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NAME OF THE ASSIGNMENT:
Date of Submission: 28th April 2012
Submitted To: M. M. Mustafiz Munir
Submitted By: Ahmed Sabbir Student ID # 11-2-15-0002 EMBA Program, Spring’12
earnings stability. restrictive covenants. companies do not have choice on paying of interest to lenders – as the rate of interest is contractually fixed. generally on a quarterly basis and may be paid only out of retained earnings. Besides. However. Rate of dividends may be fixed in case of preference shares too. The amount of dividend paid for each share depends on the organization's policy towards them. One more confusion which pops up is actually relating to the extent of impact of dividends about the share cost. management has to broadly decide its policy on its broad attitude towards distribution – liberal dividend payout ratio. The more and regular the company's profitability. the regular the payment of dividends. the management pays out dividend. how much interest should a corporation pay to its bankers. These earnings are paid either in cash or in stock. there is no fixed rate of dividends. It cannot be said that the dividend paid is the cost of . Hence. Approaching along with a dividend policy will be challenging for that Company directors and economic managers of the organization. Literature Study: There are several considerations that apply in answering this question – “How much of its profits should a corporation distribute?”. or conservative dividend payout ratio. There are other factors also which decide the payment of dividend in the organization. If one were to ask this question in context of debt sources of capital – for example. Of course. Objectives: The objective of this particular section of finance is to highlight the issues of dividend policy. etc. It also discusses the significance and implications of bonus shares and stock splits and the share buyback and explains the corporate behaviour of dividends. though the percentage of dividends per share can differ from year to year. the better it is. but to keep the investors interested in the organization. degree of debt and tax factors. As interest paid is the cost of the borrowing. Organizations are not obligated legally to pay dividends. no corporate management can afford to stick to a fixed dividend payout ratio year after year – neither is such fixity of dividend payout ratio required or expected. However. in case of equity shares. due to the fact various investors have various views on existing cash dividends as well as potential capital benefits. Dividends are only paid when the company's profitability can support this payout. critically evaluate why some experts feel that dividend policy matters and to discuss the bird in the hand argument for paying current dividends. Because of this controversial nature of the dividend plan it is usually known as the Dividend puzzle. the lesser the interest a corporation pays. not from invested capital. the answer is straight forward. companies have to frame and work on a definitive policy of dividend payout ratio. It also explains the logic of the dividend irrelevance and identifies the market imperfections that make dividend policy relevant. It focuses on the importance of the stability of dividend and understands the factors of the stability of dividend.Dividend Policy Introduction: Dividends are those earnings which are distributed among stockholders of a company. These include corporate growth rate. as it depends on the profitability of the company.
Let us further suppose that the market price of the shares is obtained by capitalizing the earnings of the corporation at a certain capitalization rate – the capitalization rate itself depending on the riskiness or beta of the industry. sometimes referred to as irrelevance of dividend policy from the viewpoint of either the company or its shareholders. Assuming there are no other factors affecting the equity price of the company. This argument generally favors retention of profits by the company rather than distribution. and (b) intuitively. shareholders gain by way of appreciation in market price to the extent of 10%. • Supposing the corporation decides to retain the entire earning. if just the expected rate of return is earned by the corporation. Note that the return on equity is relevant. share prices will fall at the expected return on equity.in the first case. corporations may try to minimize the dividend distribution. and retains the whole of it. Many investors may sustain their livelihood on dividend earnings. As a counter argument to this. On the other hand. shareholders earn a cash return of 10%. • The above two points reflect the indifference. the following points emerge as regards the dividend policy: • The cost of equity is defined as the rate at which the corporation must earn on its equity to keep the market price of the equity shares constant. (a) because of leverage which shareholders may not be able to garner. Hence. Shareholders were expecting a certain rate of return on their shareholding – hence. if the company distributes the entire earnings. Therefore. The above discussion leads to the conclusion that the cost of equity is not the dividends but the return on equity – hence. retained earnings ultimately belong to the shareholders. it is contended that shareholders do not need growth only – they need current income too. the same should remain unchanged. the retained earnings increase the net asset value (NAV) of the equity shares exactly at the rate of 10%. and there is no impact on the NAV of the shares. by way of growth or capital appreciation. and in the second case.equity capital – if that was the case. as retained earnings would be leveraged and would. In other words. a corporation cannot work on the objective of minimizing dividends. shareholders reinvest/consume the income so distributed at their own rate of return. the corporation would earn on this retained profit at the applicable return on equity. the price of equity shares remains constant if the earnings are entirely distributed. On the other hand. and exactly grows by the expected rate of return if the earnings are entirely retained. that is the very reason for the shareholders to invest in the company in the first place. Suppose the corporation does not earn any profit. the shareholders earned a return of 10% . it may be contended that whether the company retains or distributes the earnings depends on whose reinvestment rate is higher – that of the company or that of the shareholders? Quite clearly. if the corporation were to distribute the entire profits. therefore. hence. in both the cases. the rate of reinvestment in the hands of the corporation is higher than that in the hands of the shareholders. On the other hand. Supposing a company earns return on equity of 10%. • Equity shareholders are the owners of the corporation – hence. merely because the corporation is not distributing profits does not mean it is depriving shareholders of the rate of return on equity. Hence. Of what avail is the . That is to say. Obviously. by way of income. benefit from the impact of leverage too. the market price of the shares should exactly go up by 10% commensurate with the increase in the NAV of the shares.
increase in market value of shares. if I need cash to spend for my expenses? However. dividend policy still remains an important consideration. Alternatively. and still be left with stock worth Tk. 110 due to retention. or by way of tax on distribution – like dividend distribution tax in India). Hence. While making the above points. growth and income are almost equivalent. if the shareholders have a capital appreciation. there are certain special points that affect particular situation that need to be borne in mind: • Company’s reinvestment rate lower than that of shareholders: Sometimes. • Tax disparities between current dividends and growth: In our discussion on indifference between current dividends and share price appreciation. they do. 100. Majority of retail investors insist on balance between growth and income. which they encash by partial liquidation of holdings. and there are those who are income-inclined. in case of preference shares. There are investors who are growth-inclined. as they do not see an exact equivalence between appreciation in market value and current cashflows. For example. the conclusion that emerges is that companies do have to strike a balance between shareholders’ need for current income. obviously. Taxability of a capital gain may not be the same as that of dividends. 10. • Shares with fixed returns: Needless to say. a certain minimum distribution is required to attain tax transparent status. the same may be taxed (either as income in the hands of shareholders. There might be other regulations or regulatory motivations for companies to distribute their profits. These regulations may impact our discussion on relevance of dividend policy on price of equity shares. the reality of the marketplace is that investors do have varying preferences for growth and income. in case of real estate investment trusts. or what is anyway intuitively understandable. More precisely. and growth opportunities by retained earnings. earn cash equal to Tk. there is no relevance of dividend policy where dividends are payable as per terms of issue – for example. Hence. we have assumed that taxes do not play a spoilsport. it is better to pay earnings out than to retain them. For example. While the above argument may point to indifference between growth and income. quite often. which is exactly the same as earning cash dividend of Tk. taxes may differentiate between current dividends and share price appreciation. shareholders have a capital gain. . In fact. For example. In such cases. Hence. 100. if I am holding equity shares worth Tk. 10 with no retention at all. As the classic theories of impact of dividends on market value of a share suggest. I can dispose off 10/110% of my shareholding. retention of earnings makes sense only where the reinvestment rate of the company is higher than that of shareholders. there are companies that do not have significant reinvestment opportunities. in the age of demat securities and liquid stock markets. if a company distributes dividends. • Entities requiring minimum distribution: There might also be situations where entities are required to do a minimum distribution under regulations. which appreciate in value to Tk. we say the reinvestment rate of the company is lesser than the reinvestment rate of shareholders.
However. is higher than cost of equity (which. ------. it would be in the interest of the firm to retain the earnings. is keeping in mind listed firms. as far is relates to market price of equity shares. If the company’s reinvestment rate on retained earnings is the less than shareholders’ rate of return. that is. as shareholders after all are the owners of the residual wealth of the company. If the two rates are the same. and is based on a simple argument that where the reinvestment rate. Hence. then. Technically speaking. . In addition. and winding up is a rarity. the company should not retain earnings. in case of unlisted firms too.• Unlisted companies: Finally. then the company should be indifferent between retaining and distributing. M&M have theorised on the irrelevance of the capital structure. that is.(2) Modigliani and Miller approach: Franco Modigliani was awarded Nobel prize in 1985 and Merton Miller in 1990 (along with Markowitz and Sharpe). the expected returns of the shareholders. rate of return that the company may earn on retained earnings. and a corollary. (b) It distributes dividends. or rate of return of the shareholders). as we have discussed before. The discussion in this chapter on dividend policy. that residual ownership may be a myth as companies do not distribute assets except in event of winding. irrelevance of the dividend payout ratio to the value of the firm. classical models such as Walter’s model or Gordon Growth model discussed below may hold relevance than market price-based models. In case of unlisted firms. the basis of Walter formula is: ------.(1) Gordon growth model: Gordon’s growth model is simply Equation (1) above. Dividend-based equity models: Walter Approach: The Walter formula belongs to James E Walter. retained earnings belong to the shareholders. Like several financial theories. one must also note that discussion above on the parity between distributed earnings and retained earnings – the latter leading to market price appreciation – will have relevance only in case of listed firms. we believe that a firm has two options: (a) It retains earnings and finances its new investment plans with such retained earnings. The Walter formula is based on a simple analysis that the market value of equity is the capitalisation of the current earnings and growth in price. M&M hypothesis is based on the argument of efficient capital markets. and finances its new investment plans by issuing new shares.
http://www. M. J.html 8.articlesbase. Modigliani (1961).tutorspoint.uk/sample-assignments/economics/ 5.co. and the valuation of shares. Gordon. Optimal investment and financing policy. and F. 34:4. http://www.aspx 6.com/finance-assignment-help. Lintner. 411-433. Review of Economics and Statistics.pdf . 18:2. growth. Dividend policy. http://vinodkothari. http://www.theglobaltutors. http://www. Dividends. M. One branch of this literature has focused on an agency-related rationale for paying dividends. Journal of Finance. Some shareholders may be monitoring manage rest. 264-272. Miller. 44:3. 3. (1963). earnings.com/index. (1962). and the supply of capital to corporations. Journal of Finance.com/college-and-university-articles/ 7.com/tutorials/dividend%20policy.powerfulwords. References: 1. 4. stock prices.Conclusion: There has been considerable research that seeks to identify the determinants of corporate Dividend policy. leverage. 2. but the problem of collective action results in too little monitoring taking place. 243-269. It is based on the idea that monitoring of the firm and its management is helpful in reducing agency conflicts and in convincing the market that the managers are not in a position to abuse their position.
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