Bhupendra Dividend Policy

WELCOME TO
ALL OF U
Bhup.manas@gmail.co
UNDERPOLICY
DIVIDEND GUIDENCE:
& VALUE OF
PROF. ANUBHA GUPTA FIRM
IMRT BUSINESS SCHOOL
VIPUL KHAND GOMTINAGAR
LUCKNOW
FROM: BHUPENDRA
PT SINGH
PGDM-2nd TRIMESTER
Bhup.manas@gmail.c
Topics Covered
How Dividends are Paid
Share Repurchase
How Do Companies Decide on Dividend
Payments
Why Dividend Policy Should Not Matter
Why Dividends May Increase Firm Value
Why Dividends May Reduce Firm Value
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Dividend Payments
 Regular vs. extra dividend
 Regular payment is an important issue
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 before this date
is entitled to a dividend.
Record Date - Person who owns stock on this

date received the dividend.
Procedure for Cash Dividend
Payment
25 Oct. 1 Nov. 2 Nov. 6 Nov. 7 Dec.
…
Declaration Cum- Ex- Record Payment

Date dividend dividend Date Date
Date Date
Declaration Date: The Board of Directors declares a payment of
dividends.
Cum-Dividend Date: The last day that the buyer of a share is
entitled to the dividend.
Ex-Dividend Date: The first day that the seller of a share is
entitled to the dividend.
Record Date: The corporation prepares a list of all individuals
believed to be shareholders as of 6 November.
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Payments
Some legal limitations on
dividends
Bondholders are often against excessive
dividend payments
Most state prohibit a company from paying
dividends such that make the company
insolvent
Sometimes state law prevents a company
from payingBhup.manas@gmail.com
a dividend if it cuts into the
Taxes, Issuance Costs, and
Dividends
In a tax-free world, cash dividends are a wash between the
firm and its shareholders.
Cash: Share Issue

Share
Firm Bhup.manas@gmail.com Holders
Cash: Dividends
Taxes In a world with taxes, the

government gets a cut.
Gov.
Payments
Stock Dividend - Distribution of additional
shares to a firm’s stockholders.
Stock Splits - Issue of additional shares to

firm’s stockholders.
Example - Amoeba Products has 2 million shares
currently outstanding at a price of $15 per share.
The company declares a 50% stock dividend. How
many shares will be outstanding after the dividend is
paid?
Answer
2 mil x .50 = 1 mil + 2 mil = 3 mil shares
Dividend
Example - cont - After the stock dividend what
is the new price per share and what is the
new value of the firm?
Answer
The value of the firm was 2 mil x $15 per
share, or $30 mil. After the dividend the
value will remain the same.
Price per share = $30 mil / 3 mil share =
$10 per share
Payments
Stock Repurchase - Firm buys back stock
from its shareholders. (cash dividend vs.
share repurchase )
 If there are a few investment opportunities, and

the companies do not want to commit a regular
abundant dividend, then stock repurchase seems to
be a good strategy
Example - Cash dividend versus share repurchase
Assets Liabilities & Equity

A. Original balance sheet
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
Price per share = $1,000,000 / 100,000 = $10
B. After cash dividend
Cash $50,000 Debt 0
Other assets 850,000 Equity 900,000
Value of Firm 900,000 Value of Firm 900,000
Price per share = $900,000 / 100,000 = $9
C. After stock repurchase
Cash $50,000 Debt 0
Other assets 850,000 Equity 900,000
Value of Firm 900,000 Value of Firm 900,000
Price per share = $900,000 / 90,000 = $10
Decision
 How Dividends are Determined?
1. Firms have long-term target dividend payout
ratios.
2. Managers focus more on dividend changes
than on absolute levels.
3. Dividends changes follow shifts in long-run,
sustainable levels of earnings rather than
short-run changes in earnings .
4. Managers are reluctant to make dividend
changes that might have to be reversed.
(They are particularly worried about having to
rescind a dividend increase)
Level of dividends can be taken as a signal
about the company’s future prospect
Policy
 Three points of view about dividend policy
and the value of firm
1. Dividend policy makes no difference
2. High dividends increase firm value
3. High dividends bring high taxes and
therefore reduce firm value
Dividend policy
 Higher dividend payout means:
 More current dividend amount, consequently higher
stock price
 But lower retention rate with lower amount available for
reinvestment leading to lower growth depressing stock
price
 Thus needs to strike a balance to maximize stock price
 Referred as optimal dividend policy
 MM’s proposition: value of a firm depends only on the
income produced by its assets
 Not on how the income is split between dividends and
retained earnings (growth)
 Investors more certain of present dividend (bird-in-hand)
and prefer present dividend yield, as against capital
gain yield (less certain of receiving capital gain in future
 Tax rate on capital gains and on dividend income are
usually different for investors (long-term capital gains
attract normally lower tax rate)
 Again, capital gains tax not payable until stock is sold
 Wealthy investors (who own most of the stock and
receive most of the dividends) likely to prefer higher
retention rate for plough back of profits rather than
high dividend rate
 Most firms try to follow a policy of paying a constant or
steadily increasing dividend
 That provides stable income to investors
 Any departures from it give investors information about
management’s expectations for future earnings
(signalling effects)
 Other dividend policies may pertain to:
 Residual (after capital budgeting) dividend policy
 Constant payout ratio policy
 Low regular dividend plus extra policy (can be
maintainedBhup.manas@gmail.com
in difficult years and then pay extra
 The major issue involved:
 At what rate earned inside the organization vs. at
what rate earned in outside opportunities (besides the
differential tax impact on dividend and capital gains)
from investors’ point of view
 Cost of retaining earnings vs. cost of distributing
earnings from the company’s point of view.
 Clientele effect:
 Individuals in high tax bracket likely to prefer either no
or less dividends, on the contrary low tax bracket
investors would prefer the opposite
 This disparity eventually narrowed down, and the
market stabilizes
 As investors desirous of specific pattern of dividends
switch over their investments to those firms where they
would get their preferred choice of dividends, known as
clientele effect
 Linter model:
 Managers estimate what portion of firms’ earnings is
likely to be permanent and what portion of earnings is
likely to be temporary
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 Dividends likely to be raised following a permanent
(rather than temporary) increase in earnings and firms
have a long-run target for their dividends to earnings
ratio
 Managers need to decide the target payout ratio and the
speed of adjustment of current dividend to target
 Dividend may be paid by way of cash, or stock dividend
depending on company’s cash position and its likely
impact on its capital structure
 Stock split refers to increasing the number of shares,
such as doubling the number of shares outstanding by
giving each stockholder two new shares for each one
formerly held- to keep the stock prices within the
optimal trading range
 Stock repurchase plan- firm buys back some of its
outstanding stock, thereby decreasing the number of
shares and consequently increasing EPS and stock price
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X & Y ARE TWO FAST GROWING COMPANIES IN THE ENGINEERING INDUSTRY. THEY ARE
CLOSE COMPITITORS & THEIR ASSETS COMPOSITION, CAPITAL STRUCTURE &
PROFITABILITY RECORDS HAVE BEEN VERY SIMILAR FOR SEVERAL YEARS. THE PRIMARY
DIFFERENCE BETWEEN THEM FROM FINANCIAL MANAGEMENT PERSPECTIVE IS THEIR
DIVIDEND POLICY. THE COMPANY X TRIES TO MAINTAIN A NON DECREASING DIVIDEND
PER SHARE, WHILE THE COMPANY Y MAINTAINS A CONSTANT DIVIDEND PAY OUT RATIO.
THEIR RECENT EARNING PER SHARE(EPS), DIVIDEND PER SHARE (DPS), & SHARE
PRICE (P) HISTORY ARE AS FOLLOWS:::::
Year COMPANY X COMPANY Y
EPS DPS P(RANGE) EPS DPS P(RANGE
)
1 Rs 9.30 Rs 2 Rs 75-90 Rs 9.50 Rs Rs 60-80
2 7.40 2 55-80 7.00 1.90
1.40 25-65
3 10.50 2 70-110 10.50 2.10 35-80
4 12.75 2.25 85-135 12.25 2.45 80-120
5 20.00 2.50 135-200 20.25 4.05 110-225
6 16.00 2.50 150-190 17.00 3.40 140-180
7 19.00 2.50 155-210 20.00 4.00 130-190
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QUESTIONS OF EXAMPLE
IN ALL CALCULATIONS BELOW THAT REQUIRE A SHARE PRICE, USE THE
AVERAGE OF THE TWO PRICES GIVEN IN THE SHARE PRICE RANGE.
(A) DETERMINE THE DIVIDEND PAYOUT RATIO (D/P) & PRICE TO

EARNINGS(P/E) RATIO FOR BOTH COMPANIES FOR ALL THE
YEARS.
(B) DETERMINE THE AVERAGE D/P & P/E FOR BOTH THE COMPANIES
OVER
THE PERIOD 1 THROUGH 7.
(C) THE MANAGEMENT OF COMPANY Y IS PUZZLED AS TO WHY THEIR

SHARE PRICES ARE LOWER THAN THOSE OF COMPANY X, IN
SPITE OF THE BETTER PROFITABILITY RECORD PARTICULARLY
OF THE PAST 3 YEARS.
AS A FINANCIAL CONSULTANT, HOW WOULD YOU EXPLAIN THE

SITUATION ?????????
SOLUTION
D
(A) & (B)
D/P & P/E RATIOS
YE COMPANY X COMPANY Y
AR EPS DPS D/P P P/E EPS DPS D/P P P/E
RATI RATIO RATI RATIO
O O
1 9.30 2.00 21.5 82.50 8.87 9.50 1.90 20 70 7.37
2 7.40 2.00 27.5 67.50 9.12 7.00 1.40 20 45 6.43
3 10.50 2.00 19.0 90.00 8.57 10.50 2.10 20 57.50 5.48
4 12.75 2.25 17.6 110.0 8.63 12.25 2.45 20 100.0 8.16

0 0
5 20.00 2.50 12.5 167.5 8.37 20.25 4.05 20 167.5 8.27
0 0
6 16.00 2.50 15.6 170.0 10.62 17.00 3.40 20 160.0 9.41
0 0
7 19.00 2.50 13.2 182.5 9.6 20.00 4.00 20 160.0 8.00
0 0
94.95 15.75 16.6 870.0 9.16 96.50 19.30 20 760.0 7.88
0 0
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(c) COMPANY X IS FOLLOWING A STABLE DIVIDEND POLICY WHEREAS
COMPANY Y IS FOLLOWING A STABLE DIVIDEND PAYOUT RATIO.
IN THE LATTER TYPE OF POLICY, SPORADIC DIVIDEND PAYMENTS

OCCUR WHICH MAKE ITS OWNERS VERY UNCERTAIN ABOUT THE
RETURNS THEY CAN EXPECT FROM THEIR INVESTMENT IN THE FIRM
&, THEREFORE, GENERALLY DEPRESS THE SHARE PRICES.
IT IS PROBABLY FOR THIS REASON THAT THE COMPANY X’S

AVERAGE PRICE PER SHARE EXHIBITED A CONSISTENT INCREASE
COMPARED TO COMPANY Y, VOLATILE PATTERN OF EARNINGS OF
BOTH COMPANIES (DURING THE LAST 3 YEARS)
NOTWITHSTANDING.
SO COMPANY Y IS ADVISED TO FOLLOW A STABLE DIVIDEND

POLICY. Bhup.manas@gmail.c
om
Irrelevant
Since investors do not need dividends to
convert shares to cash (because they can do
it themselves), they will not pay higher
prices for firms with higher dividend
payouts. In other words, dividend policy will
have no impact on the value of the firm
★ MM dividend-irrelevance proposition: Under
ideal conditions, the value of the firms is
unaffected by dividend policy
★ Given the firm’s capital budgeting and
borrowing decisions, dividend policy is a trade-off
between cash dividends and the issue or
repurchase of common stock
Dividend Policy is
Irrelevant
Example - Assume Rational Semiconductor has no extra cash,
but declares a $1,000 dividend. They also require $1,000
for current investment needs. Using M&M Theory, and given
the following balance sheet information, show how the
value of the firm is not altered when new shares are issued
to pay for the dividend.
Record Date
Cash 1,000
Asset Value 9,000
Total Value 10,000 +
New Proj NPV 2,000
# of Shares 1,000
price/share $12
Irrelevant
but declares a $1,000 dividend. They also require $1,000 for
current investment needs. Using M&M Theory, and given the
following balance sheet information, show how the value of the
firm is not altered when new shares are issued to pay for the
dividend.
Record Date Pmt Date

Cash 1,000 0
Asset Value 9,000 9,000
Total Value 10,000 + 9,000
New Proj NPV 2,000 2,000
# of Shares 1,000 1,000
price/share $12 $11
Dividend Policy is Irrelevant
but declares a $1,000 dividend. They also require $1,000 for
current investment needs. Using M&M Theory, and given the
following balance sheet information, show how the value of the
firm is not altered when new shares are issued to pay for the
dividend.
Record Date Pmt Date Post Pmt

Cash 1,000 0 1,000 (91 sh @
$11)
Asset Value 9,000 9,000 9,000
Total Value 10,000 + 9,000 10,000
New Proj NPV 2,000 2,000 2,000
# of Shares 1,000 1,000 1,091
price/share $12 $11 $11
NEW SHARES ARE ISSUED
Dividend Policy is
Irrelevant
Example - continued - Shareholder Value
Record
Stock 12,000
Cash 0
Total Value 12,000
Stock = 1,000 sh @ $12 = 12,000
Dividend Policy is
Irrelevant
Record Pmt
Stock 12,000 11,000
Cash 0 1,000
Total Value 12,000 12,000
Stock = 1,000sh @ $11 = 11,000
Dividend Policy is
Irrelevant
Record Pmt Post

Stock 12,000 11,000
12,000
Cash 0 1,000 0
Total Value 12,000 12,000

12,000
Stock = 1,091sh @ $11 = 12,000

Dividends Increase
Value
Market Imperfections and Clientele
Effect
There are natural clients for high-payout
stocks, but it does not follow that any
particular firm can benefit by increasing its
dividends. The high dividend clientele
already have plenty of high dividend stock
to choose from.
Dividends Increase
Value
Dividends as Signals
Dividend increases send good news
about cash flows and earnings. Dividend
cuts send bad news. (information content
of dividends)
Because a high dividend payout policy

will be costly to firms that do not have
the cash flow to support it, dividend
increases signal a company’s good
fortune and Bhup.manas@gmail.com
its manager’s confidence in
Dividends Decrease
Value
Tax Consequences
Companies can convert dividends into
capital gains by shifting their dividend
policies. If dividends are taxed more
heavily than capital gains, taxpaying
investors should welcome such a move and
value the firm more favorably.
In such a tax environment, the total cash

flow retained by the firm and/or held by
shareholders Bhup.manas@gmail.com
will be higher than if dividends
Firm A Firm B
Next years price $112.50 $102.50
Dividend $0 $10.00
Total pretax payoff $112.50 $112.50
Todays stock price $100 $97.78
Capital gain $12.50 $4.72
Pretax rate of return (%) 12.5
100 = 12. 5% 14. 72
97. 78 = 15. 05%
Tax on dividend @ 40% $0 .40 x $10 = $4.00
Tax on capital gain @ 20% .20 x $12.50 = $2.50 .20 x $4.72 = $.94
Total after tax income (10.00 + 4.72)
(0 + 12.50) - 2.50
(dividend plus capital - (4.00-.94)
= $10.00
gains less taxes) = $9.78
100 =
. 10 = 10% 97. 78 =
. 10 = 10%
10 9. 78
Aftertax rate of return (%)
Dividends Decrease
Value
Before 1986, dividends tax was up to
50%, the realized capital gains were
taxed only 20%
Taxes on dividends have to be paid
immediately, but taxes on capital gains
can be deferred until shares are sold and
capital gains are realized
Pension funds are untaxed, so there is no
difference for them
Corporations have to pay a 35% tax on
the full amount of any realized capital
gain. However, they pay corporate
income tax on only 30% of any dividend

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WELCOME TO

Cash Dividend - Payment of cash by the firm

Record Date - Person who owns stock on this

Declaration Cum- Ex- Record Payment

Cash: Share Issue

Taxes In a world with taxes, the

Stock Splits - Issue of additional shares to

 If there are a few investment opportunities, and

Assets Liabilities & Equity

(A) DETERMINE THE DIVIDEND PAYOUT RATIO (D/P) & PRICE TO

(C) THE MANAGEMENT OF COMPANY Y IS PUZZLED AS TO WHY THEIR

AS A FINANCIAL CONSULTANT, HOW WOULD YOU EXPLAIN THE

2 7.40 2.00 27.5 67.50 9.12 7.00 1.40 20 45 6.43

3 10.50 2.00 19.0 90.00 8.57 10.50 2.10 20 57.50 5.48

4 12.75 2.25 17.6 110.0 8.63 12.25 2.45 20 100.0 8.16

IN THE LATTER TYPE OF POLICY, SPORADIC DIVIDEND PAYMENTS

IT IS PROBABLY FOR THIS REASON THAT THE COMPANY X’S

SO COMPANY Y IS ADVISED TO FOLLOW A STABLE DIVIDEND

Record Date Pmt Date

Record Date Pmt Date Post Pmt

Total Value 12,000

Stock = 1,000 sh @ $12 = 12,000

Total Value 12,000 12,000

Stock = 1,000sh @ $11 = 11,000

Record Pmt Post

Total Value 12,000 12,000

Stock = 1,091sh @ $11 = 12,000

Because a high dividend payout policy

In such a tax environment, the total cash

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