FMT2 - Session 1

Pradeepta Sethi
TAPMI

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

A payment made by
a company to its
shareholders, usually
as a distribution of
profits.

Dividend payments

Cash dividend

Stock repurchase

Firm buys back stock from its shareholders

Stock dividend

Payment of cash by the firm to the shareholders

Distribution of additional shares to firms stockholders

Stock splits

Issue of additional shares to firms stockholders

Dividend process

Dividend declaration date

Ex-Dividend date

At this point of time investors must have bought the

stock to receive the dividend

Record date

The date on which the board of directors declares

the dividend that will be paid

Makes up a list of shareholders till date. These

shareholders will receive dividend.

Payment date

Dividend got credited in the account.

Colgate Palmolive Dividend

November
19, 2015

December
10, 2015

Colgate
declares
dividend
of Rs 3.00 per
share

Shares start to
trade exdividend

Declaration
date

Ex-dividend
date

December 11,
2015
Dividend will be
paid
to shareholders
registered
on this date

Record
date

December 9, 2015

Rs. 981.00

December 10, 2015

Rs. 979.00

December 11, 2015

Rs. 983.00

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

Payment
date

Measures of dividend policy

Dividend yield = Dividends per share/Price per share

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.

Dividend Yield
30
25
20
15
10
5
0
2010

2011

2012

2013

Bajaj Auto Ltd.

Cipla Ltd.

Infosys Ltd.

Mahindra & Mahindra Ltd.

Maruti Suzuki India Ltd.

Tata Steel Ltd.

Source: CMIE Prowess

2014

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

Payout ratios
300
250
200
150
100
50
0

2010

2011

2012

2013

Bajaj Auto Ltd.

Cipla Ltd.

Infosys Ltd.

Mahindra & Mahindra Ltd.

Maruti Suzuki India Ltd.

Tata Steel Ltd.

Source: CMIE Prowess

2014

Dividend changes

Dividends are sticky.

Dividends follow a smoother path than earnings.
Vary across countries.
Dividend changes
40000
30000
20000
10000

0
2010

2011

2012

2013

Bajaj Auto Ltd.

Cipla Ltd.

Infosys Ltd.

Mahindra & Mahindra Ltd.

Maruti Suzuki India Ltd.

Tata Steel Ltd.

2014

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

Modigliani & Miller (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

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.

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