Module V

Dividend
decisions
MBA 2nd Semester
Financial Management
Kavitha Menon1
WHAT ARE DIVIDENDS?
 Dividends refer to the corporate net profits
distributed among shareholders.
 Here our focus is on equity dividend & not
preference dividend as preference
shareholders are entitled to a stipulated rate
of dividend. & also relevant to widely-held
public limited companies


2
Introduction….
 There is inverse relationship between retained
earnings and cash dividends: Larger retentions,
lesser dividends; Smaller retentions, larger
dividends.
 Dividend decision is an important decision as the
firm has to choose between distributing the profits
to shareholders & ploughing them back into the
business
 Thus, the choice hinges on the effect of the decision
on the maximization of shareholder’s wealth.

3
Introduction….
§ Payment of dividends not only depends upon profitability, but
also the recommendation of Directors, i.e. known as
‘Dividend Policy’.
§ Shareholders approve the dividend as recommended by the
Directors. Dividend rate can be reduced by shareholders, but
cannot be increased
§ Dividend declared must be paid in cash only (incl. cheques and
DD)
§ Companies must transfer a percent of profits to reserves, based
on rate of dividend declared
§ Dividends (including interim dividend) are returns given to
4
shareholders out of profits earned by a company.

Dividend policy-significance
ÄOutflow of cash will create pressure on liquidity of the
company
ÄOpportunity cost of the funds distributed
ÄDividend payment maximizes shareholders’ current wealth
while retention facilitates future wealth generation.
ÄDividend payment is a sign of goodwill, and a positive impact
on investors, and in turn the market price / share.
ÄRetention leads to faster growth resulting in higher
profitability and increase in shareholders’ wealth.
ÄHarmony between payout & retention – key mgt. decision
5
Understanding dividend pay-out ratio
& retention ratio
 Retention ratio is that portion of earnings per share which is
retained in the business for its further growth. Denoted as
‘b’
 Dividend Payout ratio is that portion of earnings per share
which is paid out as dividend. Denoted as (1-b)

Retained Earnings
Corporate Profits After Tax
Dividends

6
Understanding dividend pay-out ratio
& retention ratio….An Example
EPS DPS D/P Ratio b
5 2.00 0.40 0.60
6 4.50 0.75 0.25
8 2.00 0.25 0.75
10 4.00 0.40 0.60
12 3.00 0.25 0.75

7
Dividend Payments
Mechanics of Cash Dividend Payments
Declaration Date
 this is the date on which the Board of Directors meet and declare the
dividend. In their resolution the Board will set the date of record,
the date of payment and the amount of the dividend for each share
class.
Date of Record

 is the date on which the shareholders register is closed after the

trading day and all those who are listed will receive the dividend.
Ex dividend Date

 is the date that the value of the firm’s common shares will reflect the
dividend payment (ie. fall in value)
 ‘ex’ means without.
 At the start of trading on the ex-dividend date, the share price will
normally open for trading at the previous days close, less the value
of the dividend per share. This reflects the fact that purchasers of
the stock on the ex-dividend date and beyond WILL NOT receive
the declared dividend.
Date of Payment
8
 is the date the cheques for the dividend are mailed out to the
shareholders.
Dividend Declaration Process Date-wise

December 25 January 10 January 13 February 11

Declaration Date Declaration Date Date of

Payment 9
 Dividends Declared - Dividends
declared by companies during the year-
2011
COMPANY NAME DIVIDEND DATE
Type % Announcement Record Ex-Dividend

MRO-TEK Final 0.00 05-04-2011 - 14-06-2011

Castrol Final 80.00 21-02-2011 - 13-06-2011
Goodyear Final 70.00 21-02-2011 - 08-06-2011
Infosys Final 400.00 15-04-2011 - 26-05-2011
Rel Ind Infra Final 35.00 15-04-2011 - 23-05-2011
Hexaware Tech Final 70.00 16-02-2011 25-02-2011 24-02-2011
Bosch Final 400.00 28-02-2011 - 12-05-2011
De Nora India Final 50.00 17-02-2011 - 12-05-2011
Rain Commoditie Final 46.00 25-02-2011 - 03-05-2011
Amrutanjan Heal Interim 50.00 10-02-2011 22-02-2011 21-02-2011
ABB Final 100.00 23-02-2011 - 02-05-2011
GM Breweries Final 25.00 07-04-2011 - 02-05-2011
JK Paper Interim 22.50 28-01-2011 14-02-2011 11-02-201110

Source: www.moneycontrol.com
Effect of the dividend on the stock price –
a live example
 Colgate-Palmolive (India) fell 1.01% at
Rs. 819.35 at 15:01 IST after the stock
turned ex-dividend today, 30 March
2011, for a third interim dividend of Rs.
7 per share for the year ending March
2011.
 Before turning ex-dividend, the stock offered a
dividend yield of 0.84%, based on closing
price of Rs. 827.75 on Tuesday, 29 March
2011

11
Schools of thought
 The subject matter of the dividend policy is whether payout
ratio has any impact on the market price of the share or not.
 i.e. if we change the pay-out ratio, whether market price of the
share will change
 For example, if we increase the D/P ratio, whether the market
price of the share will increase or decrease or there will be
no change.
 Hence, two schools of thought …

12
TWO SCHOOLS OF THOUGHT

13
RELEVANCE OF DIVIDENDS
 Dividend relevance implies that shareholders prefer
current dividends and there is no direct
relationship between dividend policy and market
value of a firm.
 Two theories representing this notion are:

1 Walter’s model
2 Gordon’s model


14
WALTER’S MODEL

 Professor James E. Walter studied that the choice of an

appropriate dividend policy affects the value of an enterprise.
 The key argument in support is the relationship between the
return on a firm’s investment (r ) and its cost of capital(k).
 Three types of firms:

(a)Growth firms
(b)Decline firms
(c)Normal firms

15
 Continued…
Type of firm Growth firm Normal firm Decline firm
Relation r>k r=k r<k
between r and
k
D/P ratio Zero i.e. retain Anything 100% i.e. all
its earnings as between 0 to 100 earnings are
they earn more distributed as
Market price on
Willtheir
increase No effect on the dividends
Market price
of the share investments value of the firm maximized by
– market price distribution of
is constant dividends

16
ASSUMPTIONS

 All financing through retained earnings, no external

sources of funds used.
 No change in Business risk, hence rate of return ‘r’ &
cost of capital ‘k’ remain constant
 100% payout or retention: All earnings are either
distributed as dividends or reinvested internally
 Constant EPS and dividend per share
 Firm has a perpetual life

17
Mathematical formula
r
D + ( E − D)
ke
P=
ke
 Where –
 P – The prevailing market price of the share
 D – Dividend per share
 E – Earnings per share
 r – Rate of return on the firm’s investment

18
Exercise - 1
 The following information is available in respect of a
firm:
 Capitalization rate (ke) = 0.10

 Earnings per share (E) = Rs. 10

 Assume rate of return on investments (r)
 (i) 15% (ii) 8% and (iii) 10%
Show the effect of dividend policy on the market price of

shares, using Walter’s model, but assuming a D/P ratio of

0%, 25%, 50%, 75% and 100%.

19
Conclusions from the previous exercise

20
Exercise - 2
 The earnings per share of a company is Rs. 8 and the rate of
capitalization 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 company’s quoted shares as
per Walter’s model if it can earn a return of (a) 15% (b)
10% (c) 5 % on its retained earnings.

21
Criticism of walter’s model

 No external financing – Assumes that retained earnings

finance the investment opportunities of the firm & no
external financing – debt or equity – is used.
 Constant ‘r’ – Wrong assumption as ‘r’ actually decreases
as more & more investments are made as the most
profitable investments are made first & then the poorer
investments are made. The firm should stop when r = k.
After that r<k, hence all profits should be distributed as
dividends.
 Constant cost of capital, k – Wrong assumption. It
changes directly with the risk. Hence, Walter is not
considering the effect of risk on the value of the firm.
22
GORDON’S 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.

23
Assumptions

z All equity firm – The firm is an all equity firm, it has

no debt
zNo external financing
zr and k are constant
zPerpetual earnings – The firm & its stream of
earnings perpetual.
zCorporate taxes do not exist
zRetention ratio once decided is constant forever.
Thus, growth rate(g= br) is also constant.
z ke > br = g
24
Mathematical formula
E (1 − b) D
P= =
ke − br ke − br
 Where –
 P –Price of a share
 E – Earnings per share
 b – retention ratio
 1-b – dividend payout ratio
 ke – capitalization rate or cost of capital
 br = g = growth rate * rate of return on investment
25
 D = Dividend per share
Application of gordon’s dividend model
 The market price of the share, P0, increases with the
retention ratio, b, for firms with growth opportunities
i.e. when r > k
 The market value of the share, P0, increases with the
payout ratio, 1-b, for declining firms with r < k
 The market price of the share is not affected by dividend
policy when r = k

26
Exercise - 1
 The following information is available in respect of the rate of
return on investment (r), the capitalization rate (ke) and the
EPS (E) of Hypothetical Ltd.
 r = 12%, E = Rs. 20
 Determine the value of the shares, assuming the following:

1-b ke(%)
(a) 10 20
(b) 20 19
(c) 30 18
(d) 40 17
(e) 50 16
(f) 60 15
(g) 70 14 27
Exercise 2
 Following are the details regarding three companies X
Ltd., Y Ltd., & Z Ltd.:


X Ltd. Y Ltd. Z Ltd

r 20% 15% 10%

ke 15% 15% 15%
 E Rs. 4 Rs. 4 Rs. 4

 Calculate the value of an equity share using Gordon
Model if dividend payout ratio is 50 %and 75 %.

28
Exercise - 3
 A company has a total investment of Rs. 5 lakhs in assets, and
50,000 outstanding ordinary shares of Rs. 10 per share (par
value). It earns a rate of 15% on its investments, and has a
policy of retaining 50% of the earnings. If the appropriate
discount rate of the firm is 10%, determine the price of its
share using Gordon model.
 What shall happen to the price of the share if the company has
a payout of 80% or 20%?

29
ARGUMENTS

 The crux of Gordon's arguments is a two fold

assumption:
1 Investors are risk averse
2 They put a premium on certain return and discount
/penalize uncertain returns

30
Continued…
 As investors are rational, they avoid risk.
 Payments of current dividends completely removes
the chances of any risk.
 Investors think current dividends are less risky than
potential future capital gains, hence they like
dividends.
 Hence, investors would value high payout firms more
highly, i.e. a high payout would result in a high P0.
 The above model underlying Gordon's model of
dividend relevance is also described as the bird-in –
hand argument. 31
Continued..

 Investorswould like to avoid uncertainty and would

be inclined to pay higher price for those shares on
which current dividends are paid.
 The omission of dividends or payment of low
dividends would lower the value of the shares.
 The value of market price of the share( P) increases
with the increase in the D/P ratio, and is maximum
when there are no retentions.
32
Bird-in-the-hand- Argument
 This theory states that a dividend-in-the-hand is worth more than the
present value of a future dividend.
 Myron Gordon and John Lintner (Gordon/Litner) assumed that k
would decrease as a company's payout increased.
 Thus, as a company increases its payout ratio, investors become
concerned that the company's future capital gains will dissipate
since the retained earnings that the company reinvests into the
business will be less.
 They argued that investors value dividends more than capital gains
when making decisions related to stocks.
 The bird-in-the-hand may sound familiar as it is taken from an old
saying: "a bird in the hand is worth two in the bush." In this
theory "the bird in the hand' is referring to dividends and "the
bush" is referring to capital gains.
33
IRRELEVANCE OF DIVIDENDS
 From an investor's perspective, suppose a company's
dividend is too big.
 That investor could then buy more stock with the dividend
that is over his or her expectations.
 Likewise, if, from an investor's perspective, a company's
dividend is too small, an investor could sell some of the
company's stock to replicate the cash flow he or
she expected.
 As such, the dividend is irrelevant to investors, meaning
investors care little about a company's dividend policy.
 The dividend-irrelevance theory indicates that there is no
effect of dividends on a company's capital structure or
stock price
34
 MM HYPOTHESIS
 Modigliani – Miller’s Hypothesis support the irrelevance of
dividends.
 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.
 Investors are indifferentbetween 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.
 In other words, dividend irrelevance implies that the price of
equity shares of a firm depends solely on its earnings
power and is not influenced by the manner in which its
earnings are split between dividends and retained 35

earnings.

ASSUMPTIONS OF MM HYPOTHESIS

 Perfect capital markets 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.
 No taxes exist.
 Investment policy does not change
 Investors are able to forecast future prices and
dividends with certainty
 36
Mathematical formula
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:

D1 + P1
P0 =
 Where,
1 + ke
 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 37
Explanation
 Suppose a firm has 1,00,000 shares outstanding and is planning to
declare a dividend of Rs. 5 at the end of current financial year. The
present market price of the share is Rs. 100. The cost of equity
capital, ke, may be taken at 10%. The expected market price at the
end of the year 1 may be found under two options:
 If dividend of Rs. 5 is paid
 If dividend is not paid
When Dividend of Rs. 5 is paid (the value of D1 is 5) :

 P0 = (D1 + P1)/ (1+ ke)

 P1 = P0 (1+ ke) – D1
 = 100(1.10) – 5 = Rs. 105
So, the market price is expected to be Rs. 105, if the firm pays dividend of

Rs. 5 38


 Explanation…..contd…
When, Dividend of Rs. 5 is not paid (the value of D1 is 0):
 P0 = (D1 + P1)/ (1+ ke)
 P1 = P0 (1+ ke) – D1
 = 100(1.1) - 0 = Rs. 110
 So, the market price of the share is expected to be Rs. 110, if the
firm does not pay any dividend.
 However, in both the cases, the position of the shareholders would be the
same. A shareholder having for example, one share will be having
same worth of his holding if the firm pays dividend or not. In case, the
dividend of Rs. 5 is paid, he will receive Rs. 5 from the firm as
dividend and the market price of the share would be Rs. 105, giving a
total worth of Rs. 110. In case, the dividend is not paid then the market
price of the share or the worth of the shareholder would be still Rs.
110.
39
 So, the shareholder would be indifferent if dividend is paid or not to him.
Mathematical formula -
Derivation
STEP 1 : 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:

D1 + P1
P0 =
 Where,
1 + ke
 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 40
Mathematical formula -
Derivation
STEP 2 : 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:

n( D1 +P1 )
V = nP0 =
1 +ke

41
Mathematical formula -
Derivation
STEP 3: 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:

n( D1 +P1 ) +mP1 −mP1

V = nP0 =
1 +ke
nD 1 +nP1 +mP1 −mP1
V = nP0 =
1 +ke
nD 1 +( n +m) P1 −mP1
V = nP0 =
1 +ke 42
Mathematical formula -
Derivation
STEP 4 : A firm can finance its investment programme either by
ploughing back of its earnings or by issue of new shares or by
both. Thus, total amount of new share that the firm will issue to
finance its investment will be:

mP1 = I1 − ( X 1 − nD1 ) = I1 − X 1 + nD1

 Where,
 P1 = Price of a share at the end of year 1
 I1 = total amount of investment during the first
period
 X1 = total net profit of the firm during the first
43
period
 m = new no. of shares issued
Mathematical formula -
Derivation
STEP 5 : Substituting the equation in Step 4.

nD 1 +( n +m) P1 −mP1
V = nP0 =
1 +ke
nD1 + ( n + m) P1 − ( I1 − X 1 + nD1 )
V = nP0 =
1 + ke
(n + m) P1 − I1 + X 1
V = nP0 =
1 + ke
44
Since dividend is absent in final equation, MM conclude that
dividend does not affect the market price of share.
Calculation of number of new shares
issued
 From Step 4, the number of new shares issued, m, can be
calculate

I1 − X 1 + nD1
m=
P1

45
How do the prices of shares react in
each situation ?
Situation 1 The company has sufficient cash to
Situation 2 The company does not have enough
pay dividends
Situation 3 The
cashcompany does notand
to pay dividends payrun
dividends
the
but the shareholder
company smoothly needs cash

46
Situation 1: he company has sufficient
cash to pay dividends
 What happened to the cash position after payment of
dividend?
 Cash is part of the assets owned by the shareholders. They
will now have fewer assets to claim.
 This implies there is no change in the total value of the firm
to the owners.
 The wealth of the company is reduced to the extent of the
cash payment. This leads to wealth increase of the
shareholders
 Hence, no change in the wealth position.

47
Situation 2: The company does not have
enough cash to pay dividends and run the
company smoothly
 In such a situation, the company issues new shares at the ex-
dividend price to pay dividends.
 New shareholders come into existence.
 The existing shareholder’s share will reduce but they collect
their price in the form of cash dividend.

48
Situation 3: The company does not pay
dividends but the shareholder needs cash
 Shareholders can sell part of their shares in the market at a
fair price and meet their needs.
 Thus, existing shareholders will possess lesser number of
shares and the shares will be owned by new investors.
 Therefore, value of the company will remain unchanged.

49
conclusion
 The valuation of the company under the three possible
scenarios created by various dividends decisions is not
altered.
 This suggests that dividend decision is insignificant.

50
Exercise - 1
 Agile Ltd. belongs to a risk class of which appropriate
capitalization rate is 10 per cent. It currently has 1,00,000
shares selling at Rs.100 each. The firm is contemplating the
declaration of a dividend of Rs.6 per share at the end of
current fiscal year, which has just begun.
 Answer the following questions on the basis of MM model.

1 What will be the price of the shares at the end of the year if a
dividend is not declared?
2 What will it be if it is declared?
3 Assuming that the firm pay dividend, has net income of
Rs.10,00,000 and makes new investment of Rs.20,00,000
how many new shares must be issued.
51
Exercise - 2
 ABC Ltd. has 50,000 outstanding shares. The current market
price per share is Rs.100 each. It hopes to make a net
income of Rs.5,00,000 at the end of current year. The
Company’s Board is considering a dividend of Rs.5 per
share at the end of current financial year. The company
needs Rs.10,00,000 for an approved investment expenditure.
The company belongs to a risk class for which the
capitalization rate is 10%. Show, how does the M-M
approach affect the value of firm if the dividends are paid or
not paid.

52
Exercise 3
 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 capitalization 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.
53
Exercise - 4
 X company earns Rs 5 per share, is capitalized at a rate of 10
per cent and has a rate of return on investment of 18 per
cent. According to Walter’s model, what should be the price
per share at 25 per cent dividend payout ratio? Is this the
optimum payout ratio according to Walter?


54
Exercise - 5
 Omega company has a cost of equity capital of 10 per
cent, the current market value of the firm (V) is Rs
20,00,000 (@ Rs 20 per share). Assume values for I
(new investment), Y (earnings) and D (dividends) at the
end of the year as I = Rs 6,80,000, Y = Rs 1,50,000 and
D = Re 1 per share. Show that under the MM
assumptions, the payment of dividend does not affect
the value of the firm.

55
CRUX OF THE ARGUMENT
 The crux of the MM position on the irrelevance of dividend is the
arbitrage argument.
 Arbitrage implies the distribution of earnings to shareholders and
raising an equal amount externally, the effect of dividend
payment would be offset by the effect of raising additional
funds.
 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
56
retention of earnings. This suggests that dividend decision is
irrelevant
CRITICISIMS OF MM APPROACH
 Perfect capital market does not exist in reality.
 Information about the company is not available to all the
persons.
 The firms have to incur flotation costs while issuing securities.
 Taxes do exist and there is normally different tax treatment for
dividends and capital gain.
 The firms do not follow a rigid investment policy.
 The investors have to pay brokerage, fees etc., while doing any
transaction.
 Shareholders may prefer current income as compared to furture
gains
57
Factors determining dividend policy of
a firm

58
 FACTORS DETERMINING DIVIDEND 
POLICY OF A FIRM – EXTERNAL 
[General state of Economy – in cases of uncertainty, depression in the
FACTORS
economy, the management may like to retain the earnings and build up
reserves to absorb shocks in the future and preserve liquidity.
[Capital Markets – if a firm has easy access to capital markets to raise
funds, it may follow liberal dividend policy and vice versa.
[Legal Restrictions – the management must comply to all legal
restrictions such as transfer to reserves etc.
[Contractual Restrictions – lending financial institutions may put
restrictions on dividend payments to protect their interests.
[Taxation Policy – consideration of corporate taxes and dividend
59
distribution tax to be paid by the companies.
 FACTORS DETERMINING DIVIDEND 
POLICY OF A FIRM – INTERNAL 
[Desire of Shareholders – the shareholders, being the owners of the
FACTORS
company influence the dividend payout. Their expectation for dividend
depicts companies strength, certainty and liquidity.
[Financial needs of Company – financial needs of the company may
directly conflict with shareholders’ desire. Company’s vision for future
growth and profitability may bypass the dividend expectation.
[Nature of Earnings – a firm with a stable income can afford to have
higher dividend payout and vice versa
[Desire of Control – higher dividend implies liquidity crunch that can be
met by new equity issue. New equity dilutes management control.
[Liquidity Position – prime importance for dividend payments. 60
(a) Dividend payout Ratio

 It is the percentage of the net earnings distributed to

the shareholders as dividends.
 It involves decision to payout earnings or to retain
them for re-investment.
 Indicates the percentage earnings distributed to
shareholders in cash, calculated by dividing the cash
dividend per share by its earnings per share.

61
(b)Stability of dividends

 Dividend stability refers to the payment of a certain

minimum amount of dividend regularly.
1 Constant dividend per share
2 Constant payout ratio

62
Constant dividend per share
 A policy of paying certain fixed amount per share as dividend.
 This doesn’t mean amount of dividend is fixed at all times to
come.
 Dividends are increased over the years when the earnings of the
firm increases.
EPS
EPS and DPS (Rs.)

DPS

Time in years 63
Constant payout ratio
 A policy to pay a constant percentage of net earnings as
dividend to shareholders in each dividend period.
 Dividends would fluctuate proportionately with earnings
and are likely to be highly volatile in the wake of wide
fluctuations in the earnings of a company.


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Stable rupee dividend plus extra dividend

 Stable rupee plus extra dividend: is a policy based on

paying a fixed dividend to shareholders
supplemented by an additional or extra dividend in
years of marked prosperity


65
 Why investors prefer
stable dividend policy?

 Desire for current income by investors like retired persons who

use such funds for their living expenses
 Informational contents – investors are thought to use dividends
& changes in dividends as a source of information about the
firm’s profitability
 Requirements of institutional investors - like life insurance
companies, mutual funds who invest in companies. Owing to
their large size of their investible funds, there may be an
enhancing effect on its price, and thereby shareholders’
wealth.
 66
WHAT ARE STOCK SPLITS?
 A stock split is a corporate action which splits the existing
shares of a particular face value into smaller denominations so
that the number of shares increase, however, the market
capitalization or the value of shares held by the investors post
split remains the same as that before the split.
 As the price of a security gets higher and higher, some investors
may feel the price is too high for them to buy, or small
investors may feel it is unaffordable. Splitting the stock
brings the share price down to a more "attractive" level.
 Thus, if ABC company’s shares were worth Rs 1,000 each, an
investor would need Rs 1 lakh to invest in 100 shares. If,
however, the company splits its share in the ratio of 10:1 and
the price was Rs 100, you would need a mere Rs 10,000 to
buy 100 of these shares.

67
Example
 So if a firm has a capital of Rs 10 crore, with 1 crore shares, each
with a face value of Rs 10, and when this firm opts to split its
shares into a face value of Rs 5, then it would issue 2 shares,
against 1 share held by each shareholder.
 The firm will now have two crore shares, with a face value of Rs 5,
and its equity capital would be the same at Rs 10 crore
 Once a company decides to split its shares, it calls for a book
closure. Post the book closure, the stock price falls to the same
extent as the split.
 So if the stock was trading at Rs 200, before the split, post the split,
it would trade at Rs 100 per share. However, the market value, or
market capitalization, which is the number of shares multiplied
by the market value of the stock, would not change and remain
the same.
 68
LIVE EXAMPLE – Stock split
 HDFC BANK’S BOARD APPROVES STOCK SPLIT
 The bank's board approved a share split which will result in
subdivision of each share with a nominal value of Rs 10
each into five equity shares of a nominal value of Rs 2
each, a step which will make the stock more affordable to
retail investors (April 2011)
 TATA TEA ADDS FLAVOUR TO STOCK SPLIT
 Tata Tea today joined a growing list of companies
announcing stock splits. The company has sub-divided its
equity shares of face value of Rs 10 each to Re 1 a piece.
 (April, 2010)
69
Reserve stock split

 A reduction in the number of a corporation's shares

outstanding that increases the par value of its stock
or its earnings per share. The market value of the
total number of shares (market capitalization)
remains the same.
 For example, a 1-for-2 reverse split means you get
half as many shares, but at twice the price.

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BUYBACK OF SHARES

 A buyback can be seen as a method for company to

invest in itself by buying shares from other investors
in the market.
 Buybacks reduce the number of shares outstanding in
the market.
 Buy back is done by the company with the purpose to
improve the liquidity in its shares and enhance the
shareholders’ wealth.

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BONUS SHARES

 Bonus shares involve payment to existing owners of dividend

in the form of shares.
 New shares are issued to shareholders in proportion to their
holdings ie. Shares are issued on pro rata basis to the current
shareholders while the firm’s assets, its earnings ,risk being
assumed and investors percentage ownership in the
company remains unchanged.
 For example, the company may give one bonus share for every
five shares held.

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