Dividend Policy and Firm value

Dividend Decisions Session No. 8 & 9

Manish Parmar

Key Concepts
Understand dividend types and how they

are paid
Understand the difference between cash

and stock dividends

Understand why share repurchases are an

alternative to dividends
Understand the issues surrounding

dividend policy decisions

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Dividend payments can be made in either of the following ways:Cash Dividend - Payment of cash by the firm to its
shareholders. (Normally companies pay regular

dividends and sometimes it pays special dividend)

Public Ltd companies often pay quarterly or semi

annually i.e. regular Dividend.

Sometimes firms will pay an extra cash dividend,

i.e. Special Dividend.

The extreme case would be a liquidating
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dividend.

Dividend payments can be made in either of the following ways:Stock Dividend - Distribution of additional shares to
a firms Shareholders. (Bonus shares)

Stock Splits The par value per share is reduced

and the number of shares is increased proportionately. In both the above cases: No cash leaves the firm The firm increases the number of shares

outstanding
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TABLE 1 Effect of Bonus Shares and Share Splits (I) Equity portion before the bonus issue:

Equity share capital (30,000 share of Rs 100 each)

Share premium (@ Rs 25 per share) Retained earnings

Rs 30,00,000
7,50,000 62,50,000

Total equity
(II) Equity portion after the bonus issue (1 : 2 ratio): Equity share capital (45,000 shares of Rs 100 each) Share premium (45,000 shares Rs 25) Retained earnings (Rs 62,50,000 15,000 shares Rs 125) Total equity (III) Equity portion after the share splits (10 : 1 ratio): Equity share capital (3,00,000 shares of Rs 10 each) Share premium Retained earnings

1,00,00,000

45,00,000 11,25,000 43,75,000 1,00,00,000

30,00,000 7,50,000 62,50,000

Total equity
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1,00,00,000

Standard Method of Cash Dividend

Cash Dividend - Payment of cash by the firm to its shareholders.
Ex-Dividend Date - Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock immediately before this date is entitled to a dividend. Record Date Date on which company determines existing shareholders.
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Procedure for Cash Dividend

25 Oct. 1 Nov. 2 Nov. 4 Nov. 7 Dec.

Declaration Date ExCumdividend dividend Date Date Record Date Payment Date

Declaration Date: The Board of Directors declares a payment of dividends. Cum-Dividend Date: Buyer of stock still receives the dividend. Ex-Dividend Date: Seller of the stock retains the dividend. Record Date: The corporation prepares a list of all individuals believed to be stockholders as of 4 November.
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Price Behavior
In a perfect world, the stock price will fall by

the amount of the dividend on the exdividend date.

-t

-2

-1

+1

+2

$P
$P - div

The price drops Exby the amount of dividend Date the cash dividend. Assumptions: No tax on dividend payments
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The Irrelevance of Dividend Policy

A compelling case can be made that dividend policy

is irrelevant.
Since investors do not need dividends to convert

shares to cash; they will not pay higher prices for firms with higher dividends.
In other words, dividend policy will have no impact

on the value of the firm because investors can create whatever income stream they prefer by using homemade dividends.
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Homemade Dividends
Bianchi Inc. is a $42 stock about to pay a $2 cash dividend. Bob Investor owns 80 shares and prefers a $3 dividend. Bobs homemade dividend strategy:

Sell 2 shares ex-dividend

homemade dividends Cash from dividend $160 Cash from selling stock $80 Total Cash $240 Value of Stock Holdings $40 78 = $3,120 $3 Dividend $240 $0 $240 $39 80 = $3,120

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Dividend Policy is Irrelevant

In the above example, Bob Investor began with

a total wealth of $3,360:

$ 42 $ 3,360 80 shares share
After a $3 dividend, his total wealth is still $3,360:

$ 39 $ 3 ,360 80 shares $ 240 share

After a $2 dividend and sale of 2 ex-dividend shares, his

total wealth is still $3,360:

$ 40 $ 3,360 78 shares $ 160 $ 80 share
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Dividends and Investment Policy

Firms should never forgo positive NPV projects to

increase a dividend (or to pay a dividend for the first time).

Recall that one of the assumptions underlying the

dividend-irrelevance argument is: The investment policy of the firm is set ahead of time and is not altered by changes in dividend policy.

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Repurchase of Shares
In India, repurchase of shares is commonly known as

buyback of shares.
Instead of declaring cash dividends, firms can get rid

of excess cash through buying shares of their own stock.

Recently, share repurchase has become an important

way of distributing earnings to shareholders.

Buyback of shares is allowed in India from 1998 (Sec
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77A of companies act)

Concept Question
How does share buyback impact companies financial condition vis--vis paying cash dividends?

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Stock Repurchase versus Dividend

Consider a firm that wishes to distribute $100,000 to its shareholders. Assets A.Original balance sheet Liabilities & Equity

Cash $150,000 Debt 0 Other Assets 850,000 Equity 1,000,000 Value of Firm 1,000,000 Value of Firm 1,000,000 Shares outstanding = 100,000

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Stock Repurchase versus Dividend

If they distribute the $100,000 as a cash dividend, the balance sheet will look like this: Assets Liabilities & Equity
B. After $1 per share cash dividend

Cash
Other Assets

$50,000
850,000

Debt
Equity

0
900,000

Value of Firm 900,000

Value of Firm 900,000

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Stock Repurchase versus Dividend

If they distribute the $100,000 through a stock repurchase, the balance sheet will look like this:
Assets C. After stock repurchase Liabilities& Equity

Cash $50,000 Debt 0 Other Assets 850,000 Equity 900,000 Value of Firm 900,000 Value of Firm 900,000

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Concept Question
If the Board of directors hold ESOPS in the company and they are about to choose dividend vs buyback decision, what will they choose?
Let us have a re-look at the balance sheets we just saw!!

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Stock Repurchase versus Dividend

If they distribute the $100,000 as a cash dividend, the balance sheet will look like this: Assets Liabilities & Equity
B. After $1 per share cash dividend

Cash
Other Assets

$50,000
850,000

Debt
Equity

0
900,000

Value of Firm 900,000

Value of Firm 900,000

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Stock Repurchase versus Dividend

If they distribute the $100,000 through a stock repurchase, the balance sheet will look like this:
Assets C. After stock repurchase Liabilities& Equity

Cash $50,000 Debt 0 Other Assets 850,000 Equity 900,000 Value of Firm 900,000 Value of Firm 900,000

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Stock Repurchase versus Dividend

If they distribute the $100,000 as a cash dividend, the balance sheet will look like this: Assets Liabilities & Equity
B. After $1 per share cash dividend

Cash
Other Assets

$50,000
850,000

Debt
Equity

0
900,000

Value of Firm 900,000

Value of Firm 900,000

Shares outstanding = 100,000 Price per share = $900,000/100,000 = $9

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Stock Repurchase versus Dividend

If they distribute the $100,000 through a stock repurchase, the balance sheet will look like this:
Assets C. After stock repurchase Liabilities& Equity

Cash $50,000 Debt 0 Other Assets 850,000 Equity 900,000 Value of Firm 900,000 Value of Firm 900,000
Shares outstanding= 90,000 Price pershare = $900,000 / 90,000 = $10

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Methods of Share Buybacks in India

Open market offer purchase. E.g. HUL, Madras cements.

Tender offer. E.g.Bajaj Auto. [Check NSE & BSE

websites for announcements].

Targeted

buybacks.

E.g.

GESCO.

http://www.rediff.com/money/2001/jan/12inter.htm
Book Building process to buyback shares.
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Regulation of buybacks (Sec 77A)

A company can buyback 10 percent of its

shares

annually

with

board

resolution.

Beyond that a special resolution is required.

The buyback should not exceed 25 percent of

the total paid up capital and free reserves.

The post-buyback debt-equity ratio should

not exceed 2:1

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Regulation of buybacksContd
The shares bought should be extinguished &

physically destroyed.
A declaration of solvency has to be filed with

SEBI & registrar of companies.

The company should not make further issue

within a prescribed time limit.

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SEBI'S PROPOSALS (BT article* as on 25/01/2013)

Buy-back period to be reduced to three

months from 12. Minimum buy-back to be 50 per cent of the proposed size. 25 per cent of the amount earmarked for buyback to be kept in an escrow account Capital raising from equity markets to be prohibited for two years after a buy-back
* Will SEBI's proposals help in checking misuse of the share buy-back route by companies _ Business Today.pdf
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Dividend Vs Buyback: Real world considerations

Flexibility. Keeps stock price higher, good for insiders who hold

stock options (Previous Example)

Undervaluation-(Signaling theory) Taxation (Discussed in detailed after few slides)

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Personal Taxes and Dividends

To get the result that dividend policy is irrelevant,

we needed three assumptions:

No taxes No transactions costs No uncertainty

In the United States, both cash dividends and

capital gains are taxed at a maximum rate of 15 percent. (In India-?)

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Section 46A of Income Tax Act.

Capital Gains on buyback of its own shares:The difference between the cost of acquisition and the value of consideration received by the shareholder shall be deemed to be the capital gains arising to such shareholder Are all capital gains taxable? LTCG on transfer of equity shares listed on a stock exchange in India, where STT has been paid, is tax exempt, while STCG in the same situation is taxed at a rate of 15%
Dividends : Companies pay DDT @15% & Dividends are exempt in investors hand.
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Firms without Sufficient Cash

Investment Bankers

The direct costs of stock issuance will add to this effect.

Stock Holders

Cash: stock issue Firm

Cash: dividends
Taxes Gov.
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In a world of personal taxes, firms should not issue stock to pay a dividend.

Firms with Sufficient Cash

The above argument does not necessarily apply to

firms with excess cash.

Consider a firm that has $1 million in cash after

selecting all available positive NPV projects.

Select additional capital budgeting projects (by

assumption, these are negative NPV).

Acquire other companies

Purchase financial assets

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Repurchase shares

The Clientele Effect

Clienteles for various dividend payout policies are

likely to form in the following way:

Stock Type
Zero-to-Low payout (Prefer Capital gains) Low-to-Medium payout Medium payout High payout (Prefer Stable income) Once the clienteles have been satisfied, a corporation is unlikely to create value by changing its dividend policy.
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DIVIDEND POLICY : STABILITY Steadily Changing Dividends

Earnings/Dividends Earnings

Dividends

Time
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What We Know and Do Not Know

Corporations smooth dividends.
Dividends provide information to the market.

(Signaling) Firms should follow a sensible policy:

Do not forgo positive NPV projects just to pay a

dividend. Avoid issuing stock & debt to pay dividends. Consider share repurchase when there are few better uses for the cash.

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Stock Dividends & Stock Splits

Stock Dividends: Pay additional shares of stock instead of cash

Increases the number of outstanding shares

Stock splits essentially the same as a stock dividend

except it is expressed as a ratio

For example, a 2 for 1 stock split is the same as a 100% stock dividend. Stock price is reduced when the stock splits. Common explanation for split is to return price to a

more desirable trading range.

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Other factors affecting dividend policy

Legal constraints
The companies are not allowed to declare

dividends when they have overdue liabilities or

are bankrupt.
Contractual constraints
Restrictive provisions in loan agreements & bond

indentures.
Internal constraints; like liquidity problems.
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*Fresh loans can be takenbut its not advisable.

We had a good discussion on theoretical concepts.lets do a practical case

.next session.case is FPL

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