Concept note on Dividend Policy: Dividend Theories and Rational Expectation Theory_Dr.

Bhavana Raj Dividend policy involves the balancing of the shareholders desire for current dividends and the firms needs for funds for growth. Issues in Dividend Policy: (1)Earnings to be Distributed High Vs. Low Payout. (2)Objective Maximize Shareholders Return. (3)Effects Taxes, Investment and Financing Decision. Relevance Vs. Irrelevance: (1)Walter's Model (2)Gordon's Model (3)Modigliani and Miller Hypothesis (4)The Bird in the Hand Argument (5)Informational Content (6)Market Imperfections DIVIDEND RELEVANCE: WALTERS MODEL: Walters model is based on the following assumptions: (1)Internal financing (2)Constant return and cost of capital (3)100 per cent payout or retention (4)Constant EPS and DIV (5)Infinite time Walters formula to determine the market price per share :P=[DIV+(r/k)*(EPS-DIV)]/k; where P=Market Price per Share ,DIV=Dividends Price per Share ,EPS=Earnings Price per Share, r=firms average rate of return, k=firms cost of capital or capitalization rate Optimum Payout Ratio: (1)Growth Firms Retain all earnings (2)Normal Firms Distribute all earnings (3)Declining Firms No effect Criticism of Walters Model: (1)No external financing (2)Constant return, r (3)Constant opportunity cost of capital, k DIVIDEND RELEVANCE: GORDONS MODEL: Gordons model is based on the following assumptions: (1)All-equity firm (2)No external financing (3)Constant return (4)Constant cost of capital (5)Perpetual earnings (6)No taxes (7)Constant retention (8)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. Po=[EPS1(1-b)]/[k-g] OR Po=[EPS1(1-b)]/[k-br]; g=growth rate of the firm, b=retention ratio,(1-b)=payout ratio; DPS=payout ratio,(1-b) times EPSDIV(t)=(1-b)*EPS(t) where b=fraction if retained earnings. It is revealed that under Gordons model: (1)The market value of the share, Po, increases with the retention ratio, b, for firms with growth opportunities, i.e., when r>k. (2) The market value of the share, Po, increases with the payout ratio, (1-b), for declining firms with r<k. (3) The market value of the share, Po, is not affected by dividend policy when r=k.

DIVIDEND AND UNCERTAINTY:THE BIRD-IN-THE-HAND ARGUMENT: (1)Argument put forward, first of all, by Kirshman. (2)Investors are risk averse. (3)They consider distant dividends as less certain than near dividends. (4)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. DIVIDEND IRRELEVANCE: THE MILLERMODIGLIANI (MM) HYPOTHESIS: (1)According to M-M, under a perfect market situation, the dividend policy of a firm is irrelevant as it does not affect the value of the firm. (2)They argue that the value of the firm depends on firm earnings which results from its investment policy. (3) Thus when investment decision of the firm is given, dividend decision is of no significance. It is based on the following assumptions:(1)Perfect capital markets (2)No taxes Market Imperfections: (1)Tax Differential Low Payout Clientele (3)Transaction and Agency Cost (5)Diversification (7)Desire for Steady Income

(3)Investment policy

(4)No risk

(2)Flotation Cost (4)Information Asymmetry (6)Uncertainty High Payout Clientele (8)No or Low Tax on Dividends

Informational Content of Dividend: . In an uncertain world in which verbal statements can be ignored or misinterpreted, dividend action does provide a clear cut means of making a statement that speaks louder than a thousand words. Solomon Different Types of Dividends: (1)Many companies pay a regular cash dividend. (a)Public companies often pay quarterly. (b)Sometimes firms will throw in an extra cash dividend. (c)The extreme case would be a liquidating dividend. (2)Often companies will declare stock dividends. (a)No cash leaves the firm. (b)The firm increases the number of shares outstanding. (3)Some companies declare a dividend in kind. (a)Wrigleys Gum sends around a box of chewing gum. (b)Dundee Crematoria offers shareholders discounted cremations. Standard Method of Cash Dividend Payment: (1) Cash Dividend - Payment of cash by the firm to its shareholders. (2) Ex-Dividend Date - Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock before this date is entitled to a dividend. (3) Record Date - Person who owns stock on this date received the dividend. Procedure for Cash Dividend Payment: (1) Declaration Date: The Board of Directors declares a payment of dividends. (2) Cum-Dividend Date: The last day that the buyer of a stock is entitled to the dividend.

(3) Ex-Dividend Date: The first day that the seller of a stock is entitled to the dividend. (4)Record Date: The Corporation prepares a list of all individuals believed to be stockholders as of 6 November. Procedure for Cash Dividend Payment: 25 Oct 1 Nov 2 Nov 6 Nov 7 Dec

Declaration Date

Cum-Dividend Date

Ex-Dividend date

Record Date

Payment Date

Price Behavior around the Ex-Dividend Date: In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date. Taxes complicate things a bit. -T -2 -1 0 +1 +2 Empirically, the price drop is less than the dividend and $P occurs within the first few minutes of the ex-date. The price $P - div drops by the Examount of dividend the cash Date dividend Dividends and Investment Policy: (1) Firms should never forgo positive NPV projects to increase a dividend (or to pay a dividend for the first time). (2)Recall that one of the assumptions underlying the dividend-irrelevance arguments was The investment policy of the firm is set ahead of time and is not altered by changes in dividend policy. Repurchase of Stock: (1)Instead of declaring cash dividends, firms can rid itself of excess cash through buying shares of their own stock. (2)Recently share repurchase has become an important way of distributing earnings to shareholders. Share Repurchase: (1)Lower tax (2)Tender offers : If offer price is set wrong, some stockholders lose. (3)Open-market repurchase (4)Targeted repurchase (5)Repurchase as investment : Recent studies has shown that the long-term stock price performance of securities after a buyback is significantly better than the stock price performance of comparable companies that do not repurchase.

Personal Taxes, Issuance Costs, and Dividends: (1)To get the result that dividend policy is irrelevant, we needed three assumptions: (a)No taxes (b)No transactions costs (c) No uncertainty (2)In the United States, both cash dividends and capital gains are taxed at a maximum rate of 15 percent. (3) Since capital gains can be deferred, the tax rate on dividends is greater than the effective rate on capital gains. Firms Without Sufficient Cash to Pay a Dividend: Investment Bankers Cash: Stock issue Firm Cash: Dividends In a world of personal taxes, firms should not issue stock to pay a dividend. Stockholders The direct costs of stock issuance will add to this effect.

Taxes

Government

Firms With Sufficient Cash to Pay a Dividend: 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. The firm has several options: (1)Select additional capital budgeting projects (by assumption, these are negative NPV). (2)Acquire other companies (3)Purchase financial assets (4)Repurchase shares Taxes, Issuance Costs, and Dividends: In the presence of personal taxes: (1)A firm should not issue stock to pay a dividend. (2)Managers have an incentive to seek alternative uses for funds to reduce dividends. (3)Though personal taxes mitigate against the payment of dividends, these taxes are not sufficient to lead firms to eliminate all dividends. Real World Factors Favoring a High Dividend Policy: (1)Desire for Current Income: The homemade dividend argument relies on no transactions costs. To put this in perspective, mutual funds can repackage securities for individuals at very low cost: they could buy low-dividend stocks and with a controlled policy of realizing gains, pay their investors at a specified rate. (2)Resolution of Uncertainty: It would be erroneous to conclude that increased dividends can make the firm less risky. A firms overall cash flows are not necessarily affected by dividend policyas long

as capital spending and borrowing are not changes. Thus, it is hard to see how the risks of the overall cash flows can be changed with a change in dividend policy. (3)Tax Arbitrage: Investors can create positions in high dividend-yield securities that avoid tax liabilities. Thus, corporate managers need not view dividends as tax-disadvantaged. (4)Agency Costs: Agency Cost of Debt Firms in financial distress are reluctant to cut dividends. To protect themselves, bondholders frequently create loan agreements stating dividends can only be paid if the firm has earns, cash flow and working capital above pre-specified levels. Agency Costs of Equity Managers will find it easier to squander funds if they have a low dividend payout.

Real World Factors: (1)Reasons for Low Dividend: (a)Personal Taxes (b)High Issuing Costs (2)Reasons for High Dividend: (a)Information Asymmetry : Dividends as a signal about firms future performance (b)Lower Agency Costs : (b1)capital market as a monitoring device (b2)Reduce free cash flow, and hence wasteful spending (c)Bird-in-the-hand: Theory or Fallacy?: Uncertainty resolution (d)Desire for Current Income The Clientele Effect: A Resolution of Real-World Factors?: Clienteles for various dividend payout policies are likely to form in the following way: Group (1) High Tax Bracket Individuals (2) Low Tax Bracket Individuals (3) Tax-Free Institutions (4) Corporations Stock (1) Zero to Low payout stocks (2) Low-to-Medium payout (3) Medium Payout Stocks (4) High Payout Stocks

Once the clienteles have been satisfied, a corporation is unlikely to create value by changing its dividend policy. What We Know and Do Not Know About Dividend Policy: (1)Corporations Smooth Dividends. (2)Dividends Provide Information to the Market. (3)Firms should follow a sensible dividend policy: (a)Dont forgo positive NPV projects just to pay a dividend. (b)Avoid issuing stock to pay dividends. (c)Consider share repurchase when there are few better uses for the cash. OBJECTIVES OF DIVIDEND POLICY: (1)Firms Need for Funds (2)Shareholders Need for Income

PRACTICAL CONSIDERATIONS IN DIVIDEND POLICY: (1)Firms Investment Opportunities and Financial Needs (2)Shareholders Expectations (3)Constraints on Paying Dividends :(a)Legal restrictions (c)Financial condition and borrowing capacity (e)Restrictions in loan agreements STABILITY OF DIVIDENDS: (1)Constant Dividend per Share or Dividend Rate. (c)Constant Dividend per Share Plus Extra Dividend. Significance of Stability of Dividends: (1)Resolutions of investors uncertainty. (3)Institutional Investors Requirement. FORMS OF DIVIDENDS: (1) Cash Dividends (2)Bonus Shares (Stock Dividend) Advantages of Bonus Shares: To shareholders: (1) Tax benefit (2) Indication of higher future profits (3) Future dividends may increase (4) Psychological value

(b)Liquidity (d)Access to the capital market (f)Inflation (g)Control

(b)Constant Payout.

(2)Investors desire for current income. (4)Raising Additional Finances.

To company: (1) Conservation of cash (2) Only means to pay dividend under financial difficulty (3) contractual restrictions (4) More attractive share price

Limitations of Bonus Shares: (1)Shareholders wealth remains unaffected (3)Problem of adjusting EPS and P/E ratio

(2)Costly to administer

Conditions for the Issue of Bonus Shares: (1) Residual reserve criterion

(2)Profitability criterion

Share split: A share split is a method to increase the number of outstanding shares through a proportional reduction in the par value of the share. A share split affects only the par value and the number of outstanding shares; the shareholders total funds remain unaltered. Bonus Share vs. Share Split: (1)The bonus issue and the share split are similar except for the difference in their accounting treatment. (2)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. The par value per share remains unaffected. (3)With a share split, the balance of the equity accounts does not change, but the par value per share changes.

Reasons for Share Split: (1)To make trading in shares attractive. (2)To give higher dividends to shareholders. (3)To signal the possibility of higher profits in the future. Reverse Split: (1)Under the situation of falling price of a companys share, the company may want to reduce the number of outstanding shares to prop up the market price per share. (2)The reduction of the number of outstanding shares by increasing per share par value is known as a reverse split. (3)The reverse split is generally an indication of financial difficulty, and is, therefore, intended to increase the market price per share. BUYBACK OF SHARES: (1)The buyback of shares is the repurchase of its own shares by a company. (2)As a result of the Companies Act (Amendment) 1999, a company in India can now buyback its own shares. Methods of Shares Buyback: (1)First, a company can buy its shares through authorized brokers on the open market. (2)Second, the company can make a tender offer, which will specify the purchase price, the total amount and the period within which shares will be bought back. In India the following conditions apply in case of the buyback shares: (1)A company buying back its shares will not issue fresh capital, except bonus issue, for the next 12 months. (2)The company will state the amount to be used for the buyback of shares and seek prior approval of shareholders. (3)The buyback of shares can be affected only by utilizing the free reserves, viz., reserves not specifically earmarked for some purpose. (4)The company will not borrow funds to buy back shares. (5)The shares bought under the buyback schemes will be extinguished and they cannot be reissued. Effects of the Shares Buyback: (1)It is believed that the buyback will be financially beneficial for the company, the buying shareholders and the remaining shareholders. (2)Increase in the companys debt-equity ratio due to reduced equity capital. Advantages of the Buyback: (1)Return of surplus cash to shareholders (2)Increase in the share value (3)Increase in the temporarily undervalued share price (4)Achieving the target capital structure (5)Consolidating control (6)Tax savings by companies (7)Protection against hostile takeovers Drawbacks of the Buyback: (1)Not an effective defense against takeover (3)Loss to the remaining shareholders

(2)Shareholders do not like the buyback (4)Signal of low growth opportunities

MM formula: (1)r=[Dividends + Capital gains or losses]/Share Price=r=[DIV(t)+(Pt-Po)]/Po; Po=Market price per share or purchase price per share @ time o, DIV(t)=Dividend per share at time t, Pt=Market price of share at time t, r=return on equity (ROE) or cost of equity (2)The ROEto the required return on investment, r. Thus, MPS of a firm is, Po=[DIV(t)+Pt]/[1+r]=[ DIV(t)+Pt]/[1+k] ,Since, r=k, as no risk exists for the firm, assuming a world of certainty and perfect markets. (3)Value of the firm, V=N(No. of shares outstanding)*Po(MPS)V=N*Po (4)Total amount of new outstanding shares issued, mPt=It-[Xt-nDIVt]; nDIVt=Retained earnings, n=number of shares outstanding, DIVt=DPS, m=no. of shares issued in time t @ price Pt, I=total new investments in period t, Xt=Total net profit for the firm @ time t (5) Value of the firmnPo=[(n+n)*P1-I + E]/ [1+Ke]. (6) Number of additional shares to be issued n={[I-(E-nD1)]}/ P1. Dividend Decision: Dividend Life Cycle: (1)The Dividend Payout Policy depends largely on the market imperfections & firms position in its life cycle.(2)The key imperfections are taxes, agency costs, flotation costs & informational asymmetry. (3)The major stages in a firms life cycle are infancy, rapid growth, maturity & decline. (4)Ignoring Taxes for the time being, Imperfection Stages Infancy Rapid Growth Maturity Decline Flotation Costs Very High Moderate Low Low Agency Costs Low Moderate High Very High Informational Asymmetry Very High Moderate Falling Low Implied Dividend Policy Nil or Negligible Dividends Low Dividend Payout Policy Increasing Dividend Payout Policy Generous Dividend Payout Policy

Corporate Dividend Behavior: Bonus Issue Vs Stock Split: Bonus Issue Stock Split (1)The par value of the share is unchanged. (1) The par value of the share is reduced. (2)A part of reserves is capitalized. (2)There is no capitalization of reserves. (3)The shareholders proportional ownership (3) The shareholders proportional ownership remains unchanged. remains unchanged. (4)The book value per share (BVPS), earnings (4) The book value per share (BVPS), earnings per share (EPS) & the market price per share per share (EPS) & the market price per share (MPS) decline. (MPS) decline. (5)The MPS (market price per share) is brought (5) The MPS (market price per share) is brought within a more popular trading range. within a more popular trading range. SUMMING UP: (1)The optimal payout ratio cannot be determined quantitatively. (2)In a perfect capital market, dividend policy is irrelevant due to the homemade dividend concept. (3)A firm should not reject positive NPV projects to pay a dividend. (4)Personal taxes and issue costs are real-world considerations that favor low dividend payouts. (5)Many firms appear to have along-run target dividend-payout policy. There appears to be some value to dividend stability and smoothing. (6)There appears to be some information content in dividend payments.