DIVIDEND POLICY

S.CLEMENT

What is Dividend• According to ICAI(Institute of

chartered Accountants of India) ,• ” A dividend is distribution to

share holders out of profits or reserves available for this purpose “

• Divisible profits which are distributed amongst the members of a company in proportion to their shares in a manner as is prescribed by law.

• Dividend is arrived on the basis of PAT and % of retention of profits

TYPES OFDIVIDENDS

TYPE OF SECURITY

TIMINGS

MEDIUM OF PAYMENT

EQUITY PREFERENCE

INTERIMREGUALR

CASHBONUS SHARES

Why companies pay dividend?• Investor preference –for self

control and aversion to regret . Self control theory – to check

temptations, investors prefer dividend to protect principal from spendthrift tendencies.

Aversion to regret – Purchase of TV out of dividend

income or sale of shares . Which one is preferred?

Why companies pay dividend?

• Information signaling – increased dividends indicates earnings prospects

• Clientele effect – capital gain or dividend income

• Bird-in-hand policy – current income vs future income

• Temporary surplus cash and No investment opportunities

• ODI (over seas direct investment) – ADRs/GDRs.

Dividend decision • It is a complex one.• Question is how much to retain and how

much to pay.• Growth opportunities Vs dividend pay

out.• It is whether fixed percentage or fixed

portion of profits• Dividend payment may affect the mood,

behaviour and response of existing share holders, prospective investors, stock exchanges , financial institutions etc

• It creates conflict of interest among lenders, share holders, board of directors etc

Dividend theories• Relevant – affects over all value of firm.• Dividend forms integral part of

investing and financing decision• Share holders prefer current dividend• Bearing on market price• Irrelevant –• Value of firm is impacted by profitability

and earnings rather than dividend.• Theories – Walter model/Gordon

model/Miller & Modigliani model (MM)

Miller & Modigliani theory

• Dividend irrelevance theory- advocates that value of the firm depends solely on its earnings power and not influenced by the ratio between dividends and retained earnings.

• Formula – • Po = D1 + P1

1 + kPo = value of shares in the beginning or zero

periodP1 = value of shares in the end of periodD1 = dividend per share at the end of the

periodK = cost of capital

Miller & Modigliani theory• A company ahs an outstanding

10,000 shares.• Company is contemplating a

dividend of Re 5 per share at the of the current year

• Capitalization rate @ 10%• What will be the priceat the end of

the year if• A) no dividend is declared• B) dividend is declared

Miller & Modigliani theory• A) When no dividend is declared • Po = Rs 100. D1 = 0. k = 10%• P1 = Po (1+k) – D 1• = 100(1 + .10)-0• = Re 110.• B) When dividend is declared • Po = Rs 100.D1 =5. k =10%• P1 = 100 (1+.10) -5• = 110 – 5• = 105• Total wealth of share holders incase of A is Rs

110• Total wealth of share holders incase of B is Rs

105 + 5 = 110• So, there is no change in wealth

MM theory -Assumptions • No tax advantage or disadvantage

associated with dividends• Investment and dividends decisions are

independent• Firms can issue shares with out

floatation or transaction cost• If retained earnings is more ,share

holders enjoy capital appreciation equal to retained earnings.

• Dividend payout is more which may equal to capital appreciation.

• So, value of firm depends on earnings power.

• Current MV of a company $ 1,00,000 and 2000 shares outstanding. Current share price $50. Company to pay diviend of $ $10 per share. What will be the price after payment of dividend.

• Dividend payment $10 X 2000 =20000

• Company value will be 80000(100000-20000)

• Share price 80000/2000=40 i.e. Ex dividend price

Miller & Modigliani theory - irrlevance

• If company goes for share repurchase • With dividend amount of 20000,

company can repurchase 400 shares (20000/50).

• After share repurchase, 1600 shares outstanding and value will be 80000 (1600 X50)

• Share repurchase does not alter share price

• Individuals are indifferent between dividend and share repurchases

Miller & Modigliani theory - irrlevance

MM theory - comments• Dividend pay out is information about

earnings prospects of the company.• Uncertainty and fluctuations - share holders

prefer dividend to capital gain.• Pricing of shares for additional equity – new

issues are always priced lower than MP. No fluctuation in cost of capital can be assumed.

• Transaction, taxation and issue cost exist .• Investment and dividend decision are inter

connected.• When share holders sell their shares, it is

subject to capital gains but not dividend. So, Share holders prefer dividend.

• Equity is not the only source of financing.

Walter Model • Investment decision are inter related.

• Dividend policy depends upon investment opportunities.

• If rate of return on investment is greater than cost of capital ,company's retained earnings will go up

• cost of capital > return, dividend will be distributed.

Walter Model - Implications• Growth firm – when the rate of return

is greater than the cost of capital (r>k).

• Future earnings expected to go up due to profitable investment opportunities.

• 0 pay out ratio as entire earnings are retained for future investments.

• Market value of share move up as share holders expectations also soar.

• In short, Price will be maximum when Pay out ratio is 0

• Bharti Air Tel – No dividend between 2003 – 08.

Walter Model - Implications• Normal firm – when the rate of return is

equal to cost of capital (r= k).• Do not have unlimited profitable

opportunities.• Once profitable opportunities are

exhausted, return (r) from investment equals to cost of capital (k)

• Returns on reinvestment will just equal to dividend income

• Price per share does not vary with changes in dividend pay out ratio as the share holders are indifferent to dividend ratio.

Walter Model - Implications• Declining firm – when the rate of

return is lesser than cost of capital (r < k).

• profitable investment opportunities are less.

• Dividend pay out ratio may be 100%

• Market price may go up due to higher dividends.

• E.g. Hindustan Lever

Walter Model• Valuation formula –

• P = D + r/k ( E – D ) kP - Market price per shareD – dividend per shareE – earnings per share(E-D) – retained earnings per sharer - rate of return on investmentsk – cost of capital

Walter model• EPS Re 10• Market capitalization rate – 10%• Pay out option – 50%,75% & 100%• Rate of return -it it is 15%,10% &

8 %• Compute market value of share

Pay out ratio

a) R =15%(r > k )Growth firm

b) R =10% ( r = k)Normal firm

c) R = 8%(r < k)Declining firm

r/k .15/.10=1.5

r/k .10/.10=1.0 r/k .08/.10=.8

a) Pay out @ 50%

D =5

P = 5+1.5(10-5) .10 = Rs 125

P = P = 5+1.0(10-5) .10 = Rs 100

P= 5+0.8(10-5) .10 = Rs 90

b) Pay out 75%D = 7.5

P=7.5+1.5(10-7.5) .10= Rs 112.50

P=7.5+1.0(10-7.5) .10= Rs 100

P=7.5+0.8(10-7.5) .10= Rs 95

c) Pay out @ 100%D = 10

P = 10+ 1.5 (10 -10) .10 = Rs 100

P=10+1.0(10-10.0) .10= Rs 100

P=10.0+0.8(10-10.0) .10= Rs 100

Walter Model• ABC co – • EPS Re per share 5. • Cost of equity 10%. • Rate of return 18%.• According to Walter’s formula• What is the share price if dividend

pay out ratio is 25%

Walter Model• P = 1.25 + 18/10(5-1.25) 0.10 = Re 80

Gordon’s Model• It is similar to Walter's model.• Dividend is relevant to the value of the firm and

dividend policy certainly affects the value of the firm i.e. market price

• Assumptions –• It is all equity company• Retained earnings represent only source for

financing the firm.• Rate of return and cost of capital remain constant• Retention ratio is constant• Investor values current dividend more highly than

expected future dividends (capital gain) because future is full of risks.

• MP represents discounted value of future dividends.• Corporate tax does not exist

Gordon’s Model• Formula - E (1-b)• Ke – br • Dividend = E(1-b) – E is earning

per share and 1-b is proportion of dividend distributed.

• E earnings per share• 1-b = pay out ratio• Ke = cost of capital • br = growth rate

Gordon’s Model• Formula - E (1-b)• Ke – br • R=30%,k-20%,EPS – Re 5 & b =

25%• Price of the share will be• Dividend is 20% i.e.(5*25%)

Re1.25.Retention is 5- 1.25 = 3.75• 5(1-0.25)/0.20-25*0.30• br - .25 X .30 =0.075• 3.75/0.20 - 25*30%• 3.75/.20 – 0.075• 3.75/0.125 = Re 30

Dividends and tax impact• Taxation – dividend and capital gains • Usually tax rate is higher for dividends

than capital gains • Companies can pay less cash dividend

which will result low payout.• Company will go for share buy back

which will in turn increase the share price.

• It will reduce the impact of tax on dividends for investors

Dividend Policy • Dividend policy determines what

proportion of earnings is paid to share holders by way of dividend and retention of earnings for reinvestment

• Capital budgeting decision is impacted by dividend policy, since it has a bearing on EPS.

• Continuous trade off between retained earnings versus dividend pay out.

• Dividend and market price

Factors impacting Dividend Policy • Funds requirement – Pay out ratio is lower when

investment prospects are bright. E.g. RIL – low pay out ratio due to rapid expansion. Hindustan Lever has higher pay out ratio is 90 % (dividend @ 500% for Dec 2004)

• Access to External sources of financing.

• Share holders preference – current dividend or capital gain. Composition of share holders such as MF /corporates etc.

• Cost factor – Equity versus retained earnings.• Control aspect – regulatory /lenders covenants

Factors impacting Dividend Policy• Tax implications• Legal constraints• Magnitude and stability of earnings• Liquidity position

Share buy back - rationale• Efficient allocation of resources• Price stability• Tax advantage• To avoid hostile take over• Increase in MP & EPS• To substitute for cash dividends • Reduced dividend payment in future• Useful in case of stock option/convertibility.• Voluntary nature

Share buy back - rationale• Philps India –• Buy back 17.1 % of its stake @ Re

105 per share in Nov 2001. • to increase the parent company

(Royal Philps Electronics ).• Buy back helped the company to

delist.•

Bonus shares• Issued in lieu of cash to existing

share holders in proportion to their holding.

• It is a capitalization process• Arises due to inadequate cash or

company wants retention of profits• Capitalization process through

converting partly paid shares or issuance of new shares.

• Special occasion , Infosys- silver jubilee in Mar,2007. Bonus share 1: 1

Bonus shares• Increases the size of capital and

strengthens the balance sheet• Increases the number of shares

and promotes active trading• Improves the prospects of raising

additional funds

Dividends - Regulatory• Companies can pay cash dividends ( except for bonus

shares) out of current and past profits.

• Depreciation to be provided before declaring dividend

• Dividends -10 to 12.5%. Trnasfer to reserves not less than 2.5% of current profits

• >12.5- 15%. 5% of current profits

• >15-20%. 7.5% of current profit

• > 20%. 10% of current profits.

• Dividend cannot declared for past yearsfor which accounts have been closed.

• Procedural aspects – Board resolution/share holders approval/ Record date/dividend apyment

Dividend planning• Do not pay dividend at the cost of

positive NPV projects• Minimize the need to external

equity• Define a target dividend pay out

ratio and also DE ratio• Flexibility in dividend & DE• Avoid dividend cuts

Evaluation • All theories are too incomplete to provide

evidence on dividend policy followed by the companies and behaviour of investors

• Sudden shift in dividend policies can cause abrupt changes in stock price since investors read into company’s action. If sudden change is warranted , forewarning is desirable.

• It is necessary to smooth dividends by defining dividends payout ratio and make relatively slow adjustments toward it.

• Company to strive to minimize reliance on external equity to get the cash back after dividend payment.

Dividend policies in practice• Chemicals – “ We do not think of

accumulating surplus and declaring bonus shares”

• TEA - pay out ratio is 30 to 50%• Automobiles – we like to maintain a

dividend rate of 15%• Pharma –pay out ratio is 30%.Dividemd

around 18%• Textiles – due to drop in profits,

dividend was skipped.

Dividends story in India• Data on top 20 dividend paying

companies show that for the financial year ended March 2008, nearly Rs 18,000 crore have been handed over to their shareholders.

• Of these, the top five PSU and private corporate houses have distributed about Rs 9,000 crore and Rs 6,000 crore respectively. Since under the current tax rules, dividends are tax-free in the hands of the receiver, market players say this is a real wealth in the hands of investors.

Dividends story in India• Among the PSUs, it is the navaratna

companies which have given handsome dividends, which in a major way filled up the government’s coffers, other than paying its non-government shareholders.

• Among the private companies and corporate houses, other than the traditional frontline entities like Reliance (Mukesh Ambani and ADAG) groups, Tatas, Birlas and ITC, the Indiabulls group stands out for its huge payout to its shareholders.

•