prices, while a high ratio may lead to rise in the market price of the shares.

Stability of Dividends• Refers to the payment of a certain minimum amount

of dividend regularly1. Constant dividend per share policy: it is a policy of

paying a certain fixed amount per share as dividend

2. Constant /target payout ratio: it is a policy to pay a constant % of net earnings as dividend to shareholders in each dividend period

3. Stable rupee plus extra dividend: it is a policy based on paying a fixed dividend to shareholders supplemented by an additional dividend when earnings warrant it

Legal, contractual & internal restrictions

• Legal stipulations do not require a dividend declaration but they specify the conditions under which dividends must be paid –

• (i) capital impairment: firm can not pay dividends out of its paid-up capital, adversely affecting the security of its lenders

• (ii) net profits: firm can not pay cash dividends greater than the amount of current profits plus the accumulated retained earnings

• (iii) insolvency: firm would not pay dividend if it leads to insolvency• The contractual restrictions on payment of

dividends are imposed by loan agreements• The internal constraints impinging on the

dividend restrictions relate to growth prospects, availability of funds, earning stability, and control

Remaining Factors• Owners’ considerations: The dividend policy is also likely

to be affected by the owners’ consideration of (a) tax status of the shareholders,(b) their opportunities for investment and (c) dilution of ownership

• Capital market considerations: While a firm which has easy access to the capital market can follow a liberal dividend policy, a firm having only limited access to the capital markets is likely to adopt low dividend payout ratio as they are likely to rely, to a greater extent, on retained earnings as a source of financing their investments.

• Inflation: With rising prices, funds generated from depreciation may be inadequate to replace obsolete equipments. As a result, the D/P ratio tends to be low during periods of inflation.

Dividend PaymentsDividend Reinvestment Plans

(DRIPs)• Involve shareholders deciding to use the cash

dividend proceeds to buy more shares of the firm– DRIPs will buy as many shares as the cash dividend

allows with the residual deposited as cash– Leads to shareholders owning odd lots (less than 100

shares)

• Firms are able to raise additional common stock capital continuously at no cost and fosters an on-going relationship with shareholders.

Dividend PaymentsStock Dividends / Bonus Shares

• Stock dividends simply amount to distribution of additional shares to existing shareholders

• They represent nothing more than recapitalization of earnings of the company. (that is, the amount of the stock dividend is transferred from the R/E account to the common share account.

• Because of the capital impairment rule stock dividends reduce the firm’s ability to pay dividends in the future.

Dividend PaymentsStock Dividends /Bonus Shares

Implications– reduction in the R/E account– reduced capacity to pay future dividends– proportionate share ownership remains unchanged– shareholder’s wealth (theoretically) is unaffected

Effect on the Company– conserves cash– serves to lower the market value of firm’s stock modestly– promotes wider distribution of shares to the extent that current

owners divest themselves of shares...because they have more– adjusts the capital accounts– dilutes EPS

Effect on Shareholders– proportion of ownership remains unchanged– total value of holdings remains unchanged– if former DPS is maintained, this really represents an increased

dividend payout

CHAPTER 22 – Dividend Policy 22 - 11

Dividend PaymentsStock Dividend / Bonus Shares Example

ABC CompanyEquity Accounts

as at February xx, 20x9Common stock (215,000) $5,000,000Retained earnings 20,000,000Net Worth $25,000,000

The company, on March 1, 20x9 declares a 10 percent stock dividend when the current market price for the stock is $40.00 per share.

This stock dividend will increase the number of shares outstanding by 10 percent. This will mean issuing 21,500 shares. The value of the shares is:

$40.00 (21,500) = $860,000

This stock dividend will result in $860,000 being transferred from the retained earnings account to the common stock account:

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Dividend PaymentsStock Dividend /Bonus Shares Example

After the stock dividend:

ABC CompanyEquity Accounts

as at March 1, 20x9

Common stock (236,500) $5,860,000Retained earnings 19,140,000Net worth $25,000,000

The market price of the stock will be affected by the stock dividend:

New Share Price = Old Price/ (1.1) = $40.00/1.1 = $36.36

The individual shareholder’s wealth will remain unchanged.


Dividend PaymentsStock Splits

• Although there is no theoretical proof, there is some who believe that an optimal price range exists for a company’s common shares.

• It is generally felt that there is greater demand for shares of companies that are traded in the $40 - $80 dollar range.

• The purpose of a stock split is to decrease share price.• The result is:

– increase in the number of share outstanding– theoretically, no change in shareholder wealth

• Reasons for use:– better share price trading range– psychological appeal (signalling affect)


Dividend PaymentsStock Split Example

The Board of Directors of XYZ Company is considering using a stock split to put its shares into a better trading range. They are confident that the firm’s stock price will continue to rise given the firm’s outstanding financial performance. Currently, the company’s shares are trading for $150 and the company’s shareholders equity accounts are as follows:

Commons shares (100,000 outstanding) $1,500,000Retained earnings 15,000,000Net Worth $16,500,000

A 2 for 1 Stock Split:

New Share Price = P0[1/(2/1)] = $150[1/(2/1)] = $150[.5] = $75.00

The firm’s equity accounts:Commons shares (200,000 outstanding) $1,500,000Retained earnings 15,000,000Net Worth $16,500,000


Dividend PaymentsFurther Stock Split Examples

A 4 for 3 Stock Split:New Share Price = P0[1/(4/3)] = $150[1/(4/3)] = $150[.75] = $112.50


A 3 for 4 Reverse Stock Split:New Share Price = P0[1/(3/4)] = $150[1/(3/4)] = $150[1.33] = $200.00


Clearly the Board can use stock splits and reverse stock splits to place the firm’s stock in a particular trading range.


Dividend PaymentsStock Split Effects

• shareholders wealth should remain unaffected:Original Holdings: (100 shares @ $150/share) = $15,000

After a 4 for 1 split: (400 shares @ $37.50/share) = $15,000

• the above will hold true if there is no psychological appeal to the stock split.

• There is some evidence that the share price of companies which split stock is more bouyant because of a positive signal being transferred to the market by this action.


- lowers stock price slightly - large drop in stock price- little psychological appeal - much stronger potential

signalling effect- recapitalization of earnings - no recapitalization- no change in proportional - same

ownership- odd lots created - odd lots rare- theoretically, no value to - same

the investor

Stock Dividends versus Stock Splits

Stock Dividends Stock Splits


• allowed under the amended Companies Act, 1999

• reasons for use:– Offsetting the exercise of executive stock options– Leveraged recapitalizations– Information or signalling effects– Repurchase dissident shares– Removing cash without generating expectations for future

distributions– Take the firm private.

Share Repurchases /Buyback


• they are usually done on an irregular basis, so a shareholder cannot depend on income from this source.

• if regular repurchases are made, there is a good chance that statutory authorities will rule that the repurchases were simply a tax avoidance scheme (to avoid tax on dividends) and will assess tax

• there may be some agency problems - if managers have inside information, they are purchasing from shareholders at a price less than the intrinsic value of the shares.

Disadvantages of Share Repurchases


• tender offer:– this is a formal offer to purchase a given number of shares at a given

price over current market price at a given time.• open market purchase:

– the purchase of shares through an investment dealer like any other investor

– this is not designed for large block purchases.• private negotiation with major shareholders

In any repurchase program, the securities commission/ SEBI requires disclosure of the event as well as all other material information through a prospectus.

Methods of Share Repurchases


• EPS should increase following the repurchase if earnings after-tax remains the same

• a higher market price per outstanding share of common stock should result

• stockholders not selling their shares back to the firm will enjoy a capital gain if the repurchase increases the stock price.

Effects of A Share Repurchase


• signal positive information about the firm’s future cash flows• used to effect a large-scale change in the firm’s capital structure• increase investor’s return without creating an expectation of higher

future cash dividends• reduce future cash dividend requirements or increase cash dividends

per share on the remaining shares, without creating a continuing incremental cash drain

• capital gains treated more favourably than cash dividends for tax purposes.

Advantages of Share Repurchases


• signal negative information about the firm’s future growth and investment opportunities

• the provincial securities commission may raise questions about the intention

• share repurchase may not qualify the investor for a capital gain

Disadvantages of Share Repurchases

Dividend Policy• If the company is confident of generating more than

market returns then only it should retain higher profits and pay less as dividends (or pay no dividends at all), as the 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 pay out more dividends (or 100% dividends).

• This is done for two reasons: 1. the shareholders prefer early receipt of cash

(liquidity preference theory) and 2. the shareholders can invest this cash to generate

more returns (since market returns are expected to be higher than returns generated by the company).

Issues in Dividend Policy• The subject matter of the dividend policy is

whether pay-out ratio has any impact on the market price of the share or not.

• In other words, if we change the pay-out ratio, whether market price of the share will change (if yes, in which direction) or not.

• Earnings to be Distributed – High Vs. Low Payout.• Objective – Maximize Shareholders Return.• Effects – Taxes, Investment and Financing Decision.

Relevance Vs. Irrelevance• Walter's Model• Gordon's Model• Modigliani and Miller Hypothesis• The Bird in the Hand Argument• Informational Content• Market Imperfections

DIVIDEND RELEVANCE: WALTER’S MODEL

James E. Walter Walter’s model is based on the following assumptions:

• Internal financing (only source of financing is through retained earnings)

• Constant return and cost of capital• 100 per cent payout or retention• Constant EPS and DIV• Infinite time• The model considers internal rate of return (IRR), market

Capitalization rate, and dividend payout ratio in determination of share prices.

• However, it fails to appropriately calculate prices of companies that resort to external sources of finance.

• Further, the assumption of constant cost of capital and constant return are unrealistic.

Walter’s formula to determine the market price per share

Optimum Payout Ratio

• Growth Firms – Retain all earnings ( if the rate of return that the company may earn on retained earnings, is higher than cost of equity (the expected returns of the shareholders) then, it would be in the interest of the firm to retain the earnings)

• Normal Firms – Distribute all earnings (If the company’s reinvestment rate on retained earnings is the less than share-holders’ rate of return, the company should not retain earnings)

• Declining Firms – No effect (If the two rates are the same, then the company should be indifferent between retaining and distributing)

dividend theory & policy

Economy & Finance