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Earnings to be Distributed High Vs. Low Payout. Objective Maximize Shareholders Return. Effects Taxes, Investment and Financing Decision.
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r k
( E D) K
P= Price per equity share D = is the dividend per share E = is the earnings per share (E-D) is the retained earnings per share R = is the rate of return on investments and K= is cost of capital
Price per share is a sum of two components:
( E D) D K K
r k
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Dividends are that portion of a firms net earnings which are paid to the shareholders. Preference shareholders are entitled to a fixed rate of dividend irrespective of the firms earnings.
Equity holders dividends fluctuate year after year. Dividend decisions depend on what portion of earnings is to be retained by the firm and what portion is to be paid off.
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There is an inverse relationship between these two larger the retentions, lesser the dividends and vice versa.
The constituents of net profits dividends and retentions, are always competitive and conflicting.
Dividend policy has a direct influence on the two components of shareholders return dividends and capital gains. A low payout and high retention may have the effect of accelerating earnings growth. Investors of growth companies realise their money in the form of capital gains. Dividend yield will be low for such companies. The influence of dividend policy on future capital gains is to happen in distant future and therefore by all means uncertain.
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Walter model Prof. James E. Walter considers dividend pay-outs are relevant and have a bearing on the share prices of the firm. investment policies of a firm cannot be separated from its dividend policy and both are inter-linked Walter model clearly establishes a relationship between the firms rate of return r and its cost of capital k to give a dividend policy that maximises shareholders wealth.
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If r>k, the firms earnings can be retained as the firm has better and
profitable investment opportunities and the firm can earn more than what the shareholders could by re-investing, if earnings are distributed. Firms which have r>k are called growth firms and such firms should have a zero pay-out ratio.
If r<k, the firm should have a 100% pay-out ratio as the investors have better investment opportunities than the firm. Such a policy will
maximise the firm value.
If r = k, the firms dividend policy will have no impact on the firms value.
The dividend pay-outs can range between zero and 100% and the firm value will remain constant in all cases. Such firms are called normal firms.
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r k
( E D) K
P= Price per equity share D = is the dividend per share E = is the earnings per share (E-D) is the retained earnings per share R = is the rate of return on investments and K= is cost of capital
Price per share is a sum of two components:
( E D) D K K
r k
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( E D) D K K
r k
The first component is the present value of an infinite stream of dividends. The second component is the present value of an infinite stream of returns from retained earnings
The second component is derived as follows: The return from the first retained earnings, (E-D), would be
Time 0 1 2
(E-D)r
3
(E-D)r
4
(E-D)r
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Retained Earnings at time 1 earns return from time 2 onwards). The present value of this stream of returns is:
( E D) ( E D) ( E D) ( E D)r ..... (1 K ) 2 (1 K )3 (1 K ) 4 K (1 K ) n
The return from the second retained earnings, (E-D), would be Time 0 1 2 3 (E-D)r 4 (E-D)r 5 (E-D)r
( E D) ( E D) ( E D) ( E D) r ..... (1 K )3 (1 K ) 4 (1 K )5 K (1 K ) 2
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Likewise present value of stream of return from the third retained earnings
would be : ( E D ) r K (1 K )3
Adding the present value of the stream of returns from all retained earnings, we get:
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If D = Rs.2
0.20 2 (2) 0.15 Rs.31.11 P 0.15
If D = Rs.2
0.15 2 (2) 0.15 Rs.26.67 P 0.15
If D = Rs.2
P 2 (2) 0.10 0.15 Rs.22.22 0.15
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Case Study The following information relates to Alpha Ltd. Show the effect of the dividend policy on the market price of its shares using the Walters Model
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[r / Ke (E D)] D Ke Ke
a.DP = 0
c.
DP = 50%
d. DP = 75% e. DP = 100% .
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When r>k, that is, in growth firms, the value of shares is inversely related to dividend policy (DP) ratio, as the DP increases, market value of shares decline. Market value of share is highest when DP is zero and least when DP is 100%. When r=k, the market value of share is constant irrespective of the DP ratio. The market value of the share is not affected, though the firm retains the profits or distributes them. In the third situation, when r<k, in declining firms, the market price of a share increases as the DP increases. There is a positive correlation between the two
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Limitations of Walters Model Walter has assumed that investments are exclusively financed by retained earnings and no external financing is used Walters model is applicable only to all-equity firms. Also, r is assumed to be constant which again is not a realistic assumption Finally, Ke is also assumed to be constant and this ignores the business risk of the firm which has a direct impact on the firm value
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Investors prefer certain returns to uncertain returns and therefore give a premium to the constant returns and discount to uncertain returns.
The shareholders therefore prefer current dividends to avoid risk. In other words, they discount future dividends. Retained earnings are evaluated by the shareholders as risky and therefore the market price of the shares would be adversely affected.
Gordon explains his theory with preference to the current income. Investors prefer to pay higher price for stocks which fetch them current dividend income.
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E (1 b) P Ke br
Where P is the price of the share, E is Earnings per share, b is Retention ratio, (1 b) is dividend payout ratio, Ke is cost of equity capital,
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Case Study Given Ke as 11%, E as Rs. 10, calculate the stock value for (a) r=12%, (b) r=11% and (c) r=10% for various levels of DP ratios given under:
A B C D E
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Interpretation Gordon is of the opinion that dividend decision does have a bearing on the market price of the share. When r > k, the firms value decreases with an increase in pay-out ratio. Market value of share is highest when dividend policy (DP) is least and retention highest When r = k, the market value of share is constant irrespective of the DP ratio. It is not affected whether the firm retains the profits or distributes them When r < k, market value of share increases with an increase in DP ratio
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The Miller and Modigliani (MM) hypothesis seeks to explain that a firms dividend policy is irrelevant and has no effect on the share prices of the firm. This model advocates that it is the investment policy through which the firm can increase its share value and hence this should be given more importance.
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assumptions
Existence of perfect capital markets: All investors are rational and have access to all information, free of cost. There are no floatation or transaction costs, securities are infinitely divisible and no single investor is large enough to influence the share value No taxes: There are no taxes, implying there is no difference between capital gains and dividends Constant investment policy: The investment policy of the company does not change. The implication is that there is no change in the business risk position and the rate of return Certainty about future investments, dividends and profits of the firm had no risk. This assumption was, however, dropped at a later stage Based on the above assumptions, Miller and Modigliani have explained the irrelevance of dividend as the crux of the arbitrage argument. 6/2/2012
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The arbitrage process refers to setting off or balancing two transactions which are entered into investment programmes simultaneously.
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Step I: The market price of a share in the beginning is equal to the PV of dividends paid and market price at the end of the period.
1 Po X ( D1 P1) 1 Ke
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Hence, the division of earnings between dividends and retained earnings is irrelevant from the view point of share holders.
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Step II: Assuming there is no external financing, the value of the firm is:
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Step III: If the firms internal sources of financing its investment opportunities fall short of funds required, new shares are issued at the end of year 1 at price P1. The capitalised value of the dividends to be received during the period plus the value of the number of shares outstanding is less than the value of new shares.
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Firms will have to raise additional capital to fund their investment requirements after utilising their retained earnings, that is, n1 P1 = I (E nD1) which can be written as n1 P1 = I E + nD1 Where I is total investment required, nD1 is total dividends paid, E is earnings during the period, (E nD1) is retained earnings.
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Case Study A company has a capitalisation rate of 10%. It currently has outstanding shares worth 25,000 selling currently at Rs. 100 each. The firm expects to have a net income of Rs. 400000 for the current financial year and it is contemplating to pay a dividend of Rs. 4 per share.
The company also requires Rs. 600000 to fund its investment requirement. Show that under MM model, the dividend payment does not affect the value of the firm.
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Stability of Dividends
Stability of dividends is the consistency in the stream of dividend payments. This method relates to the payment of certain amount of minimum dividend to the shareholders. The steadiness is a sign of good health of the firm and may take any of the following forms constant dividend per share constant DP ratio constant dividend per share plus extra dividend
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Constant dividend per share As per this form of dividend policy, a firm pays a fixed amount of dividend per share year after year.
Example A firm may have a policy of paying 25% dividend per share on its paidup capital of Rs. 10 per share. It implies that Rs. 2.50 is paid out every year irrespective of its earnings. Generally, a firm following such a policy will continue payments even if it incurs losses. In such years when there is a loss, the amount accumulated in the dividend equalisation reserve is utilised. As and when the firm starts earning a higher amount of revenue it will consider payment of higher dividends and in future it is expected to maintain the higher level.
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Constant DP ratio With this type of DP policy, the firm pays a constant percentage of net earnings to the shareholders. For example, if the firm fixes its DP ratio as 25% of its earnings, it implies that shareholders get 25% of earnings as dividend year after year. In such years where profits are high, they get higher amount.
Constant dividend per share plus extra dividend Under this policy, a firm usually pays a fixed dividend ordinarily and in years of good profits, additional or extra dividend is paid over and above the regular dividend.
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Building confidence amongst investors A stable dividend policy helps to build confidence and remove uncertainty in investors. A constant dividend policy will not have any fluctuations thereby suggesting to the investors that the firms future is bright. In contrast, shareholders of a firm having an unstable DP will not be certain about their future in such a firm. Investors desire for current income A firm has different categories of investors old and retired persons pensioners youngsters salaried class Housewives Of these, people like retired persons prefer current income. Their living expenses are fairly stable from one period to another. Sharp changes in current income, that is, dividends, may necessitate sale of shares. Stable dividend policy avoids sale of securities and inconvenience to investors. 6/2/2012 43
Information about firms profitability Investors use dividend policy as a measure of evaluating the firms profitability. Dividend decision is a sign of firms prosperity and hence a firm should have a stable DP. Institutional investors requirements Institutional investors like LIC, GIC and MF prefer to invest in companies with a record of stable DP. A company having erratic DP is not preferred by these institutions. Thus to attract these organisations which have large quantities of investible funds, firms follow a stable DP. Raise additional finance Shares of a company with stable and regular dividend payments appear as quality investment rather than a speculation. Investors of such companies are known for their loyalty and whenever the firm comes with new issues, they are more responsive and receptive. Thus raising additional funds becomes easy. Stability in market The market price of shares varies with the stability in dividend rates. Such shares will not have wide fluctuations in the market prices which is good for investors. 6/2/2012 44