Chapter XDividend Policies

Dividend

The return given to the shareholders on their investment

First Stage in Dividend Policy: Conservative

Second Stage: Liberal Third Stage: No Dividend Policy India is in the second stage right now

Factors Determining Dividend Policy

Company Policy Stability in Earnings Liquidity of the Co. Past Dividend Rates Projects under

Consideration Market Expectation Taxation Legal restriction

Independent Opportunities

Restrictions of FIs Nature of Business Cost of Capital Phase of Trade

Cycle Accumulated

Reserves Co’s Growth Needs Bonus Issue

Types of Dividend Policies

Conservative Dividend Policy

Liberal Dividend Policy

Conservative Dividend Policy: Merits

Good Treasury Mgt.

Stability in Dividend

Provision for Contingency

Organic Growth

Inorganic Growth

Modest Expectation

Taxation

Higher Book Value

Value Unlocking

Research Oriented Companies

Demerits of Conservative Dividend Policy

Lesser Image as a Creator of value for the Shareholders

Book Value will be far more than Market Value of the Shares

Accessing Capital Market becomes Difficult in the Future

Lesser Liquidity for the Shares

Liberal Dividend Policy

Handsome Dividend A Number of Interim Dividends

within a Year Regular Issue of Bonus Shares Special dividends on Important

Occasions Taking Care of Enhancing

Shareholder Value as much as maximising Profits of the Company

Merits of Liberal Dividend Policy

Good Image Shareholder Satisfaction Liquidity of the Scrip High Market Price Growth Driven Policy Accessing the Market Raising Finance Globally Constant Innovation

Demerits of Liberal Dividend Policy Difficult Treasury Management

Lack of Stability in Dividend Payment

Affecting Growth Prospects

Insatiable Appetite of Shareholders

High Dividend Tax

Bonus Shares

Stock Dividend

Capitalising the Reserves

Given as a ratio 1:2

Conserves Cash

For the Shareholder, tax liability is less as stock dividend is not treated as income

Benefits of Bonus Shares to the Company

No cash Outflow Higher Liquidity Good Image Higher Market Capitalisation Reduction in Rate of Dividend No Dividend Tax Undercapitalisation

Benefits of Bonus Shares to the Shareholders

Higher Holding

Partial Liquidation

Taxability

Higher Liquidity

Higher Future Dividend

Impact of Bonus Shares

On Balance Sheet: Asset side not affected, Reserves come down and Share Capital goes up-Net worth does not change

On Share Price: Immediate high, subsequent lower and higher in the long term

On EPS: Gets reduced- Suggestible when the operating profit is expected to go up

Bonus Shares & SEBI Guidelines Provision in Articles of Association Increasing Authorised Capital Out of Free Reserves/Share Premium Not Out of revaluation Reserve Only on Fully Paid Shares Not in Lieu of Dividend Implementation within six months No Default on Financial Obligations Not in one year of Public Issue/Rights

Issue Applicable to Listed Companies

Dividend Models

Walter’s Model

Gordon’s Model

Modigliani-Miller Model

Walter’s Model

James Walter & his Article, ”Dividend Policy: Its Influence on the value of the Firm”

Growth Firm: ROI > k-optimal dividend is 0%

Normal Firm: ROI =k, Any rate of dividend

Declining Firm: ROI < k , 100% Pay-Out Ratio

Assumptions of Walter’s Model

Only Two Sources of Finance: Equity Shares and Retained Earnings

ROI is constant from one year to another

K is constant from one year to another

Firm has an infinite life

Computation of Market Value of Shares

Where

P=Market Price of Equity

R=Rate of Return

K=cost of capital

E=Earnings per Share

D=Dividend per Share

kkDE

RDP

)(

Problem No. 1

The National Sports Company with an EPS of Rs.11 and a cost of capital at 13%, achieved a Return on Investment at 18%. As per Walter’s Model, what would be the optimum pay-out ratio? What would be the share price at this ratio?

Problem No.2

The earning per share of a company are Rs.8.It has an internal rate of return of 14% and the capitalisation of its risk class is 12%. If Walter’s Model is used,

(i) What should be the optimum pay-out ratio of the firm?

(ii) What would be the price of its share at this pay-out ratio?

(iii)How shall the price of the share be affected, if 20% pay-out ratio was employed?

Percentage of Dividend & Dividend Pay-Out Ratio

If Dividend is given as a percentage, it should be calculated on the face value.

If it is given as a pay-out ratio, it should be calculated on the EPS

Problem No.3

Company A has achieved an EPS of Rs.8 for the year2007-08. What is the Dividend per Share if,

(a) 25% dividend is declared on the share of Rs.10 face value

(b) dividend pay-out ratio is 25%

Problem No.4

Fairever Cosmetics achieved an EPS of Rs.9 per share on its equity share of Rs.10 each., for the year 2006-07.It achieved a Return on Investment @ 14% with a cost of capital @ 16%. What is the ideal pay-out ratio?

At that ratio, calculate the market value of share of the firm.

If Board of Directors recommend a Dividend of Rs.4, what would be the market price of share of the firm?

Problem No.5

For the year 2006-07, Sellwell Ltd., achieved an EPS of Rs.9. Its cost of capital is 11% and Rate of Return is 14%.

Determine its market price when

the dividend pay-out ratio is (a) o% (b) 25% © 50% (d) 100%

Problem No. 6

Trywell Ltd., achieved an EPS of Rs.12 on its equity shares of Rs.10. The cost of capital of the company was 7% while the rate of return was 4%.

Calculate the market price of the share if the Dividend Pay-out ratio was (a) 0% (b) 20% © 40% (d) 80% (e) 100%

Problem No.7

Consider the following data: Growth Normal

Declining Firm Firm

FirmROI 17% 18%

19%K 15% 18%

20%EPS (Rs) 6 6

6Calculate the market price of shares of

thefirms if the pay-out ratio is 20%, 45%

or 70%.Also comment on it.

Criticisms of Walter’s Model

Only zero debt companies have equity and retained earnings as the only two sources of finance

ROI will not be constant

K also will not remain constant

Dividend Capitalisation Model

Myron J. Gordon concurred with Walter in Dividend being relevant to Market price of Share

He differed in advocating growth as the driver of the market price

Growth is the product of retention ratio (b) and Rate of Return (R)

Assumptions of Gordon’s Model

Only Equity and Retained Earnings are the only sources of finance

R is constant from one year to another

Taxes do not exist

K is also constant

The Firm has a perpetual life

Computation of Market Price

bRK

bEP

e

)1(

Miller-Modigliani Dividend Model

Merton Miller & Franco Modigliani presented a paper in 1958 and argued that Dividend

was irrelevant in determining the price of the share

- It was the Investment policy and earnings of the firm that determined the share price

- In 1961, an Article was published by them, which came to be known as Irrelevance Theory

Arbitrage Process

Price may go up post declaration of dividend

After the payment of dividend, the firm may have to access the capital market for the future requirement

This will bring down the price of the shares to the previous levels

The Theory impacted the capital market so much that nearly 70% of American Corporations became ‘No Dividend’ Corporations

Assumptions

1. Perfect Capital Markets: - all the investors are rational -price sensitive information is available

to all the investors simultaneously -securities are infinitely divisible - no single investor is big enough to influence the price2. Non-Existence of Taxes3. Constant Investment Policy4. Forecasting Ability

Computation of Share Price

Where Po = Price at the beginning P1 = Price at the end ke = Cost of Equity D = Dividend per Share

101 )1( DkPP e

Exercise-page No.289

17. The share price of TVS Electronics Ltd. was ruling at Rs. 57.60. The Board of Directors declared a dividend of Re. 0.70 per share of Rs. 10. If cost of equity is 3%, calculate the share price after declaration of dividend using Miller Modigliani Dividend Model.

Exercise-Page No.289

16. Cost of Equity of VIP Industries Ltd. was 5% and the price of equity share was Rs. 122.60. The company declared a dividend at 20% on its equity shares having the face value at Rs. 10. What will be the share price after the declaration of dividend? 

18. Triumph Engineering Ltd had 5,000 equity shares of Rs. 100 each. During a financial year, its cost of equity was 17%%. Using Miller - Modigliani model, decide what will be the price of the share, if no dividend is declared? If a dividend of Rs. 23 per share is declared, what will be the share price?

Exercise-Page No.289

19. United Pharma Ltd. had 3,00,000 outstanding equity shares of Rs.10 each on Jan 1,2007. The company now intends to pay Rs.6 per share for the current year. It belongs to a risk class whose appropriate capitalisation rate is 9%. Determine the price of the company’s share using Modigliani-Miller model,

(i) when dividend is declared (ii) when no dividend is declared.

19. United Pharma Ltd. had 3,00,000 outstanding equity shares of Rs.10 each on Jan 1,2007. The company now intends to pay Rs.6 per share for the current year. It belongs to a risk class whose appropriate capitalisation rate is 9%. Determine the price of the company’s share using Modigliani-Miller model, (i) when dividend is declared (ii) when no dividend is declared.

19. United Pharma Ltd. had 3,00,000 outstanding equity shares of Rs.10 each on Jan 1,2007. The company now intends to pay Rs.6 per share for the current year. It belongs to a risk class whose appropriate capitalisation rate is 9%. Determine the price of the company’s share using Modigliani-Miller model, (i) when dividend is declared (ii) when no dividend is declared.

Exercise-Page No.292

17. Two chemical companies A Ltd. and B Ltd. had equity shares priced at Rs. 300 each. During the financial year 2006-07, each one made a net profit of Rs. 430 crores. Cost of equity is the same for both the companies at 16%. A Ltd. decided to declare a dividend at Rs. 7 per share and B Ltd. decided not to declare any dividend.

Using Miller-Modigliani hypothesis, a) Calculate the share price of A Ltd. after dividend

declaration b) Calculate the share price of BLtd. after the results c) Is there any difference in the total shareholder

wealth between the two companies?

Exercise-Page No 292 16. The following seven engineering companies

undertake turn-key projects in India. Their financials for 2004-05 are given below. All the companies have Rs. 10 as the Face value of share of a Company

P0 D ke (%)

ABG Heavy Industries Ltd 264 1.504.4 Engineers India Ltd 8237.502.4 Hindustan Dorr-Oliver Ltd 813 1.202.2 MC. Nally Bharath Ltd 1300.302.3 Petronet Engineering Ltd 168 1.005.9 PSL Ltd 251 4.504.14 Sanghvi Motors Ltd. 8405.002.1 Using Modigliani - Miller hypothesis, calculate the

market price of shares after the declaration of dividend.

 

Exercise-page No.292

18. Apply Modigliani - Miller hypothesis and determine the share prices of the following companies after the declaration of dividend.

Problem No. 19

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