Date post: | 16-Nov-2015 |
Category: |
Documents |
Upload: | shardulwaikar |
View: | 13 times |
Download: | 4 times |
CHAPTER I
INTRODUCTION
!1.1 Background of the Study
Dividend policy for business organization is a very important decision, which
depends upon the long-term and short-term strategy of a firm. Dividend policy of a
firm is an effect of dividing its net earning into two parts: the retained earnings and
dividend payment. (Pandey; 1999: 770) Business firms use the retained earnings to
provide funds to the firm for long-term growth; we call it as internal financing source
also. Dividend is that portion of earning, which is paid to the common stock holders,
is a return on their investment. By a dividend policy we mean some kind of consistent
approaches to the distribution versus retention decision rather than making the
decision on the purely ad hoc basis from period to period. (Pearson, William &
Gordon; 1972: 405)
!Likewise, dividend policy must be considered in relation to the overall financing
decision. In practice, net earnings always may not be appropriate measure of the
ability of the firm to pay dividend, that's why, what and how much it is desirable to
pay dividend is always a controversial topic because shareholders expect higher
dividend but companies ensure towards setting aside funds for maximizing the
shareholders wealth.
! 1
When a company pays out a portion of it's earnings to the shareholders in the form of
dividend, the shareholders are directly benefited. If company is hopeful to exploit
other growth opportunities, the firm can avoid for paying cash dividends. In this
condition, shareholders consider their future growth of their stock instead of getting
cash dividend. On the other hand, the firm has to pay enough dividends to satisfy
investors. If they are paid higher dividends, the market price of the stock also rises.
This means of maximizing the shareholder's wealth. Thus shareholders wealth
(return) can be increased through either dividends or capital gains. As the division and
retention are considered as dividend policy, all aspects and questions related to the
payment of dividends are contained in dividend policy.
!Financial institutions have definitely contributed and played a gigantic role for
domestic resource mobilization and economic development to build up the confidence
of the businessmen for promoting their business and industrialists for encouraging
opening new business venture. It maintains confidence for various segments and
extends credit to people. (Hastings; 1996: 72)
The banking concepts and activities started in Nepal only after the establishment of
Nepal Bank Limited in 1937. A central bank (Nepal Rastra Bank) was established to
regulate the banking activities and, declare & implement monetary policy of the
nation. Then after, it was realised that the commercial bank has its own role and
contribution in the economic development. It is the source of economic development;
it maintains economic confidence of various segments and extends credit to people.
So, another commercial bank, Rastriya Banijya Bank was established on 1966.
! 2
Capital market plays an important role in the economics development of a nation. But,
in Nepal, the capital market is very small and developing slowly with disorganized.
The Nepalese companies (especially government enterprises) have not been able to
generate sufficient as compared to the organizations that are established and operated
on public sector. Hence the government is not receiving dividends from public
enterprises for several years.
In the global perspective, joint ventures are the modes of trading through partnership
among the nations and also a form of negotiation between various groups of industries
and traders to achieve competitive advantages. Nepal's reform efforts in the financial
sectors, begun in 1980's, when Nepal Rastra Bank eased entry restrictions and
amendment of the Commercial Bank Act 1974. As a result, three banks namely,
NABIL Bank Ltd, Nepal Investment Bank Ltd. and Standard Chartered Bank Nepal
Ltd. came into operation prior to 1990s. In 1992, Nepal Rastra Bank adopted liberal
outlook in permitting commercial banks to open. Then after, the financial
liberalization really took place. Many more banks came into operation making the
total number of the commercial banks to twenty five.
Dividend practice in public corporations is still having problem for taking dividend
policy. Thus, here neither corporation are able to generate sufficient earnings for
dividend payment nor is the government expecting dividends, since it has been
observed that dividend payment is practically a crucial problem of the public
corporations. Corporation like Nepal Oil Corporation and Nepal Electricity Authority
! 3
are not distributing earnings as dividend but total effort is focused on minimization of
losing through better utilization of capital. Noticeable matter is that this shifting aim
of public corporation is failed to minimize the losses.
The joint venture banks in Nepal have brought new hope for productive mobilization
of funds according to their new trends of dividend.
Although, twenty eight commercial banks are in operation in the nation; only twenty
one commercial banks are listed in security board, on the Nepal Stock Exchange. Out
of which only five commercial banks have been taken as sample. They are as follows:
a. Standard Chartered Bank Nepal Ltd.
b. Nepal Arab Bank Ltd.
c. Everest Bank Ltd
d. Bank of Kathmandu Ltd.
e. Himalayan Bank Ltd.
!!
1. Profile of the Selected Banks
a) Standard Chartered Bank Nepal Limited
Standard Chartered Bank Nepal Limited has been in operation in Nepal since 1987.
The Bank is an integral part of Standard Chartered Group having an ownership of
75% and the balance owned by the Nepalese public. The Bank is the largest
international bank currently operating in Nepal.
!! 4
With 17 points of representation, 21 ATMs and more than 375 local staff, Standard
Chartered Bank Nepal Ltd. is in a position to serve its customers through an extensive
domestic network. In addition, the global network of Standard Chartered Group gives
the Bank a unique opportunity to provide truly international banking services in
Nepal. Standard Chartered Bank Nepal Limited offers a full range of banking
products and services in Wholesale and Consumer banking. The Bank has been the
pioneer in introducing customer focused products and services and aspires to
continue to be a leader in introducing new products in delivering superior services.
Corporate Social Responsibility is an integral part of Standard Chartereds ambition to
become the worlds best international bank and is the mainstay of the Banks values.
!b) Nabil Bank Limited
Nabil Bank Limited, the first foreign joint venture bank of Nepal, started operations in
July 1984. Nabil was incorporated with the objective of extending international
standard modern banking services to various sectors of the society. Pursuing its
objective, Nabil provides a full range of commercial banking services through its 40
points of representation across the nation and over 170 reputed correspondent banks
across the globe.
Nabil, as a pioneer in introducing many innovative products and marketing concepts
in the domestic banking sector, represents a milestone in the banking history of Nepal
as it started an era of modern banking with customer satisfaction measured as a focal
objective while doing business. Operations of the bank including day-to-day
operations and risk management are managed by highly qualified and experienced
! 5
management team. Bank is fully equipped with modern technology which includes
ATMs, credit cards, state-of-art, world-renowned software from Infosys Technologies
System, Banglore, India, Internet banking system and Telebanking system.
!c) Everest Bank Limited
Everest Bank Limited (EBL) started its operations in 1994 with a view and objective
of extending professionalized and efficient banking services to various segments of
the society. The bank is providing customer-friendly services through its Branch
Network. All the branches of the bank are connected through Anywhere Branch
Banking System (ABBS), which enables customers for operational transactions from
any branches. Moreover, EBL was one of the first bank to introduce Any Branch
Banking System (ABBS) in Nepal.
!In addition, EBL has introduced Mobile Vehicle Banking system to serve the segment
deprived of proper banking facilities through its Birtamod Branch, which is the first
of its kind. EBL has introduced branchless banking system first time in Nepal to cover
unbanked sector of Nepalese society. EBL is first bank that has launched e-ticketing
system in Nepal. EBL customer can buy yeti airlines ticket through internet.
With an aim to help Nepalese citizens working abroad, the bank has entered into
arrangements with banks and finance companies in different countries, which enable
quick remittance of funds by the Nepalese citizens in countries like UAE, Kuwait,
Bahrain, Qatar, Saudi Arabia, Malaysia, Singapore and UK.
!! 6
d) Bank of Kathmandu Limited
Bank of Kathmandu started its operation in March 1995 with the objective to
stimulate the Nepalese economy and take it to newer heights. BOK also aims to
facilitate the nation's economy and to become more competitive globally. To achieve
these, BOK has been focusing on its set objectives right from the beginning.
!The bank targets to contribute to the sustainable development of the nation by
mobilizing domestic savings and channeling them to productive area, to use the latest
banking technology to provide better, reliable and efficient services at a reasonable
cost, to facilitate trade by making financial transactions easier, faster and more
reliable through relationships with foreign banks and money transfer agencies and to
contribute to the overall social development of Nepal. Bank of Kathmandu Limited
(BOK) has today become a landmark in the Nepalese banking sector by being among
the few commercial banks which is entirely managed by Nepalese professionals and
owned by the general public.
!e) Himalayan Bank Limited
Himalayan Bank was established in 1993 in joint venture with Habib Bank Limited of
Pakistan. Despite the cut-throat competition in the Nepalese Banking sector,
Himalayan Bank has been able to maintain a lead in the primary banking activities-
Loans and Deposits. Legacy of Himalayan lives on in an institution that's known
throughout Nepal for its innovative approaches to merchandising and customer
service. Products such as Premium Savings Account, HBL Proprietary Card and
! 7
Millionaire Deposit Scheme besides services such as ATMs and Tele-banking were
first introduced by HBL.
!All Branches of HBL are integrated into Globus (developed by Temenos), the single
Banking software where the Bank has made substantial investments. This has helped
the Bank provide services like Any Branch Banking Facility, Internet Banking and
SMS Banking. Living up to the expectations and aspirations of the Customers and
other stakeholders of being innovative, HBL very recently introduced several new
products and services. Millionaire Deposit Scheme, Small Business Enterprises Loan,
Pre-paid Visa Card, International Travel Quota Credit Card, Consumer Finance
through Credit Card and online TOEFL, SAT, IELTS, etc. fee payment facility are
some of the products and services. HBL also has a dedicated offsite Disaster
Recovery Management System.
! 8
!1.2 Statements of the Problem
Dividend is desirable for the shareholders, which inspires them for the further
investment on company's shares. But it is found that there is no satisfactory result
about dividend decision of commercial banks in Nepal. Likewise, dividend
distribution does not match with the earnings of the commercial banks, there does not
exist a proper relationship between dividend and quoted market price of share.
Similarly, commercial banks with lower returns record stable (rigid) price of share
and banks making sound returns do not rigid in share price.
!Dividend, the most inspiring factor for the investment on shares of the corporation, is
an important aspect of financial management because the dividend policy determines
the division of earnings between payment to stockholders and reinvestment in the
firm to exploit growth opportunities. It affects the value of firm as well as overall
financing decision such as financial structure, the flow of funds, corporate liquidity
and investors satisfaction.
!The dividend decision, however, is still a crucial as well as controversial area of
managerial finance. There is no consensus among the financial scholars on this
subject matter and its relation with stock price. Some financial scholars say that stock
prices are least influenced by dividend per share while some others believe that its
relevance to the stock prices is quite significant. The idea of relevance is vague as
well. It is rather hard to define whether dividend per share has positive effect or its
effect is negative one.
! 9
!Thus for the study, the following research problems have been raised;
a) What is the situation of earning and dividend distribution of commercial banks
of Nepal?
b) What impacts do DPS and DPR and have on the MPS of the bank?
c) Does the dividend yield and the joint effect of DPS and EPS changes the
MPS?
d) What will be the trend of DPS, DPR and MPS of the commercial banks in
forthcoming years?
!1.3 Objective of the Study
The study primarily focuses on the dividend practices of commercial banks with a
view to suggest ways to maximize the shareholders return, i.e. value of their
investment is maximized. Followings are the specific objectives of the study.
a) To analyze the earnings and the dividend distribution of the commercial banks.
b) To examine the impact of DPS on MPS, and the effect of dividend payout ratio
on the MPS, and the joint effect of EPS and DPS on MPS.
c) To evaluate the relationship of dividend yield on DPS, EPS and MPS of the
corresponding bank.
d) To estimate the value of DPS, MPS and DPR for the forthcoming two fiscal
years.
!
! 10
1.4 Significance of the Study
Due to excess liquidity and lack of investment opportunities in the capital market,
nowadays people are very much interested and attracted to invest in shares for getting
higher returns. When any new company issues (floats) shares through capital markets,
very big congregation gathers to apply for owner's certificate. It reveals that people
have expectation on higher return for investing in shares. So the dividend decision is
one of the most important decisions of financial management. It is an effective tool
(way) to attract new investors, maintain present investors and controlling position of
the firm.
Having lack of adequate knowledge, the people are haphazardly investing in shares. It
shows that there is an extreme necessity to establish clear conception about the return
that yields from investing in securities. In the Nepalese perspective, we find that there
exist almost none of the companies adopting consistent dividend policy. There may be
many reasons behind it. But there is not sufficient study conducted in this regard.
Therefore, considering all these facts, the study is undertaken which will help to meet
deficiency of the literature relating to dividend practice and price of stock. So this
study is of considerable importance.
!So many persons and parties such as shareholders, management of banks, financial
institutions, general public (depositors, prospective customers, investors etc.) and
other policy making bodies which are concerned with banking (especially NABIL
Bank Ltd, Standard Chartered Bank Ltd., Everest Bank Ltd., Bank of Kathmandu and
Himalayan Bank Ltd.) business will be benefited from this study. It is also believed
that it will provide valuable inputs for future research scholars.
! 11
1.5 Limitations of the Study
The limitations of the study are as follows:
a) The accuracy of secondary data depends on the reliability of the annual reports
of the concerned banks.
b) The study is focused only on dividend practice, earning and price of stock only
and does not cover the other financial aspects.
c) Only five banks are taken as samples to fulfill the objectives of the study.
d) This study covers five fiscal year period only, i.e. from 2004/05 to 2008/09.
e) Limited time and resources are also constraints.
!1.6 Chapter Scheme
The study has been organized into five chapters;
!Chapter I: Introduction
It consists of background of the study, statement of the problem, objectives of the
study, significance of the study and limitation of the study.
!Chapter II: Review of Literature
It includes a discussion on the conceptual framework on dividend and its practices. It
also reviews the major studies relating with dividend decision of several authors/
researchers and from the several books, journals and article, and thesis.
!Chapter III: Research Methodology
! 12
It explains the research methodology used to evaluate dividend practices of
commercial banks in Nepal. It consists of research design, population and sample,
source of data collection, method of analysis financial tools and statistical tools used
in the analysis.
!Chapter IV: Data Presentation and Analysis
Chapter four fulfills the objective of the study by presenting data and analyzing them
with the help of various statistical tools as per methodology. It is concluded with the
findings of the study.
!Chapter V: Summary, Conclusion and Recommendations
It states summary, conclusion and recommendation of the study based on the data
presentation and its analysis using the tools used in the analysis.
!Besides these chapters, Bibliography and Appendix are also included at the end of
the study.
! 13
Chapter II: Review of Literature
DIVIDEND DECISION AND VALUE OF FIRM:
The value of the firm can be maximized if the shareholders wealth is maximized.
There are contradictory views about the impact of dividend decision on the value of
the firm.
According to one school of thought dividend decision does not affect the
shareholders wealth and hence the value of the firm. On the other hand, according to
the other school of thought, dividend decision significantly affects the shareholders
wealth and also the value of the firm. There are the views of the two schools of
thought under two groups:
a. The Relevance Concept of Dividend or the Theory of Relevance
b. The Irrelevance Concept of Dividend or the Theory of Irrelevance
The Relevance Concept of Dividends: According to this school of thought,
dividends are relevant and the amount of dividend paid affects the value of the firm.
Walter, Gordon and others advocated that dividend decisions are important in
determining the value of the firm. Walter argues that the choices of dividend policies
almost and always affect the value of the enterprise.
The Irrelevance Concept of Dividend: The other school of thought propounded by
Modigliani and Miller in 1961. According to MM approach, the dividend policy of a
firm is irrelevant and it does not affect the wealth of the shareholders. They advocate
that the value of the firm depends on the market price of the share; the dividend
decision is of no use in determining the value of the firm.
WALTERS MODEL:
! 14
Walters model, clearly indicates that the choice of appropriate dividend policy
always affects the value of the enterprise. Professor James E.
Walter has very scholarly studied the importance of the relationship between the
firms internal rate of return, r, (or actual capitalization rate) and its Cost of Capital,
Ke (normal capitalization rate) in determining such dividend policy as will maximize
the wealth of the stockholders.
Walters model is based on the following premises:
1) The firm finance its entire investments by means of retained earnings. New equity
stock or debenture is not issued to raise funds.
2) Internal rate of return (r) and cost of capital (Ke) of the firm remain constant.
3) The firms earnings are either distributed as dividends or reinvested internally.
4) Earnings and dividends of the firm never change.
5) The firm has long or infinite life.
The formula used by Walter to determine the market price per share is:
!
Where,
P = Market price per share
D = Dividend per share
E = Earnings per share
r = Internal rate of return (Actual capitalization rate)
K = Cost capital (External capitalization rate)
! 15
It may be noted that Walters formula has the same effect as the continuing dividend
growth formula. It seeks to measure the effect of dividends on common stock value
by comparing actual and normal capitalization rates.
Another characteristic of Walters formula is that it provides an added or reduced
Weight to the retained earnings portion of the capitalization earnings formula. The
factors r and k are placed in front of retained earnings to change its weighted value
under different situations as discussed below:
!1. Growth Firms:
In growth firms internal rate of return is greater than the normal rate(r > k). Therefore,
r/k factor will greater than 1.
Such firms must reinvest retained earnings since existing alternative investments offer
a lower return than the firm is able to secure. Each rupee of retained earnings will
have a higher weighting in Walters formula than a comparable rupee of dividends.
Thus, large the firm retains, higher the value of the firm. Optimum dividend payout
ratio for such a firm will be zero.
2. Normal Firm
Normal firms comprise those firms whose internal rate of return is equal to normal
capitalization (r=k). These firms earn on their investments rate of return equal to
market rate of return. For such firms dividend policy will have no effect on the market
value per share in the Walters model. Accordingly, retained earnings will have the
same weighted value as dividends. In this case the market value per share is affected
by the payout ratio.
3. Declining Firms
! 16
Firms which earn on their investments less than the minimum rate required are
designated as declining firms. The management of such firms would like to distribute
its earnings to the stockholders so that they may either spend it or invest elsewhere to
earn higher return than earned by the declining firms. Under such a situation each
rupee of retained earnings will receive lower weight than dividends and market value
of the firm will tend to be maximum when it does not retain earnings at all.
4. Evaluation of the Walters Model
Professor Walter has endeavoured to show in an erudite manner the effects of
dividend policy on value of equity shares under different situations of a firm.
However, the basic premises on which edifice of the theory are laid down are
unrealistic and therefore, conclusions drawn from the Walters model are hardly true
for real life situations.
!Thus, for instance assume that a firm finances its investment opportunities only by
means of internal sources and no external financing is resorted to for this purpose.
Under such a situation, either the value of the firms investment or dividend or both
will be sub-optimum.
In its attempt to maximize the value of the firm, the management should go on
making investments so long as return of investment is equal to the cost of capital.
This is the optimum level of investment; the remaining amount should be raised from
external sources. On the contrary, Walter argues that value of the firm is maximized
by retaining all the profits because magnitude of investments financed by retained
earnings may be less than the optimum level of investment.
! 17
Further, Professor Walter has assumed that r remains constant under all the
situations. As
a matter of fact, r tends to decrease in correspondence with increase in level of
investments.
This is why it is suggested that the management should make investments upto
optimal level where r = k.
Finally, assumption of constant cost of capital k is incorrect. On the contrary, it varies
in tune with change in risk of the firm.
!Illustration 1 : The earnings per share of a company is Rs. 8 and the rate of
capitalisation applicable is 10%. The company has before it an option of adopting (i)
50%, (ii) 75% and (iii)100% dividend payout ratio. Compute the market price of the
companys quoted
shares as per Walters model if it can earn a return of (i) 15%, (ii) 10% and (iii) 5% on
its retained earnings.
Computation of market price of Companys share by applying Walters formula
!
Now, we can calculate the market price per share based on different IRRs and
dividend payout rations.
(i) Market price per share when Ra = 15%
(a) When dividend payout ratio is 50%
Dividend paid = 8 50/100 = Rs. 4
! 18
!
!(b) When dividend payout ratio is 75%
Dividend paid = Rs. 875/100 = Rs. 6
!
!(c) When dividend payout ratio is 100%
i.e., dividend paid = Rs. 8
!
!
! 19
!
GORDONS MODEL:
Myron Gordon has also developed a model on the lines of Prof. Walter suggesting
that dividends are relevant and the dividend decision of the firm affects its value. His
basic valuation model is based on the following assumptions:
1. The firm is an all equity firm.
2. No external financing is available or used. Retained earnings represent the only
source of financing investment programmes.
3. The rate of return on the firms investment r, is constant.
4. The retention ratio, b, once decided upon is constant. Thus, the growth rate of the
firm (g = br), is also constant.
5. The cost of capital for the firm remains constant and it is greater than the growth
rate, i.e. k > br.
6. The firm has perpetual life.
7. Corporate taxes do not exist.
! 20
According to Gordon, the market value of a share is equal to the present value of
future stream of dividends. Thus, Gordons basic valuation formula is as under:
!
OR
!
!Where,
P = Price of shares
E = Earnings per share
b = Retention Ratio
ke = Cost of equity capital
br = g = growth rate in r, i.e., rate of return on investment of an all-equity firm
D = Dividend per share
The implications of Gordons basic valuation model may be summarized as below :
1. When the rate of return of firms investment is greater than the required rate of
return, i.e. when r > k, the price per share increases as the dividend payout ratio
decreases.
Thus, growth firm should distribute smaller dividends and should retain maximum
earnings.
2. When the rate of return is equal to the required rate of return, i.e, when r = k, the
price per share remains unchanged and is not affected by dividend policy. Thus, for a
normal firm there is no optimum dividend payout.
! 21
MODIGLIANI-MILLERS MODEL (M-MS MODEL) :
Modigliani-Millers (M-Ms) thoughts for irrelevance of dividends are most
comprehensive and logical. According to them, dividend policy does not affect the
value of a firm and is therefore, of no consequence. It is the earning potentiality and
investment policy of the firm rather than its pattern of distribution of earnings that
affects value of the firm.
Basic Assumptions of M-M Approach
(1) There exists perfect capital market where all investors are rational. Information is
available to all at no cost; there are no transaction costs and floatation costs. There is
no such investor as could alone influence market value of shares.
(2) There does not exist taxes. Alternatively, there is no tax differential between
income on dividend and capital gains.
(3) Firm has uncertainty as to future investments and profits of the firm. Thus,
investors are able to predict future prices and dividend with certainty. This assumption
is dropped by M-M later.
M-Ms irrelevance approach is based on arbitrage argument. Arbitrage is the process
of entering into such transactions simultaneously as exactly balance or completely
offset each other. The two transactions in the present case are payment of dividends
and garnering funds to exploit investment opportunities. Suppose, for example, a firm
decides to invest in a project it has alternatives:
(1) Pay out dividends and raise an equal amount of funds from the market;
(2) Retain its entire earnings to finance the investment programme. The arbitrage
process is involved where a firm decides to pay dividends and raise funds from
outside.
! 23
When a firm pays its earnings as dividends, it will have to approach market for
procuring funds to meet a given investment programme. Acquisition of additional
capital will dilute the firms share capital which will result in drop in share values.
Thus, what the stockholders gain in cash dividends they lose in decreased share
values. The market price before and after payment of dividend would be identical and
hence the stockholders would be indifferent between dividend and retention of
earnings. This suggests that dividend decision is irrelevant.
M-Ms argument of irrelevance of dividend remains unchanged whether external
funds are obtained by means of share capital or borrowings. This is for the fact that
investors are indifferent between debt and equity with respect to leverage and cost of
debt is the same as the real cost of equity.
Finally, even under conditions of uncertainty, divided decision will be of no relevance
because of operation of arbitrage. Market value of share of the two firms would be the
same if they identical with respect to business risk, prospective future earnings and
investment policies.
This is because of rational behavior of investor who would prefer more wealth to less
wealth.
Difference in respect of current and future dividend policies cannot influence share
values of the two firms.
M-M approach contains the following mathematical formulations to prove irrelevance
of dividend decision.
The market value of a share in the beginning of the year is equal to the present value
of dividends paid at the year end plus the market price of the share at the end of the
year, this can be expressed as below :
! 24
!
Where,
P0 = Existing price of a share
K = Cost of capital
D1 = Dividend to be received at the year end
P1 = Market value of a share at the year end
If there is no additional financing from external sources, value of the firm (V) will be
number of share (n) multiplied by the price of each share (Po). Symbolically:
!
If the firm issues m number of share to raise funds at the end of year 1 so as to finance
investment and at price P1, value of the firm at time o will be :
!
Thus, the total value of the firm as per equation (3) is equal to the capitalized value of
the dividends to be received during the period, plus the value of the number of share
outstanding at the end of the period, less the value of the newly issued shares.
A firm can finance its investment programme either by ploughing back of its earnings
or by issue of new share or by both. Thus, total amount of new share that the firm will
issue to finance its investment will be :
mP1 = I1 (X1 - nD1)
Where,
! 25
mP1 = Total amount of funds raised by issue of new share to finance investment
projects.
I1 = Total amount of investment during first period
X1 = Total amount of net profit during first period
Criticism of MM Approach
MM hypothesis has been criticised on account of various unrealistic assumptions as
given below.
1. Perfect capital market does not exist in reality.
2. Information about the company is not available to all the persons.
3. The firms have to incur flotation costs while issuing securities.
4. Taxes do exit and there is normally different tax treatment for dividends and capital
gain.
5. The firms do not follow a rigid investment policy.
6. The investors have to pay brokerage, fees etc., while doing any transaction.
7. Shareholders may prefer current income as compared to further gains.
Illustration: Agile Ltd. belongs to a risk class of which the appropriate capitalisation
rate is
10%. It currently has 1,00,000 shares selling at Rs. 100 each. The firm is
contemplating declaration of a dividend of Rs.6 per share at the end of the current
fiscal year which has just begun. Answer the following questions based on Modigliani
and Miller Model and assumption of no taxes:
(i) What will be the price of the shares at the end of the year if a diviend is not
declared?
(ii) What will be the price if dividend is declared?
! 26
(iii) Assuming that the firm pays dividend, has net income of Rs. 10 lakh and new
investments of Rs. 20 lakhs during the period, how many new shares must be issued?
!Solution:
Modigliani and Miller - Dividend Irrelevancy Model
!
!
100 1.10 = P1 + 6
110 = P1 + 6
P1 = 110 - 6
P1 = Rs. 104
! 27
!(ii) Calculation of No. of Shares to be issued
!Alternatively, the number of new shares to be issued is calculated as follows :
!
Where,
n = Number of Shares outstanding at the beginning of the period i.e., 1,00,000 shares
N = Change in the number of Shares outstanding during the period (to be
ascertained)
I = Total investment required for capital budget i.e., Rs. 20,00,000
E = Earning of the firm during the period after payment of dividend.
If dividend declared =10,00,000 - 6,00,000 = Rs. 4,00,000
If no dividend declared = 10,00,000
Now we can calculate the number of new shares to be issued :
(I) If dividend declared:
!
Particulars Dividend Declared
Dividend not declared
Net Income Less: Dividend Paid Retained Earning New investment Amount to be raised by new issue (A) Market Price per share (B) New shares to be issued (A / B)
10,00,000 6,00,000
10,00,000
4,00,000 10,00,000
16,00,000 10,00,000
104 110
15,385 9,091
! 28
(II) If no dividend declared :
!
MM Dividend irrelevance theory
!
Therefore, whether dividends are paid or not, value of the firm remains the same as
per M.M. approach.
!TYPES OF DIVIDEND POLICY:
The various types of dividend policies are discussed as follows:
1. Regular Dividend Policy
Payment of dividend at the usual rate is termed as regular dividend. The investors
such as retired persons, widows and other economically weaker persons prefer to get
regular dividends.
A regular dividend policy offers the following advantages.
a. It establishes a profitable record of the company.
b. It creates confidence amongst the shareholders.
c. It aids in long-term financing and renders financing easier.
d. It stabilizes the market value of shares.
Particulars Dividend Declared
Dividend not declared
Existing shares New shares issued Total No. of shares at the end Market price per share Total market value of shares at the year end
1,00,000 15,385
1,00,000 9,091
1,15,385 1,09,091
104 110
1,20,00,000 1,20,00,000
! 29
e. The ordinary shareholders view dividends as a source of funds to meet their day-
today living expenses.
f. If profits are not distributed regularly and are retained, the shareholders may have to
pay a higher rate of tax in the year when accumulated profits are distributed.
However, it must be remembered that regular dividends can be maintained only by
companies of long standing and stable earnings. A company should establish the
regular dividend at a lower rate as compared to the average earnings of the company.
2. Stable Dividend Policy
Under this policy, stable or almost stable rate of dividend is maintained.
Company maintains reserves in the years of prosperity and uses them in paying
dividend in lean years. If company follows stable dividend policy, the market price
of its shares shall be higher. 'There are several reasons why investors prefer
stable dividend policy. Main reasons are
(a) Confidence among Shareholders: A regular and stable dividend payment
may serve to resolve uncertainty in the minds of shareholders. There are 'many resorts
not to cut the dividend rate even if its profits are declining, it maintains the -rate of
dividend by appropriating its reserves. Stable dividend presents a good
image of the company and thus gains the confidence of the shareholders and the
goodwill of the company increases in the eyes of the investors
(b) Income Conscious Investors: The second factor favoring stable dividend
policy is that some investors are income conscious and favor a stable rate of
dividend. They, too, never favor an unstable rate of dividend. A stable
dividend policy may also satisfy such investors.
! 30
(c) Stability in Market Price of Shares: Other things being equal, the market
price vary with the rate of dividend the company declares on its equity shares.
The value of shares of a company 'laving a stable dividend policy fluctuates
not widely even if the earnings of the company is lower than the previous year.
Thus, this policy buffers the market price of the stock.
(d) Encouragement to Institutional Investors: A stable dividend policy attracts
investments from institutional investors. Such institutional investor generally
prepare a list of securities, mainly incorporating the securities of the companies
having stable dividend policy in which they invest their surpluses or their long-
term funds such as pensions or provident funds etc.
In this way, stability and regularity of dividends not only affects
the market price of shares but also increases the general credit of the
company that benefits the company in the long run. The company with stable
dividend policy can formulate its financial planning very easily because the
financial manager can correctly estimate the future demand and supply of
capital in the firth. Timing of dividend payment can also be forecasted
easily by preparing cash flow statement.
!Stability of dividends can taken three distinct forms:
!(a) Constant dividend per share: Under this policy, the management follows the policy
of paying a fixed amount of dividend per share every year irrespective of the
fluctuations in the earnings. It does not imply that the rate of dividend will never
! 31
be increased. When the earnings of the company increase at a new level and the
management is of the view that it can easily .maintain that level of earnings, it
increases the rate of dividend per share. The policy is easy to follow when company
earnings are stable. lf earnings fluctuate widely, the company can policy by
maintaining a dividend fluctuation fund in surplus years.
!
(b) Constant payout ratio: Some companies follow the policy of paying a fixed per cent
or net profits as dividend every year, i e., policy of constant' payout ratio.
Suppose, a
company adopts a 40 per cent payout ratio, it means, 40 per cent net earnings of
the company will be paid-out to shareholders every year as dividend. In the year of
loss, no dividend is paid. Internal financing under this policy is automatic. For
example, in the above case, 60% of the profits are transferred to reserves. Thus the
policy leaves nothing to the management discretion.
! 32
!
(c) Stable rupee dividend plus extra dividend: Some companies follow a policy of
paying constant low dividend per share plus an extra dividend in the years of high
profits.
Such a policy is most suitable to the firm having fluctuating earnings from year to
year.
Dangers of Stable Dividend Policy
In spite of many advantages, the stable dividend policy suffers from certain
limitations. Once a stable dividend policy is followed by a company, it is not easier to
change it. If the stable dividends are not paid to the shareholders on any account
including insufficient profits, the financial standing of the company in the minds of
the investors is damaged and they may like to dispose off their holdings. It adversely
affects the market price of shares of the company.
And if the company pays stable dividends in spite of its incapacity, it will be suicidal
in the long-run.
!3. Irregular Dividend Policy
! 33
Some companies follow irregular dividend payments on account of the following:
a. Uncertainty of earnings.
b. Unsuccessful business operations.
c. Lack of liquid resources.
d. Fear of adverse effects of regular dividends on the financial standing of the
company.
!4. No Dividend Policy
A company may follow a policy of paying no dividends presently because of its
unfavourable working capital position or on account of requirements of funds for
future expansion and growth.
!5. Residual Dividend Policy
When new equity is raised floatation costs are involved. This makes new equity
costlier than retained earnings. Under the Residual approach, dividends are paid out
of profits after making provision for money required to meet upcoming capital
expenditure commitments.
!STABILITY OF DIVIDEND:
Another important dimension of a dividend policy is the stability of dividends i.e.
how stable, regular or steady should the dividend stream be, over time? It is generally
said that the shareholders favour stable dividends and those dividends, which have
prospects of steady upward growth. If a firm develops such a pattern of paying stable
and steady dividends, then the investors/shareholders may be willing to pay a higher
! 34
price for the shares. So while designing a dividend policy for the firm, it is also to be
considered as to whether the firm will have a consistency in dividend payments or the
dividends will fluctuate from one year to another. In the long run, every firm will like
to have a consistent dividend policy, yet fluctuations from one year to another may be
unfavourable.
Rationale for stability of dividend
Most of the firms follow stable dividends or gradually increasing dividends due to
following reasons
a. Many investors consider dividends as a part of regular income to meet their
expenses.
Hence, they prefer a predictable pattern of dividends rather than fluctuating pattern.
A fall in the dividend income may lead to sale of some shares. On the other hand
when the dividend income increases, an investor may invest some of the proceeds as
reinvestment in shares. Both the cases involve transaction cost and inconvenience for
investor. Hence, they prefer regular dividends.
b. The dividend policy of firms conveys a lot to the investors. Increasing dividends
means better prospects of the company. On the contrary, decreasing dividends suggest
bad earnings expectations. In addition, stable dividends are sings of stable earnings of
the company. On the other hand, varying dividends lead to uncertainty in the mind of
shareholders.
c. Certain investors mainly institutional, consider the stability of dividends as an
important criterion before they decide on the investment in that particular firm.
!
! 35
Illustration 1
A company has following capital :
7% Preference Shares of Rs. 100 each 6,00,000
Ordinary Shares of Rs. 10 each 16,00,000
22,00,000
The following information are available relating to its financial year ending
31-12-2008:
i) Profit, after taxation @ 40%, Rs. 5,42,000
ii) Ordinary dividend paid 20%.
iii) Depreciation Rs. 1,20,000
iv) Market price of Ordinary Shares Rs. 40
v) Capital Commitment Rs. 2,40,000.
You are required to calculate the following:
a) The dividend yield on the Ordinary Shares.
b) The cover for the preference and Ordinary dividends.
c) The earnings yield,
d) The price - earnings ratio,
e) The Net Cash Flow,
f) The reason for the comparison of net cash flow with capital commitment.
Solution:
a) Dividend yield on ordinary shares (or) dividend yield ratio
= (DPS / market price) 100
= (10 20% /40) 100
= 5%
! 36
[Market price = Capitalized value of dividend]
b) Dividend coverage ratio:
Preference = (PAT / Preference dividend)
= 542000 / 42000
= 12.9 times
Equity = (PAT Preference dividend) / equity dividend
= 500000 / 320000
= 1.5625 times
c) Earnings yield ratio = (EPS / market price ) x 100
= (3.125 / 40) x 100
= 7.8125 %
[EPS = 500000 / 160000 = Rs 3.125]
d) Price Earning Ratio = [(40 / 3.125)] = 12.8 times
(Market price / EPS)
e) Net cash flow Rs
PAT 542000
(+) depreciation 120000
662000
(-) preference dividend 42000
(-) equity dividend 320000
Net cash flow 300000
f) Since the cash flow position shows the firms ability to meet the capital expenditure
/ Capital commitment.
!! 37
Illustration 2: ABC Ltd. has a capital of Rs.10 lakhs in equity shares of Rs.100 each.
The shares currently quoted at par. The company proposes declaration of a dividend
of Rs.10 per share at the end of the current financial year. The capitalisation rate for
the risk class to which the company belongs is 12%.
What will be the market price of the share at the end of the year, if
i) A dividend is not declared?
ii) A dividend is declared?
iii) Assuming that the company pays the dividend and has net profits of Rs.5,00,000
and makes new investments of Rs.10 lakhs during the period, how many new shares
must be issued? Use the M.M. model.
!Solution:
Modigliani Miller Approach
n = no of shares = 10000
P0 = market price = Rs100
D1 = Expected dividend = Rs10
Ke = cost of capital = 12%
i. Market price of share ( P1) if dividend not declared
Given D1 = 0
We know,
P0 = (D1+P1)/ (1+Ke)
P1 = 112
ii. P1 if dividend declared
D1 = Rs10
! 38
P0 = (D1+P1) / (1+ Ke )
P1 = Rs.102
iii. No of shares to be issued :
n = (I E + n D1 )/ P1
= (1000000 500000 + 100000) / 102
= 5882 shares
!Illustration 3
A textile company belongs to a risk-class for which the appropriate PE ratio is 10. It
currently has 50,000 outstanding shares selling at Rs.100 each. The firm is
contemplating the declaration of Rs.8 dividend at the end of the current fiscal year
which has just started. Given the assumption of MM, answer the following questions:
i) What will be the price of the share at the end of the year: (a) if a dividend is not
declared, (b) if it is declared?
ii) Assuming that the firm pays the dividend and has a net income of Rs.5,00,000 and
makes new investments of Rs.10,00,000 during the period, how many new shares
must be issued?
iii) What would be the current value of the firm: (a) if a dividend is declared, (b) if a
dividend is not declared?
!Solution:
Given,
P/E ratio = 10
n = 50,000shares
! 39
P0 = Rs. 100
D1 = Rs. 8
E = Rs. 5,00,000
I = Rs. 10,00,000
Ke = 1 / (P/E ratio)
1. Calculation of P1
1. If dividend not declared:
P0 = (D1+ P1) / (1+Ke)
P1 = Rs110
2. if dividend declared:
P0 = (D1+ P1) / (1+Ke)
P1 = Rs.102
3. If the company pay dividend:
P1 = Rs102
n = (I E +nD1) / P1
No of new shares, n = 900000 / 102 = 8823.5294 shares
4. Value of the firm:
a) If the company pay dividend:
V = (n + n) P1 = (58823.5294) 102
= Rs6000000
b) If the company does not pay dividend:
V = (n+n) P1 = 54545.4545 x 110
= Rs6000000
Working notes:
! 40
n = (1000000 - 500000) / 110 = 4545.4545
!Illustration 4
(i) From the following information supplied to you, ascertain whether the firms D/P
ratio is optimal according to Walter. The firm was started a year ago with an equity
capital of Rs. 20 lakh.
Earnings of the firm Rs 2,00,000.00
Dividend paid 1,50,000.00
P/E ratio 12.50
Number of shares outstanding, 20,000 @ Rs.100 each. The firm is expected to
maintain its current rate of earnings on investment.
ii) What should be the P/E ratio at which the dividend payout ratio will have no effect
on the value of the share?
iii) Will your decision change if the P/E ratio is 8, instead of 12.5?
Solution:
i. Ke = (EPS / market price) = 1 /(12.5) = 8 %
r = (200000 / 2000000) x 100 = 10 %
Payout ratio = (150000/200000) x 100 = 75%
It is the growth firm (r > Ke), as per WALTERs model the optimum payout ratio is
Zero.
So in the given case pay out ratio is not optimum.
Proof:
a). Market price at 75% payout ratio
EPS = Rs10
! 41
DPS =Rs7.5
r = 10 % & Ke = 8%
!
!b). Market price at zero payout:
EPS = Rs10
DPS = Rs0
r = 10 % & Ke = 8 %
!
Therefore Zero Payout is optimum.
i. The payment of dividend in case of normal firms(r = Ke) has no effect on the
market value of the share.
Ke = r = 10%
P/E ratio = 10times i.e [ 1 / Ke]
ii. If P/E ratio = 8 , Ke= 12.5 %
r = 10%
When r < Ke the firm is Decline firm as per WALTER and its Optimum payout ratio
is 100%.
So in the given case it is 75% payout only, it is not optimum payout.
!! 42
Proof:
Market price at 75% payout:
!
100% payout
!
!Illustration 5
Excellence Ltd registered earnings of Rs. 800,000 for the year ended 31st March.
They finance all investments out of retained earnings. The opportunities for
investments are many. If such opportunities are not availed their earnings will stay
perpetually at Rs. 800,000. Following figures are relevant.
!
The returns to shareholders are expected to rise if the earnings are retained because of
the risk attached to new investments. As for the current year, dividend payments will
be made with or without retained earnings. What according to you, should be
retained?
!Solution:
!
! 43
Evaluation of different dividend policies:
!
!From the above policies, policy B gives more value to the share holders. Hence it is
advisable to adopt the policy B.
Illustration 6
X Ltd. has 1000 shares of Rs 10 each raised at a premium of Rs. 15 per share. The
companys retained earnings are Rs. 552500. The Companys stock sells for Rs. 20
per share.
a. If a 10% stock dividend is declared how many new shares would be issued?
b. What would be the market price after the stock dividend?
c. How would the equity account change?
d. If a 25% stock dividend is declared what changes will take place?
e. If the company instead declares a 5:1 stock split, how many shares will be
outstanding?
What would be the new par value? What would be the new market price?
! 44
f. If the company declares a 1:4 reverse split, how many shares will be outstanding?
What would be the new par value? What would be the new market price?
g. If the company declares a dividend of Rs. 2 per share and the stock goes ex
dividend tomorrow, what will be the price at which it will sell?
!Solution:
a) If 10% stock dividend declared:
No of new shares issued as bonus = 100
b) Market price after bonus issue = [(1000 x 20) + (100 x 0 )] / 1100
= Rs.18.18
c) Change in equity account
Equity share capital increased by Rs1000
Reserves decreased by Rs1000.
Hence, there is no change in the Net Equity
d) If 25% stock dividend declared
1) No. of new shares issued = 1000 @ 25 % = 250 shares
2) Market price after stock dividend = [(1000 x 20) + (250 x 0)] / 1250
= Rs.16
3) Change in EQUITY account:
Capital increased by Rs. 2500
Reserve decreased Rs.2500
There is no change in Net Equity.
e) If the company declares 5 : 1 stock split i.e. 5 shares issued in exchange of 1 share
each.
! 45
No of shares outstanding = 5000
New face value of share = 10/ 5 = Rs.2
New market price = 20 / 5 = Rs.4
f) If the company declares 1: 4 reverse split i.e 1 share issued in exchange of every 4
shares.
No of shares outstanding = 250
New face value = 4 x 10 = Rs.40
Market price = 20 x 4 = Rs.80
g) Cum dividend market price = Rs. 20
(-) dividend = 2
Ex-dividend market price Rs. 18
Illustration 7
Following is the capital structure of Progressive Co. Ltd. as on 31st March, 2009.
Rs.
Equity Share Capital (1,00,000 shares of Rs. 10 each) 10,00,000
Share premium 15,00,000
Reserves & Surpluses 5,00,000
Net worth 30,00,000
On 1st April, 2007, the company made a bonus issue of two shares for every five held.
The market price at the time of bonus issue was Rs. 40 per share. X holds 100 shares
of the Progressive Co. Ltd. purchased on 1st April, 2003 a market price of Rs. 30. He
sold these shares on 31st March, 2009 at Rs. 50 per share. The income tax rate for X
is 20% and capital gain tax is 15% for him. If the company pays a regular dividend of
10% on par before transferring earnings to reserves and surpluses, state whether X
! 46
was able to earn his required rate of return of 10% on his investment? (The PV at 10%
1st year 0.91; 2nd year 0.83; 3rd year 0.75; 4th year 0.68; 5th year 0.62 and 6th year
0.56)
Solution:
Appraisal of Investment decision: [NPV method ]
1) Initial Investment (out flow): 100 shares @ 30 each = 3000
2) Present value recurring cash inflows
!
!3) Present value of terminal cash inflow:
Sale proceeds 140shares @ 50 each = 7000
(-) capital gain tax 4000@ 15% = 600
6400
Its present value = 6400 x 0.56 = 3584
4) NET PRESENT VALUE:
Present value of cash inflow (407.52+3584) = 3,991.52
(-) outflow 3,000
Net present value 991.52
The investment yields more than 10 % return to the investor.
! 47