MM THEORY OF DIVIDEND POLICY: NUMERICAL

Xavier Corporation is providing 25% returns to its shareholders. The current

market price of its share is Rs. 80 with 1.25 crore shares outstanding.

The firm is expected to earn Rs. 4 crores in the year, while its investment
requirements for the period are Rs. 6 crores. It has been distributing dividend at
75% of the earnings.

In view of its expansion requirement, it is exploring the proposition of skipping

the dividend altogether for the year while mobilizing the remaining funds by issue
of fresh shares.

Using the MM Irrelevance theory of dividend policy, examine the value of the firm
when:-

(a) The firm continues with the current dividend policy of 75% dividend pay-outs,

(b) The firm decides to skip the dividends for the year.
Solution:

By problem,

Expected Return on Equity (or, Cost of Equity) = Ke = 25% = 0.25

Market Price per share at the end of Year-0 = P0 = Rs. 80 = Prevailing Market price per
share

No. of existing equity shares = n = 1.25 crore

Investment required = I = Rs. 6 crore

Earnings available = E = Rs. 4 crore

Amount of Dividends to be paid at the end of Year-1 = Rs. 3 crores

Rs. 3 crores
Or, Dividend per share at the end of year-1 = D1 = -------------------- = Rs. 2.40 per share
1.25 crore

(a) When the firm pays out Dividends (b) When No Dividends are being paid

Step-1: Market Price per share at the end of Step-1: Market Price per share at the end of
year-1 (P1) year-1 (P1)

D1 + P 1 D1 + P1
P0 = --------------------- P0 = ---------------------
(1 + Ke) (1 + Ke)

Or, P1 = (1 + Ke) x P0 – D1 Or, P1 = (1 + Ke) x P0 – D1

P1 = (1 + 0.25) x 80 – 2.40 = Rs. 97.60 P1 = (1 + 0.25) x 80 – 0 = Rs. 100

Step-2: Amount to be raised by the issue of Step-2: Amount to be raised by the issue of
new shares (n1P1) new shares (n1P1)

n1P1 = I – (E – nD1) n1P1 = I – (E – nD1)

= 6 – (4 – 3) = 6 – (4 – 0)

= Rs. 5 crores = Rs. 2 crores

Step-3: Number of new additional shares to Step-3: Number of new additional shares to
be issued (n1) be issued (n1)

n1P1 n1P1
n1 = ------------------------ n1 = ------------------------
P1 P1

Rs. 5 crores Rs. 2 crores

n1 = ------------------------ n1 = ------------------------
Rs. 97.60 Rs. 100

Or, n1 = 0.05123 crore Or, n1 = 0.02 crore

Step-4: Value of the firm (V) Step-4: Value of the firm (V)

(n + n1) x P1 – I + E (n + n1) x P1 – I + E
V = -------------------------------------- V = --------------------------------------
(1 + Ke) (1 + Ke)

(1.25 + 0.05123) x 97.60 – 6 + 4 (1.25 + 0.02) x 100 – 6 + 4

V = ------------------------------------------------- V = -------------------------------------------------
(1 + 0.25) (1 + 0.25)

Or, Value of the firm = Rs. 100 crores Or, Value of the firm = Rs. 100 crores
 ISSUE OF BONUS SHARES

A company can pay bonus to its shareholders either in cash or in the form of
shares. Many a times, a company is not in a position to pay bonus in cash in spite
of sufficient profits because of unsatisfactory cash position or because of its
adverse effects on the working capital of the company.

In such cases, if the company so desires and the articles of association of the
company provide, it can pay bonus to its shareholders in the form of shares by
making partly paid shares as fully paid up, or by the issue of fully paid bonus
shares.

THE EFFECT OF BONUS ISSUE IS TWO-FOLD:

(a) It amounts to reduction in the amount of accumulated profits and reserves.

(b) There is a corresponding increase in the paid-up share capital of the company.

By the issue of bonus shares, the accumulated profits and reserves of the
company are converted into share capital which is used permanently in the
business and hence it is also known as Capitalization of Profits and Reserves.

SOURCES OF BONUS ISSUES

The Bonus shares can be issued out of the following:

1. Balance in the Profit & Loss Account

2. General Reserve

3. Capital Reserve

4. Balance in the Sinking Fund Reserve, after debentures have been redeemed.

5. Development Rebate reserve, Development Allowance Reserve etc. allowed

under the Income Tax Act, 1961 after the expiry of specified period (8 years).
6. Capital Redemption Reserve account

7. Share Premium account

ADVANTAGES OF ISSUE OF BONUS SHARES

1. From the view-point of the company

(a) When a company pays bonus to its shareholders in the form of shares (i.e.
Stock Dividend), and not in cash, its liquid reserves are maintained and the
working capital position of the company is not affected.

(b) Conservation of cash for meeting profitable investment opportunities.

(c) The Balance Sheet will reveal a more realistic picture of the capital structure
and the capacity of the company.

2. From the view-point of investors/shareholders

(a) The bonus shares are a permanent source of income to the investors.

(b) Even if the rate of dividend falls, the total amount of dividend may increase as
the investor gets dividend on a larger number of shares.

(c) The investors can easily sell these shares which they received free of cost and
get immediate cash, if they so desire.
DISADVANTAGES OF ISSUE OF BONUS SHARES

1. It is generally said that an investor gains nothing from the issue of Bonus
shares. It is so because the shareholder receives nothing except some additional
share certificates. But his proportionate ownership in the company remains
unchanged.

2. The issue of bonus shares leads to a drastic fall in the future rate of dividend as
it is only the capital that increases and not the earnings of the company. Thus, if a
company earns a profit of Rs. 2,00,000 against a share capital of Rs. 5,00,000 and
the capital of the company is raised by the issue of bonus shares to Rs. 8,00,000;
the rate of dividend on capital falls from 40% to 25%.

3. The earnings do not usually increase with the issue of bonus shares. The fall in
the future rate of dividend results in the fall in the market price of shares
considerably, this may cause unhappiness among the shareholders.

4. The reserves of the company after the bonus issue decline and leave lesser
security to investors.
 ISSUE OF BONUS SHARES: ACCOUNTING TREATMENT

1. The extracts are given from the draft Balance Sheet of Bharat Gears Ltd. as on
31st December, 2015:

Liabilities Amt. (Rs)

Authorized Capital:
20,000 Equity shares of Rs. 10 each 2,00,000
Issued & Subscribed Capital:
7000 Equity shares of Rs. 10 each fully called-up 70,000
Reserve Fund 36000
Profit & Loss Account 29000

The Board of Directors passed a resolution to capitalize a part of existing reserves

and profits by issuing Bonus shares. One Bonus share is being issued for every 4
equity shares held at present. For this purpose, Rs. 10,000 is to be provided out of
Reserve Fund and the balance out of Profit & Loss Account.

Set out the journal entries to give effect to the resolution and show how they
would affect the Balance Sheet of the company.

Solution:

Journal Entries

Date Particulars L/F Dr. Amt. Cr. Amt.

(Rs) (Rs)
2015 Reserve Fund A/c Dr 10,000
Dec. 31 Profit & Loss A/c Dr 7500
17,500
To Bonus to Shareholders A/c
(Being the declaration of Bonus to
shareholders at the rate of 1 share
for every 4 shares held)
Dec. 31 Bonus to Shareholders A/c Dr 17,500
To Equity Share Capital A/c 17,500
(Being the issue of bonus shares in
the ratio of 1:4)

Extracts of the Balance Sheet of Bharat Gears Limited as on Dec. 31, 2015 (after
Bonus issue)

Liabilities Amt. (Rs)

Authorized Capital:
20,000 Equity shares of Rs. 10 each 2,00,000
Issued & Subscribed Capital:
8750 Equity shares of Rs. 10 each fully called-up 87,500
Reserve Fund 26000
Profit & Loss Account 21,500
2. The extracts are given from the draft Balance Sheet of ABC Ltd. as on 31 st
December, 2015:

Liabilities Amt. (Rs)

Authorized Capital:
20,000 Equity shares of Rs. 10 each 2,00,000
Issued & Subscribed Capital:
10,000 Equity shares of Rs. 10 each 1,00,000
Reserve Fund 80,000
Profit & Loss Account 30,000

The Board of Directors passed a resolution to capitalize a part of existing reserves

and profits by issuing Bonus shares. A resolution was passed by the company
declaring bonus of 25% on Equity shares to be provided as to Rs. 15000 out of
Reserve Fund and the balance out of Profit & Loss Account. The Bonus was to be
satisfied by issuing fully paid equity shares.

Set out the journal entries to give effect to the resolution and show how they
would affect the Balance Sheet of the company.

Solution:

Journal Entries

Date Particulars L/F Dr. Amt. Cr. Amt.

(Rs) (Rs)
2015 Reserve Fund A/c Dr 15,000
Dec. 31 Profit & Loss A/c Dr 10,000
25000
To Bonus to Shareholders A/c
(Being the declaration of Bonus @
25% on Equity shares i.e. 25% on Rs.
1,00,000)
Dec. 31 Bonus to Shareholders A/c Dr 25000
To Equity Share Capital A/c 25000
(Being the issue of bonus shares in
the ratio of 1:4)

Extracts of the Balance Sheet of ABC Limited as on Dec. 31, 2015 (after Bonus
issue)

Liabilities Amt. (Rs)

Authorized Capital:
20,000 Equity shares of Rs. 10 each 2,00,000
Issued & Subscribed Capital:
12,500 Equity shares of Rs. 10 each fully called-up 1,25,000
Reserve Fund 65,000
Profit & Loss Account 20,000