Chapter 22

DIVIDEND DECISION

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 OUTLINE
• Why Firms Pay Dividends
• Dividend Policy : Payout Ratio
• Dividend Policy : Stability
• Dividend as a Residual Payment
• Corporate Dividend Behaviour
• Legal and Procedural Aspects of Dividends
• Bonus Shares and Stock Splits
• Share Buyback
• Dividend Policy in Practice
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 WHY FIRMS PAY DIVIDENDS

Plausible Reasons

• Investor preference for dividends

• Information signaling

Dubious Reasons for Paying Dividends

• Bird-in-hand fallacy

• Temporary excess cash

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 DIVIDEND POLICY : PAYOUT RATIO
The considerations relevant for determining the dividend
payout ratio are:
• Funds requirement
• Liquidity
• Access to external sources of financing
• Shareholder preferences
• Difference in the cost of external equity and retained

earnings
• Control
• Taxes  Centre for Financial Management , Bangalore
 DIVIDEND POLICY : STABILITY
Stable Dividend Payout Ratio
Earnings/Dividends

Earnings

Dividends

Time

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 DIVIDEND POLICY : STABILITY
Steadily Changing Dividends
Earnings/Dividends

Earnings

Dividends

Time

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KEY CONSIDERATIONS IN FORMULATING
THE DIVIDEND POLICY
• Investment decisions have the greatest impact on value creation.

• External equity is more expensive than internal equity (retained

earnings) because of issue costs and underpricing.
• Most promoters are averse to dilute their stake in equity and
hence are reluctant to issue external equity.

• There is a limit beyond which a firm would have real difficulty in

raising debt financing.
• The dividend decision of the firm is an important means by which
the management conveys information about the prospects of the
firm.
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 GUIDELINES FOR DIVIDEND POLICY
• Don’t pay dividends at the expense of positive NPV projects.

• Minimise the need to sell external equity.

• Define a target dividend payout ratio along with a target

debt-equity ratio, taking into account the investment needs,

managerial preferences, capital market norms, and tax code.
• Accept temporary departures from the target dividend payout
ratio and the target debt-equity ratio.
• Avoid dividend cuts.
In essence, the above guidelines imply that a firm should pursue a
smoothed residual dividend policy and not a pure residual
dividend policy or a fixed dividend payout policy.
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 DIVIDEND STREAM UNDER
DIFFERENT POLICIES

1 2 3 4 5 6 Total
Earnings Et 150.0 190.0 140.0 220.0 280.0 250.0 1230.0
Investment budget 137.0 160.0 180.0 200.0 210.0 220.0 1107.0
Equity investment Ite 68.5 80.0 90.0 100.0 105.0 110.0 553.5
Pure residual dividends Dt 81.5 110.0 50.0 120.0 175.0 140.0 676.5
Fixed dividend payout ratio 82.5 104.0 77.0 121.0 154.0 137.5 676.5
Dt (pt = 0.55)
Smoothed residual dividends 105.0 105.0 106.5 120.0 120.0 120.0 676.5

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 CONFERENCE BOARD SURVEY
A survey of dividend policies and practice, conducted by the
Conference Board in the U.S., revealed that five considerations or
guidelines were dominant in the minds of dividend decision
makers:
• The company’s earnings record and its future prospects.
• The company’s record of continuity or regularity of dividend
payments.
• The need to maintain a stable rate of dividends per share of
stock.
• The company’s cash flow, present cash position, and the
anticipated need for funds.
• The needs and expectation of the owners of the common stock.
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 CORPORATE DIVIDEND BEHAVIOUR
Lintner’s survey of corporate dividend behaviour showed
that:
• Firms set long-run target payout ratios.
• Managers are concerned more about the change in the
dividend than the absolute level.
• Dividends tend to follow earnings, but dividends follow a
smoother path than earnings.
• Dividends are sticky in nature because managers have a
reluctance to effect dividend changes that may have to be
reversed.

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 LINTNER’S MODEL

Lintner expressed corporate dividend behaviour in the form

of the following model:

Dt = cr EPSt + (1-c) Dt-1

where Dt = dividend per share for year t

c = adjustment rate
r = target payout rate
EPSt = earnings per share for year t

Dt-1 = dividend per share for year t-1

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 EXAMPLE OF LINTNER’S MODEL

Kinematics Ltd. has earnings per share of Rs 4.00 for

year t. Its dividend per share for year t – 1 was Rs 1.50.
Assume that the target payout ratio and the adjustment
rate for this firm are 0.6 and 0.5, respectively. What would
be the dividend per share for Kinematics Ltd. for year t, if
the Lintner model applies to it?

Kinematics dividend per share for year t would be:

0.5 x 0.6 x Rs 4.00 + 0.5 x Rs 1.5 = 1.95

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 LEGAL ASPECTS
The key provisions of company law pertaining to dividends
are:
• Companies can pay only cash dividends (with the exception
of bonus shares).
• Dividends can be declared for any financial year only out of

the profits of the company for that year arrived at after

providing for depreciation in accordance with the provisions
of Section 205 or out of the profits of the company for any
previous financial year or years arrived at after………….
• The Companies (Transfer to Reserves) Rules, 1975, provide
that before dividend declaration a specified percentage of
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 PROCEDURAL ASPECTS

The important events and dates in the dividend payment

procedure are:

• Board resolution

• Shareholders’ approval

• Record date

• Dividend payment

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 BONUS SHARES

• A bonus issue represents capitalisation of free reserves

built out of the genuine profits or share premium
collected in cash only

• In the wake of a bonus issue:

(a) The shareholders’ proportional ownership remains
unchanged.
(a) The book value per share, the earnings per share,
and the market price per share decrease, but the
number of shares increases.
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 STOCK SPLITS
In a stock split the par value per share is reduced and the number of shares is
increased proportionately
A comparison between a bonus issue and a stock split is given below:

Bonus Issue Stock Split

• The par value of the share is
unchanged
• A part of reserves is capitalised
• The shareholders’ proportional
ownership remains unchanged
• The book value per share, the
earnings per share, and the
market price per share decline
• The market price per share is
brought within a popular trading
range.
• The par value of the share is
reduced
• There is no capitalisation of reserves
• The shareholders’ proportional
ownership remains unchanged
• The book value per share, the
earnings per share, and the market
price per share decline
• The market price per share is
brought within a more popular
trading range.

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 SHARE BUYBACKS

• Share buybacks, referred to as equity repurchases or

stock repurchases in the US, have become possible since
1998 in India.

• In India, corporates generally choose the open market

purchase method. Under this method, a company buys
shares from the secondary market over a period of one
year subject to a maximum price fixed by the
board/shareholders

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 RATIONALE FOR BUYBACKS

• Efficient allocation of resources

• Price stability

• Tax advantage

• Control

• Voluntary Character

• No implied commitment

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 OBJECTIONS TO BUYBACKS

• Unfair advantage

• Manipulation

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 SURVEY FINDINGS
A survey of equity repurchases in the US, conducted by
S.G.Badrinath and Nikhil Varaiya, suggested five basic
reasons for equity repurchases:

• To boost stock price.

• To rationalise the company’s capital structure.

• To substitute for cash dividends.

• To prevent dilution from stock market grants.

• To give excessive cash back to shareholders.

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 REGULATION OF BUYBACKS .

• A company can buyback 10 percent of its shares annually with

board resolution. Beyond that a special resolution of
shareholders is required.
• The post-buyback debt-equity ratio should not exceed 2:1
• The buyback should not exceed 25 percent of the total paid up
capital and free reserves.
• After completing a buyback programme, a company should not
make a further issue of equity securities within a period of 6
months, except in certain cases.
• A buyback cannot be done through negotiated deals.
• The buyback process has to be handled by a merchant banker/s
duly appointed by the company.
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 DIVIDEND POLICIES IN PRACTICE

• Generous dividend and bonus policy

• More or less fixed dividend policy

• Erratic dividend policy

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 SUMMING UP
• There are several reasons for paying dividends, some
plausible and some dubious.
• The two important dimensions of a firm’s dividend policy
are: what should be the average payout ratio? How stable
should the dividends be over time?
• The smoothed residual dividend approach, which produces a
stable and steadily growing stream of dividend, often
appears to be the most sensible approach in practice.
• Lintner’s classic study of corporate dividend behaviour
showed that firms think primarily in terms of the proportion
of earnings that should be ploughed back in the firm and
firms try to reach the target payout ratio gradually over
time.
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• The amount of dividend that can be legally distributed is
governed by company law.
• The important events and dates in the dividend payment
procedure are: board resolution, shareholder approval,
record date, and dividend payment.
• Bonus shares are shares issued to existing shareholders as a
result of capitalisation of reserves.
• In a stock split the par value per share is reduced and the
number of share is increased proportionately.
• In a share buyback a company purchases its own shares from
the stock market.

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