Professional Documents
Culture Documents
Dividend
decisions
MBA 2nd Semester
Financial Management
Kavitha Menon1
WHAT ARE DIVIDENDS?
Dividends refer to the corporate net profits
distributed among shareholders.
Here our focus is on equity dividend & not
preference dividend as preference
shareholders are entitled to a stipulated rate
of dividend. & also relevant to widely-held
public limited companies
2
Introduction….
There is inverse relationship between retained
earnings and cash dividends: Larger retentions,
lesser dividends; Smaller retentions, larger
dividends.
Dividend decision is an important decision as the
firm has to choose between distributing the profits
to shareholders & ploughing them back into the
business
Thus, the choice hinges on the effect of the decision
on the maximization of shareholder’s wealth.
3
Introduction….
§ Payment of dividends not only depends upon profitability, but
also the recommendation of Directors, i.e. known as
‘Dividend Policy’.
§ Shareholders approve the dividend as recommended by the
Directors. Dividend rate can be reduced by shareholders, but
cannot be increased
§ Dividend declared must be paid in cash only (incl. cheques and
DD)
§ Companies must transfer a percent of profits to reserves, based
on rate of dividend declared
§ Dividends (including interim dividend) are returns given to
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shareholders out of profits earned by a company.
Dividend policy-significance
ÄOutflow of cash will create pressure on liquidity of the
company
ÄOpportunity cost of the funds distributed
ÄDividend payment maximizes shareholders’ current wealth
while retention facilitates future wealth generation.
ÄDividend payment is a sign of goodwill, and a positive impact
on investors, and in turn the market price / share.
ÄRetention leads to faster growth resulting in higher
profitability and increase in shareholders’ wealth.
ÄHarmony between payout & retention – key mgt. decision
5
Understanding dividend pay-out ratio
& retention ratio
Retention ratio is that portion of earnings per share which is
retained in the business for its further growth. Denoted as
‘b’
Dividend Payout ratio is that portion of earnings per share
which is paid out as dividend. Denoted as (1-b)
Retained Earnings
Corporate Profits After Tax
Dividends
6
Understanding dividend pay-out ratio
& retention ratio….An Example
EPS DPS D/P Ratio b
5 2.00 0.40 0.60
6 4.50 0.75 0.25
8 2.00 0.25 0.75
10 4.00 0.40 0.60
12 3.00 0.25 0.75
7
Dividend Payments
Mechanics of Cash Dividend Payments
Declaration Date
this is the date on which the Board of Directors meet and declare the
dividend. In their resolution the Board will set the date of record,
the date of payment and the amount of the dividend for each share
class.
Date of Record
is the date that the value of the firm’s common shares will reflect the
dividend payment (ie. fall in value)
‘ex’ means without.
At the start of trading on the ex-dividend date, the share price will
normally open for trading at the previous days close, less the value
of the dividend per share. This reflects the fact that purchasers of
the stock on the ex-dividend date and beyond WILL NOT receive
the declared dividend.
Date of Payment
8
is the date the cheques for the dividend are mailed out to the
shareholders.
Dividend Declaration Process Date-wise
Source: www.moneycontrol.com
Effect of the dividend on the stock price –
a live example
Colgate-Palmolive (India) fell 1.01% at
Rs. 819.35 at 15:01 IST after the stock
turned ex-dividend today, 30 March
2011, for a third interim dividend of Rs.
7 per share for the year ending March
2011.
Before turning ex-dividend, the stock offered a
dividend yield of 0.84%, based on closing
price of Rs. 827.75 on Tuesday, 29 March
2011
11
Schools of thought
The subject matter of the dividend policy is whether payout
ratio has any impact on the market price of the share or not.
i.e. if we change the pay-out ratio, whether market price of the
share will change
For example, if we increase the D/P ratio, whether the market
price of the share will increase or decrease or there will be
no change.
Hence, two schools of thought …
12
TWO SCHOOLS OF THOUGHT
13
RELEVANCE OF DIVIDENDS
Dividend relevance implies that shareholders prefer
current dividends and there is no direct
relationship between dividend policy and market
value of a firm.
Two theories representing this notion are:
1 Walter’s model
2 Gordon’s model
14
WALTER’S MODEL
(a)Growth firms
(b)Decline firms
(c)Normal firms
15
Continued…
Type of firm Growth firm Normal firm Decline firm
Relation r>k r=k r<k
between r and
k
D/P ratio Zero i.e. retain Anything 100% i.e. all
its earnings as between 0 to 100 earnings are
they earn more distributed as
Market price on
Willtheir
increase No effect on the dividends
Market price
of the share investments value of the firm maximized by
– market price distribution of
is constant dividends
16
ASSUMPTIONS
17
Mathematical formula
r
D + ( E − D)
ke
P=
ke
Where –
P – The prevailing market price of the share
D – Dividend per share
E – Earnings per share
r – Rate of return on the firm’s investment
18
Exercise - 1
The following information is available in respect of a
firm:
Capitalization rate (ke) = 0.10
19
Conclusions from the previous exercise
20
Exercise - 2
The earnings per share of a company is Rs. 8 and the rate of
capitalization applicable is 10%. The company has before it
an option of adopting (i) 50 % (ii) 75 % and (iii) 100 %
dividend payout ratio.
Compute the market price of the company’s quoted shares as
per Walter’s model if it can earn a return of (a) 15% (b)
10% (c) 5 % on its retained earnings.
21
Criticism of walter’s model
23
Assumptions
26
Exercise - 1
The following information is available in respect of the rate of
return on investment (r), the capitalization rate (ke) and the
EPS (E) of Hypothetical Ltd.
r = 12%, E = Rs. 20
Determine the value of the shares, assuming the following:
1-b ke(%)
(a) 10 20
(b) 20 19
(c) 30 18
(d) 40 17
(e) 50 16
(f) 60 15
(g) 70 14 27
Exercise 2
Following are the details regarding three companies X
Ltd., Y Ltd., & Z Ltd.:
X Ltd. Y Ltd. Z Ltd
r 20% 15% 10%
ke 15% 15% 15%
E Rs. 4 Rs. 4 Rs. 4
Calculate the value of an equity share using Gordon
Model if dividend payout ratio is 50 %and 75 %.
28
Exercise - 3
A company has a total investment of Rs. 5 lakhs in assets, and
50,000 outstanding ordinary shares of Rs. 10 per share (par
value). It earns a rate of 15% on its investments, and has a
policy of retaining 50% of the earnings. If the appropriate
discount rate of the firm is 10%, determine the price of its
share using Gordon model.
What shall happen to the price of the share if the company has
a payout of 80% or 20%?
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ARGUMENTS
30
Continued…
As investors are rational, they avoid risk.
Payments of current dividends completely removes
the chances of any risk.
Investors think current dividends are less risky than
potential future capital gains, hence they like
dividends.
Hence, investors would value high payout firms more
highly, i.e. a high payout would result in a high P0.
The above model underlying Gordon's model of
dividend relevance is also described as the bird-in –
hand argument. 31
Continued..
earnings.
ASSUMPTIONS OF MM HYPOTHESIS
D1 + P1
P0 =
Where,
1 + ke
P0 = Existing price of a share
k = Cost of capital
D1 = Dividend to be received at the year end
P1 = Market value of a share at the year end 37
Explanation
Suppose a firm has 1,00,000 shares outstanding and is planning to
declare a dividend of Rs. 5 at the end of current financial year. The
present market price of the share is Rs. 100. The cost of equity
capital, ke, may be taken at 10%. The expected market price at the
end of the year 1 may be found under two options:
If dividend of Rs. 5 is paid
If dividend is not paid
When Dividend of Rs. 5 is paid (the value of D1 is 5) :
Rs. 5 38
Explanation…..contd…
When, Dividend of Rs. 5 is not paid (the value of D1 is 0):
P0 = (D1 + P1)/ (1+ ke)
P1 = P0 (1+ ke) – D1
= 100(1.1) - 0 = Rs. 110
So, the market price of the share is expected to be Rs. 110, if the
firm does not pay any dividend.
However, in both the cases, the position of the shareholders would be the
same. A shareholder having for example, one share will be having
same worth of his holding if the firm pays dividend or not. In case, the
dividend of Rs. 5 is paid, he will receive Rs. 5 from the firm as
dividend and the market price of the share would be Rs. 105, giving a
total worth of Rs. 110. In case, the dividend is not paid then the market
price of the share or the worth of the shareholder would be still Rs.
110.
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So, the shareholder would be indifferent if dividend is paid or not to him.
Mathematical formula -
Derivation
STEP 1 : The market value of a share in the beginning of the
year is equal to the present value of dividends paid at the year
end plus the market price of the share at the end of the year, this
can be expressed as below:
D1 + P1
P0 =
Where,
1 + ke
P0 = Existing price of a share
k = Cost of capital
D1 = Dividend to be received at the year end
P1 = Market value of a share at the year end 40
Mathematical formula -
Derivation
STEP 2 : If there is no additional financing from external
sources, value of the firm (V) will be number of share (n)
multiplied by the price of each share (Po). Symbolically:
n( D1 +P1 )
V = nP0 =
1 +ke
41
Mathematical formula -
Derivation
STEP 3: If the firm issues ‘m’ number of share to raise funds at
the end of year 1 so as to finance investment and at price P1,
value of the firm at time o will be:
nD 1 +( n +m) P1 −mP1
V = nP0 =
1 +ke
nD1 + ( n + m) P1 − ( I1 − X 1 + nD1 )
V = nP0 =
1 + ke
(n + m) P1 − I1 + X 1
V = nP0 =
1 + ke
44
Since dividend is absent in final equation, MM conclude that
dividend does not affect the market price of share.
Calculation of number of new shares
issued
From Step 4, the number of new shares issued, m, can be
calculate
I1 − X 1 + nD1
m=
P1
45
How do the prices of shares react in
each situation ?
Situation 1 The company has sufficient cash to
Situation 2 The company does not have enough
pay dividends
Situation 3 The
cashcompany does notand
to pay dividends payrun
dividends
the
but the shareholder
company smoothly needs cash
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Situation 1: he company has sufficient
cash to pay dividends
What happened to the cash position after payment of
dividend?
Cash is part of the assets owned by the shareholders. They
will now have fewer assets to claim.
This implies there is no change in the total value of the firm
to the owners.
The wealth of the company is reduced to the extent of the
cash payment. This leads to wealth increase of the
shareholders
Hence, no change in the wealth position.
47
Situation 2: The company does not have
enough cash to pay dividends and run the
company smoothly
In such a situation, the company issues new shares at the ex-
dividend price to pay dividends.
New shareholders come into existence.
The existing shareholder’s share will reduce but they collect
their price in the form of cash dividend.
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Situation 3: The company does not pay
dividends but the shareholder needs cash
Shareholders can sell part of their shares in the market at a
fair price and meet their needs.
Thus, existing shareholders will possess lesser number of
shares and the shares will be owned by new investors.
Therefore, value of the company will remain unchanged.
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conclusion
The valuation of the company under the three possible
scenarios created by various dividends decisions is not
altered.
This suggests that dividend decision is insignificant.
50
Exercise - 1
Agile Ltd. belongs to a risk class of which appropriate
capitalization rate is 10 per cent. It currently has 1,00,000
shares selling at Rs.100 each. The firm is contemplating the
declaration of a dividend of Rs.6 per share at the end of
current fiscal year, which has just begun.
Answer the following questions on the basis of MM model.
1 What will be the price of the shares at the end of the year if a
dividend is not declared?
2 What will it be if it is declared?
3 Assuming that the firm pay dividend, has net income of
Rs.10,00,000 and makes new investment of Rs.20,00,000
how many new shares must be issued.
51
Exercise - 2
ABC Ltd. has 50,000 outstanding shares. The current market
price per share is Rs.100 each. It hopes to make a net
income of Rs.5,00,000 at the end of current year. The
Company’s Board is considering a dividend of Rs.5 per
share at the end of current financial year. The company
needs Rs.10,00,000 for an approved investment expenditure.
The company belongs to a risk class for which the
capitalization rate is 10%. Show, how does the M-M
approach affect the value of firm if the dividends are paid or
not paid.
52
Exercise 3
ABC Ltd. has a capital of Rs.10 lakhs in equity shares of Rs.100
each. The shares currently quoted at par. The company proposes
declaration of a dividend of Rs.10 per share at the end of the
current financial year. The capitalization rate for the risk class to
which the company belongs is 12%.
What will be the market price of the share at the end of the year, if
i) A dividend is not declared?
ii) A dividend is declared?
iii) Assuming that the company pays the dividend and has net
profits of Rs.5,00,000 and makes new investments of Rs.10 lakhs
during the period, how many new shares must be issued? Use the
M.M. model.
53
Exercise - 4
X company earns Rs 5 per share, is capitalized at a rate of 10
per cent and has a rate of return on investment of 18 per
cent. According to Walter’s model, what should be the price
per share at 25 per cent dividend payout ratio? Is this the
optimum payout ratio according to Walter?
54
Exercise - 5
Omega company has a cost of equity capital of 10 per
cent, the current market value of the firm (V) is Rs
20,00,000 (@ Rs 20 per share). Assume values for I
(new investment), Y (earnings) and D (dividends) at the
end of the year as I = Rs 6,80,000, Y = Rs 1,50,000 and
D = Re 1 per share. Show that under the MM
assumptions, the payment of dividend does not affect
the value of the firm.
55
CRUX OF THE ARGUMENT
The crux of the MM position on the irrelevance of dividend is the
arbitrage argument.
Arbitrage implies the distribution of earnings to shareholders and
raising an equal amount externally, the effect of dividend
payment would be offset by the effect of raising additional
funds.
When a firm pays its earnings as dividends, it will have to
approach market for procuring funds to meet a given
investment programme. Acquisition of additional capital will
dilute the firms share capital which will result in drop in share
values. Thus, what the stockholders gain in cash dividends, they
lose in decreased share values. The market price before and
after payment of dividend would be identical and hence the
stockholders would be indifferent between dividend and
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retention of earnings. This suggests that dividend decision is
irrelevant
CRITICISIMS OF MM APPROACH
Perfect capital market does not exist in reality.
Information about the company is not available to all the
persons.
The firms have to incur flotation costs while issuing securities.
Taxes do exist and there is normally different tax treatment for
dividends and capital gain.
The firms do not follow a rigid investment policy.
The investors have to pay brokerage, fees etc., while doing any
transaction.
Shareholders may prefer current income as compared to furture
gains
57
Factors determining dividend policy of
a firm
58
FACTORS DETERMINING DIVIDEND
POLICY OF A FIRM – EXTERNAL
[General state of Economy – in cases of uncertainty, depression in the
FACTORS
economy, the management may like to retain the earnings and build up
reserves to absorb shocks in the future and preserve liquidity.
[Capital Markets – if a firm has easy access to capital markets to raise
funds, it may follow liberal dividend policy and vice versa.
[Legal Restrictions – the management must comply to all legal
restrictions such as transfer to reserves etc.
[Contractual Restrictions – lending financial institutions may put
restrictions on dividend payments to protect their interests.
[Taxation Policy – consideration of corporate taxes and dividend
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distribution tax to be paid by the companies.
FACTORS DETERMINING DIVIDEND
POLICY OF A FIRM – INTERNAL
[Desire of Shareholders – the shareholders, being the owners of the
FACTORS
company influence the dividend payout. Their expectation for dividend
depicts companies strength, certainty and liquidity.
[Financial needs of Company – financial needs of the company may
directly conflict with shareholders’ desire. Company’s vision for future
growth and profitability may bypass the dividend expectation.
[Nature of Earnings – a firm with a stable income can afford to have
higher dividend payout and vice versa
[Desire of Control – higher dividend implies liquidity crunch that can be
met by new equity issue. New equity dilutes management control.
[Liquidity Position – prime importance for dividend payments. 60
(a) Dividend payout Ratio
62
Constant dividend per share
A policy of paying certain fixed amount per share as dividend.
This doesn’t mean amount of dividend is fixed at all times to
come.
Dividends are increased over the years when the earnings of the
firm increases.
EPS
EPS and DPS (Rs.)
DPS
Time in years 63
Constant payout ratio
A policy to pay a constant percentage of net earnings as
dividend to shareholders in each dividend period.
Dividends would fluctuate proportionately with earnings
and are likely to be highly volatile in the wake of wide
fluctuations in the earnings of a company.
64
Stable rupee dividend plus extra dividend
65
Why investors prefer
stable dividend policy?
70
BUYBACK OF SHARES
71
BONUS SHARES
72