Bhupendra Dividend Policy

8/14/2019 Bhupendra Dividend Policy

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DIVIDEND POLICY & VALUE OF

FIRM

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UNDER GUIDENCE:

PROF. ANUBHA GUPTAIMRT BUSINESS SCHOOL

VIPUL KHAND GOMTINAGAR

LUCKNOW

FROM: BHUPENDRA

PT SINGHPGDM-2nd TRIMESTER


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Topics CoveredHow Dividends are Paid

Share Repurchase

How Do Companies Decide on DividendPayments

Why Dividend Policy Should Not Matter

Why Dividends May Increase Firm Value

Why Dividends May Reduce Firm Value


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Payments

Some legal limitations on

dividendsBondholders are often against excessive

dividend payments

Most state prohibit a company from paying

dividends such that make the companyinsolvent

Sometimes state law prevents a company

from paying a dividend if it cuts into the


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PaymentsStock Dividend - Distribution of additionalshares to a firms stockholders.

Stock Splits - Issue of additional shares tofirms stockholders.


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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


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DividendExample - cont - After the stock dividend what

is the new price per share and what is thenew value of the firm?

AnswerThe 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


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PaymentsStock 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


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Assets Liabilities & Equity

A. Original balance sheet

Cash $150,000 Debt 0Other 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

Example - Cash dividend versus share repurchase


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B. After cash dividend

Cash $50,000 Debt 0Other assets 850,000 Equity 900,000

Value of Firm 900,000 Value of Firm 900,000


Price per share = $900,000 / 100,000 = $9



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C. After stock repurchase

Cash $50,000 Debt 0Other assets 850,000 Equity 900,000

Value of Firm 900,000 Value of Firm 900,000


Price per share = $900,000 / 90,000 = $10



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DecisionHow Dividends are Determined?

1. Firms have long-term target dividend payoutratios.

2. Managers focus more on dividend changesthan on absolute levels.

3. Dividends changes follow shifts in long-run,sustainable levels of earnings rather thanshort-run changes in earnings .

4. Managers are reluctant to make dividend

changes that might have to be reversed.(They are particularly worried about having torescind a dividend increase)

Level of dividends can be taken as a signalabout the companys future prospect


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Policy Three points of view about dividend policy

and the value of firm

1. Dividend policy makes no difference2. High dividends increase firm value

3. High dividends bring high taxes and

therefore reduce firm value

Di id d li


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Dividend policyHigher dividend payout means:

More current dividend amount, consequently higherstock price

But lower retention rate with lower amount available forreinvestment leading to lower growth depressing stockprice

Thus needs to strike a balance to maximize stock priceReferred as optimal dividend policyMMs proposition: value of a firm depends only on the

income produced by its assets

Not on how the income is split between dividends andretained earnings (growth)

Investors more certain of present dividend (bird-in-hand)and prefer present dividend yield, as against capitalgain yield (less certain of receiving capital gain in [email protected]


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Tax rate on capital gains and on dividend income areusually different for investors (long-term capital gainsattract normally lower tax rate)

Again, capital gains tax not payable until stock is sold

Wealthy investors (who own most of the stock andreceive most of the dividends) likely to prefer higherretention rate for plough back of profits rather thanhigh dividend rate

Most firms try to follow a policy of paying a constant or

steadily increasing dividendThat provides stable income to investorsAny departures from it give investors information about

managements expectations for future earnings(signalling effects)

Other dividend policies may pertain to:

Residual (after capital budgeting) dividend policyConstant payout ratio policyLow regular dividend plus extra policy (can be

maintained in difficult years and then pay [email protected]


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Dividends likely to be raised following a permanent(rather than temporary) increase in earnings and firmshave a long-run target for their dividends to earningsratio

Managers need to decide the target payout ratio and thespeed of adjustment of current dividend to target

Dividend may be paid by way of cash, or stock dividenddepending on companys cash position and its likely

impact on its capital structureStock split refers to increasing the number of shares,such as doubling the number of shares outstanding bygiving each stockholder two new shares for each oneformerly held- to keep the stock prices within the

optimal trading rangeStock repurchase plan- firm buys back some of its

outstanding stock, thereby decreasing the number ofshares and consequently increasing EPS and stock price

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X &YARE TWO FAST GROWING COMPANIES IN THE ENGINEERING INDUSTRY. THEY ARECLOSE COMPITITORS & THEIR ASSETS COMPOSITION, CAPITAL STRUCTURE &PROFITABILITY RECORDS HAVE BEEN VERY SIMILAR FOR SEVERAL YEARS. THE PRIMARYDIFFERENCE BETWEEN THEM FROM FINANCIAL MANAGEMENT PERSPECTIVE IS THEIRDIVIDEND POLICY. THE COMPANY X TRIES TO MAINTAIN A NON DECREASING DIVIDENDPER SHARE, WHILE THE COMPANYYMAINTAINS A CONSTANT DIVIDEND PAY OUT RATIO.THEIR RECENT EARNING PER SHARE(EPS), DIVIDEND PER SHARE (DPS), & SHAREPRICE (P) HISTORY ARE AS FOLLOWS:::::

YearYear COMPANY XCOMPANY X COMPANY YCOMPANY Y

EPSEPS DPSDPS P(RANGE)P(RANGE) EPSEPS DPSDPS P(RANGEP(RANGE

))

11 Rs 9.30Rs 9.30 Rs 2Rs 2 Rs 75-90Rs 75-90 Rs 9.50Rs 9.50 RsRs

1.901.90

Rs 60-80Rs 60-80

22 7.407.40 22 55-8055-80 7.007.00 1.401.40 25-6525-65

33 10.5010.50 22 70-11070-110 10.5010.50 2.102.10 35-8035-80

44 12.7512.75 2.252.25 85-13585-135 12.2512.25 2.452.45 80-12080-12055 20.0020.00 2.502.50 135-200135-200 20.2520.25 4.054.05 110-225110-225

66 16.0016.00 2.502.50 150-190150-190 17.0017.00 3.403.40 140-180140-180

77 19.0019.00 2.502.50 155-210155-210 20.0020.00 4.004.00 130-190130-190

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QUESTIONS OF EXAMPLEIN 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 TOEARNINGS(P/E) RATIO FOR BOTH COMPANIES FOR ALL THEYEARS.

(B) DETERMINE THE AVERAGE D/P & P/E FOR BOTH THE COMPANIESOVERTHE PERIOD 1 THROUGH 7.

(C) THE MANAGEMENT OF COMPANY Y IS PUZZLED AS TO WHY THEIRSHARE PRICES ARE LOWER THAN THOSE OF COMPANY X, INSPITE OF THE BETTER PROFITABILITY RECORD PARTICULARLYOF THE PAST 3 YEARS.

AS A FINANCIAL CONSULTANT, HOW WOULD YOU EXPLAIN THESITUATION ?????????

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YEYE

ARARCOMPANY XCOMPANY X COMPANY YCOMPANY Y

EPSEPS DPSDPS D/PD/P

RATIRATI

OO

PP P/EP/E

RATIORATIOEPSEPS DPSDPS D/PD/P

RATIRATI

OO

PP P/EP/E

RATIORATIO

11 9.309.30 2.002.00 21.521.5 82.5082.50 8.878.87 9.509.50 1.901.90 2020 7070 7.377.37

22 7.407.40 2.002.00 27.527.5 67.5067.50 9.129.12 7.007.00 1.401.40 2020 4545 6.436.43

33 10.5010.50 2.002.00 19.019.0 90.0090.00 8.578.57 10.5010.50 2.102.10 2020 57.5057.50 5.485.48

44 12.7512.75 2.252.25 17.617.6 110.0110.0

008.638.63 12.2512.25 2.452.45 2020 100.0100.0

008.168.16

55 20.0020.00 2.502.50 12.512.5 167.5167.5

008.378.37 20.2520.25 4.054.05 2020 167.5167.5

008.278.27

66 16.0016.00 2.502.50 15.615.6 170.0170.0

0010.6210.62 17.0017.00 3.403.40 2020 160.0160.0

009.419.41

77 19.0019.00 2.502.50 13.213.2 182.5182.5

009.69.6 20.0020.00 4.004.00 2020 160.0160.0

008.008.00

94.9594.95 15.7515.75 16.616.6 870.0870.0

009.169.16 96.5096.50 19.3019.30 2020 760.0760.0

007.887.88

(A) & (B) D /P & P/E RATIOSD/P & P/E RATIOS

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(c) COMPANY X IS FOLLOWING A STABLE DIVIDEND POLICY WHEREASCOMPANYYIS FOLLOWING A STABLE DIVIDEND PAYOUT RATIO.

IN THE LATTER TYPE OF POLICY, SPORADIC DIVIDEND PAYMENTSOCCUR WHICH MAKE ITS OWNERS VERY UNCERTAIN ABOUT THERETURNS THEY CAN EXPECT FROM THEIR INVESTMENT IN THE FIRM&, THEREFORE, GENERALLY DEPRESS THE SHARE PRICES.

IT IS PROBABLY FOR THIS REASON THAT THE COMPANY XSAVERAGE PRICE PER SHARE EXHIBITED A CONSISTENT INCREASECOMPARED TO COMPANYY, VOLATILE PATTERN OF EARNINGS OFBOTH COMPANIES (DURING THE LAST 3 YEARS)NOTWITHSTANDING.

SO COMPANYYIS ADVISED TO FOLLOW A STABLE DIVIDENDPOLICY. [email protected]

om


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Irrelevant

Since investors do not need dividends toconvert shares to cash (because they can doit themselves), they will not pay higherprices for firms with higher dividendpayouts. 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 isunaffected by dividend policy

Given the firms capital budgeting andborrowing decisions, dividend policy is a trade-offbetween cash dividends and the issue orrepurchase of common stock


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IrrelevantExample - 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 giventhe following balance sheet information, show how thevalue of the firm is not altered when new shares are issuedto 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


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IrrelevantExample - Assume Rational Semiconductor has no extra cash,

but declares a $1,000 dividend. They also require $1,000 forcurrent investment needs. Using M&M Theory, and given thefollowing balance sheet information, show how the value of thefirm is not altered when new shares are issued to pay for thedividend.

Record Date Pmt DateCash 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

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Dividend Policy is IrrelevantExample - 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 thefollowing balance sheet information, show how the value of thefirm is not altered when new shares are issued to pay for thedividend.

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 [email protected]


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Irrelevant

Example - continued - Shareholder Value

Record

Stock 12,000

Cash 0

Total Value 12,000

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


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Irrelevant


Record Pmt

Stock 12,000 11,000

Cash 0 1,000

Total Value 12,000 12,000

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


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Irrelevant


Record Pmt Post

Stock 12,000 11,000

12,000Cash 0 1,000 0

Total Value 12,000 12,000

12,000

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


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Value

Market Imperfections and ClienteleEffect

There are natural clients for high-payout

stocks, but it does not follow that anyparticular firm can benefit by increasing itsdividends. The high dividend clientelealready have plenty of high dividend stock

to choose from.


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Value

Tax Consequences

Companies can convert dividends intocapital gains by shifting their dividend

policies. If dividends are taxed moreheavily than capital gains, taxpayinginvestors should welcome such a move andvalue the firm more favorably.

In such a tax environment, the total cashflow retained by the firm and/or held byshareholders will be higher than if dividends


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Firm A Firm B

Next years price $112.50 $102.50Dividend $ 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 (%)

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 = $.94Total after tax income

(dividend plus capitalgains less taxes)

(0 + 12.50) - 2.50

= $10.00

(10.00 + 4.72)

- (4.00-.94)= $9.78

Aftertax rate of return (%)

12.5100

10100

= =

= = = =

12 5 15 05

10 10 10 10

14 7297 78

9 7897 78

. % . %

. % . %

.

.

.

.


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Value

Before 1986, dividends tax was up to50%, the realized capital gains weretaxed only 20%Taxes on dividends have to be paid

immediately, but taxes on capital gainscan be deferred until shares are sold andcapital gains are realizedPension funds are untaxed, so there is no

difference for themCorporations have to pay a 35% tax on

the full amount of any realized capitalgain. However, they pay corporate


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