DIVIDEND POLICY

DIVIDEND POLICYK.VISWANATAHAN3/23/20151DIVIDEND POLICYWhat is dividend policy?The proportion of earnings to be paid to the shareholders and the amount to be ploughed back into the business.A higher dividend pay out will entail higher external financing. Thus Dividend decision affects capital budgeting decision. There is a reciprocal relationship between dividend payout and retained earnings The relationship between dividend policy and market price of shares is one of the most controversial and unresolved questions in corporate finance.

3/23/20152DIVIDEND POLICYWhat factors affect Dividend Policy decisions?External Factors affecting Dividend decisions:1. General State of Economy2. State of Capital Market3. Legal Restrictions Contractual Restrictions

Internal Factors affecting Dividend decisions: Desire of the Shareholders Financial Needs of the Company Nature of earnings Desire to retain the control of management Liquidity position

3/23/20153DIVIDEND POLICYDividend Policy Models In most of the Models, investment and dividend decisions are unrelated and independent.But some models assume dependence of one on another. They consider dividend as relevant for the investors to decide on investing in a company. The models we will study are:Walter Model- relevant Gordon Model- relevantTraditional Position-relevant Miller and Modigliani Position- irrelevant

3/23/20154DIVIDEND POLICYWalter Model:James Walters Model supports the view that the dividend policy of a firm has bearing on share valuation. The model is based on the following assumptions:The firm is an all equity financed entity, which will rely only on retained earnings to finance its future investments. The rate of return on investments is consistent. The firm has infinite life. The following is the formula put forward: Equation 1P- Price per Equity shareD- Dividend per shareE- Earnings per sharer- Rate of return on investmentk- Cost of capital So price per share is a sum of two components : Equation 2

The first is the present value of an infinite stream of dividends The second is the present value of an infinite stream of returns from retained earnings.

3/23/20155DIVIDEND POLICY

3/23/20156The present value of an infinite stream of dividends (D) is:

The second component is derived as follows:The return from the first retained earnings (E-D) would be Time 0 12 3 4 (E-D)r (E-D)r (E-D)r ( Since the retained earnings at the end of period 1 earns returns only at the end of period 2.)The present value of this stream of returns is:

Time 0 12 3 4 5 (E-D)r (E-D)r (E-D)rThe present value of this stream of returns is:

DIVIDEND POLICY

The present value of this stream of returns is : (4)

Likewise the present value of the stream of returns from the 3rd retained earnings will be :

(5)

and so on and so forth. Adding the present value of stream of returns from all retained earnings , we get (6)

This sum is equal to :

(7)

3/23/20157DIVIDEND POLICYExercise:Consider a growth firm (r > k), a normal firm(r=k) and a declining firm (r < k), each of them with the following details: r=20%,15% and 10%; k=15%, E=Rs.4, D=Rs.4Find the value of their shares using Walter Model.Find their value if D=Rs.2 instead of Rs.4

3/23/20158DIVIDEND POLICYNumerical Examples for Walter Model:

3/23/20159DIVIDEND POLICYImplications of Walter Model:When the rate of return is greater than the cost of capital (r>k), the price per share increases as the dividend payout ratio decreases.When the rate of return is equal to the cost of capital (r=k), the price per share does not vary with changes in dividend payout ratio.When the rate of return is lesser than the cost of capital (rk) is Nil.The optimal payout ratio for a normal firm (r=k) is irrelevant.The optimal payout ratio for a declining firm (r k), a normal firm(r=k) and a declining firm (r < k), each of them with the following details: r=20%, 15% AND 10%; k=15%, E=Rs.4, b=0.25Find the value of their shares using Gordon Model.Find their value if B=0.50

3/23/201515DIVIDEND POLICYGordon Model- Illustration

3/23/201516DIVIDEND POLICYGordon Model- Implications:When the rate of return is greater than the discount rate (r>k), the price per share increases as dividend payout ratio decreasesWhen the rate of return is equal to the discount rate (r=k), the price per share remains unchanged in response to the variations in dividend payout ratio.When the rate of return is less than the discount rate (rk) is Nil.The payout ratio for a normal firm (r=k) is irrelevantThe optimal payout ratio for a declining firm (rc implies that a higher dividend payout increases stock value cannot be vindicated.

3/23/201521DIVIDEND POLICYMiller and Modigliani Position:They are of the view that the value of the firm depends solely on its earning power and is not influenced by the manner in which the earnings are split between dividend and retained earning. Their view, referred to as the dividend irrelevance theorem, is based on following assumptions:Capital markets are perfect and investors are rational, transactions are instantaneous and costless, securities are divisible and no investor can influence the market prices.Floatation costs are nil .There are no taxesInvestment costs and future profits of the firm are known with certainty (Assumption dropped later)Investment and dividend decisions are independent

3/23/201522DIVIDEND POLICYMiller and Modigliani Position:If a company retains earnings, the investor enjoys capital appreciation.If earnings are distributed, they earn dividend equal in value to the capital appreciation.Hence the division is irrelevant for valuation.The valuation formula used is : Equation 1

P0 = Market price at time 0,D1 = Dividend per share at time 1.P1 = Market price per share at time 1.p = Discount applicable to the risk class to which the share belongs

3/23/201523DIVIDEND POLICYMiller and Modigliani Position:From the above equation, the value of the outstanding shares of the firm at time 0: Equation 2

n = No of equity shares at time 0;nP0 = the total mkt value of the o/s shares at time 0;nD1 = total dividends in year 1 payable on equity shares o/s at time1 @price P1( prevailing mkt price at time1);m = No of equity shares issued at time 1 @price P1 (prevailing market price at Time 1)(n+m)P1 = total market value of all equity shares o/s at time1;mP1 = Market value of shares issued at time 1p = discount rate 3/23/201524

DIVIDEND POLICYMiller and Modigliani Position-Illustration:The position of Zeta Ltd is as under:No of shares: 1000 (n0)Price per share Rs. 10 (P0)Expected earning Rs. 1000 (X1)Investment need for next year Rs. 1110 (I1)Dividend paid Re 1 (D1)If Zeta Ltd pays out the dividend, P1 will be Rs.10 and it will have to issue 111shares @ Rs. 10 each to raise the finance for its investment If it does not pay dividend , but retains it, then the share price will be Rs. 11 and it will have to issue only 10 shares @ Rs. 11 each to fund the investment

Thus irrespective of what D1 is (n+m)P1 ( the total value of equity at then end of year 1 ) will be Rs. 11,110.

3/23/201525DIVIDEND POLICYMiller and Modigliani Position-Implications :MM dividend irrelevance theorem rests on their leverage irrelevance theorem. In the Zeta Ltd example, it was assumed that external finance was raised by issuing additional equity. Since the real cost of debt and equity as per MM Leverage irrelevance theorem is the same, it is immaterial how the finance is raised- by way of debt or equity.There is no conflict between dividend capitalisation approach to valuation and the MM dividend irrelevance theorem. MM dividend irrelevance does not imply that the value of an equity share is not equal to the present value of future streams of dividends expected from its ownership. It only means that even though the dividend policy of the firm may influence the timing and magnitude of the dividend payments, it cannot change the present value of the total stream of dividends.

3/23/201526DIVIDEND POLICYMiller and Modigliani Position-Criticism :According to critics, dividends matter due to uncertainty characterising the future, imperfections of the capital market and the existence of taxes.Information about future prospects of the co. Uncertainty and fluctuations make investors prefer a higher pay out ratio.MM assumes offering additional equity at same price. In reality it will be at lower prices

Higher dividend payout Greater Volume of underpriced equity issue to finance a given level of investmentGreater dilution of the value of equity3/23/201527DIVIDEND POLICYMiller and Modigliani Position-Criticism :Issue Cost : In real world , issue costs are there.Transaction costs- commission etc increase the cost of share sale and purchase Differential rates of taxes- taxes on current income and capital gains are differentRationing: Dividend policy and investment policy may have correlation.Firms may make unwise investments- where return is lower than cost of capital.Information content: Lower or higher dividend announcement signals managements view of the future of the company.3/23/201528DIVIDEND POLICYRational Expectation hypothesis: A way of reconciliationIts central argument is that what matters is not what happens, but the difference between what happens and what was expected to happen.If the dividend declared is what the market expected, there would be no change in the market price of the share, even if the dividend is higher or lower than the previous dividend. Market normally discounts the dividend in advance.But if the dividend is higher than that expected by the market, market revises its assessment. This will push up prices. A similar downward revision is also possible.The revisions are nothing but the underlying revision of the estimate of the earning potential. 3/23/201529DIVIDEND POLICYRadical position:Since dividends are taxed heavier than capital gains , the argument is that there should be lesser dividends.

3/23/201530DIVIDEND POLICYExplanation of Radical Position:Capital gains are taxed lighter than dividends. Hence preferred.In the example both A and B have the same expected pre-tax pay off of Rs. 120 . Investors consider the worth of the share of A = Rs. 120 even though it does not plan to pay dividend next year. From the share of B investors expect Dividend of Rs. 15 and capital of Rs. 105.Even though both offer Rs. 120 pay off in the next year, As stock sells at a higher price because investors prefer capital gains as against dividend. Again capital gains tax has to be paid only at the time of sale. The longer the shares are held, the lesser the present value of the tax liability. Dividend tax is to be paid immediately. 3/23/201531DIVIDEND POLICYTHANK YOU3/23/201532Growth Firm: r>kNormal Firm : r=kDeclining Firm : rkNormal Firm : r=kDeclining Firm : r