Payout Policy

What is “Payout Policy”?

• Dividend policy involves the balancing of the shareholders’
desire for current dividends and the firm’s needs for funds for
growth.

• How to Pay?
• How much to pay?

• Objective – Maximize Shareholders Return.

• Effects – Taxes, Investment and Financing Decision.
Cash Dividends and Repurchases
• In April 2009, SEBI has made it mandatory for the Indian
companies to declare dividends on per share basis.
• Dividend Yield in India has fallen down and hardly 13%
companies issue dividends.
• Share buybacks happen to achieve a target capital
structure, returning value to shareholders, facilitating exit
to shareholders or even stabilising the share price.
• As per SEBI, 1998, a company can buyback its shares on a
tender route or open market basis.
• Out of the 160 buy back offers between 2004 -19 only 67
are tender. The remaining 93 are open market route.
Share Repurchases
• 55587crore share buybacks in 2019. (35% CAGR)
• In FY21, 61 companies offered to buy back shares worth ₹39,295 crore, according to
data from Prime Database. This compares to 52 and 63 companies that made similar
offers totaling ₹19,972 crore and ₹55,587 crore in FY20 and FY19 respectively.
• This sudden affinity is after 2016 budget that slapped additional 10% on shareholders
receiving 10 lakh or above dividends.
• Remember, the conventional wisdom does not work in buybacks. ( Of increase in
share price)
• Signalling is primary reason – Of prospects and change in capital structure
• But has the game changed after tax on share buyback and removal of dividend
distribution taxes
Buy back vs. Dividend - Brief overview

Recent amendment
• Pursuant to amendment vide Budget 2020, domestic Promoter individuals
companies are no longer required to pay DDT and
dividend income is instead taxable in the hands of
shareholders at the applicable tax rates. Dividend /
Buy-back
Buy back A Co.
• Maximum permissible buy back is 25% of paid up
capital and free reserves
Buy Back Scenario Amount
− provided total shares to be bought back do not Cash available for distribution (inclusive of tax) 100.0
exceed 25% of paid up equity capital; and Less: Buy Back Tax @ 23.3% (18.9)
A Cash received by shareholders# 81.1
− debt equity ratio < 2:1 (on consolidated basis for Dividend Scenario Amount
listed companies) Cash available for distribution 100.0
Less: Tax in the hands of resident individual shareholders @ 35.88%* (35.9)
• Buy back can be done out of free reserves, securities B Net Cash in the hands of resident individual shareholder 64.1
premium account, proceeds of issue of any shares C Indicative tax Impact - Buy Back vs Dividend (A-B) 17.0
or other specified securities # The amount received on issue of shares has been considered as Nil in
computing the buy-back tax
*For the purpose of dividend tax, the highest tax slab and surcharge
Dividend applicable to resident individual shareholder is assumed
• Dividends can be declared out of the profits of the
company for that year, after providing for depreciation;
or
• Out of the profits of the company for any previous
financial year arrived at after providing for depreciation

Indicative tax impact of ~ 17% on cash repatriation through buy back vis-à-vis dividend.
Modes for buy back

Buy back of
securities

Compliance with Unlisted Compliance with

Company law & Listed company Company law
company
SEBI

Tender offer Open market Odd lot

operation

Stock exchange Book building

Promoters cannot
participate in buy
back through stock
exchange

As per SEBI regulations on buy back, specified securities include ESOPs

Tax and regulatory framework

Tax Company law SEBI FEMA

• Company to pay tax on
buy back @ 23.3%
• Amount received on
buy back exempt in the
hands of shareholders
• Tax credit on buy back
may not be available to
non resident
shareholders. However,
one needs to analyse
the tax provisions of
the foreign jurisdiction
on allowability of the
credit.
• Maximum buy back
limit – 25% (paid up
capital + free reserves)
• Debt – equity ratio post
buy back to not exceed
2:1 (on consolidated
basis for listed
companies)
• Trading window to be • Pricing guidelines to be
closed for adhered to
designated persons
and their immediate • Compliance with
reporting requirements
relatives
• Stock exchanges to be
given prior intimation
about the board
meetings to consider
proposals for buy back
• There may be an
obligation to make an
open offer if certain
limits are breached on
buy back

• During pendency of buy back, promoter group are restricted from dealing in shares on the stock exchange or off-
market, including inter - se transfer promoters
• Buy back through open market operations to be restricted to 15% of paid up capital + free reserves (both on
standalone and consolidated basis)
• No public announcement of buy back can be made during the pendency of any scheme of amalgamation or
compromise or arrangement pursuant to the provisions of the Companies Act
• Company cannot not raise further capital for a period of one year from the expiry of buy back period, except in
discharge of its subsisting obligations. However, SEBI has recently relaxed the cooling off period temporarily for
raising further capital to 6 months until 31 December 2020.
Dividends and stock market
reactions
 Relevance Vs. Irrelevance
•
10 Relevance
- Walter's Model
- Gordon's Model
• The Bird in the Hand Argument

• Irrelevance
- Modigliani and Miller Hypothesis
• Informational Content
• Market Imperfections
 Dividend relevance: Walter’s model
11

Walter’s model is based on the following assumptions:

• Internal financing – Debt or new equity is not issued
• Constant return and cost of capital
• 100 per cent payout or retention
• Constant EPS and DIV – Beginning EPS and DIV never change
• Infinite time – firm has long or infinite life
 Walter’s formula to determine the market price per
share

• Where,
P = market price per share
DIV = Dividend per share
EPS = Earnings per share
r = Firm’s rate of return
k = Firm’s cost of Capital
 Optimum Payout Ratio
•
13
Growth Firms – Retain all earnings, payout ratio = zero
• Normal Firms – No effect of dividend policy on share price
• Declining Firms –Distribute all earnings, payout ratio = 100%
 Dividend relevance: Gordon’s model
Gordon’s model is based on the following assumptions:
 All-equity firm
 No external financing
 Constant return
 Constant cost of capital
 Perpetual earnings
 No taxes
 Constant retention and growth rate
 Cost of capital greater than growth rate
 Valuation
• Market value of a share is equal to the present value of an infinite
stream of dividends to be received by shareholders.
It is revealed that under Gordon’s model:

• P0 increase with b, for firms with growth opportunities, r>k

• P0 increase with payout, for firms, where r<k, declining firm
• Market Value of shares not affected by dividend policy, r=k
 Dividend and uncertainty: The Bird-in-the-hand argument

• Argument put forward, first of all, by Kirshman

• Investors are risk averters. They consider distant dividends as less

certain than near dividends. Rate at which an investor discounts
his dividend stream from a given firm increases with the futurity
of dividend stream and hence lowering share prices.

• Investors think dividends are less risky than potential future capital
gains, hence they like dividends.

• If so, investors would value high payout firms more highly, i.e., a
high payout would result in a high P0.
Lintner’s Model of Corporate Dividend Behaviour

• Dividend for the current Year

- Dividend per share for year t

- c = Adjustment Factor
- r = Target Payout Ratio
- EPSt = Earning Per Share at time t
- Dt-1 = Dividend per share for the year t-1
Change in Dividend

DIV1 - DIV0  adjustment rate  target change

 adjustment rate  target ratio  EPS1 - DIV0 
Three other factors
• Signalling Theory: If there is a change in outlook , not represented in
the cash flow projections given by management, the company can cut
dividends.

• Taxes: Because tax treatments of Dividends and capital gains differ, it

has an effect on dividends
• Transaction Costs: These are deadweight costs and don’t benefit the
investor.
Dividend and Signalling
Three worries
• Change in dividends signal profitability
• Cash cow corporation may run out of positive NPV projects and waste
cash on perks or poor projects.
Modigliani and Millers Theory of
Dividend Irrelevance
 Dividend Irrelevance: The Miller–Modigliani (MM)
Hypothesis
• Dividends do not affect value

• They argue that the value of the firm depends on firm earnings which results
from its investment policy. Thus when investment decision of the firm is given,
dividend decision is of no significance.

• Underlying Assumptions:
- Perfect capital markets
- There are no tax differences to investors between dividends and capital gains.
- If companies pay too much in cash, they can issue new stock, with no flotation
costs or signaling consequences, to replace this cash.
• We must separate payout decisions from investment and borrowing.

• The crux of MM argument is that in the perfect capital market the effect of
dividends on the wealth of shareholders is exactly offset by the effect of other
means of financing. Thus, the shareholders are indifferent between dividend and
retention of earnings.
 Bonus Shares (Stock Dividends)
• Distribution of additional shares free of cost to existing
shareholders
• Issued out of Free Reserves, thus declaration of the bonus share
will increase the paid-up share capital and reduce reserves and
surplus (retained earnings) of the company, total net-worth
remains unaffected. It is merely an accounting transfer from
reserve and surplus to paid-up capital
• Increases the number of outstanding shares of the company
• Shares are distributed proportionately to the existing shareholders,
hence no dilution of ownership
Illustration-I
Equity Portion Before Bonus Issue
Paid-up capital (10 lakhs shares of Rs. 10) 10,000,000
Reserve and Surplus 30,000,000
40,000,000
Equity Portion After Bonus Issue in the Ratio of 1:1
Paid-up capital (20 lakhs shares of Rs. 10) 20,000,000
Reserve and Surplus (3 crore -1 crore) 20,000,000
40,000,000
Bonus Shares: Impact
• Increases the no of outstanding shares
• Market Price per share fall proportionately to the bonus share
- EPS decrease: Increasing the no of shares

Stock dividend neither increases nor decreases the value of

investors’ shareholdings
 Share split
•
28 It is a method to increase the number of outstanding shares
through a proportional reduction in the par value of the share
• Thus, share price declines because the number of outstanding
shares increases.
• Shareholders total funds or owner’s equity remain unaltered
• Low stock price appeal to the retail investors
Illustration
Equity Portion Before Share Split
Paid-up capital (500,000 shares of Rs. 10) 5,000,000
Reserve and Surplus 10,000,000
15,000,000
Equity Portion After Stock Split in the Ratio 5:1
Paid-up capital (2,500,000 shares of Rs. 2) 5,000,000
Reserve and Surplus 10,000,000
15,000,000
 Bonus Share vs. Share Split
•
30 In both cases, the net worth does not change and number of
outstanding shares increase substantially
• The bonus issue and the share split are similar except for the
difference in their accounting treatment.
• In the case of bonus shares, the balance of the reserves and
surpluses account decreases due to a transfer to the paid-up capital
and the share premium accounts.
• With a share split, the balance of the equity accounts does not
change, but the par value per share changes.
Life Cycle analysis of Dividend Policy
 Issues in Dividend Policy
• Try to avoid reducing dividends
32
• Try to maintain a smooth dividend stream
• Current dividend level
• Reluctant to make a change that may have to be reversed.
• Consider change in the dividends
• Rather than reducing dividends raise new funds
• Cost of external capital is lower than cost of dividend cut
 Practical considerations in Dividend Policy
Particulars Dividend Retained Earnings
(High Payout) (Low Payout)
Tax Advantage of Capital Gains over dividend √
Uncertainty (Birds-in-Hand Argument) √
Brokerage Cost √
Issuance Cost (makes external financing costlier) √
Steady Source of Income √
Diversification √
Financial Signaling (Information Asymmetry) √
Control √
Restrictions in Debt Covenants/Loan agreement √
Liquidity concern- as payment of dividend means cash √
outflow
Ability to Borrow at Short Notice (Financial Flexibility) √
Funding Needs of Firm (Investment Opportunities) √
Economic Upturn √
Economic Downturn √
Mature Firm √
Growth Firm (have a large number of opportunities) √
Highly Levered (becomes fifficult to raise funds externally) √
Easy access to Capital Market √
Agency Cost √
Clientele Effect Retired Persons High Earning
(Low Tax Bracket) (High Tax Bracket)
 MAXIMIZE THE VALUE OF THE
BUSINESS (FIRM)

The Investment The Financial The Dividend

Decision
Invest in assets that
earn a return greater
than the minimum
acceptance hurdle rate
Decision
Find the right kind of debt
for your firm and the right
mix of debt and equity to
fund your operations
Decision
If you cannot find
investments that make
your minimum acceptable
rate, return the cash to
owners of your business

The hurdle The return The optimal The right How much How you
rate Should reflect mix of debt kind of debt cash you can choose to
Should reflect the magnitude and equity matches the return return cash
the riskiness and the timing maximizes tenor of your depends on to the
of the of the cash firm value assets current and owners will
investment flows as well potential depend on
and the mix of as all side
effects
investment whether they
debt and
opportunities prefer
equity used to
dividends or
fund it
buybacks