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Explain meaning of dividend, dividend policy and management of profits. Discuss the different types of dividend policies, advantages and dangers of stable dividend policy. Understand the factors that influence firms dividend policy. Explain the forms of dividend payment. Understand what is stock dividend? Reasons for issue, advantages and disadvantages of stock dividend. Give the meaning of stock split. Compare bonus share and stock split. Give the reasons for stock split.

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A firm earns for its shareholders The income generated after meeting all obligations by the firm belongs to the shareholders. The part of earning that is distributed is called dividend. The optimum dividend policy would be one that maximizes the value of the firm The question of in what ratio to retain or distribute the earned income, is referred as dividend decision or policy

`Thus

the ultimate objective remains the undisputed maximization of shareholders wealth.

 Equity Earnings: Net earnings available to equity shareholders Management of Earnings: Apportion of equity earnings between dividends and retained earnings Dividend: The portion of companys net earnings that are paid out to the ordinary shareholders.

EPS

EPS and DPS (Rs)

DPS

Years

EPS and DPS (Rs)

EPS

DPS

Years

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Builds confidence among investors Current income to investors Information about firms profitability Institutional investors requirements Raising additional finance Stability in market price of share Easy availability of debt funds

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Difficult to change Adverse effect on market price of share Long-run effect on company

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Nature of earnings Age of company Liquidity position of company Equity shareholders preference for current income Requirements of institutional investors Contractual requirements Financial needs of company Control objective Accepts to capital market Inflation Dividend policy of competitors Past dividend rates of the company Legal Rules: Capital impairment rule; Insolvency rule; net profits

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Cash dividend Scrip dividend Bond dividend Property dividend Stock dividend (bonus share)

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Bonus refers an unsought or unexpected extra profits. A company that follows stable dividend policy would retain some portion of EPS. When a company is doing this for long time & company financial performance is fair, then free reserves have to be distributed to shareholders. Distribution of free reserves to shareholders is bonus, because they have not expected the extra profit. Bonus can be paid to shareholders either in the form of cash or in the form of equity shares. When the Bonus is paid in the form of shares then it is called as Bonus shares.

Bonus Share: Payment of bonus in the form of stock to the existing owners Objectives: ` To bring down market price of share within more popular range ` To promote active trading of shares ` To reduce EPS ` To achieve respectable stage in the eyes of investors ` To say company future is prospective ` To improve prospects of raising additional funds

To Company:
More liquidity position Attractive share price Enhance company prestige Widening share for market Availability of funds for expansion

To Shareholders:
Tax savings Indication of future benefits Psychological value

To Company:
x Costly x Reduces EPS and PE Ratio x Misuse of management power

To Shareholders:
x x x x Disappointment of shareholders Wealth remains unaffected Lower existing stock value Less security to investors

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No bonus issue is made which will dilute the rights of debenture holders, convertible partly or fully Bonus issue should be made out of free reserves built from genuine profits Reserve created by revaluation of assets cannot be capitalized Bonus in lieu of dividend can not be made Bonus issue can not be made unless partly paid shares are converted fully paid stock Issue must be implement within six months from approval of Bodes AOA should allow Bonus issue, otherwise general body meeting resolution is necessary After issue of bonus stock paid capital should not exceed authorized capital

Issue of bonus shares does not affect the total capital structure of a company. Because it is just capitalization of free reserves created out of equity shareholders funds or share premium collected.

In other words, the amount of free reserves comes down & the same amount of equity capital increases.

Stock Split: It is the decision of a firm to increase the number of shares by splitting the existing shares into different proportions It is the action of corporate to reduce the par value of stock & increase the number of shares proportionately. It has no impact on the companies capital structure-i.e market capitalization remains constant.

Motive is make shares more affordable to small investors without changing the value of the company. Even company can bring down share price to affordable level for a short period only (immediately after stock split)

To make share trading attractive Indication of Higher Profits in the future To give higher dividends to shareholders

Objectives

Reasons

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is quite opposite to the stock split where a company reduces the number of outstanding shares to increase the market share price per share.

Buy Back of Shares: Repurchase of outstanding shares by a firm in the market to discourage unfriendly takeover Objectives:
To increase promotion holding Rationalize the capital structure To thwart takeover Unused cash Show better financed ratios Tax gain Market perception Avoid legal controls

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Free reserves Security premium account Proceeds of any shares

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Tender method Book-building process Open market

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Should be authorized by AOA A special resolution in general meeting, when Buyback exceeds 10% It should not exceed 25% of paid up capital plus free reserves No default in debt service; redemption debt; payment of dividend No default in complying with the provisions of filing annual return, dividend, and former contents of annual accounts Full paid-up share can only allowed to buyback After buying them should be extinguished and physically destroyed Company should not make further issue within 6 months

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Promoters are barred from offering shares Buyback cannot be done through negotiations Buyback need to be done through Merchant banker Company should file Form C with registrar within 30 days of such buyback completion

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Public announcement atleast one English national daily one Hindi national daily and one regional language Give specified date in public announcement Public announcement shall contain disclosures as per Schedule I of SEBI guidelines A draft letter of off shall be filed with SEBI through a Merchant banker

Copy of Board resolution shall be filed with SEBI and Stock Exchange Buyback date shall not be less than 7 days or later than 30 days after the specified date A company opting for buyback through public offer a tender offer shall open an euro account Buyback of share had to be implemented within 12 months from the date of passing the special resolution

Concept ` Factors affecting dividend policies ` Relevance of Dividend 1) Walters Model 2) Gordons Model
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Irrelevance of Dividend 1) Miller & Modiglianis Theory of Irrelevance ` Assumptions of Irrelevance of Dividend ` Gordons Model vs. Irrelevance ` Limitations of Theory of Irrelevance ` Stability of Dividend ` Alternative forms of Dividend
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a)

High dividend payout

Presence of agency cost (reduces) Presence of transaction cost. Resolution of uncertainty. Desire of investors for current income Low outlay required on available investment opportunities.

` a) b)

c)

b)

d)

c)

d)

e)

Low dividend payout Presence of floatation cost. Phenomenon of under pricing Preferential treatment of capital gains . High outlay required on available investment opportunities. Legal & administrating factors.

e)

However whenever changes are to be made, following are the factors every firm should considerWhat signal the changes in dividend provides to the shareholders. What reaction the change would have on the firms clientele The question of whether the changes would cause shifting of clientele & impact the complexion of shareholding patterns. Sustainability of the changed dividend.

a) b) c)

d)

There are two schools of thought regarding dividend policy.

RELEVANCE OF DIVIDEND ` One set of people believes that dividend policy affects the value of the firm IRRELEVANCE OF DIVIDEND ` Other set of people believes that dividend policy does not affects the value of the firm

One set of people believes that dividend policy affects the value of the firm A firm therefore must pay a dividend to shareholders to fulfill their expectations in order to maintain or increase the market price of the share. Two models support this argumentWalters Model and Gordons Model.

1) 2)

These models of valuation of the firm link the dividend policy to the investment opportunities available. rate of return on investment opportunities as compared with expectations of the shareholders

Walters model considers the value of the firm as sum of two components 1.an infinite stream of dividend, D and 2.an infinite stream of retained earning, E D reinvested at constant rate of k, which are generated each year for infinite length of time.
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Walters Model links the value of the firm to the earning level, dividend level, reinvestment rate and the shareholders' expectations.

Po = D /r + k (E-D)/ r ------------r Where, Po = current price D = dividend E = earnings r = expected returns by shareholders k = reinvestment rate of the firm.
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Walters Model supports the view of dividend policy of an enterprise has bearing on value of firm. The Model is based on r (Return On Investment or Internal Rate Return) and K o (Cos of capital or required rate of return). Model divides firms into: Growth firms: r>K o Normal firms: r=K o Declining firms: r<K o Assumptions:
x x x x x Only internal source of funds used r and K o constant All earnings are paid as dividends or completely reinvested EPS; and DPS never change Perpetual life

D  ( r z K 0 )( E  D) D ( E  D) r z K  P! or K0 K0 K0 Where: P = Price per equity share; D = Dividends per share; E = Earnings per share; (ED)= Retained earnings per share; r = Rate of return on investment; K0 = Cost of capital.

Interpretation: r>K o=optimum DP Ratio is zero r=K o=No optimum DP Ratio r<K o=Optimum DP Ratio 100% Criticism: * No external financing * Constant rate of return as investment * Constant cost of capital

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Funding of new projects is done through the retained earnings alone & no external finance is available to the firm. The growth opportunities do not alter the risk profile of the firm as a whole, and therefore the market capitalization rate remains constant The firm is a going concern and the pricing model assumes perpetual earnings.(infinite life) There is an implied assumption that the reinvestment rate k remains constant. Walters model assumes inter-dependence of the investment and dividend decisions.

Another model that supports the view that dividend policy is relevant is Gordons Model.

Its assumptions and conclusions are similar to Walters model.

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Gordon Model says that firms share price is dependent on dividend payout ratio. Assumptions: All equity firm; Properties financed by retained earnings; r is constant; K o remains constant; K o>b. r; Perpetual stream of earnings; Perpetual life; Retention ratio constant; No corporate taxes

E (1  b) P! K o  b. r

Where:P = Price per share E = Earnings per share b = Retention ratio (1- b) = Proportion of earnings of the firm distributed as dividends; Ko = Capitalization rate or cash of capital or required return by equity shareholders r = Rate of returns earned an investment made by the firm g = b. r = growth rate Gordons argument: Investors are risk averse, and need to put a premium on a certain return for uncertain return

Like Walters model the value of the firm under Gordons model is also dependent upon the reinvestment rate and shareholders expectations. Walters model keeps the dividend amount constant in each period while Gordons model assumes growing dividend in each period.

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2)

The advocates of this school of thought argue that the dividend policy has no effect on the market value of the firm. The underlying intuition is simpleFirms that pay more dividends offer less price appreciation but provide the same return to shareholders, given the risk characteristics of the firm. The investors should be indifferent of receiving their returns in the form of current dividends or in the form of price increase in the market.

MM argument of irrelevance of dividend rests on the assumption that earnings and the investment policy determine the value of the firm and not how the earnings are distributed. ` Increased dividends today are compensated by reduced dividends tomorrow and vice-versa. ` To keep the investment policy same the firm would have to issue larger number of new shares in case they increase the dividend.
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The capital markets are perfect & the investors behave rationally. All information are freely available to all the investors. There is no transaction cost & no time lag. No investor can effect the market price. There are no taxes & no floatation cost. Firm has defined investment policy & the future profits are known with certainity.

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Market Price of Share at the end of Period 1: The market price per share (Po) in the beginning of the period is equal to the present value of dividends paid at the end of the period plus market price of share at the end of the period. Po = 1 ( D1  P1 )
(1  k )

Where: Po D1 P1 k P1

= = = =

Market price per share at period o Dividends per share at end of period 1 Market price per share at the end of period 1 Discount rate applicable to the risk less to which the firm belongs to (cost of equity capital) = Po (1 + Ke) D1

2 The total capitalization value of outstanding equity shares of the firm at period 0 is obtained by the use of following formula.
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nPo =


 nP

3.Amount needed to be raised by the Issue of New Shares nP1 = I (E nD1) Where: nP1 = Amount raised by sale of new shares I = Total funds required for investment E = Total earnings of the firm during the period nD1 = Total dividends period (E nD1)= Retained earnings. 4.No. of additional Shares to be Issued; n = nP1 P1 5.Value of the Firm:
( n (n) P1  I E nPo ! (1 K e )

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There is no perfect capital market Tax deferential Existence of flotation cash Existence of transaction costs Information asymmetry Institutional restrictions Resolution of uncertainty Near vs. Distant dividend Desire for current income Under pricing

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The assumption of perfect capital market is theoretical in nature . No floatation cost & no time lag transactions cost are unrealistic. No transaction cost is imaginary No tax is questionable. It has assumed that the investment policy of the firm is independent of the financing policy. It may not hold good if the firm is not able to issue additional equity share capital at the then prevailing current market price when dividends are paid & are to be replaced by fresh funds.

Under perfect market conditions the theory of irrelevance holds good. ` But several real world factors make the dividend policy relevant. ` Preferential tax treatment of capital gains favours retention of earnings for increasing the value of the firm. ` Presence of transaction cost makes dividend more valuable, while flotation cost, phenomena of under pricing, and legal hassles favour retention of earnings. ` Prominent among these factors are presence of taxes and frictions in the markets.
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Constant investment policy ` Investors indifference to dividend and capital gains ` No uniform taxes ` Absence of flotation costs ` Uniform/homogeneous expectations ` Perfect capital markets there were no transaction (brokerage) costs involved the shares were infinitesimally divisible buying/selling actions does not influence the price investors are equally well informed they incur no cost of information, and interpret the information in homogeneous way.
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Investment policies Existence of taxes Transaction cost