FMT2 - 1

Pradeepta Sethi
TAPMI

Our voyage

Dividend decision

What is dividend?

What are the forms of distributions?

Why do firms pay dividend?

How do firms decide how much to pay in

dividends?

Why do investors pay attention to

dividends?

Dividend

Dividend payments

Cash dividend
Payment

Stock repurchase
Firm

of cash by the firm to the shareholders

buys back stock from its shareholders

Stock dividend
Distribution

of

additional

shares

to

firms

stockholders

Stock splits
Issue

of additional shares to firms stockholders

Dividend process

Dividend declaration date

The

date on which the board of directors declares

the dividend that will be paid

Ex-Dividend date
At

this point of time investors must have bought the

stock to receive the dividend

Record date
Makes

up a list of shareholders till date. These

shareholders will receive dividend.

Payment date
Dividend

got credited in the account.

ONGC Dividend
November
28, 2014

December
16, 2014

ONGC
declares
dividend
of Rs 5.00
per share

Shares start to
trade exdividend

Declaration
date

Ex-dividend
date

December 17,
2014
Dividend will be
paid
to shareholders
registered
on this date

Record
date

December 15, 2014

Rs. 343.00

December 16, 2014

Rs. 335.00

December 17, 2014

Rs. 343.00

2/3 weeks
after record
date
Dividend
checks
mailed
to shareholders

Payment
date

Measures of dividend policy

Dividend yield = Dividends per share/Price

share

per

Measures the return that an investor can make from

dividends alone

Becomes part of the expected return on the

investment

Expected return on stock = Dividend yield

Price appreciation

Invest

in stocks with high dividend yields.

Source: CMIE Prowess

Dividend payout ratio

Dividend payout ratio = Dividends/Earnings

Measures

the % of earnings that the company pay in

dividends
Payout ratio > 100% = firms paid more dividend than
their earnings.
Payout ratio tends to follow the life cycle of the firm.
If the net income is negative, the payout ratio cannot
be computed.

Retention ratio= (1- payout ratio)

Used

in valuation as a way of estimating dividends

in future periods.

Dividend payout ratios

Source: CMIE Prowess

Dividend changes

Dividends are sticky.

Dividends follow a smoother path than earnings.
Vary across countries.

Investors preferences

Investors preferences for returns in the

form of dividend yields versus capital
gains.
the

dividend irrelevance theory

the

dividend preference theory

the

tax effect theory

Do investors prefer high or

low payouts?

Dividends are irrelevant: Investors dont

care about payout.

Bird-in-the-hand: Investors prefer a high

payout.

Tax preference: Investors prefer a low

payout, hence growth.

Dividend Irrelevance Theory

Miller and Modigliani (1961)

Under the assumption of

No

tax, No transaction cost

Dividends that a firm pays do not affect the

value of its shares or return to the investors.

Choice between a stock that pays dividend

and a stock that pays no dividend is similar.

What a firm pays in dividends is irrelevant

and that stockholders are indifferent about
receiving dividends.

Dividend preference theory

Gordon (1963), Linter(1962)

The Bird-in-the-Hand Fallacy

Investors prefer dividends to capital gains
because dividends are certain, whereas
capital gains are uncertain.
Risk-averse investors will therefore prefer
dividend.
Possibility of agency cost leads to similar
conclusion.
High payouts reduce the risk of agency costs.

Tax effect theory

Dividends are taxed more highly than capital

gains.

Investors might require a higher pre-tax rate of

return to induce them to buy dividend-paying
stocks

The time value of money means that a dollar of

taxes paid in the future has a lower effective cost
than a dollar paid today.

If a stock is held until the shareholder dies, then

no capital gains tax is due at all.

Taxes dividend policy

Returns to shareholders taxed twice

Clientele effect

Despite the tax disadvantages of dividends,

some different groups, or clienteles, of
stockholders prefer different dividend
payout policies.

On the other hand, stockholders in their

peak
earning
years
might
prefer
reinvestment, because they have less need
for current investment income.

Clientele effect

Therefore, investors who want current

investment income should own shares in
highdividend payout firms, while investors
with no need for current investment income
should own shares in lowdividend payout
firms.

This clustering of stockholders in companies

with dividend policies that match their
preferences in called the clientele effect.

Consequences of clientele effect

Firms get the investors they deserve, because the

dividend
policy
of
a
firm
attracts investors who like it.

Firms
will
have
a
difficult
changing an established dividend policy.

Provides an alternative argument

irrelevance of dividend policy.

If investors migrate to firms that pay the dividends

that most closely match their needs no firms
value should be affected by its dividend policy.

time
for

the