3_Retained_Earnings_and_Dividends

8/7/2019 3_Retained_Earnings_and_Dividends

1/34

Retained EarningsRetained Earnings&&

Dividend DistributionDividend Distribution


2/34

Dr Raju Indukoori

Dividend Yields for Selected Industries

Equity Internal

External

Debt Bonds / Debentures

Loans

Hybrid

Convertible debenture Convertible preferential shares

Alternatives : Leasing


3/34

Dr Raju Indukoori

Dividend Yields for Selected Industries

Industry Div. Yield %

Airline 0.2

Software & Programming 0.3

Biotechnology & Drugs 0.3Restaurants 1.0

Chemical Manufacturing 2.2

Paper & Paper Products 2.7

Electric Utilities 4.4Tobacco 5.6


4/34

Dr Raju Indukoori

What is distribution policy?

It defines:

The level of cash distributions to shareholders

The form of the distribution (dividend vs. stock

repurchase)

The stability of the distribution


5/34

Dr Raju Indukoori

Dividend Distribution Policy

Forecast capital needs over a planning horizon, often 5years.

Set a target capital structure.

Estimate annual equity needs.

Set target payout based on the residual model.

Generally, some dividend growth rate emerges.Maintain target growth rate if possible, varying capitalstructure somewhat if necessary.


6/34

Dr Raju Indukoori

Theories of investor preferences

Signaling effects

Stock repurchases

Stock dividends and stock splits

Dividend reinvestment plans

Retained Earnings & Dividend Distribution


7/34

Irrelevant Models


8/34

Do investors preferDo investors preferHigh payoutsHigh payouts

oror

low payouts?low payouts?


9/34

Dr Raju IndukooriDr Raju Indukoori

Theories of Investors PreferenceTheories of Investors Preference

IrrelevantIrrelevant ModelModel MMMM TheoryTheory

RationaleRationale ExpectationExpectation ModelModel

DividendsDividends areare RelevantRelevant TraditionalTraditional ModelModel

WalterWalter ModelModel

GordonsGordons ModelModel

BirdBird--inin--thethe--handhand

TaxTax preferencepreference


10/34

Irrelevant ModelsIrrelevant Models


11/34


MM ModelMM Model

InvestorsInvestors dontdont carecare aboutabout payoutpayout..

InvestorsInvestors areare indifferentindifferent betweenbetween dividendsdividends andand retentionretention--

generatedgenerated capitalcapital gainsgains..

IfIf theythey wantwant cash,cash, theythey cancan sellsell stockstock.. IfIf theythey dontdont wantwantcash,cash, theythey cancan useuse dividendsdividends toto buybuy stockstock..

TheoryTheory isis basedbased onon unrealisticunrealistic assumptionsassumptions (no(no taxestaxes ororbrokeragebrokerage costs),costs), hencehence maymay notnot bebe truetrue.. NeedNeed empiricalempiricaltesttest..


12/34


Rational Expectations ModelRational Expectations Model

AsAs longlong asas thethe dividenddividend raterate isis upup toto thethe expectationsexpectations

therethere isis nono impactimpact ofof dividenddividend declarationdeclaration onon marketmarket

priceprice..

IfIf dividendsdividends areare aboveabove thethe expectations,expectations, priceprice goesgoes upup

IfIf dividendsdividends areare belowbelow thethe expectations,expectations, priceprice goesgoes upup


13/34

Relevant ModelsRelevant Models


14/34


15/34


Walter Model : James E WalterWalter Model : James E Walter

ItIt givesgives thethe relationshiprelationship betweenbetween IRRIRR (r)(r)andand CostCost ofof capitalcapital ofof thethe firmfirm whichwhich givesgives aadividenddividend policypolicy toto maximizemaximize wealthwealth..

AssumptionsAssumptions RetainedRetained earningsearnings onlyonly sourcesource ofof financefinance

rr andand kk constantconstant

InfiniteInfinite companiescompanies firmsfirms lifelife DPSDPS andand EPSEPS remainremain constantconstant


16/34


Walter Model : James EWalter Model : James E

Walter

Walter

PropositionsPropositions rr >> keke :: MarketMarket valuevalue decreasesdecreases asas thethe DPDP ratioratio increasesincreases..

rr


17/34


Gordon Model : MyronGordon Model : Myron

Gordon

Gordon

Similar to Walter model but considers current dividendsSimilar to Walter model but considers current dividends

AssumptionsAssumptions 100% equity firm100% equity firm

Retention ratio and growth rates are constantRetention ratio and growth rates are constant

Investors are rational and risk averseInvestors are rational and risk averse

Investors prefer certain to uncertain returnsInvestors prefer certain to uncertain returns

Ke > br (Cost of equity is greater than growthKe > br (Cost of equity is greater than growth


18/34


Gordon Model : MyronGordon Model : Myron

GordonGordon

PropositionsPropositions

r > ke : Market value decreases asr > ke : Market value decreases asthe DP ratio increases.the DP ratio increases.

r < ke : Market value increases asr < ke : Market value increases asthe DP ratio increases.the DP ratio increases.

r = ke : Market value remains samer = ke : Market value remains sameat any DP ratio.at any DP ratio.

brk

bEP

e

O

!)1(


19/34


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

InvestorsInvestors preferprefer highhigh dividendsdividends

InvestorsInvestors thinkthink dividendsdividends areare lessless riskyriskythanthan potentialpotential futurefuture capitalcapital gains,gains, hencehencetheythey likelike dividendsdividends..

InvestorsInvestors wouldwould valuevalue highhigh payoutpayout firmsfirmsresultresult inin aa highhigh PP00..


20/34


Tax Preference TheoryTax Preference Theory

InvestorsInvestors preferprefer aa lowlow payout,payout, hencehence growthgrowth..

LowLow payoutspayouts meanmean higherhigher capitalcapital gainsgains.. CapitalCapital

gainsgains taxestaxes areare deferreddeferred..

ThisThis couldcould causecause investorsinvestors toto preferprefer firmsfirms withwith lowlow

payouts,payouts, ii..ee..,, aa highhigh payoutpayout resultsresults inin aa lowlow PP00..


21/34


Implications of 3Implications of 3

Theories for ManagersTheories for ManagersTheory Implication

- Any payout OK

- Set high Payout

- Depends on r and k

- Depends on r and k

- Set high payout

- Set low payout

MMs Irrelevance

Traditional Model

Walter Model

Gordon Model

Bird-in-the-hand

Tax preference


22/34


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

EmpiricalEmpirical testingtesting hashas notnot beenbeen ableable totodeterminedetermine whichwhich theory,theory, ifif any,any, isis correctcorrect..

Thus,Thus, managersmanagers useuse judgmentjudgment whenwhen settingsettingpolicypolicy..

AnalysisAnalysis isis used,used, butbut itit mustmust bebe appliedapplied withwith

judgmentjudgment..


23/34


Stock RepurchasesStock Repurchases

ItIt isis aa processprocess ofof aa companycompany buyingbuying itsits ownown stockstock

ReasonsReasons :: AlternativeAlternative toto distributingdistributing cashcash asas dividendsdividends..

ToTo disposedispose ofof oneone--timetime cashcash fromfrom anan assetassetsalesale..

ToTo makemake aa largelarge capitalcapital structurestructure changechange..


24/34



AdvantagesAdvantages

OptionalOptional toto StockholdersStockholders

HelpsHelps avoidavoid settingsetting aa highhigh dividenddividend thatthat cannotcannot bebemaintainedmaintained..

RepurchasedRepurchased stockstock cancan bebe usedused inin takeoverstakeovers oror resoldresold toto raiseraisecashcash asas neededneeded..

IncomeIncome receivedreceived isis capitalcapital gainsgains ratherrather thanthan higherhigher--taxedtaxeddividendsdividends..

StockholdersStockholders maymay taketake asas aa positivepositive signalsignal--managementmanagementthinksthinks stockstock isis undervaluedundervalued..


25/34



DisadvantagesDisadvantages

MayMay bebe viewedviewed asas aa negativenegative signalsignal (firm(firm hashas poorpoor

investmentinvestment opportunities)opportunities)..

SellingSelling stockholdersstockholders maymay notnot bebe wellwell informed,informed, hencehencebebe treatedtreated unfairlyunfairly..

FirmFirm maymay havehave toto bidbid upup priceprice toto completecomplete purchase,purchase,thusthus payingpaying tootoo muchmuch forfor itsits ownown stockstock..


26/34


Stock Dividends vs. Stock SplitsStock Dividends vs. Stock Splits

StockStock dividenddividend

FirmFirm issuesissues newnew sharesshares inin lieulieu ofof payingpaying aa

cashcash dividenddividend.. IfIf 1010%%,, getget 1010 sharesshares forforeacheach 100100 sharesshares ownedowned..

StockStock splitsplitFirmFirm increasesincreases thethe numbernumber ofof sharessharesoutstanding,outstanding, saysay 22::11.. SendsSends shareholdersshareholdersmoremore sharesshares..


27/34


DRIPDRIP

DividendDividend ReRe--InvestmentInvestment PlanPlan (DRIP)(DRIP)

ShareholdersShareholders cancan automaticallyautomatically reinvestreinvesttheirtheir dividendsdividends inin sharesshares ofof thethe companyscompanyscommoncommon stockstock.. GetGet moremore stockstock thanthan cashcash..

ThereThere areare twotwo typestypes ofof plansplans::

OpenOpen marketmarket

NewNew stockstock


28/34

Dr Raju Indukoori

Problem 1

Gamma Medicals stock trades at Rs 90 a share. The

company is contemplating a 3 for 2 stock split.

Assuming that the stock split will have no effect on the

total market value of its equity, what will be the

companys stock price following the stock split?


29/34

Dr Raju Indukoori

Solution 1

P0 = Rs 90

Split = 3 for 2

New P0 = ?

P0New = = Rs60.2/3

90Rs


30/34

Dr Raju Indukoori

Problem 2

The Adarsh Company expects next years net income to be

Rs 1,50,00,000. The firms debt ratio is currently 40%. Adarsh

has Rs 1,20,00,000 of profitable investment opportunities, and it

wishes to maintain its existing debt ratio. According to the

residual distribution model, how large should Adarshs dividend

payout ratio be next year?


31/34

Dr Raju Indukoori

Solution 2

Equity financing = Rs1,20,00,000(0.60)

= Rs72,00,000.

Dividends = Net income - Equity financing= Rs1,50,00,000 - Rs72,00,000

= Rs78,00,000.

Dividend payout ratio = Dividends/Net income

= Rs78,00,000/Rs1,50,00,000

= 52%.


32/34

Dr Raju Indukoori

Problem 3

Axel Telecommunications has a target capital structure that

consists of 70 % debt and 30% equity. The company anticipates

that its capital budget for the upcoming year will be Rs 3,000,000.

If Axel reports net income of Rs 2,000,000 and it follows a

residual distribution model with all distributions as dividends, what

will be its dividend payout ratio?


33/34

Dr Raju Indukoori

Solution 3

Debt =70%

Equity = 30%

Capital Budget = Rs3,000,000

NI = Rs2,000,000;

DP = ?

Equity retained = 0.3(Rs3,000,000) = Rs900,000.

NI Rs2,000,000

-Additions 900,000Earnings Remaining Rs1,100,000

Payout = (Rs 1,100,000 / Rs 2,000,000) = 55%.


34/34


Thank YouThank You

Any Questions???Any Questions???

Date post:	08-Apr-2018
Category:	Documents
Upload:	niraj-thakur
View:	219 times
Download:	0 times

3_Retained_Earnings_and_Dividends

Documents