Payout Policy, capital structure and Market Value of the Firm

• What are payout and retention policies?

• Giving the wealth back to shareholders

• Dividends out of current profits or free reserves

• What to do with cash surplus and cash deficit?

• Cash surplus will lead to either, payout cash dividends, repurchase the stock or retain
and invest in the same or new projects
 Payout Policy and Market Value of the Firm

• Thus dividend can be

• Cash Dividend or

• Stock or scrip dividend

• Stock dividend in turn can be

• Stock repurchase or buy back….discuss if it results in cash outflow

• Bonus issue…discuss if it results in cash out flow

• Stock split…discuss if it results in cash outflow

 Cash Dividends Vs Stock Dividend
Basis Cash Dividends Stock Dividend
Cash Outflow Yes No
Outstanding Shares Constant Increase
Ownership dilution No Yes
Tax Yes No
DRIPs No Yes
Liquidity Constant Increases
Option No Yes
Psychological attachment No Yes
Implicit promise Yes No
Future expectations Yes No
Growth rate Yes No
Impact on price Yes Yes
Frequency Every year Very less
Time perspectivess Short term Long term
Supporters Rightists Leftists
 Dividend payment flow chart

Announcement Ex-dividend
Record Date Payment Date
Date Date
 Factors affecting the pay out policy

• Shareholders’ expectations
• Debt indenture and agreements
• Life cycle and growth plans
• Liquidity
• Availability of cash (profits alone will not help)
• Cost of debt and financing policy
• Managerial control
• Tax implications
• Legal provisions
 Does pay out policy matter? i.e does it affect MVPS?

Pre-requisite knowledge….

• ROE, Ke and Growth Rate (g)

• How is ‘g’ computed?

• EPS, DPS and FCFPS

• Discounted Cash Flow (DCF) technique

• Zero growth model, single growth model, multi-stage growth model

• Continuous growth model and horizon value

 Does pay out policy matter? i.e does it affect MVPS?

Pre-requisite knowledge….

• Pay out Ratio and Retention Ratio

(DPS/EPS) and (REPS/EPS) or ((EPS-DPS)/EPS)

• Dividend Ratio….this is what the firm announces

(DPS/FVPS)

• Dividend Yield

(DPS/MVPS)
 Dividend Policies

Dividend policy decision is about

• What to do with the profits

• Whether to pay dividends or to reinvest back in the business

• If to pay….

• How much to pay

• How frequently to pay

• What factors to consider in deciding the above

 Dividend Policies

Three Dividend policies

1. Stable Dividend Policy: Paying the dividends irrespective of profits

2. Constant policy: Paying a predetermined portion of profits as dividends

3. Residual Policy: Paying only after taking care of CAPEX and WC investments
 Pay out and Valuation

Does pay out policy matter? i.e does it affect MVPS?

“YES” (i.e Relevance school of thought)

Vs
“NO” (i.e Irrelevance school of thought)
 Does pay out policy matter? i.e does it affect MVPS?

Relevance School of thought

Walter Model – Assumptions

• All-equity finance i.e un-levered

• Hence it depends only on retained earnings to finance future investments

• Hence investment decision is dependent on pay out decision

• Return On Investment (ROI) is constant through out

• Going concern concept i.e the firm’s life in infinite

 Does pay out policy matter? i.e does it affect MVPS?

Relevance School of thought

Walter Model – MVPS consists of two components

1. PV of infinite stream of dividends i.e (D/k)

2. PV of return from stream of retained earnings i.e {[(E – D)*r/k]/k}

Price = (D/Ke) + {[(E – D)*r/k]/k}

Price = [(D+(E-D)*r/k)]/K
 Does pay out policy matter? i.e does it affect MVPS?

Relevance School of thought

Gordon Model – Assumptions
• Retained earnings is only the source of financing
• Hence investment decision depends on pay out decision
• Constant ROI
• Growth rate, ‘g’ of the firm is the product of ROI and retention ratio i.e (ROI*b),
where ‘b’ is the retention ratio
• ‘K’ remains constant and is always greater than ‘g’
• No taxes
• Going concern concept i.e firms continuous perpetually
 Does pay out policy matter? i.e does it affect MVPS?

Relevance School of thought

Gordon Model – MVPS
• Price is the PV of dividends growing continuously i.e infinitely

• This takes the form of time value of money concept i.e [D1/(k-g)]

Price = [(D0*(1+g)]/(k-g)
 Does pay out policy matter? i.e does it affect MVPS?

Relevance School of thought

Traditional Approach by Benjamin Graham and David Dodd – Assumptions
• Stock market places more weight on dividends than retained earnings
• Market verdict is more favorable to liberal dividend policy
• Dividends are favored for being certain when compared to capital appreciation which uncertain
(a bird in the hand is worth two in the bush)
• It is a standard practice to take dividends into consideration in the valuation of stock
• Weight attached to dividends is four times the weight attached to retained earnings
• Hence it is also known as multiplier effect… (Price = m(D+(E/3)), where m is the multiplier

• They proposed their view can be empirically tested through the following regression model
Price = a + (β*Dividends) + (β*Retained Earnings)
• Therefore (β*Dividends) is expected to have more bearing on price
 Does pay out policy matter? i.e does it affect MVPS?

Irrelevance School of thought

Miller and Modigliani Proposition, only the irrelevant thought
Assumptions
• Free flow of information
• Tax free environment
• No brokerage costs, no transaction costs and no floatation costs
• No agency costs
• No individual can exert power to influence the price of the stock
• Investment and financing decisions are independent
 Does pay out policy matter? i.e does it affect MVPS?
Irrelevance School of thought
Miller and Modigliani Proposition, only the irrelevant thought
Argument
• If the firm retains earnings instead of paying dividends, shareholders will enjoy share
price appreciation equal to that of earnings retained
• If the firm pays dividends instead of retaining the earnings, shareholders will enjoy
the dividends equal to market appreciation in share price
• In other words, shareholders can utilize dividends to increase their wealth equal to
that of retained earnings
• Hence splitting EPS into DPS and REPS does not matter
ttps://www.accaglobal.com/an/en/student/exam-support-resources/fundamentals-exams-study-
resources/f9/technical-articles/dividend-theory.html

MM argument is heavily criticized due to impractical assumptions