Submitted to: TSA, PGPMSL - 123 Dividend Policy

“Dividend Policy”

Term Paper – I
On
Corporate Financial
Management

Submitted to: The Academy

Submitted by: B.Bhaumik, PGPMSL-123
Date: April 8, 2010.

Submitted by: B.Bhaumik, PGPMSL-123, April 8, 2010. Page No. 1

Submitted to: TSA, PGPMSL - 123 Dividend Policy

Part A

Dividend Policy
Dividends are cash payments made to stockholders. Decisions
about when and how much of earnings should be paid as
dividends are part of the firm’s dividend policy. Earnings that are
paid out as dividends cannot be used by the firm to invest in
projects with positive net present values—that is, to increase the
value of the firm. The dividend policy that maximizes the value of
the firm is said to be the optimal dividend policy.

Dividend Policy and Stock Value—researchers argue whether

there exists an optimal dividend policy. Some academicians argue
that a firm’s dividend policy does not affect the value of a firm
(dividend irrelevance theory), while other argue that the dividend
policy is an important factor in the determination of a firm=s
value (dividend relevance theory).

Investors and Dividend Policy—investors’ reactions to changes in

dividend policies can be summarized as follows:

Information content, or signaling—there is a belief that

managers change dividends (increase or decrease) only when it is
necessary—that is, decreases occur only when the firm is facing
financial difficulty, while increases occur only when it is expected
that the firm can continue to pay higher dividends long into the
future. If this is true, then changes in a firm’s dividend policy
provide information to investors, who will react accordingly. For
example, investors would consider an increase (decrease) in
dividends to be good (bad) news, and thus increase (decrease)
the price of the firm’s stock.

Clientele effect
Investors might choose a particular stock due to the firm’s
dividend policy—that is, some investors prefer dividends and
others do not. If such a clientele effect does exist, then we would

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Submitted to: TSA, PGPMSL - 123 Dividend Policy

expect that a firm’s stock price will change when its dividend
policy is changed.

Free cash flow hypothesis

If investors truly want managers to maximize the value of the
firm, then dividends should be paid only when the firm has no
investments with positive net present values. In other words, a
firm should pay dividends only when it has funds that are not
needed to invest in positive NPV projects—that is, only free cash
flows should be paid as dividends. If this theory is correct, then
we might expect a firm’s stock price to increase when it
decreases dividends to invest in positive NPV projects, and we
might expect the stock price to decrease when the firm increases
dividends because it no longer has as many positive NPV projects
as it did in prior years.

Types of dividend payments

Residual dividend policy

As an investor, you should want the firm to retain any earnings it
can invest at a rate of return that is at least as high as your
opportunity cost. Firms that agree with this concept might follow
a residual dividend policy where dividends are paid only if
earnings are greater than what is needed to finance the equity
portion of the firm’s optimal capital budget for the year.
Therefore, if the residual dividend policy is followed, the firm
should not pay dividends when it is necessary to issue new
common stock to provide equity financing for the current capital
budgeting needs.

Stable, predictable dividends

Some managers believe that dividends should never be
decreased unless it is absolutely necessary. These managers
probably follow a stable, predictable dividend policy, which
requires that the firm pays a dividend that is the same every year
or is constant for some period and then is increased at particular
intervals—that is, dividend payments are fairly predictable.
Greater predictability is associated with greater certainty and lees

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Submitted to: TSA, PGPMSL - 123 Dividend Policy

risk, which implies a lower overall WACC and a higher firm value.
In practice, more firms actually follow some form of this dividend
policy.

Constant payout ratio

A firm’s dividend payout ratio is defined as the proportion of
earnings per share (EPS) that is paid out as dividends (DPS)—that
is, payout ratio = DPS/EPS. Firms that follow a constant payout
ratio dividend policy pay the same percentage of earnings as
dividends each year. For example, a firm might pay 60 percent of
its earnings as dividends. If so, then dividends will fluctuate as
earnings fluctuate.

Low regular dividend plus extras

Requires a firm to pay some minimum dollar dividend each year
and then to pay an extra dividend when the firm’s performance is
above normal (or above some minimum standard)

Payment procedures
Dividends are usually paid quarterly. The following dates are
important when establishing a dividend policy:

Declaration date
The date the board of directors states that a dividend will be paid
to stockholders. A dividend is not a liability to the firm until it is
declared.

Holder-of-record date
The date the firm “opens” its ownership books to determine who
will receive dividends. Persons whose names appear in the
ownership books after the holder-of-record date, which is also
termed the date of record, but prior to the date the dividend is
paid will not receive a dividend payment.

Ex-dividend date
Two working days before the holder-of-record date. Ex dividend
means without dividend; so, on the ex-dividend date, the stock
begins to sell without the right to receive the next dividend
payment. In essence, the stock sells without the right to receive

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Submitted to: TSA, PGPMSL - 123 Dividend Policy

the dividend payment because there is not enough time for the
names of new stockholders to be registered before the holder-of-
record date.

Payment date
The date the firm mails the dividend checks.

Dividend reinvestment plans

Plans that permit stockholders to have dividend payments
automatically reinvested in the firm’s stock. Dividend
reinvestment plans, which are referred to as DRIPs, allow
stockholders to buy additional shares of a firm’s stock on a pro
rata basis using the cash dividend paid by the firm. Often there
are little or no brokerage fees involved with DRIPs.

Factors Influencing Dividend Policy

When developing a dividend policy, the following factors should
be considered:

Constraints on dividend payments

The amount of dividends a firm pays might be limited by:

1) Restrictions in debt agreements that state the maximum

amount of dividends that can be paid in any year
2) The amount of retained earnings, which represents the
maximum amount of dividends that can be paid at any time
3) The liquidity position of the firm—if cash is not available,
dividends cannot be paid
4) Limits of the IRS on the amount of earnings a firm can retain
for non-specific reasons.

Investment opportunities
Firms that need great amounts of funds for positive NPV
investments usually pay relatively lower amounts of dividends
than firms with few positive NPV investments.

Alternative sources of capital

The higher the costs of issuing new common stock, generally the
lower the relative amount of dividends paid by a firm; firms that

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Submitted to: TSA, PGPMSL - 123 Dividend Policy

are concerned about diluting current ownership through new

issues of common stock are likely to pay relatively low dividends.

Effects of dividend policy on Cost of equity

In an effort to minimize its WACC through the cost of equity, a
firm will examine the effect a dividend policy has on its required
rate of return. Factors such as risk perception, information
content (signaling), and preference for current returns versus
future returns (that is, dividend yield or capital gains) are
considered when the dividend policy is established.

Stock Splits and Stock Dividends

Some firms pay dividends in the form of stock or change the
number of shares of stock that is outstanding through a stock
split.

Neither of these actions by themselves has economic

value in the sense that each does nothing to change
stockholders’ wealth.

Stock splits
An action taken by a firm to change the number of outstanding
shares of stock. Many firms believe their stock has an optimal
price range within which their stock should trade. If the price of
the stock exceeds the price range, then the firm will execute a
stock split. If a firm initiates a 2-for-1 stock split, each existing
stockholder will receive two shares of stock for each one share he
or she now owns. This action should cut the market price of the
stock exactly in half. But, there is evidence that shows the price
of the stock actually settles above one half the pre-split price.
Perhaps the reason this occurs is because investors believe the
split provides positive information; specifically that the firm
expects the price of the stock to increase further above the
optimal range in the future. In any event, there really is no
specific economic value associated with a stock split. As an
investor, unless the market reacts positively or negatively to the
split, the only effect the split has is to increase the number of

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Submitted to: TSA, PGPMSL - 123 Dividend Policy

shares of stock you own, with each share valued at a lower

relative price such that your wealth position has not changed.

Stock dividends
Dividends paid in the form of stock rather than cash. Like stock
splits, a stock dividend does not have specific economic value;
rather, it increases the total number of shares of stock each
stockholder owns. At the same time, the stock price per share
decreases because investors have not provided any funds for the
additional shares of stock. A firm might use a stock dividend to
keep the price of its stock within a particular range.

Balance sheet effects

For stock splits, the only effect on the balance sheet is that the
number of shares outstanding changes relative to the split, which
also changes the stated par value of the stock (if there is one). If
a firm executes a 2-for-1 split, for example, it would double the
number of shares outstanding and halve the par value of the
stock reported on the balance sheet. The total dollar values in
each common equity account would not change. When a stock
dividend is paid, on the other hand, the firm must transfer capital
from retained earnings to the “Common stock” account and the
“Additional paid-in capital” account to reflect the fact that a
dividend was paid. The transfer from retained earnings is
computed as follows:

Funds transferred No. of share stock dividend

Market price
From retained earning outstanding as a percent
of the stock

Price effects
Even though both stock splits and stock dividends only increase
the number of outstanding shares of stock, studies have shown
that the market price of the stock affected by such actions might
change—if investors expect future earnings and cash dividends to
increase (decrease), then the price will increase (decrease) above
the relative price associated with the stock split or the stock
dividend. For example, if investors believe a firm initiated a 2-for-

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Submitted to: TSA, PGPMSL - 123 Dividend Policy

1 stock split because its future earnings will cause the price of the
stock to increase well above its optimal range, then their reaction
to the split will cause the post-split price of the stock to be
greater than one half the pre-split price. If the future expectations
do not pan out, however, the price of the stock will eventually
settle at about one half the pre-split price.

Dividend Policies around the World

There is great variation in dividend policies of firms in different
parts of the world. In most parts of the world, dividend policies
are based on local tax laws. For example, in countries where the
tax on capital gains is less than the tax on dividends, firms tend
to retain greater amounts of earnings than in countries where the
tax on dividends is relatively small. Also, in countries that have
few regulations to protect small stockholders, companies tend to
pay greater amounts of earnings as dividends.

Part B

Sudarshan Chemical & Dividend

Sudarshan has specialized in colors and chemicals for over 50

years and has acquired a strong position in especially the color
business in India. With over 35% market share we are the largest
pigment supplier, among both Indian and MNC’s, in the fastest
growing economy in the world.

We are technology-focussed company with a high investment in

R&D, offering excellent technical service and customized products

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Submitted to: TSA, PGPMSL - 123 Dividend Policy

– a partnership approach, providing solutions that make sense. In

addition, we remain the only effect pigment producer in India,
offering a unique package.

For the last decade we have been aggressively expanding into

international markets. And with growing sales in each continent it
is our aspiration to establish Sudarshan as a leading chemical
brand, worldwide.

Sudarshan is a public limited company listed on the Mumbai stock

exchange and last 5 years dividend history is as under.

Yea Mont Dividend

r h (%)
200
Jun 80
9
200
Jun 30
8
200
Jun 25
7
200
Jul 50
6
200
Jun 30
5

Sudarshan is now expanding rapidly. Compared to last year its

topline has grown by 25 % and its bottomline has more than
doubled. The dividend paid out by Sudarshan reflects this fact.
The surge in profits has necessitated an increase in the amount of
capital expenditures to save in corporate taxes. After the
allocation of money in capital expenditures the dividend is paid
out after approval from the board. This policy can be equated with
the Residual dividend policy describe above.

Part C

For understanding dividend policy we also need to understand the

financial structure of the company its sources of funds , EPS ,

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Submitted to: TSA, PGPMSL - 123 Dividend Policy

Distributable profits ploughing back of funds and profit and loss

accounts.

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