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Dividend Decisions

Dividend Decisions Dividend Policy determines the proportion of total earnings is to be paid as dividends and the proportion to be retained in the business for reinvestment purposes. Dividend decision links the Investment decision with the Financing Decision. Higher dividends means lower Retained earnings, which in turn means more reliance on external funds.

Dividend Decisions

Forms of Dividends
Cash Dividend: Companies mostly pay dividends in cash. Regular, special, and interim dividends Have liquidity issues. Stock Dividend (Bonus Shares): Issue of shares free of cost to the existing shareholders of the company. Represents the capitalisation of reserves. Proportionate shareholding remains the same, while shareholding of each shareholder increases. In India, bonus shares cannot be issued in lieu of cash dividends.  RIL recently declared a cash dividend of Rs. 13 per share and a 1:1 bonus.
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Forms of Dividends
 Why Bonus shares:  Brings the market price within a popular price range.
A share of Rs 1000/- is less affordable than Rs 100/- share.

 Increases the no.of shares, hence the liquidity of the stock.  Indicates bright future prospects.

Stock Splits: The par value of the shares is reduced, thereby increasing the no. of shares outstanding. (Not a form of

Dividend) Bonus Debentures: HLL issued (1:1) debentures on bonus (free) basis (2001).

Dividend Decisions

Forms of Dividends
Share Repurchase: Purchase by the company of its own equity shares. rewarding the shareholders as the repurchase is at a price higher than the current market price, besides mode of capital restructuring.  Modes of Share Repurchase: Open Market Repurchase (India) Tender Offer (India) Dutch Auction

Dividend Decisions

Procedural Aspects of Dividends

Board Resolution: Board of Directors at their board meeting adopt a resolution to pay dividends. Shareholders approval: Boards resolution has to be approved by the shareholders at the Annual General Meeting. Record date: Upon approval of the resolution, the Company fixes a Record date to freeze the shareholders to whom dividends has to be paid. Dividend payment: Once the dividend is declared, dividend warrants must be posted within 30 days.
Announcement date Ex-Dividend Record Date Payment date

Company approves Dividend

Stock has to be bought by this date for investor to receive dividends

Company closes books and records owners of stock

Dividend is paid to shareholders

Dividend Decisions

Dividend Decisions - Overview of Theories

Dividends are Bad

Dividend Policy

Dividends are Good

Middle-of -the-road (MM Theory)

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Dividends are bad

Dividends create tax disadvantage for investors who receive them as dividends are taxed heavily than capital gains. Accordingly, dividends should reduce the returns to shareholders after personal taxes. Shareholders would respond by reducing the stock prices of firms of such firms relative to firms that do not pay dividends. Consequently, firms would be better off by either retain the money they would have paid as dividends or repurchasing stock.

Dividend Decisions

Measuring the Dividend Tax disadvantage

Tax rates on dividends are generally greater than on capital gains. Measure the price change on the ex-dividend date and compare it with the actual dividend paid.
Sell before Ex-dividend Sell after Ex-dividend

CFB ! PB  (PB  P)t cg

CFA ! PA  (PA  P)t cg  D(1  t o )

PB  (PB  P)t cg ! PA  (PA  P)t cg  D(1  t o )

PB  PA (1  t o ) ! D (1  t cg )
Price drop on the ex-dividend date should reflect the tax differential between tax on dividends and capital gains. If PB-PA = D, investor is indifferent between dividends and Capital Gains If PB-PA < D, investor is taxed more heavily on dividends If PB-PA > D, investor is taxed more heavily on Capital Gains

Dividend Decisions

Implications of Dividend Tax disadvantage

Firms with an investor base composed primarily of individuals should typically have lower dividends as compared to firms with tax-exempt institutional investors. Higher the income level (and hence the tax rate) of investors, lower should be the dividend payout by the firm.

Dividend Decisions


Dividends are Good

Despite the tax disadvantage of dividends, firms continue to pay dividends. Some dubious reasons for paying dividends are: o Bird-in-hand fallacy: Certain dividends are better than uncertain capital gains.  The choice is, however, between dividends today and an almost equal amount in price appreciation today. o Temporary excess cash: Return excess cash arising due to extra-ordinary year or sale of assets might appear reasonable.  But if the firm expects shortfall in the near future, it is better to retain the excess cash now than to return it now and raise funds later, as there is cost of issuing bonds/ equity.
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Some good reasons for paying dividends

Although the dividends have tax disadvantages, esp. for individuals, they are preferred due to: 1. Investors like dividends:
Self-Control: Individuals lack self-control. They rely on external regulations to control their actions. Hence in order to conserve their savings, investors would like to limit the amount at their disposal in the form of Dividend such that the principal amount is left untouched. Clientele Effect - Over a period, shareholders tend to invest in firms whose dividend policies match their preferences. High tax investors prefer companies which pay low or no dividends, while low tax investors prefer high dividend paying firms.
Pettit (1977) regressed dividend yields on characteristics of investor base age, income, diff tax rates etc. Safer companies had older and poor investors paid more dividends than companies with rich and younger investors. 12 Dividend Decisions

Some good reasons for paying dividends

2. Dividends as Information Signal: How do firms convey information credibly to financial markets?
Signaling theory suggests that firms need to take actions that cannot be easily imitated by firms without good projects. say by increasing dividends Increasing dividends sends positive signal as it indicates improved capacity to generate higher cash flows in the future

Dividend Decisions


Some good reasons for paying dividends

3. Dividends reduce managerial discretion:
Accumulated cash left to the discretion of managers may be wasted in poor projects. Forcing firms to pay dividends is a way to discipline managers in project selection and to reduce the cash available for discretionary use. Firms with separation of ownership and management, should pay larger dividends than firms with substantial insider ownership.

Dividend Decisions


Modigliani & Miller (MM) Theory

Assume an unlevered firm which has: post-tax EBIT of Rs 100 Mn that grows @5%pa Shares outstanding:105 Mn shares cost of capital : 10%. Reinvestment requirement: Rs. 50 Mn (grows @ 5%. pa) Value of Firm = Cash flow / k-g (100-50)*(1.05)/(10%-5%) = Rs.1050 Mn Price per share = Rs 1050 Mn /105 Mn = Rs 10/ Based on its cash flow, firm could pay dividend of Rs 50 Mn Dividend per share = Rs 50 Mn/ 105 Mn = 0.476 Total value per Share = Rs 10 + Rs 0.476 = Rs 10.476.
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MM Theory

Scenario I : Company doubles the dividend:

Dividend to be paid is Rs 100 Mn instead of Rs 50 Mn. Firm would have to raise additional Rs 50 Mn for dividend pay out. Assume the firm issues new shares (at no floatation costs)

Value of Firm = (50)*(1.05)/(10%-5%) = Rs1050 Mn Existing shareholders will receive a much larger dividend Dividend per share = Rs 100 Mn/ 105 Mn = Rs 0.953 After issue of new shares, old shareholders are owning Rs.1000 Mn, out of the total firm value of Rs. 1050 Mn. Price per share = Rs 1000 Mn /105 Mn = Rs 9.523 Total value per Share = Rs 9.523 + Rs 0.953 = Rs 10.476.  Firm value remains unaffected by the dividend policy.
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MM Theory

Scenario II : Company stops paying the dividend:

The firms decides not to pay dividend and retain the residual cash of Rs 50 Mn.

Value of Firm = Cash flow/k-g + Cash Balance (50)*(1.05)/(10%-5%) + 50 = Rs1100 Mn Value per share = Rs 1100 Mn /105 Mn = Rs 10.476 Increase in stock price is offset by the loss of cash flow from dividends. When the firm pays more, the price decreases but is exactly offset by the increase in dividends per share.  Firm value remains unaffected by the dividend policy.

Dividend Decisions


MM Theory Value of the firm depends upon the earning power of the firms assets or its Investment policy. The manner in which the earnings are split between dividends & Retained earnings does not effect the value of the firm. Assumptions of MM Hypothesis: Perfect Capital Markets Investors are rational. No flotation costs No taxes No change in the given Investment policy Crux of the MM hypothesis: The effect of dividends payments on shareholders wealth is offset exactly by the impact of other means of financing. Hence, Dividend decision is a residual decision.
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Dividend policy when dividends are irrelevant

The assumptions needed to arrive at the dividend irrelevance proposition are too restrictive and we may be tempted to reject it. But the theory does contain valuable message. A firm that has invested in bad project, cannot hope to increase its value by paying higher dividends. A firm with great investments may be able to sustain its value even if it does not pay any dividends.

Dividend Decisions


Quantum vs. Stability Two aspects of Dividend Policy are: Quantum of Dividends Stability or Fluctuating Dividends Dividend payout may be High or Low and the payout be Stable or Fluctuating .

Dividend Decisions


Factors affecting Quantum of Dividend 1. Funds Requirements: Payout depends upon funds
requirements in the foreseeable future, assessed thru financial forecasts. Firms with large investment projects, hence huge requirements of funds, keep D/P low. On the other hand, firms with limited investment avenues, have high D/P ratio. E.g. Bombay Dyeing. 2. Liquidity: For paying dividends, firm needs Cash (Liquidity). Hence, liquidity status has an impact on the D/P decision. A profitable & rapidly expanding firm may not have the necessary funds to pay dividends due to liquidity constraints.
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Factors affecting Quantum of Dividend 3. Access to External Funds: Firms which has access to external sources, may feel less constrained in its dividend decision. Dividend decisions would be independent of the Investment decision & Liquidity position. Such firms may pay liberal dividends. 4. Shareholder Preference: Preference of shareholders may influence the D/P. If Shareholders prefer dividends instead of Capital Gains, Co. may be inclined to pay liberal dividends and vice versa. The clientele effect appears to work in such cases.

Dividend Decisions


Factors affecting Quantum of Dividend 5. Control: External equity (except for Rights Issue) dilutes the control over the company. Internal financing helps in maintaining the control. Management & Shareholders are averse to external financing & hence firms rely on retained earnings. 6. Difference in Cost of External Equity & Retained Earnings: Cost of External Equity is higher than the cost of Internal Equity (Retained earnings) due to Issue Cost & Under pricing. Magnitude of the differential has a bearing on the proportion of external Equity & Retained Earnings. And therefore on the D/P.

Dividend Decisions


Factors affecting Stability of Dividends

Stability of dividends is considered a desirable policy by the Management. Stable Dividend Payout Ratio Policy: % age of Dividend paid out remains constant. Dividends ,therefore, fluctuate with the Earnings. Such policy transfer the variability of earnings to dividends. Not very popular.

Earnings /Dividends


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B. Factors affecting Stability of Dividends

Stable Dividend Policy: Rupee level of dividends remains stable or gradually increases (generally). Generally this policy is followed.

Earnings /Dividends


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Dividend Decisions

Why firms follow Stable Dividend Policy?

Firms tend to follow a Stable or gradually rising Dividend Policy. 1. For many investors, dividend income is utilised to meet a portion of their living expenses. As these expenses are stable or gradually increasing, investors prefer stable or gradually increasing dividend inflow. If dividends are fluctuating widely, investors may be forced to either sell their investments or reinvest the surplus funds. Both involve transaction costs & inconvenience.

Dividend Decisions


Why firms follow Stable Dividend Policy? 2.Dividend decision provides a Signal to the investors regarding the future prospects of the Company. Increasing dividends means improved earnings prospects, and so on. Dividends, therefore, resolves uncertainty in the minds of the investors. If the firm varies the Dividends frequently based on short term influences, its dividend decision shall lack the uncertainty resolution power. Hence, firms maintain a stable dividends and change only gradually corresponding to long-term changes in prospects.

Dividend Decisions


Corporate Dividend Behaviour

Do firms follow a pattern regarding Dividends? Lintner provided an answer, based on a survey of Corporate Dividend Behaviour. Findings of the survey suggests: 1. Firms set long-run target payout ratios; 2. Management is more concerned with the changes in dividends rather than absolute dividends; 3. Dividends tend to follow earnings, but dividends follow a smoother path than earnings; 4. Dividends are sticky as managers are reluctant to change Dividends which may have to be reversed later.

Dividend Decisions


Lintners Model
Lintner expressed Corporate Dividend Behaviour in the form of a Model: Dt = cr EPSt +(1-c)Dt-1 where, Dt = Dividend per Share for year t c = adjustment rate r = target payout rate EPSt = Earnings per Share for year t Dt-1= Dividend per Share for year t-1 Lintners Model shows that current Dividend depends upon: (a) Current earnings, and (b) Previous years dividends Lintners Model is supported by empirical research conducted in India also.
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Lintners Model
Calculate the DPSt from the following data for XYZ Ltd :
EPSt = Rs 25/- ; Dt-1= Rs 14/- ; c = 0.45 & r = 60%.

Dt = (0.45 * 0.6*Rs 25 ) + ((1-0.45)*Rs14) = 6.75 + 7.70 = Rs 14.45 c the adjustment factor shall be small for conservative companies and large for aggressive companies.

Dividend Decisions

Empirical evidence of Dividend Policy

Dividends tend to follow earnings
As dividends are paid out of earnings.

Dividends are sticky

Reluctance of firms to raise dividends until they feel confident of maintaining it and to cut dividends unless absolutely required.

Dividends follow a smoother path than earnings A firms dividend policy tends to follows the life cycle of the firm
Firms in high growth stage pay low / no dividends, while stable firms with large cash balances and fewer projects pay out higher dividends.

Dividend policy varies across countries

Difference in stage of growth Difference in tax treatment Difference in corporate control
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