DIVIDEND POLICY

RT
Dividend Policy
• Business Decisions
• Investment
• Financing
• Dividend
Dividend Policy
• Dividend Policy
• Determining how much of a company’s profit is to be paid to
shareholders as dividends and how much is to be retained.

• Policy includes these elements:

1. High or low payout?
2. Stable or irregular dividends?
3. How frequent should we give dividend?
4. Do we need to announce the dividend policy?
Forms of dividend
• Regular dividend
• The dividend that is normally expected to be paid by the firm.

• Dividend reinvestment plans

• An optional plan allowing shareholders to automatically reinvest
dividend payments in additional shares of the company’s stock.

• Extra/special dividend
• A non-recurring dividend paid to shareholders in addition to the
regular dividend. It is brought about by special circumstances.
• Hero MotoCorp Ltd, Special Dividend @ 4000%, Date: 13/04/2010.
• Liquidating dividends
• Liquidation dividend occurs when a company dissolves its
business and distributes the proceeds to its shareholders.

• Stock dividends
• A distribution of additional shares of stock to shareholders. Often
used in place of or in addition to a cash dividend.
Alternates of distributing dividends
• Share repurchases
• The repurchase (buyback) of stock by the issuing firm, either in the open (secondary) market
or by self-tender offer.

• Reasons for repurchases:

• As an alternative to distributing cash as dividends.
• To dispose of one-time cash from an asset sale.
• To make a large capital structure change.

• Stock splits
• An increase in the number of shares outstanding by reducing the par value of the stock.

• Reasons for splits:

• Shares look cheaper which can be purchased by potential investors.

• MRF Limited
• NSE: MRF
• 68,898.35 INR, 1 Feb
Dividend and Buybacks in India
Dividend payment chronology
• Declaration data
• Cum-dividend date
• Ex-dividend date
• Record date
• Payment date
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 stock is
entitled to the dividend.
Ex-Dividend Date: The first day that the seller of a stock is
entitled to the dividend.
Record Date: The corporation prepares a list of all individuals
believed to be stockholders as of 6 November.
Tata Steel’s Dividend
Dividend policies Theories
• Residual dividend approach
• Stable dividend policy
• Target payout ratio
• Bird-in-the-Hand Theory
• Tax Preference Theory
• Optimal Dividend Policy
• Dividend Irrelevance Theory
Residual dividend approach
• Pay out as dividends, any profit that management does not believe
can be invested profitably.

• Find the retained earnings needed for the capital budget.

• Pay out any leftover earnings (the residual) as dividends.
Example 1
• Capital budget: $800,000. Given.
• Target capital structure: 40% debt, 60% equity. Want to
maintain.
• Forecasted net income: $600,000.
• How much of the $600,000 should we pay out as
dividends?
 Solution
• Of the $800,000 capital budget, 0.6($800,000) = $480,000
must be equity to keep at target capital structure.
[0.4($800,000) = $320,000 will be debt.]
• With $600,000 of net income, the residual is $600,000 –
$480,000 = $120,000 = dividends paid.
• Payout ratio = $120,000/$600,000
= 0.20 = 20%.
Example 1a
• How would a drop in NI to $400,000 affect the dividend?
A rise to $800,000?
 Solution
• NI = $400,000: Need $480,000 of equity, so should retain
the whole $400,000. Dividends = 0.

• NI = $800,000: Dividends = $800,000 – $480,000 =

$320,000. Payout = $320,000/$800,000 = 40%.
How would a change in investment opportunities affect
dividend under the residual policy?

• Fewer good investments would lead to smaller capital

budget, hence higher dividend payout.

• More good investments would lead to a lower dividend

payout.
Stable dividend policy
• Stable dividend policy are likely to look more towards a
forecast of their long-run sustainable earnings in
determining their dividend policy.

• Both management and shareholders prefer more

stability in their stream of dividends than strict
adherence to the residual dividend approach.

• Because they feel that dividend policy is sticky and any

change in dividend payment stream may impact
investors.
Target payout ratio
• Many companies have a target payout ratio as the basis
for their dividend policy.

• Target payout ratio is a strategic corporate goal

representing the long-term proportion of earnings that
the company intends to distribute to shareholders as
dividends.
Tax Preference Theory
• Dividends distribution are taxable @15%, non-deferrable.
• Capital gains taxes are deferrable.

• This could cause investors to prefer firms with low

payouts, i.e., a high payout results in a low P0.
Bird-in-the-Hand Theory
• Investors think dividends are less risky than potential
future capital gains, hence they like dividends.

• If so, investors would value high payout firms more highly,

i.e., a high payout would result in a high P0.
Optimal Dividend Policy
• The optimal dividend policy should maximize the price of
the firm’s stock holding the number of shares outstanding
constant.
Walter’s Model
• If r>ke, the firm should have zero payout and make
investments.
• If r<ke, the firm should have 100% payouts and no
investment of retained earnings.
• If r=ke, the firm is indifferent between dividends and
investments.
Gordon’s Model
• If r>ke, the firm should have 100% retention and make
investments.
• If r<ke, the firm should have zero retention and no
investment of retained earnings.
• If r=ke, the firm is indifferent between dividends and
investments.
Dividend Irrelevance Theory
• Modigliani-Miller (1961): Investors are indifferent between
dividends and retention-generated capital gains. If they
want cash, they can sell stock. If they don’t want cash,
they can use dividends to buy stock.

• MM says that the value of firm is only affected by its

earnings power and business risk and not by how the
income is split between retained earnings and dividend.

• See:- B&M, Payout policy, Dividend irrelevance: An illustration

Stock Repurchase and its
impact
Background
• When a corporation buys its own stock on the open stock
market, it is considered a "stock buyback" and the shares
purchased are re-titled "treasury stock.“(khajana)

• Authorized Shares - the number of shares of stock a

corporation is "authorized" to issue as per their articles of
incorporation. Additional shares can be "authorized" by
the Board of Directors with approval of shareholders.
• Outstanding Shares - the number of shares of stock that
are held by investors (including employees and
executives of the corporation). Treasury and Authorized-
not-Issued shares are not included in this figure.

• Treasury Shares - the number of shares of previously

outstanding stock that has been repurchased by the
corporation. Treasury stock can later be sold or retired
based on a shareholder vote.

• Float - the number of shares outstanding minus what is

owned by insiders and treasury stock.
Stock Repurchase versus Dividend
• Consider a firm that wishes to distribute Rs.100,000 to
its shareholders.
Assets Liabilities & Equity
A.Original balance sheet
Cash 150,000 Debt 0
Otherassets 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= Rs. 1,000,000/100000 = Rs.10
Stock Repurchase versus Dividend
• If they distribute Rs.100,000 as cash dividend, the
balance sheet will look like this:
Assets Liabilities & Equity
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
Shares outstanding = 100,000
Price per share = Rs.900,000/100,000 = Rs.9
Stock Repurchase versus Dividend
• If they distribute Rs.100,000 through a stock
repurchase, the balance sheet will look like this:
Assets Liabilities& Equity
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
Shares outstanding= 90,000
Price pershare = 900,000 / 90,000 = Rs.10
Stock Repurchase versus EPS & P/E
• Case 1
• XYZ company has 100 million shares o/s which is trading at Rs. 10,
XYZ company has NI of Rs. 50 million
• Calculate EPS and P/E of XYZ?

• Case 2
• XYZ decides to repurchase its shares worth Rs. 100 million from
free reserve. Assume that the shares will be repurchased at an
average cost of Rs. 10 each and NI is Rs. 50 million
• Calculate EPS and P/E of XYZ?

• Case 3
• XYZ decides to give cash dividend worth Rs. 100 million from free
reserve. Calculate EPS and P/E of XYZ?
• If they distribute Rs.100 M through a stock repurchase.
NI for year end is Rs.50 M
Assets Liabilities& Equity
C. Before stock repurchase
Cash 150 Debt 0
Other assets 850 Equity 1000
Value of Firm 1000 Value of Firm 1000
Shares outstanding= 100 M
Price pershare = 1000 / 100 = Rs. 10
Reasons Why Stock Buybacks Increase Profits
For Investors
• Increased Shareholder Value - The most common way to value a
profitable company is to look for Earnings Per Share (EPS). If
earnings are flat but the number of outstanding shares decreases,
EPS will increase. An increasing earnings per share indicates that the
company is earning more profits to distribute to its shareholders.

• Float - As the number of outstanding shares decreases, the free float

is reduced. If demand increases and there is less supply, then fuel is
added to a potential upward movement in the price of a stock.
• Excess Cash - Companies usually buy back their stock with excess
cash. If a company has excess cash, then at a minimum you can
bank that it doesn't have a cash flow problem. More importantly, it
signals that executives feel that cash re-invested in the corporation
will get a better return than alternative investments.
Potential Pitfalls
• Manipulation of Earnings - Assume that an analyst estimates
earnings using a higher number of outstanding shares before a
buyback is executed. If the timing is right, companies could buy-back
shares and appear to beat consensus estimates that were based on
a larger number of outstanding shares.

• Execution of Buyback - Don't be fooled into believing that all

announcements are implemented. A good portion of announced
buybacks are not executed in full. Ex: Reliance Energy
Stock Dividends and its
impact
 Small-Percentage Stock
Dividends (Rs.)
Before 5% Stock Dividend
Common stock
(5 par; 400,000 shares) 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity 10,000,000

After 5% Stock Dividend

Common stock
(5 par; 420,000 shares) 2,100,000
Additional paid-in capital 1,000,000
Retained earnings 6,900,000
Total shareholders’ equity 10,000,000
 Large-Percentage Stock
Dividends (Rs.)
Before 100% Stock Dividend
Common stock
(5 par; 400,000 shares) 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity 10,000,000

After 100% Stock Dividend

Common stock
(5 par; 800,000 shares) 4,000,000
Additional paid-in capital 1,000,000
Retained earnings 5,000,000
Total shareholders’ equity 10,000,000
 Stock Dividends,
EPS, and Total Earnings
After a small-percentage stock dividend, what
happens to EPS and total earnings of individual
investors?
• Assume that investor owns 10,000 shares and the firm
earned Rs.2.50 per share.
• Total earnings = Rs.2.50 x 10,000 = Rs.25,000.
• After giving 5% stock dividend, what is the EPS?
• After the 5% dividend, investor owns 10,500 shares and
the same proportionate earnings of Rs.25,000.
• EPS is then reduced to Rs.2.38 per share because of the
stock dividend (Rs.25,000 / 10,500 shares = Rs.2.38
EPS).
Stock Splits and its impact
Background
• Most traders view stock splits as high potential trading
opportunities. They consider splits a positive progression in value
and goodwill for companies and their investors. Corporate executives
use stock splits as marketing and investor relation tools. They know
that stock splits make shareholders feel better and engender a sense
of greater wealth.

• Critics would argue that a stock split is a non-event. They're

convinced that a split is simply an accounting function with no
relationship to stock performance. In fact, they think investors are
"foolish" to believe there is any money to make from something as
unimportant as a stock split. So who's right?
• A 1996 study by David Ikenberry of Rice University measured the
short and long-term performance of stock splits. His research
included all the 1,275 companies whose stock split 2-for-1 between
1975 and 1990. Mr. Ikenberry compared the split stocks to a control
group of stocks for similar-sized companies in similar sectors that had
no split. His results were startling. The split stock group performed
8% better than the control group after one year, and 16% better after
three years.
 Stock Splits (Rs.)
Before 2-for-1 Stock Split
Common stock
(5 par; 400,000 shares) 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity 10,000,000

After 2-for-1 Stock Split

Common stock
(2.50 par; 800,000 shares) 2,000,000
Additional paid-in capital 1,000,000
Retained earnings 7,000,000
Total shareholders’ equity 10,000,000
• Assume that investor owns 10,000 shares and the firm
earned Rs.2.50 per share.
• Total earnings = Rs.2.50 x 10,000 = Rs.25,000.
• After 2 for 1 stock split, what is the EPS?
• After 2 for 1 stock split, investor owns 20,000 shares and
the same proportionate earnings of Rs.25,000.
• EPS is then reduced to Rs.1.25 per share because of the
stock split (Rs.25,000 / 20,000 shares = Rs.1.25 EPS).

• Observations:
• No changes in the capital accounts
• Par value decreased
• Number of shares outstanding increased
Reasons Why Stock Splits Increase Profits For
Investors
• The stock split announcement draws attention to a company's
success. This results in increased buying and higher prices.

• Companies will often report high earnings and raise dividends at the
same time they announce a stock split. The synergy of these events
can drive the price of the stock up even more.

• The reduced price per share after companies split a stock attracts
many smaller investors.

• With so many news and information services reporting stock splits,

the announcements themselves have become a market-moving
force.
Factors affecting dividend payout policy
• Taxation of dividends
• Dividends are taxed @ 15% in the hands of corporate, rest is
issued to shareholders

• Restrictions on dividend payments

• Dividends can only be paid out of profit and are not to be paid out
of capital. A dividend cannot be paid if it would make the company
insolvent.
• Clientele effect
• Different groups of investors, or clienteles, prefer different dividend
policies.
• Firm’s past dividend policy determines its current clientele of
investors.

• Signaling effect
• Managers hate to change dividends. Because investors view
dividend policy as signals of management’s view of the future.
Dividend Policy Survey 2004
Thank you
Sources: B&M, Ross, and other web articles