DIVIDEND POLICY &

FIRM VALUE
(Ch-22 PC)

Dr. Tinaikar

Strictly for Private Circulation Only

DIVIDEND POLICY
 OUTLINE
• Why Firms Pay Dividends
• Dividend Policy : Payout Ratio
• Dividend Policy : Stability
• Dividend Policy Formulation
• Corporate Dividend Behaviour
• Legal and Procedural Aspects of Dividends
• Bonus Shares and Stock Splits
• Share Buyback
• Dividend Policy in Practice
 Centre for Financial Management , Bangalore
 WHY FIRMS PAY DIVIDENDS

Plausible Reasons
• Investor preference for dividends
• Information signaling
• Client Effect

Dubious Reasons for Paying Dividends

• Bird-in-hand fallacy

• Temporary excess cash

 Centre for Financial Management , Bangalore
 PLAUSIBLE REASONs
Investor Preference for Dividends
• For behavioral reasons.
• Investors like to protect their principal from spend thrift
tendencies.
• Limit spending to the dividend income so that capital
amount is maintained in tact.
Information Signaling
• Increasing dividends suggest to the market that the firm is
confident of its earning prospects and will be able to
maintain its dividend in the future as well.
• This is positive signal for the market and has a buoying
effect on the stock prices.
 PLAUSIBLE REASONS
Client Effect
• Investors have diverse preferences – some want more
dividend income; others want more capital gains; still
other want a balanced mix of dividend income and capital
gains.
• The concentration of investors in companies with dividend
policies that are matched to their preferences is called
client effect.
Agency Costs
• Shareholders are concerned that management may steal
money in some way or squander money over uneconomic
projects and may not act as a perfect agent.
• Therefore pay dividend to mitigate agency cost.
 DUBIOUS REASONS FOR PAYING DIVIDEND

Bird-in-hand Fallacy
• Investors value a security by forecasting and discounting
future dividends.
• Since there is greater uncertainty characterizing distant
dividends, investors will discount them at a higher rate.
• So Gordon suggested that stock prices will be lower for
companies that pay low dividends now in order to pay
dividends in the future.
Temporary Excess Cash
• Sometimes firms tend to pay dividend when they have
excess cash.
 DIMENSIONS OF DIVIDEND POLICY

Two Important Dimensions of a Firm’s Dividend Policy:

(1) What should be the average Payout Ratio?
(2) How stable should the dividends be over time.

The above two dimensions are conceptually distinct from one

another.

Dividend Payout Ratio = Annual Dividend per Share

Earnings per Share

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 DIVIDEND YIELD & DIVIDEND PAYOUT RATIO
 Dividend Yield = Annual Dividend Per Share
Market Price Per Share
 Dividend Payout Ratio = Annual Dividend per Share
Earnings per Share
 Dividend Yield
– Compares the amount of dividend paid by a company to its share price and
measure the return a shareholder receives through dividends per rupee invested.
– For example if a company has paid out an annual dividend Rs 10 per share on a
share trading at Rs 100 then the dividend yield is 10%. An increase in the market
price of the share reduces the dividend yield and vice-versa.
– Dividend Yield can be misleading. Some companies pay-out dividend even when
they are operating at short-term loss.
– Others may pay out dividends more aggressively, failing to reinvest the capital into
their business to maintain profitability in the long run.
 DIVIDEND YIELD & DIVIDEND PAYOUT RATIO
 Dividend Payout Ratio
– Dividend Payout ratio represents the proportion of a company’s net
earnings are paid out as dividend.
– It is a better indicator of a company’s ability to distribute dividends
consistently in the future.
– Dividend Payout ratio is highly connected to a company’s cash flow.
– It shows whether the dividend payments made by a company makes sense
given its earnings.
– If the number is too high, it may be sign that too a small percentage of the
company’s profits are being reinvested for future operations. This casts
doubt on the ability of a company to maintain high dividends in future.
– Compare dividend payout ratios over a period of time.
– It is a sign good management and financial health if the dividend payout
ratios are historically stable or trending upwards.
 DIVIDEND POLICY : PAYOUT RATIO

The considerations relevant for determining the dividend payout

ratio are:
• Funds requirement – may be assessed with the help of
financials prepared in the context of long range planning.
• Liquidity – dividends entail cash payment and so the liquidity
of the firm has a bearing on its dividend decision.
• Access to external sources of financing – a firm which has
access to external source of financing may feel less constrained
in its dividend decision.
• Shareholder preferences – when equity shareholders have
greater interest in current dividend vis-à-vis capital gains, the
firm may be inclined to follow a stable dividend policy.
 Centre for Financial Management , Bangalore
 DIVIDEND POLICY : PAYOUT RATIO

The considerations relevant for determining the dividend payout

ratio are:
• Difference in the cost of external equity and retained
earnings – the cost of external equity, except that which is raised
by way of rights issue is higher than the cost of retained earnings.
The magnitude of cost differential between external equity has a
bearing on the relative proportions of external equity and
retained earnings used by the firm and hence the dividend policy.

 Centre for Financial Management , Bangalore

 DIVIDEND POLICY : STABILITY
Stable Dividend Payout Ratio

 Irrespective of the long-term pay out ratio followed, the fluctuations

in year-to-year dividends may be determined by one of the following
guidelines:
• Stable dividend payout ratio
o According to this policy, the percentage of earnings paid out as
dividends remains constant.
o So dividends fluctuate in line with earnings.
• Stable dividends or steadily changing dividends
o The rupee level of dividends remains stable or gradually increases
(mostly) or decreases (rarely).
 DIVIDEND POLICY : STABILITY
Stable Dividends or Steadily Changing Dividends
Earnings/Dividends

Earnings

Dividends

Time

• The above graph shows the behaviour of dividend per share in response to changes in EPS
 Centre
when such a policy is followed
for Financial Management , Bangalore
 DIVIDEND POLICY : STABILITY

 Rationale for Dividend Stability – Why do firms follow a policy of

stable or gradually rising dividends?
• Many investors depend on dividend income to meet to meet a portion of their
living expenses.
• Since theses expenses remain stable or increase gradually over time they
prefer a similar behavioural pattern in dividends.
• Sharp changes in dividend income may entail selling some shares, if dividends
fall steeply, or reinvestment of a portion of dividend income if dividends rise
substantially.
• Dividend decision of the firm conveys information by the management about
the prospects of the firm:
o Increased dividends indicate improved earning prospects of the firm.

o A decrease in dividends implies lower earnings expectation; and

o Lack of change in dividends means unchanged prospects

 DIVIDEND POLICY : STABILITY

• Dividend decision of the firm resolves uncertainty in the minds of stock

holders.
• Firms may vary dividend only gradually in response to certain long-term
events changes in prospects.
• Institutional investors often view a record of steady dividend payments as a
highly desirable feature - they may also regard this as a precondition before
considering equity or debt investment in the firm.
 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.
 Centre for Financial Management , Bangalore
 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.
 Centre for Financial Management , Bangalore
 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 providing for
depreciation…

• The Companies (Transfer to Reserves) Rules, 1975, provide

that before dividend declaration a specified percentage of
profit should be transferred to the reserves of the company.
 Centre for Financial Management , Bangalore
 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 capitalization 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, because the
number of shares increases.

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 BONUS SHARES

• Bonus shares can be issued out of free reserves, securities

premium reserve and capital redemption reserve.
Effects of Bonus Issue on Equity portion of the Balance
Sheet

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 BONUS SHARES

 Reasons for Issuing Bonus Shares

– The bonus tends to bring the market price per share within a more
popular range.
– It increases the number of outstanding shares and promotes active
trading.
– Shareholders regard a bonus issue as a firm indication that the
prospects of the company have brightened and they can reasonably
look for an increase in total dividend.
– It improves the prospects of raising additional funds. In recent years
many firms have issued bonus shares prior to the issue of convertible
debentures or other financing instruments.
 BONUS SHARES

 Regulations for Issuing Bonus Shares

– Bonus issue must be made out of free reserves built out of genuine profits
or share premium collected in cash only.
– Pending conversion into shares, fully convertible debentures (FCDs) and
partly convertible debentures (PCDs) are included for determining the
eligibility to receive bonus shares. The bonus entitlement of such shares
should be kept separately and allotted at the time of conversion of such
FCDs/PCDs.
– A bonus issue cannot be made in lieu of dividend payment.
– A bonus issue cannot be made on partly paid up shares.
– A company should not be in default od servicing FDs/Dentures, and
statutory dues if it wants to issue bonus shares.
– The Articles of Association of a company should authorize a bonus issue.
 STOCK SPLITS
 In a stock split the par value per share reduced and the number of share is
increased proportionately.
 The Table below illustrated the nature of this change.
 For example, Tata Tea split into par value of Rs 2 from the earlier par
value of Rs 10.
 BONUS vs 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 • The par value of the share is
unchanged. reduced.
• A part of reserves is capitalized • There is no capitalization of reserves.
• The shareholders’ proportional • The shareholders’ proportional
ownership remains unchanged ownership remains unchanged
• The book value per share, the • The book value per share, the
earnings per share, and the earnings per share, and the market
market price per share decline price per share decline
• The market price per share is • The market price per share is
brought within a popular brought within a more popular
trading range. trading range.
 REVERSE STOCK SPLITS

• It is the opposite of a stock split.

• It involves an increase in the par value and decrease in the
number of shares proportionately.
• For e.g. LG Balakrishna did a reverse stock split in the year
2010 by increase in the face value from Rs 1 to Rs 10.
• Typically, a reverse stock split is done when the stock is quoting
too low say less than Rs 10.
 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 through brokers over a
period of one year
• The company fixes the maximum price for the open market
purchase, stipulate the number of shares it plans to buy, and
specifies the closing date of the offer.
 Centre for Financial Management , Bangalore
 RATIONALE FOR SHARE BUYBACKS

• Efficient allocation of resources – can check profligate

tendencies with surplus cash.
• Price stability – If the company buys back is shares when the
price looks depressed and re-issue the share bought back if the
price appears inflated.
• Positive Signal – Buy back decision is motivated by
management’s belief that the shares of the firm are undervalued.
• Control - Share buy backs can be used to increase insider control
of the firm.
• Voluntary Character – the investors have the option to sell or not
to sell when a firm announces buy back program.
 RATIONALE FOR SHARE BUYBACKS

• No implied commitment – share buy backs are normally viewed

as one time exercise.
• Capital Structure Changes – a share buy back shrinks the equity
(net worth) of the company in relation to its debt thereby increasing
Debt-Equity ratio. Hence it can be used to effect changes in the
capital structure.
 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 rationalize the company’s capital structure.

• To substitute for cash dividends.

• To give excessive cash back to share holders.lders.

 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.
 Centre for Financial Management , Bangalore
 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.
• 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.
 Centre for Financial Management , Bangalore
•

SUMMING UP

• 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.

 Centre for Financial Management , Bangalore

FIRM VALUE
 OUTLINE

• Models in Which Investment and Dividend Decisions are

Related

• Traditional Position
 MODELS IN WHICH INVESTMENT AND
DIVIDEND DECISIONS ARE RELATED

 Most of the discussions on dividend policy and firm value assumes

that the investment decision of a firm is independent of its dividend
decision.
 Some models assume that investment and dividend decisions are
related.
 Two such models are:
– Walter Model; and

– Gordon Model.
 MODELS IN WHICH INVESTMENT AND
DIVIDEND DECISIONS ARE RELATED

• Walter Model

• Gordon Model

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 MODELS IN WHICH INVESTMENT AND
DIVIDEND DECISIONS ARE RELATED

 James Walter Model:

– A model of share valuation which supports the view that the
dividend policy of a firm has a bearing on share valuation.
– The model is based on the following assumptions:
 The firm is an all-equity financing entity.
 The firm will rely only on retained earnings to finance its future
investments.
 Therefore the investment decision is dependent on dividend
decision.
 The rate of return in investment is constant.

 The firm has an infinite life.

 WALTER MODEL
D + (E – D) r/k
P=
k
where: P = price per equity share 1. The first term represents the PV
of infinite stream of dividends.
E = earnings per share
2. The second term is PV of infinite
D = dividend per share stream of returns from retained
r = rate of return on investments earnings.
k = cost of equity capital

Example
E = Rs.4, D = Rs.2, r = 0.20, k = 0.15
2 + 2 x 0.20/0.15
P =
0.15
= 31.11
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 WALTER MODEL

Numerical Examples of Walter Model

 WALTER MODEL

 From the Exhibit in the previous slide we find that as per the Walter
Model:

sa
 IMPLICATIONS OF THE WALTER MODEL
• When r > k (growth firm); don’t pay dividend. Therefore, the optimal
payout ratio for a growth firm is nil.

• When r = k (normal firm); dividend payout is irrelevant. Therefore, the

optimal payout ratio for a normal firm is irrelevant

• When r < k (declining); pay dividend. Therefore, the optimal payout ratio
for a declining firm is 100 percent
 GORDON MODEL

 Myron Gordon proposed a model of stock valuation using dividend

capitalization:.
 His model is based on the following assumptions:
• Retained earnings remain only a source of financing for the firm. Thus
like the Walter Model the Gordon Model related investment decisions
to dividend decisions.
• The rate of return on a firm’s investment is constant.
• The growth rate of a firm is the product of its retention ratio and its
rate of return. This follows from the first two assumptions.
• The cost of capital for the firm remains constant and it is greater than
the growth rate.
• The firm has perpetual life.
• No taxes
 GORDON MODEL
E1 (1 – b)
P0 =
k – br
where P0 = price per share at the end of year 0
E1 = earnings per share at the end of year 1
(1 – b) = dividend payout ratio
b = ploughback ratio
k = shareholders’ required rate of return
r = rate of return earned on investments made by the firm
br = growth rate of earnings / dividends
Example
r = 0.20, k = 0.15, E1 = 4.0, b = 0.25
4.0 (1 – 0.25)
P0 = = Rs. 30
0.15 – (0.25) (0.20)
 Centre for Financial Management , Bangalore
 GORDON MODEL

Numerical Examples of Gordon Growth Model

 GORDON MODEL

 From the Exhibit in the previous slide we find that as per the Gordon
Model:
 IMPLICATIONS

• When r > k (growth firm); don’t pay dividend. Therefore, the

optimal payout ratio for a growth firm is nil.
• When r = k (normal firm); dividend payout is irrelevant.
Therefore, the optimal payout ratio for a normal firm is
irrelevant.
• When r < k (declining firm); pay dividend. Therefore the
optimal payout ratio for a declining firm is 100%.

 Centre for Financial Management , Bangalore

 TRADITIONAL POSITION

 Benjamin Graham and David Dodd expressed quantitatively the

following valuation model advanced by them:

P = m (D + E/3) E=D+R

where, P = market price per share

D = dividend per share
E = Earnings per share
m = Multiplier
 TRADITIONAL POSITION
(Benjamin Graham and David Dodd)

4D R
P=m +
3 3

where P = market price per share

D = dividend per share

R = retained earnings per share

m = a multiplier

 Centre for Financial Management , Bangalore

Gordon Model
P= D0*(1+g)/(Ke-b*ROE) or EPS1*(1-b)/(k-b*ROE)
Value maximisation Presciption: ROE>Ke, Don't pay dividend, ROE = ke, dividend payout is irrelevent, ROE<ke, 100%
payout
Example
Rs EPS 1 20 Rs ROE 12% Ke 16%
Expected growh rates

Alt 1 25% payout b1 0.75 g1 9.00% P0 71.43

Alt 2 50% payout b2 0.5 g2 6.00% P0 100

Alt 3 75% payout b3 0.25 g3 3.00% P0 115.38

Since ROE < Ke, highest payout maximises value.. You can swap ROE and ke numbers to show the opposite.
Use same data to show application of Walter model with similar
recommendation

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