Financial Management

Session -22
Dividend Policy

Different Types of Dividends

Many companies pay a regular cash dividend.
Public companies often pay quarterly.
Sometimes firms will pay an extra cash dividend.
The extreme case would be a liquidating dividend.
Liquidating dividend is paid as return of capital when some or all of
the business has been liquidated. While regular, extra and special
dividends are income in the hands of shareholders, liquidating
dividend is not income but receipt of capital.

Companies will often declare stock dividends.

No cash leaves the firm.
The firm increases the number of shares outstanding.

Some companies declare a dividend in kind.

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Dividend Payout Ratio

Dividend payout ratio = DPS / EPS
Dividend payout ratio indicates the
proportion of earnings per share paid out to
ordinary shareholders as dividend.

Dividend Yield
Dividend yield
= DPS / Market Price per Share
Dividend yield measures the return received
by the investors of ordinary shares by way of
dividend in relation to an ordinary shares
market price.
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Are Dividends Relevant?

- MM Theory
Modigliani and Miller (MM) advanced a theory that
dividend policy has no effect on the market value of a
company and hence dividends are irrelevant.
It does not matter how a company divides its earnings
between dividend payment to its shareholders and
retained earnings.

Standard Method of Cash Dividend

Declaration Date Date of the announcement
of dividend.
Ex-Dividend Date - Date that determines
whether a stockholder is entitled to a dividend
payment; anyone holding stock immediately
before this date is entitled to a dividend.
Record Date Date on which company
determines existing shareholders.
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Procedure for Cash Dividend

25 Oct.

1 Nov.

2 Nov.

5 Nov.

7 Dec.

Declaration
Date

ExCumdividend dividend
Date
Date

Record
Date

Payment
Date

Declaration Date: The Board of Directors declares a payment

of dividends.
Cum-Dividend Date: Buyer of stock still receives the dividend.
Ex-Dividend Date: Seller of the stock retains the dividend.
Record Date: The corporation prepares a list of all individuals
believed to be stockholders as of 5 November.
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Price Behavior
In a perfect world, the stock price will fall by the
amount of the dividend on the ex-dividend date.
-t

-2

-1

+1

+2

$P
$P - div
The price drops
Exby the amount of
dividend
Date
the cash
Taxes complicate things a bit. Empirically, the
dividend.
price drop is less than the dividend and occurs
within the first few minutes of the ex-date.
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The Irrelevance of Dividend Policy

A compelling case can be made that dividend policy
is irrelevant. (Proposed by Miller and Modigliani)
Since investors do not need dividends to convert
shares to cash; they will not pay higher prices for
firms with higher dividends.
In other words, dividend policy will have no impact
on the value of the firm because investors can create
whatever income stream they prefer by using
homemade dividends.

Homemade Dividends

XY Inc. is a $42 stock about to pay a $2 cash dividend.

An investor owns 80 shares and prefers a $3 dividend.
Investors homemade dividend strategy:
Sell 2 shares ex-dividend

$3 Dividend
$240
$0
$240
$39 80 =
$3,120
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Dividend Policy is Irrelevant

In the above example, Bob Investor began with a
total wealth of $3,360:
$42
$3,360 80 shares
share
After a $3 dividend, his total wealth is still $3,360:

$39
$3,360 80 shares
$240
share
After a $2 dividend and sale of 2 ex-dividend shares, his

total wealth is still $3,360:

$40
$3,360 78 shares
$160 $80
share
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Dividends and Investment Policy

Firms should never forgo positive NPV projects to
increase a dividend (or to pay a dividend for the first
time).
Recall that one of the assumptions underlying the
dividend-irrelevance argument is: The investment
policy of the firm is set ahead of time and is not
altered by changes in dividend policy.

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Repurchase of Stock
Instead of declaring cash dividends, firms can rid
themselves of excess cash through buying shares of
their own stock.
Recently, share repurchase has become an important
way of distributing earnings to shareholders.

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Stock Repurchase versus Dividend

Consider a firm that wishes to distribute $100,000 to its
shareholders.
Assets
A.Original balance sheet

Liabilities & Equity

Cash
$150,000 Debt
0
Other 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

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Stock Repurchase versus Dividend

If they distribute the $100,000 as a cash dividend, the balance
sheet will look like this:
Assets

Liabilities & Equity

B. After $1 per share cash dividend

Cash

$50,000

Debt

Other Assets

850,000

Equity

Value of Firm 900,000

0
900,000

Value of Firm 900,000

Shares outstanding = 100,000

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

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Stock Repurchase versus Dividend

If they distribute the $100,000 through a stock repurchase, the
balance sheet will look like this:
Assets
C. After stock repurchase

Liabilities& Equity

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 = $10

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Share Repurchase Why?

Flexibility for shareholders
Firms view dividend as a commitment

Keeps stock price higher

Good for insiders who hold stock options

Offset to dilution
The exercise of stock option reduce # shares

As an investment of the firm (undervaluation)

Tax benefits
Capital gain tax and dividends tax may be different

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Factors Driving Share Repurchase

Unused Cash
Tax Gains
Market Perceptions
Show Rosier Financials
ROA and ROE increases

Increase Control
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Firms without Sufficient Cash

Investment Bankers

Cash: stock issue

Firm

The direct costs of

stock issuance will
add to this effect.
Stock
Holders

Cash: dividends
Taxes
Gov.

In a world of personal taxes,

firms should not issue stock to
pay a dividend.
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Firms with Sufficient Cash

The above argument does not necessarily
apply to firms with excess cash.
Consider a firm that has $1 million in cash
after selecting all available positive NPV
projects.
Select additional capital budgeting projects (by
assumption, these are negative NPV).
Acquire other companies
Purchase financial assets
Repurchase shares
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Taxes and Dividends

In the presence of personal taxes:
1. A firm should not issue stock to pay a dividend.
2. Managers have an incentive to seek alternative
uses for funds to reduce dividends.
3. Though personal taxes mitigate against the
payment of dividends, these taxes are not
sufficient to lead firms to eliminate all dividends.

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Real-World Factors Favoring High Dividends

Desire for Current Income
Behavioral Finance
It forces investors to be disciplined.

Tax Arbitrage
Investors can create positions in high dividend
yield securities that avoid tax liabilities.

Agency Costs
High dividends reduce free cash flow.

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The Clientele Effect

Clienteles for various dividend payout
policies are likely to form in the following
way:
Group
Stock Type
High Tax Bracket Individuals
Low Tax Bracket Individuals
Tax-Free Institutions
Corporations

Low-to-Medium payout

Once the clienteles have been satisfied, a corporation is

unlikely to create value by changing its dividend policy.
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Usual Practices
Corporations smooth dividends. (Lintner theory)
Dividend Change = Div(1) Div(0)
= s.(t*EPS(1) Div(0))
s- speed of adjustment
t-payout ratio

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Smooth Dividend
Suppose VIL has a target payout ratio of 0.30.
last year EPS were Rs 10 and accordingly VIL
paid Rs 3 as dividend. However, earnings have
jumped to Rs. 20 this year what would be the
dividend next year if speed of adjustment is
0.5

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Usual Practices
Dividends provide information to the market.
Dividend Signaling
Cash Flow = Capital Expenditure + Dividend
Increase in dividends raise stock price

Firms should follow a sensible policy:

Do not forgo positive NPV projects just to pay a
dividend.
Avoid issuing stock to pay dividends.
Consider share repurchase when there are few
better uses for the cash.
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Stock Dividends
Pay additional shares of stock instead of cash
Increases the number of outstanding shares
Small stock dividend
Less than 20 to 25%
If you own 100 shares and the company declared a
10% stock dividend, you would receive an
additional 10 shares.

Large stock dividend more than 20 to 25%

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Stock Splits
Stock splits essentially the same as a stock
dividend except it is expressed as a ratio
For example, a 2 for 1 stock split is the same as a
100% stock dividend.

Stock price is reduced when the stock splits.

Common explanation for split is to return price
to a more desirable trading range.

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Multiple Choice Question-1

What should be the target dividend payout ratio of
a company, that has high cash flow liquidity but not
enough good investment projects? It also has
unused borrowing capacity.
a) High to Medium
b) Medium to low
c) Low
d) Need more information
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Multiple Choice Question-1 (Ans.)

Ans. (a)
Explanation:
The company has cash left and access to further
borrowings. So, cash flow is not a problem. Also, it
cannot use available cash in new investments. So,
based on residual dividend approach, it should pay
medium to high level of dividends.
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Multiple Choice Question-2

A company has expected earnings of Rs.5 million.
It is planning a total investment outlay of Rs.3.5
million this year. Historically, the company has had
a dividend payout ratio of 25 percent. Calculate the
amount of dividends that the company will
distribute.
a) Rs.1.5 million
b) Rs.1.25 million
c) Rs.1.00 million
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Multiple Choice Question-2 (Ans.)

Ans. (b)

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Multiple Choice Question-3

A company has made a profit of Rs.300,
000. It has plans to invest Rs.600, 000 in
new projects. Its targeted debt-equity ratio is
2:1. How much dividend could be paid?
a) Rs.300,000
b) Rs.100,000
c) Rs.200,000
d) Nil
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Multiple Choice Question-3 (Ans.)

Ans. (b)
Explanation:
Investment = Rs.600, 000
Debt-equity ratio = 2:1
Own equity in new investment =600,000/3
= Rs.200, 000
Dividend = Rs.300, 000 - Rs.200, 000
= Rs.100, 000
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Multiple Choice Question-4

A company expects this years EPS to be Rs.2 and
projects EPS of Rs.1.80, Rs.2.30, Rs.2.80 and
Rs.2.60 over the next four years. It has long-term
target dividend payout ratio of 50 percent. Which
of the following dividend patterns would you
recommend?
a) Rs.1.00, Rs.1.00, Rs.1.00, Rs.1.40, Rs.1.30
b) Rs.1.00, Rs.0.90, Rs.1.15, Rs.1.40, Rs.1.30
c) Rs.1.00, Rs.1.00, Rs.1.10, Rs.1.20, Rs.1.30
d) Rs.1.00, Rs.0.90, Rs.1.10, Rs.1.30, Rs.1.30
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Multiple Choice Question-4 (Ans.)

Ans. (c)

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Thank You!

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