DIVIDEND

POLICY
DIVIDENDS
ARE
I R R E L E VA N T

Group 04
Khadiza Akter Lima 2022331011

Tasmiah Binte Noor 2022331015 GROUP

Rifat Ibna Lokman 2022331020 MEMBERS
Ulfat Murshed Tamanna 2022331022

Bushra Emdad 2022331040

 A dividend is the distribution of some of a company's earnings to a class
of its shareholders, as determined by the company's board of directors. It
Dividend
is paid to the shareholders out of the after-tax profits. Dividends may be
paid out as cash or in the form of additional stock.
 Dividend policy involves the balancing of the shareholder’s desire
for current dividends and the firm’s needs for funds for growth.
DIVIDEND
POLICY
Different theories have been advanced on the relationship between
dividend policy and the value of the firm.
PROBLEM
09
 Question: 09 - Which types of companies would you expect to distribute
a relatively high or low proportion of current earnings? Which would
you expect to have a relatively high or low price-earnings ratio?

a. High-risk companies.
Question: 09
b. Companies that have experienced an unexpected decline in profits.

c. Companies that expect to experience a decline in profits.

d. Growth companies with valuable future investment opportunities.

 The price-to-earnings ratio: (P/E ratio) is the ratio for valuing a company that
measures its current share price relative to its per-share earnings, EPS. It is used to
measure market value. The higher ratio is treated as good because it implies that the
firm has growth opportunities in future. It is calculated by using the following formula-

P/E Ratio = share price/ earning per share

P/E Ratio

The P/E shows what the market is willing to pay today for a stock based on its past or
future earnings. A high P/E could mean that a stock's price is high relative to earnings
and possibly overvalued. Conversely, a low P/E might indicate that the current stock
price is low relative to earnings. 
 a. High-risk companies distribute a low proportion of current earnings and
these companies will have lower price-earnings ratio.

They will distribute a low proportion of current earnings to offset fluctuations in

Answer operational cash flow. There is a significant negative relationship between business
risk and dividend policy .Risky companies may have lack of earnings to pay
shareholders. The P/E ratio implicitly incorporates the risk of a company's future
earnings. Low P/E ratio is associated with high risk and lower payouts ratios.
 b. Companies that have experienced an unexpected decline in profits
distribute a relatively high proportion of current earnings since the decline is
unexpected. These companies will have higher price-earnings ratio.

Answer

c. Companies that expect to experience a decline in profits distribute a

relatively low proportion of current earnings in order to offset anticipated
decline in earnings. These companies will have lower price-earnings ratio.
 d. Growth companies with valuable future investment opportunities: They
distribute a relatively low proportion of current earnings in order to fund
expected growth. These companies will have higher price-earnings ratio.

For the firm that has valuable growth opportunities, the higher the growth
opportunities, the lower the earnings–price ratio and the higher the price–earnings
Answer ratio. Thus the high price–earnings ratios observed for growth companies imply
that investors forecast future earnings growth and are willing to pay more for
them. But they can’t be systematically short-sighted. Growth business depends on
investments made many years in the future. Growth stocks are often higher in
volatility and this puts a lot of pressure on companies to do more to justify their
higher valuation. So shareholders of a “growth stock,” expect that the company
will retain earnings so as to fund growth internally.
PROBLEM
10
 Question 10
Little Oil has outstanding 1 million shares with a total market value of
$20 million. The firm is expected to pay $1 million of dividends next
year, and thereafter the amount paid out is expected to grow by 5% a
year in perpetuity. Thus, the expected dividend is $1.05 million in
year 2, $1.105 million in year 3, and so on.

10
a. At what price will the new shares be issued in year 1?

b. How many shares will the firm need to issue?

c. What will be the expected dividend payments on these new

shares, and what therefore will be paid out to the old shareholders
after year 2?
 a. At what price will the new shares be issued in year 1?
Given, Given,
At t=0, Share price = $20 At t=2, Dividend per share = $1.05
At t=1, Dividend per share = $1 Growth, g= 5%
Growth, g= 5% Cost of capital, r=10%

We know, So, Total value of share at t=1,

10.a   DI V 1   𝑇𝑜𝑡𝑎𝑙 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑖𝑑

P0 = V 1=
r−g r−g
  1
$ 20=  
r −0.05
r = 0.10 = 10.0% ¿  $ 21million
 a. At what price will the new shares be issued in year 1?

 At
t=1, Price per share=
New Share issued = N

V1 = P1  (1,000,000 + N) = $21,000,000

10.a V1 = (P1  1,000,000) + (P1  N) = $21,000,000

P1  N = $1,000,000

(1,000,000  P1) + $1,000,000 = $21,000,000

P1 = $20.00
 b. How many shares will the firm need to issue?
 
Given,
At t=1, Price per share=
Fund need to be raised = $1,000,000

10.b New Share issued, N = ?

  $ 1,000,000
𝑁=
$ 20
  50,000
 c. What will be the expected dividend payments on these
new shares, and what therefore will be paid out to the old
shareholders after year 2?
Given,
At t=2, Total number of share= 1,050,000
At t=2, Expected dividend payment= 1,000,000 1.05

10.c = $1,050,000
So, At t=2, Dividend per share = $1
Old share = 1,000,000
At t=2, Dividend paid to old shareholders= $1  1,000,000
= $1,000,000
PROBLEM
11
 DIVIDEND POLICY IS IRRELEVANT:
THE MILLER-MODIGLIANI (MM) HYPOTHESIS

•In 1961 Miller and Modigliani published a proof that dividend policy is irrelevant in a world without
taxes, transaction costs, or other market imperfections.
•For example, a firm wants to increase their total payout by increasing the dividend without changing
their investment and financing policy. The firm can finance the extra dividend by printing some
more shares and sell them.
•The firm can sell more shares while keeping its assets, earnings, investment opportunities, and,
therefore, market value unchanged through transfer of value from the old to the new stockholders.
•The new shareholders get the newly printed shares, each one worth less than before the dividend
change was announced, and the old shareholders bear a capital loss on their shares. The capital loss
borne by the old shareholders just offsets the extra cash dividend they receive.
•Now the old shareholders can also raise cash by selling their shares. So, investors do not need
dividends to earn cash, they will not pay higher prices for the shares of firms with high payouts. So,
the firm ought not to worry about dividend policy.
 DIVIDEND POLICY IS IRRELEVANT:
THE MILLER-MODIGLIANI (MM) HYPOTHESIS

Before After
Dividend Dividend

New
shareholders
Total value of firm

Each share
Worth this …and worth
before.. this after

Old
shareholders

Total number Total number

of shares of shares
 It was stated in Section 16-5 that MM’s proof of dividend
irrelevance assumes that new shares are sold at a fair price. Look
PROBLEM
11 back at problem 10. Assume that new shares are issued in year 1 at
$10 a share. Show who gains and who loses. Is dividend policy still
irrelevant? Why or why not?
 • From Question No. 10, the fair issue price is $20 per share. If these shares are
instead issued at $10 per share, then the new shareholders are getting a bargain,
which means that the new shareholders win and the old shareholders lose.

• As pointed out in the text, any increase in cash dividend must be offset by a stock
issue if the firm’s investment and borrowing policies are to be held constant.

PROBLEM • The old stockholders can also raise cash by selling their shares. Thus the old
shareholders can cash in either by persuading the management to pay a higher
11
dividend or by selling some of their shares. In either case there will be a transfer
of value from old to new shareholders. The only difference is that in the former
case this transfer is caused by a dilution in the value of each of the firm’s shares,
and in the latter case it is caused by a reduction in the number of shares held by
the old shareholders.

• Because investors do not need dividends to earn cash, they will not pay higher
prices for the shares of firms with high payouts. So, the firm ought not to worry
about dividend policy.
 TRANSFER OF VALUE

Dividend financed by No dividend, no stock

stock issue issue

New stockholders New stockholders

Shares
Cash

Cash Shares
Firm

Cash

Old stockholders Old stockholders

PROBLEM
18
 Formaggio Vecchio has just announced its regular quarterly cash
dividend of $1 per share.
a) When will the stock price fall to reflect this dividend payment-
on the record date, the ex-dividend date, or the payment date?
b) Assume that there are no taxes. By how much is the stock price
likely to fall?
Problem: 18 c) Now assume that all investors pay tax of 30% on dividends and
nothing on capital gains. What is the likely fall in the stock price?
d) Suppose, finally, that everything is the same as in part (c), except
that security dealers pay tax on both dividends and capital gains.
How would you expect your answer to (c) to change? Explain.
 a) When will the stock price fall to reflect this dividend payment- on the
record date, the ex-dividend date, or the payment date?
Answer: The stock price will fall to reflect this dividend payment on the ex-
dividend date

b) Assume that there are no taxes. By how much is the stock price likely
Answer
to fall?
Answer: The stock price will fall by $1.
 c) Now assume that all investors pay tax of 30% on dividends and nothing on
capital gains. What is the likely fall in the stock price?
The stock price will fall by the after-tax dividend, i.e., by $1 (1-0.3) = $0.70,
so that the after-tax return on dividends and capital gains are the same. To see
this more clearly, suppose the stock price is 10 before the dividends is paid. If
you buy the stock right before the dividend is paid and sell it right after, your
Answer net profit should be essentially zero since you have held the stock for a small
amount of time. Here are your cash flows:
buy now: -10.00
dividend: + 1.00
tax on dividend: -0.30
sell after dividend: S (to be found)
So, the sum of all these cash flows should be zero:
-10+1-0.30+S=0
S= 9.30
The stock price fell by $10.00-$9.30= $0.70.
 d) Suppose, finally, that everything is the same as in part (c), except that security
dealers pay tax on both dividends and capital gains. How would you expect your
answer to (c) to change? Explain.

In this case, there should be no tax effects, i.e., the stock price will fall
by $1. To better see this, suppose you buy the stock (for $10, say) right
before the dividend is paid, and sell it right after the dividend is paid.
Answer Because you hold the stock for a small amount of time (a second, say),
your net profit should be zero. You pay $10 for the stock; you receive
$1 as a dividend which is taxed at 30%; then you sell it for S (To be
found) and pay taxes of 30%*(S-10) on your capital gains (which are
going to be negative here).
So, your net profit is,
-10+ (1-0.30) +S-0.30 (S-10) =0
Solving for S, we find S=9. So, the change in S is $10-$9=$1
PROBLEM
20
Question 20: Firms A and B are both unlevered. The shares of both
companies are currently trading at $100, and both offer an annual pre-tax
return of 10%. In the case of firm A, the return is entirely in the form of a
dividend yield (i.e., the company pays a regular annual dividend of $10 a
share). In the case of firm B, the return comes entirely as capital gain (the
shares appreciate by 10% a year). Suppose that an investor buys a share
of each firm today, and plans to sell them in 10 years. Suppose that
dividends and capital gains are both taxed at 30%.
a. What is the annual after-tax yield (rate of return) on firm A’s
share over the 10-year period?

b. What is the annual after-tax yield (rate of return) on firm

B’s share over the 10-year period?
a. What is the annual after-tax yield (rate of return) on firm A’s
share over the 10-year period?

Every year, the investor receives $10, which is taxed at 30%. So,
after taxes, the investor receives $7 each year. At the end of year
10, the investor will sell his share of firm A for $100, and so will
not have any capital gain. His annual after-tax return on his $100,
is therefore 7/100=7%
 
b. What is the annual after-tax yield (rate of return) on firm B’s share
over the 10-year period?

The investor will not receive any money until year 10, at which point
he will sell his share of firm B for 100( = 259.37. The capital gains of
259.37-100 = 159.37 will then be taxed at 30%. Therefore, the annual
after-tax rate of return r satisfies

r = 7.781%
THANK
YOU