Corporate Finance

Email: hasanzulfiqar@yahoo.co.uk

Contents

Different Types of Dividends; Standard Method of Cash Dividend Payment; The Benchmark Case: An Illustration of the Irrelevance of Dividend Policy; Repurchase of Stock; Personal Taxes, Issuance Costs, and Dividends; Real World Factors Favoring a High Dividend Policy; The Clientele Effect: A Resolution of Real-World Factors? What We Know and Do Not Know About Dividend Policy

Different Types of Dividends

A dividend is a payment made by a corporation to its shareholders. Dividend is the part of the earnings of a corporation that is distributed to its shareholders annually.

1.Cash Dividend: Payment of cash by the firm to its shareholders.– Dividends must notionally be “paid” from profits not capital.– The cash dividend can be regular or special and may have

franking credits (full or partial) attached.2.Stock Dividends/ Bonus issues: A Stock dividend is the payment to existing owners of a dividend in form of stock.

No cash leaves the firm.The firm increases the number of shares outstanding.Extra shares issued as a dividend.May be a general issue to all shareholders, or shareholders

may participate in a bonus plan.Distribution from “income” attracts income tax, but

distribution from “capital” does not.Bonus shares create more paper, not more value

Cash Versus Stock Dividend

Issue Stock Dividend Cash Dividend

Given on Number of Shares Face value of the Share

Taxable No Yes

Number of Share Increased Remains same

Retained Earnings

100% of Net Income

Lower than net income

Advantages and Disadvantages of Stock Dividend/Bonus Share

Advantages

1.View points of Shareholders• Increase investment

• Tax benefit

• Indication of higher future profit

• Psychological value

• Zero Investment cost

2.View points of Company• Increase cash reserve

•Ability to payment of debt

• Increase Liquidity

•Purchase of asset

•Written of intangible asset

•Expansion of Business

Disadvantages1. View points of Shareholders

• Decrease market price of share

• Undiversified investment• Deprive of consumption• Ownership unchanged

2. View point of Company• Obligation to pay dividend• Procedural problem• Costly to administer• Problems of adjusting EPS

and P/E Ratio

Legal considerations for Dividends

1. Dividends can only be paid out of profit and are not to be paid out of capital.

2. A dividend cannot be paid if it would make the company insolvent.

3. Dividend restrictions may exist in covenants in trust deeds and loan agreements.

4. Franked dividend carries credits for tax paid by the company.

5. Under imputation, if a company has the capacity to pay a franked dividend then, as a general rule, it must do so.

Stock Splits

• A stock split is a method commonly used to lower the market price of firms stock by increasing the number of shares belonging to each shareholder. (L J Gitman)

• A stock split is a method to increase the number of outstanding shares through a proportional reduction in the par value of the share.

Objective of Corporate Stock Split1. To make trading in share attractive2. Indication of higher profit3. Increased dividend

Example: • Recently Islami Bank Bangladesh Ltd. has splited its Taka 1000 par

share into 10 Shares of Taka 100 each. • Social Islami Bank Limited has splited its Taka 100 par share into

10 shares of Tk 10 each.

Example 01: Stock Splits and Stock Dividends

Rooster Rocks Corporation (RRC) currently has 250,000 shares outstanding that sell for $75 per share. Assuming no market imperfections or tax effects exist, what will the share price be after:

a.RRC has a five-for-three stock split?

b.RRC has a 15 percent stock dividend?

c.RRC has a 42.5 percent stock dividend?

d.RRC has a four-for-seven reverse stock split?

e.Determine the new number of shares outstanding in parts (a) through (d).

Solution-Example 01: Stock Split

Price of 3 Shares = $75*3= $225After Splitting, 3 Shares become 5 SharesSo, Price of 05 New Shares = Price of 03 Old Shares = $225

Price of 01 new shares = $225/5 = $45

a. RRC has a five-for-three stock split?

b. RRC has a 15 percent stock dividend?

After giving 15% Stock Dividend, 100 existing share will be

= 100 (1+15%) =115 SharesPrice of 115 Shares = $75x100Price of 01 new shares = $75x100/115 =$65.22

Solution-Example 01 : Stock Split

d. RRC has a four-for-seven reverse stock split?

Price of 7 Shares = $75*7= $525

After Reverse Splitting, 7 Shares become 4 Shares

So, Price of 04 Shares = $ 525

Price of 01 new shares = $525/4 = $131.25

c. RRC has a 42.5 percent stock dividend?After giving 42.5% Stock Dividend, 100 existing share will be = 100 *(1+42.5%) =142.5 SharesPrice of 142.5 Shares = $75x100Price of 01 new shares = $75x100/142.5 =$52.63

Solution-Example 01 : Stock Split

e. To find the new shares outstanding, we multiply the current shares outstanding times the ratio of new shares to old shares, so:

a: New Total Shares = 250,000(5/3) = 416,667

b: New Total Shares = 250,000(1.15) = 287,500

c: New Total Shares = 250,000(1.425) = 356,250

d: New Total Shares = 250,000(4/7) = 142,857

Practice 01: Stock Splits and Stock Dividends

Social Islami Bank Limited currently has 26917269 shares outstanding that sell for Taka 340 per share. Assuming no market imperfections or tax effects exist, what will the share price be after:

a.SIBL has a 10-for-one stock split?

b.SIBL has a 10 percent stock dividend?

c.SIBL has a 25 percent stock dividend?

d.SIBL has a 01-for-Ten reverse stock split?

e.Determine the new number of shares outstanding in parts (a) through (d).

Example 02: Stock Dividend

The owners’ equity accounts for Hexagon International are shown in the table:

Common Stock ($1 par value) $10,000

Capital Surplus 180,000

Retained Earnings 586,500

Total owners’ equity $776,500

a. If Hexagon stock currently sells for $25 per share and a 10% stock dividend is declared, how many new shares will be distributed? Show how the equity accounts would change.

b. If hexagon declared a 25% stock dividend, how would the accounts change?

c. If Hexagon declares a four-for –one stock split, how many shares are outstanding now? What is the new par value per share?

d. If Hexagon declares a one-for – five stock split, how many shares are outstanding now? What is the new par value per share?

Solution: Example 02.. Stock Dividend

a. The shares outstanding increases by 10 percent, so:Total New shares outstanding = 10,000(1.10) = 11,000New shares issued = 1,000Capital Surplus of Every new share = Market Price – Par Value= $25-$1 = $24The total capital surplus is therefore:Capital surplus on new shares = 1,000($24) = $24,000Changes in Equity Accounts:Common stock ($1 par value) $ 11,000Capital surplus 204,000Retained earnings 561,500

$776,500

How?180000 + 24000= 204000586,500 -24000-1000 = 561500

Solution: Example 02..

2 b. The shares outstanding increases by 25 percent, so:New shares outstanding = 10,000(1.25) = 12,500New shares issued = 2,500Since the par value of the new shares is $1, the capital surplus per share is $24. The total capitalsurplus is therefore:Capital surplus on new shares = 2,500($24) = $60,000Common stock ($1 par value) $ 12,500Capital surplus 240,000Retained earnings 524,000

$776,500How?180000 + 60000= 240000586,500 -60000-2500 = 524000

Solution: Example 02. Stock Split

c. To find the new shares outstanding, we multiply the current shares outstanding times the ratio of new shares to old shares, so:New shares outstanding = 10,000(4/1) = 40,000

Price of 1 Share = $1After Splitting, 1 Old Share becomes 4 SharesSo, Price of 04 New Shares = Price of 01 Old Shares = $1Price of 01 new shares = $1/4 = $0.25So, new Par Value is = $0.25

d. New shares outstanding = 10,000(1/5) = 2,000.The equity accounts are unchanged except that the par value of the stock is changed by the ratio of new shares to old shares, so the new par value is:New par value = $1(5/1) = $5.00 per share.

Practice Problem 2: Stock Dividends

The Owners Equity accounts of Octagon International are shown here:

Common Stock ($1 par value) $20000

Capital Surplus 195, 000

Retained Earnings 537400

Total Owners Equity $752,400

a. If Octagon stock currently sells for $20 per share and a 10% stock dividend is declared, how many new shares will be distributed? Show how the equity accounts would be change?

b. If Octagon declared a 25% stock dividend, how would the accounts change?

c. if: Octagon declares a five-for-one stock split. How many shares are outstanding now? What is the new par value per share?

d. Octagon declares a one-for-four reverse stock split. How many shares are outstanding now? What is the new par value per share?

Solutions

a. The shares outstanding increases by 10 percent, so:New shares outstanding = 20,000(1.10) = 22,000New shares issued = 2,000Since the par value of the new shares is $1, the capital surplus per share is $24. The total capital surplus is therefore:Capital surplus on new shares = 2,000($24) = $48,000Common stock ($1 par value) $ 22,000Capital surplus 243,000Retained earnings 487,400

$752,400

b. The shares outstanding increases by 25 percent, so:New shares outstanding = 20,000(1.25) = 25,000New shares issued = 5,000Since the par value of the new shares is $1, the capital surplus per share is $24. The total capital surplus is therefore:Capital surplus on new shares = 5,000($24) = $120,000

Common stock ($1 par value) $ 25,000Capital surplus 315,000Retained earnings 412,400

$752,400

Solutions

c. To find the new shares outstanding, we multiply the current shares outstanding times the ratio of new shares to old shares, so:New shares outstanding = 20,000(4/1) = 80,000The equity accounts are unchanged except the par value of the stock is changed by the ratio of new shares to old shares, so the new par value is:New par value = $1(1/4) = $0.25 per share.d. To find the new shares outstanding, we multiply the current shares outstanding times the ratio of new shares to old shares, so:New shares outstanding = 20,000(1/5) = 4,000.The equity accounts are unchanged except the par value of the stock is changed by the ratio of new shares to old shares, so the new par value is:New par value = $1(5/1) = $5.00 per share.

Example 03: Stock Split

DANA Company, a forest products concern, had 20000 Common Stock of Tk. 100 par value and no preferred stock outstanding. Because the stock is selling at a high market price the firm has declare a 2 for 1 stock split. The shareholders equity capital accounts are given bellow:

Sources of Capital Taka

Common stock 20,00,000

Additional paid up capital 40,00,000

Retained Earnings 20,00,000

Shareholders total Equity 80,00,000You are required to reformulate the stockholders capitalization accounts of the firm.

Solution

000,40

1

220000

Ratio Split Stock goutstandin share of Number Share of NumberNew

Tk.502

1100

2

1 Price Current Share per PriceNew

80,00,000Shareholders Equity80,00,000Shareholders Equity

20,00,000Retained Earnings20,00,000Retained Earnings

40,00,000Additional paid up capital

40,00,000Additional paid up capital

20,00,000Common Stock

(40000 x Tk. 50)

20,00,000Common Stock

(20000 x Tk. 100)

AmountAfter Stock SplitAmountBefore Stock Split

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

• Dividend policy involves the decision or payout earnings or to retain them for reinvestment in the firm. (Weston and Brigham)

• Dividend policy refers to the choice of firm to distribute its net earnings to shareholders, or to invest them in the business. (Khan and Jain)

Factors Determining Dividend Policy1. Profitable Position of the Firm: Dividend decision depends on the

profitable position of the business concern. When the firm earns more profit, they can distribute more dividends to the shareholders.

2. Uncertainty of Future Income: Future income is a very important factor, which affects the dividend policy. When the shareholder needs regular income, the firm should maintain regular dividend policy.

3. Legal Constrains: The Companies Act 1956 has put several restrictions regarding payments and declaration of dividends. Similarly, Income Tax Act, 1961 also lays down certain restrictions on payment of dividends.

4. Liquidity Position: Liquidity position of the firms leads to easy payments of dividend. If the firms have high liquidity, the firms can provide cash dividend otherwise, they have to pay stock dividend.

5. Sources of Finance: If the firm has finance sources, it will be easy to mobilize large finance. The firm shall not go for retained earnings.

6. Growth Rate of the Firm: High growth rate implies that the firm can distribute more dividend to its shareholders.

7. Tax Policy: Tax policy of the government also affects the dividend policy of the firm. When the government gives tax incentives, the company pays more dividend.

8. Capital Market Conditions: Due to the capital market conditions, dividend policy may be affected. If the capital market is prefect, it leads to improve the higher dividend.

Types of Dividend Policy• Regular Dividend Policy: Dividend payable at the usual rate is

called as regular dividend policy. This type of policy is suitable to the small investors, retired persons and others.

• Stable Dividend Policy: Stable dividend policy means payment of certain minimum amount of dividend regularly. This dividend policy consists of the following three important forms:

• Constant dividend per share• Constant payout ratio• Stable dividend plus extra dividend.

• Irregular Dividend Policy: When the companies are facing constraints of earnings and unsuccessful business operation, they may follow irregular dividend policy. It is one of the temporary arrangements to meet the financial problems. These types are having adequate profit. For others no dividend is distributed.

• No Dividend Policy: Sometimes the company may follow no dividend policy because of its unfavorable working capital position of the amount required for future growth of the concerns.

• Compromise dividend policy• Residual dividend policy Study Details from the

Text Book & internet Source

Constant Nominal

Payments Policy

• Based on the payment of a fixed-dollar dividend in each period.

• Firms often increase the regular dividend once a proven increase in earnings has occurred.

• Firms almost never cut dividends unless they face a true crisis.

Low Regular and Extra Dividend

• Pays a low regular dividend, supplemented by an additional cash dividend when warranted by earnings.

Constant Payout Ratio Policy

• The ratio, dividing the firm’s cash dividend per share by its earnings per share, indicates the percentage of each dollar earned that is distributed to the owners.

Types of Dividend Policies

Importance of Dividend Policy

• It gives a clear guide line about dividend payout rate, reserve ratio, cash dividend etc.

• Market price of Share depends on dividend policy

• It creates the accountability of the director to the share holders

• It creates internal sources of finance by providing bonus share

• Dividends policy creates investors satisfaction

• It helps to maximize the wealth of the shareholders

Result of Non-Declaration of Dividend

1. Decrease in Share price

2. Lost of goodwill

3. Media of information

4. Dissatisfaction of Shareholders

5. Sources of external financing

6. Sales of share at discount

7. Increase in internal fund

8. Available Investment

9. Black Listed

Irrelevance of Dividend: Dividend policy may not matter

• Dividend Irrelevance Theory (Dividend policy may not matter)

– According to professors Soloman, Modigliani and Miller, dividend policy has no effect on the share price of the company. There is no relation between the dividend rate and value of the firm. Dividend decision is irrelevant of the value of the firm. Modigliani and

– Miller contributed a major approach to prove the irrelevance dividend concept.

– This theory purports that a firm's dividend policy has no effect on either its value or its cost of capital. Investors value dividends and capital gains equally. Dividend policy is the decision to pay dividends versus retaining funds to reinvest in the firm

– In theory, if the firm reinvests capital now, it will grow and can pay higher dividends in the future

Dividend Irrelevance Theory Formula (MM)

• Po = Prevailing market price of a share.

• Ke = Cost of equity capital.

• D1 = Dividend to be received at the end of period one.

• P1 = Market price of the share at the end of period one.

)1(P 11

0

eK

PD

Example 03: Price of Share when Dividend is Paid

X Company Ltd., has 100000 shares outstanding the current market price of the shares Taka 15 each. The company expects the net profit of Taka 2,00,000 during the year and it belongs to a rich class for which the appropriate capitalization rate has been estimated to be 20%. The company is considering dividend of Taka 2.50 per share for the current year. What will be the price of the share at the end of the year-

i. if the dividend is paid? and ii. if the dividend is not paid?

Solution: Example 03

Item If Div is paid If Div is not paid

P0 15 15

D1 2.50 0

Ke 20% 20%

)1(P 11

0

eK

PD

i ii

Practice 03: Price of Share when Dividend is Paid

X Company Ltd., has 100000 shares outstanding the current market price of the shares Taka 25 each. The company expects the net profit of Taka 2,00,000 during the year and it belongs to a rich class for which the appropriate capitalization rate has been estimated to be 18.5%. The company is considering dividend of Taka 2.25 per share for the current year. What will be the price of the share at the end of the year

i. if the dividend is paid? and ii. if the dividend is not paid?

Dividend Relevance Theory: Dividends matter (Walter Model)

• According to this concept, dividend policy is considered to affect the value of the firm. Dividend relevance implies that shareholders prefer current dividend and there is no direct relationship between dividend policy and value of the firm. Relevance of dividend concept is supported by two eminent persons like Walter and Gordon.

• The value of a firm is affected by its dividend policy. The optimal dividend policy is the one that maximizes the firm's value.

• the value of the stock is based on the present value of expected future dividends

• Formula in Walter Model:

e

e

K

DEKr

D

P

)(

P = Market price of an equity shareD = Dividend per sharer = Internal rate of returnE = Earning per shareKe = Cost of equity capital

Example 04: Walter Model

From the following information supplied to you, ascertain whether the firm is following an optional dividend policy as per Walter’s Model?

Total Earnings Rs. 2,00,000No. of equity shares (of Rs. 100 each 20,000)Dividend paid Rs. 1,00,000P/E Ratio 10Return Investment 15%

The firm is expected to maintain its rate on return on fresh investments. Also find out what should be the E/P ratio at which the dividend policy will have no effect on the value of the share? Will your decision change if the P/E ratio is 7.25 and interest of 10%?

Example 04: Solution

Value of the Share as per Walter Model

Example 04: Solution

Formula

100 AssetTotal

Income Net ROA

Shares of Number

Dividend Preferred-Income Net EPS

Stock Common of Number

Dividend Common DPS

100EPS

DPS Ratio Payout Dividend

ratio payout Dividend100% Ratio Retention

Share Per Earnings

Sahre Per Price Market Ratio P/E

Dividend Common-PD-NI ntreinvestme R/E

Example 01: Dividend Policy

Following information of BRB cable Ltd. are as follows:

Equity Share (per share Tk.100) Tk. 10,00,000

10% Preferred stock 500,000

Total Capital 15,00,000

Market price per equity share 200

Net income (EAT) 300,000

Preferred Dividend 50,000

Common Dividend paid 150,000Calculate the Followings:

1. Return on Asset

2. EPS

3. DPS

4. Dividend payout Ratio

5. Retention Ratio

6. Price Earnings ratio

7. Amount of retain earnings for re-investment

Solution

%20100100 1500000

300000

AssetTotal

Income Net ROA

25.Tk100 10000

50000-300000

Shares of Number

Dividend Preferred-Income Net EPS

15.Tk 10000

150,000

Stock Common of Number

Dividend Common DPS

%6010025

15 100

EPS

DPS RatioPayout Dividend

40% 60%-100% ratio payout Dividend100% Ratio Retention

x0.825

200

Share Per Earnings

Sahre Per Price Market Ratio P/E

100,000 Tk.150000-50000-300,000

Dividend Common-PD-NI ntreinvestme R/E

Practice 01: Dividend Policy

Following information of BRB cable Ltd. are as follows:

Equity Share (per share Tk.1000) Tk. 20,00,000

15% preference share 500,000

Total Capital 25,00,000

Market price per equity share 1500

Annual net income (EAT) 800,000

Preference Dividend 75,000

Common Dividend paid 300,000Calculate the Followings:

1. Return on Asset

2. EPS

3. DPS

4. Dividend payout Ratio

5. Retention Ratio

6. Price Earnings ratio

7. Amount of retain earnings for re-investment

Personal taxes on dividends

• A macroeconomic variable• Should discourage payments• Empirical evidence is ambiguous.• Dividends paid before 1936 (no taxes) vs. after

1936• Some evidence of positive relation between

payout and tPS.

Security issuance costs

• A macroeconomic variable • Should discourage payments• If costly to issue new stocks and bonds, firm

should retain cash.

Investor trading costs

• A macroeconomic variable • This factor argues in favor of dividends.• But cost of selling shares for income has fallen

steadily

Real-World Influences On Dividend Policy

Importance of institutional investors

• A macroeconomic variable

• Should discourage payments.

Corporate governance power of institutional investors

• A macroeconomic variable

• Should discourage payments.

Capital market, relative to intermediated (bank) financing

• A macroeconomic variable

• This factor argues in favor of dividends.

Real-World Influences On Dividend Policy

Asset Growth Rate• A firm-level variable• This factor should discourage payments.

Positive-NPV investment opportunities

• A firm-level variable• This factor should discourage payments.

Free cash flow generated

• A firm-level variable• This factor argues in favor of dividends.

Dividends might be a “residual” after funding investments.

But dividends are most stable of all cash flow series.

Dividends may convey information in markets with info asymmetries.

• But what specific information? Isn’t there a cheaper way to signal?

• Latest empirical evidence: dividends signal the past, not the future.

Real-World Influences On Dividend Policy

Date Related to Cash Dividend Payment

25 Oct. 1 Nov. 2 Nov. 6 Nov. 7 Dec.

Declaration Date

Cum-dividend

Date

Ex-dividend

Date

Record Date

Payment Date

…

Declaration Date: The Board of Directors declares a payment of dividends.Record (books closing) date : The corporation prepares a list of all individuals believed to be stockholders as of 6 November.

Cum-Dividend Date: The last day that the buyer of a stock is entitled to the dividendEx-Dividend Date: The first day that the seller of a stock is entitled to the dividend. Date the seller is entitled to keep the dividend. This is 4 business days before the date of record.

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 on of the assumptions underlying the dividend-irrelevance arguments was “The investment policy of the firm is set ahead of time and is not altered by changes in dividend policy.”

Dividend Reinvestment Plans

• Dividend Reinvestment Plan (DRIP) Dividend Reinvestment Plan (DRIP) -- An optional plan allowing shareholders to automatically reinvest dividend payments in additional shares of the company’s stock.

• Investor’s elect to reinvest their dividend in the company rather than take them in cash.– The company issues new shares which the

shareholder’s get at a small discount (say 5%) to the ex-div price.

– DRP’s are an important source of equity finance, but sometimes a company has more cash coming in than it can use, and the DRP is suspended.

Share repurchaseThe repurchase (buyback) of stock by the issuing firm, either in the open (secondary) market or by self-tender offer.Stock repurchase is a transacting in which a firm buys back shares of its own stock in any one of the following methods:

1. Buys shares on the market2. Makes a direct offer to Shareholders3. or private negotiation (Green Mail)

– Instead of declaring cash dividends, firms can rid itself of excess cash through buying shares of their own stock.

– Recently share repurchase has become an important way of distributing earnings to shareholders.

– shrink the firm, supplement dividends, obtain tax benefits, combat undervaluation, increase leverage, change composition of share register.

Example 03: Dividends and Taxes

The Regional Electric Company has $1,000 of extra cash. It can retain the cash and invest it in Treasury bills yielding 10 percent, or it can pay the cash to shareholders as a dividend. Shareholders can also invest in Treasury bills with the same yield. Suppose the corporate tax rate is 34 percent, and the individual tax rate is 28 percent. However, the maximum tax rate on dividends is 15 percent. How much cash will investors have after five years under each policy?

Solution: Dividends and Taxes

If dividends are paid now, shareholders will receive Cash Dividend (1- td); = $1,000 (1 - 0.15) = $850, today after personal tax. Because their return after personal tax is, Kdt = Kd (1-t) = 10% (1-28%) = 7.2%, they will have; =$850 (1.072)5 = $1203.35 in five years.

If Regional Electric Company retains the cash to invest in Treasury bills, its after tax interest rate will beKdt = Kd (1-tc) = 10% (1-0.34) = 6.6% , andAt the end of five years from now, the firm will haveFV = $1,000 (1.066)5 = $1,376.53If this is paid as a dividend, the stockholders will receive$1,376.53 (1 0.15) = $991.10

td =

Tax

Rat

e on

Div

iden

dK

d=

Cos

t on

T-B

illK

dt

= A

fter

Tax

Kd

t =

Per

sona

l Tax

rat

etc

= C

orpo

rate

Rax

Rat

e

Practice 03A: Dividends and Taxes

The Regional Electric Company has $2,000 of extra cash. It can retain the cash and invest it in Treasury bills yielding 9.5 percent, or it can pay the cash to shareholders as a dividend. Shareholders can also invest in Treasury bills with the same yield. Suppose the corporate tax rate is 40 percent, and the individual tax rate is 22 percent. However, the maximum tax rate on dividends is 10 percent. How much cash will investors have after five years under each policy?

What’s the “clientele effect”?

• Different groups of investors, or clienteles, prefer different dividend policies.

• Firm’s past dividend policy determines its current clientele of investors.

• Clientele effects impede changing dividend policy. Taxes & brokerage costs hurt investors who have to switch companies.

Stock Repurchase versus Dividend

Assets Liabilities and Owners Equity

Cash $ 150000 Debt 0

Other Assets $ 850000 Equity $ 1000000

Value of the Firm $ 1000000 Value of the Firm $ 1000000

A. Original Balance Sheet

Shares Outstanding = 100000; Price Per Share = ($ 10,00,000/100,000) = $ 10

Consider a firm that wishes to distribute $100,000 to its shareholders.

B. If they distribute the $100,000 (i.e. $1 per share) as cash dividend, the balance sheet will look like this:

Assets Liabilities and Owners Equity

Cash $ 50000 Debt 0

Other Assets $ 850000 Equity $ 900,000

Value of the Firm $ 900,000 Value of the Firm $ 900,000

Shares outstanding = 100,000; Price per Share = $900,000/100,000=$9

Stock Repurchase versus Dividend

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

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

The Clientele Effect: A Resolution of Real-World Factors?

Clienteles for various dividend payout policies are likely to form in the following way:

Group Stock

High Tax Bracket Individuals

Low Tax Bracket Individuals

Tax-Free Institutions

Corporations

Zero to Low payout stocks

Low-to-Medium payout

Medium Payout Stocks

High Payout Stocks

Once the clienteles have been satisfied, a corporation is unlikely to create value by changing its dividend policy.Some investors prefer low dividend payouts and will buy stock in those companies that offer low dividend payoutsSome investors prefer high dividend payouts and will buy stock in those companies that offer high dividend payouts

Dividend Calculation

BudgetCapital Total

RatioEquity Target - Income

Net Dividends

Using the Residual Model to Calculate Dividends Paid

Following information are available for a company:

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? (Use residual dividend model approach.)

Dividend Calculation

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%.

How would a drop in NI to $400,000 affect the dividend? A rise to $800,000?

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 = $320,000Payout = 320,000 / 800,000 = 40%.

Dividend Calculation: Residual Dividend Policy

The Readata Corporation practices a strict residual dividend policy and maintains a capital structure of 60 percent debt, 40% equity. Earnings for the year is $5000. What is the maximum amount of capital spending possible without selling new equity? Suppose that planned investment outlays for the coming year are 412000. Will Readata be paying a dividend? If so, how much?

Worked

The Readata has a debt-equity ratio of 0.60/0.40 = 1.50.

If the entire $5000 in earnings were reinvested, then $5000X 1.50 = $ 7500 in new borrowings would be needed to keep the debt-equity ratio unchanged.

Total new financing possible without external equity is thus $5000 +47500 = $12500

If planned outlays are $12500, then this amount will be financed with 40% equity. The needed equity is thus $12500 x 0.40 = $4800. This is less than the $5000 in earnings, so a dividend of $5000-$4800 = $200 will be paid.