ASSIGNMENT

Course Name- Advance Corporate

Financial Management
Module 5: Dividend Policy

1.Explain Theories of Dividend Policy: Relevance Dividend Decision?

The relevance theory of dividend argues that dividend decision affects the market value of
the firm and therefore dividend matters. This theory suggests that investors are generally
risk averse and would rather have dividends today (“bird-in-the-hand”) than possible share
appreciation and dividends tomorrow. The relevance theory of dividend proposes that
dividend policy affect the share price.
Therefore, according to this theory, optimal dividend policy should be determined which
will ensure maximization of the wealth of the shareholders.

Relevance theory can be discussed with following models:

 Walter Approach
 Gorden Approach
 Dividend Capitalization
 Dividend Signaling

Walter Approach:
The Walter approach was given by James E Walter and is based on a simple argument that
where the reinvestment rate, that is, rate of return that the company may earn on retained
earnings, is higher than cost of equity (rate of return of the shareholders), then it would be
in the interest of the firm to retain the earnings.

If the company’s reinvestment rate on retained earnings is the less than shareholders’ rate
of return, the company should not retain earnings. If the two rates are the same, then the
company should be indifferent between retaining and distributing.

The Walter’s model is based on the following assumptions:

The firm finances its entire investments by means of retained earnings only. Internal rate of
return (r) and cost of capital (KE) of the firm remains constant. The firms’ earnings are either
distributed as dividends or reinvested internally.
The earnings and dividends of the firm will never change.
The firm has a very long or infinite life.

Hence, the basis of Walter formula is:

VE = D /KE – g) …………….Eq.

Where, VE = market value of equity shares

D = initial dividend
KE = costs of equity
and
g = expected growth rate of earnings

Gordon Approach

Gordon Approach (The Bird-in-the-Hand Theory): The essence of the bird-in-the-hand

theory of dividend policy (advanced by John Litner in 1962 and Myron Gordon in 1963) is
that shareholders are risk-averse and prefer to receive dividend payments rather than
future capital gains. Shareholders consider dividend payments to be more certain that
future capital gainsthus a “bird in the hand is worth more than two in the bush”.

Gordon contended that the payment of current dividends “resolves investor uncertainty”.
Investors have a preference for a certain level of income now rather that the prospect of a
higher, but less certain, income at some time in the future.

The key implication, as argued by Litner and Gordon, is that because of the less risky nature
dividends, shareholders and investors will discount the firm’s dividend stream at a lower
rate of return, ‘r’, thus increasing the value of the firm’s shares.

Assumptions of Gordon’s Model

The Gordon’s Model is based on the following assumptions:

1. The firm is an all-equity firm.
2. There is no outside financing and all investments are financed exclusively by retained
earnings.
3. Internal rate of return (R) of the firm remains constant.
4. Cost of capital (KE) of the firm also remains same regardless of the
5. change in the risk complexion of the firm.
6. The firm derives its earnings in perpetuity
7. The retention ratio (b) once decided upon is constant.
Thus, the growth rate (g) is also constant (g = br).
8. Corporate tax does not exist.
2.Write about Modigliani and Miller (MM) Approach?

Modigliani and Miller (MM) Approach

This theory was proposed by Franco Modigliani and Merton Miller in 1961 who argued
that the value of the firm is determined by the basic earning power, the firm’s risk and
not by the distribution of earnings. The value of the firm therefore depends on the
investment decisions and not the dividend decision. However, their argument was based
on some assumptions.
 Assumptions of MM hypothesis

 The capital markets are perfect and all the investors behave rationally.
 There are no taxes and flotation costs and if the taxes are there then there is no
difference between the dividends tax and capital gains tax.
 No transaction costs associated with share floatation.
 The firm’s investment policy is independent of the dividend policy. The effect of this
assumption is that the new investments out of retained earnings will not change and
there will not change in the required rate of return of the firm.
 There is perfect certainty by every investor as to future investments and profits of the
firm. Thus, investors are able to forecast earnings and dividends with certainty.

The MM hypothesis is based upon the arbitrage theory. The arbitrage process involves
switching and balancing the operations. Arbitrage leads to entering into two transactions
which exactly balance or completely offset the effect of each other.

The two transactions are paying of dividends and raising external capital. Since the firm
uses retained earnings to finance new investments, the paying of dividends will require
the firm to raise the capital externally. The arbitrage theory suggests that the dividend
effect will be exactly offset by the effect of raising additional share capital.

When the dividends are paid to the shareholders, the market price of share decreases
(because of external financing). Thus, what is gained by the shareholders as a result of
dividends is completely neutralized by the reduction in the market value of the shares.

According to MM, the investors will thus be indifferent between dividends and retained
earnings. The market value of the shares will depend entirely on the expected future
earnings of the firm.

3.Elaborate Dividend Policies –Stable Dividend?

A business with a stable dividend policy pays out a steady dividend every given period,
regardless of the volatility in the market. The exact amount of dividends that are paid out
depends on the long-term earnings of the company. The dividend’s growth is in line with
the company’s long-term earnings.

Under a stable dividend policy, it is common for companies to distribute dividends every
quarter, with the payout in line with the quarterly earnings of the company. However, it can
also be paid out annually or semi-annually. The stable dividend policy is one of the most
popular policies because the company’s volatility is not reflected in the dividend payout.
Shareholders can be certain that they will receive a dividend payment at least once a year.

A dividend is a reward that a company gives to its shareholders for investing in the
company. The dividends can be distributed in many different ways, such as cash payment or
through stock shares. The board of directors of a company decides how much of a dividend
to give out and how to time the redistribution of profits.

One of the most important decisions made by the shareholders in the company is the
dividend policy they need to follow. At the highest level, a company faces two decisions:
retain profits or distribute them to the shareholders. Sometimes, the company may choose
to retain the profits in the company for a variety of reasons, such as potential investment
opportunities for the company, future earnings, flotation costs, tax liabilities, or other
considerations that restrict the company from paying out a dividend.

After the company makes a decision on what they should do with the profits, the next step
is to create the dividend policy. The dividend policy acts as a tool for the company to attract
investors and receive preferential treatment in the financial markets. The investors’
preferences also play a key role in deciding the type of dividend policy to use.

The tax policy of the country also determines if the shareholder would want to receive the
stock in cash or as stock repurchase options.

Implementation of the Stable Dividend Policy:

Constant payout ratio

This is when a certain specified percentage of the company’s earnings is distributed to

shareholders as dividends. Many companies prefer the constant payout policy as it makes it
easier for management to decide how much of the earnings should be retained.

Constant dividend per share

The company distributes a fixed amount of cash dividends. It creates a reserve that allows
them to pay a fixed dividend even when earnings are low or there are losses. The constant
dividend policy is more suited for companies whose earnings remain stable over a number
of years.

Combination of the two policies

Under a combination of the policies, the company distributes a fixed amount of regular
dividend in addition to an extra dividend that is paid in line with its earnings. The
 combination policy allows the management to be flexible and is a good option for
companies whose earnings constantly fluctuate.

4.Describe Stock Split Corporate Dividend Behavior?

For investors, it can be pretty exciting to hear that a stock you own is about to be split,
because a share price that is too high is a good problem to have and one that's typically
confronted by successful and growing companies. While a split doesn’t actually make
your investment any more valuable in and of itself, a lower share price and the resulting
increase in trading liquidity can certainly attract additional investors. However,
sometimes that initial feeling of pride in a stock split is followed by confusion as investors
wonder how the stock split affects things like outstanding market orders, dividend
payouts, or capital gains taxes.

The good news is that, in the electronic age, most of the necessary adjustments are made
for you. Still, it’s a good idea to understand how a split works and how it can impact—or
not impact—your investment strategy.
 Stock Splits 101

Typically, the underlying reason for a stock split is that the company’s share price is
beginning to look expensive. Say XYZ Bank was selling for $50 a share a couple of years
ago but has risen to $100 per share. Its investors, no doubt, are pretty happy.

But suppose that other stocks in the financial sector are trading well below this figure.
Those other equities aren’t necessarily a better value, but casual investors sometimes
make that assumption. To fight this perception and improve liquidity, companies will
consider increasing their shares outstanding by issuing additional shares to shareholders,
which proportionately lowers the share price.

If XYZ Bank announces a 2-for-1 stock split (also described as a 2:1 split), it will issue to
investors one additional share for each share they already own. Because the bank's value
hasn't changed but the number of shares has doubled, each share is now worth $50
instead of $100. The split may elicit additional interest in the company’s stock, but
fundamentally investors are no better or worse off than before, since the market value of
their holdings stays the same.

Advanced Trading Strategies

For most trading activity, the effect of a stock split is pretty straightforward. But naturally,
investors with more complicated positions in the stock—for instance, if they’re short-
selling it or trading options—may wonder how the split affects those trades. If this is you,
take a deep breath. In both these cases, your trades are adjusted in a way that neutralizes
the impact on your investment.

5.Write short note, Eligibility for Dividends?

Eligibility for Dividends

One of the common questions that investors have after a stock split is whether their new
shares are eligible for previously declared dividends. This usually isn’t the case, because
companies splitting their stock are not increasing total dividend payments in doing so. Only
shares held as of the dividend’s record date qualify for dividend payouts. As always,
investors shouldn’t buy the stock after a dividend record date in the hopes of receiving the
related dividend.

In general, dividends declared after a stock split will be reduced proportionately per share
to account for the increase in shares outstanding, leaving total dividend payments
unaffected. The dividend payout ratio of a company shows the percentage of net income, or
earnings, paid out to shareholders in dividends.

If before the 2:1 split, XYZ Bank's target payout ratio is 20% of $100 million in earnings, that
means its target dividend payout to shareholders in total is $20 million. If XYZ has 10 million
shares outstanding, its dividend per share is $2 per share ($20 million total dividend payout
÷ 10 million shares outstanding). After the split, the company would have 20 million shares
outstanding. Per share dividends would therefore be $1 ($20 million total dividend payout ÷
20 million shares outstanding). You can see that the total dividend payout made by XYZ to
its shareholders didn't change at $20 million, but the per share dividend decreased because
of the increase in the number of shares outstanding.

In reality, most companies avoid announcing a stock split close to the date of record in
order to avoid any confusion.