SOUTH EASTERN STEEL COMPANY

• GROUP 3• ASHWATH.G.HEGDE• NAVIN GUPTA• PRIYA RICHHARIYA• PRGATI SAXENA• SAILAJA AKELLA

Introduction • Established in 1945• Annual revenue of $10 to 20 million• Employees: 100 to 250• Business activity: Manufacturer of fabricated

metal products, exporter / importer• Products and services: carbon-cold finished bars

carbon-expanded steel carbon-grating carbon-hollow structurals.

Distribution policy

• It is the decision about how much of earnings to pay out as dividends versus retaining and reinvesting earnings in the firm.

IRRELEVANCE THEORY

• Investors are indifferent between dividends and retention-generated capital gains. If they want cash, they can sell stock. If they don’t want cash, they can use dividends to buy stock.

• Modigliani-Miller support irrelevance but their theory is based on unrealistic assumptions (no taxes or brokerage costs), and hence may not be true.

Bird-in-the-Hand Theory

• Investors think dividends are less risky than potential future capital gains, hence they like dividends.

• If so, a high payout would result in a low risk, hence a high P0.

Tax Preference Theory

• Retained earnings lead to capital gains, which are taxed at lower rates than dividends: 28% maximum vs. up to 39.6%. Capital gains taxes are also deferred.

• This could cause investors to prefer firms with low payouts, i.e. low payout results in a low ks, hence a high P0.

Implications of the three theories for managers

Theory • Irrelevance• Bird -in-the –hand• Tax preference

Implication • Any payout is suitable• Sets high payout• Sets low payout

Have empirical tests proved which theory is most correct

• No. Empirical testing has not been able to determine which theory, if any, is correct.

• Thus, managers must use judgment when setting policy.

• Analysis is used, but it must be applied with judgment.

What is the “information content,” or “signaling,” hypothesis and how does it affect

dividend policy?

• Managers hate to cut dividends, so they won’t raise dividends unless they think the increase is sustainable.

• Thus, investors view dividend increases as signals of manage-ment’s positive view of the future.

Cont….

• Therefore, if a company’s stock price increases at the time it announces a dividend increase, this could reflect expectations for higher future EPS, not a preference for dividends over retentions and capital gains.

• Conversely, a dividend cut would be a signal that managers are worried about future earnings.

• The signaling impact constrains dividend decisions by imposing a large cost on a dividend cut and by discouraging managers from raising dividends until they are sure about future earnings.

• Managers tend to raise dividends only when they believe future earnings can comfortably support a higher dividend level and they cut dividends only as a last resort.

What is the “clientele effect” and how does it affect dividend policy?

• Different groups of investors, or clienteles, prefer different policies, e.g. retirees need dividends for income.

• A firms’ past dividend policy deter-mines its current clientele of investors.

• Clientele effects impede changing policy. Taxes and brokerage costs hurt investors who switch companies.

Problem

• Capital budget: $800,000 • Target capital structure: 40% debt, 60%

equity. Plans to maintain. • Forecasted net income: $600,000. • How much of the $600,000 should be paid

out as dividends?

Cont…

• Of the $800,000 capital budget, 0.60($800,000) = $480,000 must be equity to keep at target capital structure. 0.40($800,000) = $320,000 will be debt.

• With $600,000 of net income, the residual is:$600,000 - $480,000 = $120,000= dividends paid.

• Payout ratio = $120/$600 = 0.20 = 20%.

What if Net Income dropped to $400,00? A rise to $800,000 Net Income $8,00,000

• Distribution = Net Income - [(Target equity ratio) * (Total capital budget)]

• = $8,00,000 - 60% * $8,00,000 = $3,20,000 • Resulting Payout = 40.0%

How would a change in investment opportunities affect the dividend under the

residual dividend policy?

• Fewer good investments would lead to a smaller capital budget, hence a higher dividend payout.

• More good investments would lead to a lower dividend payout.

What are the advantages and disadvantages of the residual dividend model?

• Advantages: Minimizes new stock issues, hence flotation costs and negative signals associated with new stock.

• Disadvantages: Variable dividends send conflicting signals, increase risk, and do not appeal to any specific clientele. Results in higher required return.

Stock Repurchases

• Repurchases: When a firm buys its own stock back.

• Reasons for repurchases: – An alternative to distributing cash as dividends. – To dispose of one-time cash from an asset sale. – To make a large capital structure change.

Advantages of Repurchases

• Stockholders can tender . • Distribute cash without setting high dividend

that cannot be maintained. • Treasury stock can be used in take-overs or

resold to raise cash. • Stockholders get capital gains rather than

higher-taxed dividends. • May signal that managers think stock is under-

valued.

Disadvantages of Repurchases

• May be seen as a negative signal of poor investment opportunities.

• Theoretically, IRS could impose penalties if repurchases were solely to avoid taxes on dividends.

• Selling stockholders may not be well informed, hence unfair to them.

• Firm may have to bid up the price to complete repurchase.

SEBI (BUY BACK OF SECURITIES) REGULATIONS, 1998 & Section 77A of The Companies Act, 1956

• Buy-back of equity shares in any financial year shall not exceed twenty-five per cent of its total paid-up equity capital in that financial year.• Ratio of the debt owed by the company is not more than twice the capital and its free reserves after such buy-back • The promoter shall not deal in the securities of the company in the stock exchange during the period the buy-back offer is open

Cont…

• The company shall nominate a compliance officer and investors service centre for compliance with the buy-back regulations and to redress the grievances of the investors.

• Every buy-back shall be completed within twelve months from the date of passing the special resolution passed in general meeting authorizing the buyback

Steps in Setting Dividend Policy

• Identify target capital structure. • Forecast capital needs over planning horizon,

often 5 years. • Estimate annual debt and equity needs. • Set long-run target payout ratio based on the

residual model. • Generally, some growth rate emerges. Aim for

growth at target rate if possible, varying capital structure as necessary.

Stock Dividends vs. Stock Splits

• Stock dividend: Firm issues new shares in lieu of paying cash dividend. If 10% stock dividend, get 10 shares for each 100 owned.

• Stock split: Firm increases the number of shares outstanding. If 2:1, gives stockholders twice as many shares. (Can have reverse split.)

• Different accounting treatment.

• Both stock dividends and stock splits increase the number of shares outstanding, “smaller pieces of pie.”

• Unless the stock dividend or split conveys information, or is accom-panied by another event like higher dividends, stock price generally falls so as to keep each investor's wealth unchanged.

• Splits/stock dividends may get the stock to an “optimal price range.”

What is a dividend reinvestment plan (DRIP)?

• Shareholders can automatically reinvest their dividends in shares of the company's common stock. Get more shares rather than cash.

• There are two types of plans: – Open market purchase plan. – New stock plan.

Open Market Purchase Plan

• Dividends to be reinvested are turned over to a trustee, who buys shares on the open market and holds them for participating stockholders.

• Brokerage costs are low because of volume purchases.

• Convenient and easy way to invest systematically.

• Company pays administrative costs.

New Stock Plan

• Firm issues new stock to DRIP participants, then keeps money otherwise used for dividends and uses it for other purposes.

• No fees charged. Stock is sometimes sold at discount from market price set about equal to flotation costs of underwritten stock offering.