CHAPTER I

INTRODUCTION

!1.1 Background of the Study

Dividend policy for business organization is a very important decision, which

depends upon the long-term and short-term strategy of a firm. Dividend policy of a

firm is an effect of dividing its net earning into two parts: the retained earnings and

dividend payment. (Pandey; 1999: 770) Business firms use the retained earnings to

provide funds to the firm for long-term growth; we call it as internal financing source

also. Dividend is that portion of earning, which is paid to the common stock holders,

is a return on their investment. By a dividend policy we mean some kind of consistent

approaches to the distribution versus retention decision rather than making the

decision on the purely ad hoc basis from period to period. (Pearson, William &

Gordon; 1972: 405)

!Likewise, dividend policy must be considered in relation to the overall financing

decision. In practice, net earnings always may not be appropriate measure of the

ability of the firm to pay dividend, that's why, what and how much it is desirable to

pay dividend is always a controversial topic because shareholders expect higher

dividend but companies ensure towards setting aside funds for maximizing the

shareholders wealth.

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When a company pays out a portion of it's earnings to the shareholders in the form of

dividend, the shareholders are directly benefited. If company is hopeful to exploit

other growth opportunities, the firm can avoid for paying cash dividends. In this

condition, shareholders consider their future growth of their stock instead of getting

cash dividend. On the other hand, the firm has to pay enough dividends to satisfy

investors. If they are paid higher dividends, the market price of the stock also rises.

This means of maximizing the shareholder's wealth. Thus shareholders wealth

(return) can be increased through either dividends or capital gains. As the division and

retention are considered as dividend policy, all aspects and questions related to the

payment of dividends are contained in dividend policy.

!Financial institutions have definitely contributed and played a gigantic role for

domestic resource mobilization and economic development to build up the confidence

of the businessmen for promoting their business and industrialists for encouraging

opening new business venture. It maintains confidence for various segments and

extends credit to people. (Hastings; 1996: 72)

The banking concepts and activities started in Nepal only after the establishment of

Nepal Bank Limited in 1937. A central bank (Nepal Rastra Bank) was established to

regulate the banking activities and, declare & implement monetary policy of the

nation. Then after, it was realised that the commercial bank has its own role and

contribution in the economic development. It is the source of economic development;

it maintains economic confidence of various segments and extends credit to people.

So, another commercial bank, Rastriya Banijya Bank was established on 1966.

! 2

Capital market plays an important role in the economics development of a nation. But,

in Nepal, the capital market is very small and developing slowly with disorganized.

The Nepalese companies (especially government enterprises) have not been able to

generate sufficient as compared to the organizations that are established and operated

on public sector. Hence the government is not receiving dividends from public

enterprises for several years.

In the global perspective, joint ventures are the modes of trading through partnership

among the nations and also a form of negotiation between various groups of industries

and traders to achieve competitive advantages. Nepal's reform efforts in the financial

sectors, begun in 1980's, when Nepal Rastra Bank eased entry restrictions and

amendment of the Commercial Bank Act 1974. As a result, three banks namely,

NABIL Bank Ltd, Nepal Investment Bank Ltd. and Standard Chartered Bank Nepal

Ltd. came into operation prior to 1990s. In 1992, Nepal Rastra Bank adopted liberal

outlook in permitting commercial banks to open. Then after, the financial

liberalization really took place. Many more banks came into operation making the

total number of the commercial banks to twenty five.

Dividend practice in public corporations is still having problem for taking dividend

policy. Thus, here neither corporation are able to generate sufficient earnings for

dividend payment nor is the government expecting dividends, since it has been

observed that dividend payment is practically a crucial problem of the public

corporations. Corporation like Nepal Oil Corporation and Nepal Electricity Authority

! 3

are not distributing earnings as dividend but total effort is focused on minimization of

losing through better utilization of capital. Noticeable matter is that this shifting aim

of public corporation is failed to minimize the losses.

The joint venture banks in Nepal have brought new hope for productive mobilization

of funds according to their new trends of dividend.

Although, twenty eight commercial banks are in operation in the nation; only twenty

one commercial banks are listed in security board, on the Nepal Stock Exchange. Out

of which only five commercial banks have been taken as sample. They are as follows:

a. Standard Chartered Bank Nepal Ltd.

b. Nepal Arab Bank Ltd.

c. Everest Bank Ltd

d. Bank of Kathmandu Ltd.

e. Himalayan Bank Ltd.

!!

1. Profile of the Selected Banks

a) Standard Chartered Bank Nepal Limited

Standard Chartered Bank Nepal Limited has been in operation in Nepal since 1987.

The Bank is an integral part of Standard Chartered Group having an ownership of

75% and the balance owned by the Nepalese public. The Bank is the largest

international bank currently operating in Nepal.

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With 17 points of representation, 21 ATMs and more than 375 local staff, Standard

Chartered Bank Nepal Ltd. is in a position to serve its customers through an extensive

domestic network. In addition, the global network of Standard Chartered Group gives

the Bank a unique opportunity to provide truly international banking services in

Nepal. Standard Chartered Bank Nepal Limited offers a full range of banking

products and services in Wholesale and Consumer banking. The Bank has been the

pioneer in introducing customer focused products and services and aspires to

continue to be a leader in introducing new products in delivering superior services.

Corporate Social Responsibility is an integral part of Standard Chartereds ambition to

become the worlds best international bank and is the mainstay of the Banks values.

!b) Nabil Bank Limited

Nabil Bank Limited, the first foreign joint venture bank of Nepal, started operations in

July 1984. Nabil was incorporated with the objective of extending international

standard modern banking services to various sectors of the society. Pursuing its

objective, Nabil provides a full range of commercial banking services through its 40

points of representation across the nation and over 170 reputed correspondent banks

across the globe.

Nabil, as a pioneer in introducing many innovative products and marketing concepts

in the domestic banking sector, represents a milestone in the banking history of Nepal

as it started an era of modern banking with customer satisfaction measured as a focal

objective while doing business. Operations of the bank including day-to-day

operations and risk management are managed by highly qualified and experienced

! 5

management team. Bank is fully equipped with modern technology which includes

ATMs, credit cards, state-of-art, world-renowned software from Infosys Technologies

System, Banglore, India, Internet banking system and Telebanking system.

!c) Everest Bank Limited

Everest Bank Limited (EBL) started its operations in 1994 with a view and objective

of extending professionalized and efficient banking services to various segments of

the society. The bank is providing customer-friendly services through its Branch

Network. All the branches of the bank are connected through Anywhere Branch

Banking System (ABBS), which enables customers for operational transactions from

any branches. Moreover, EBL was one of the first bank to introduce Any Branch

Banking System (ABBS) in Nepal.

!In addition, EBL has introduced Mobile Vehicle Banking system to serve the segment

deprived of proper banking facilities through its Birtamod Branch, which is the first

of its kind. EBL has introduced branchless banking system first time in Nepal to cover

unbanked sector of Nepalese society. EBL is first bank that has launched e-ticketing

system in Nepal. EBL customer can buy yeti airlines ticket through internet.

With an aim to help Nepalese citizens working abroad, the bank has entered into

arrangements with banks and finance companies in different countries, which enable

quick remittance of funds by the Nepalese citizens in countries like UAE, Kuwait,

Bahrain, Qatar, Saudi Arabia, Malaysia, Singapore and UK.

!! 6

d) Bank of Kathmandu Limited

Bank of Kathmandu started its operation in March 1995 with the objective to

stimulate the Nepalese economy and take it to newer heights. BOK also aims to

facilitate the nation's economy and to become more competitive globally. To achieve

these, BOK has been focusing on its set objectives right from the beginning.

!The bank targets to contribute to the sustainable development of the nation by

mobilizing domestic savings and channeling them to productive area, to use the latest

banking technology to provide better, reliable and efficient services at a reasonable

cost, to facilitate trade by making financial transactions easier, faster and more

reliable through relationships with foreign banks and money transfer agencies and to

contribute to the overall social development of Nepal. Bank of Kathmandu Limited

(BOK) has today become a landmark in the Nepalese banking sector by being among

the few commercial banks which is entirely managed by Nepalese professionals and

owned by the general public.

!e) Himalayan Bank Limited

Himalayan Bank was established in 1993 in joint venture with Habib Bank Limited of

Pakistan. Despite the cut-throat competition in the Nepalese Banking sector,

Himalayan Bank has been able to maintain a lead in the primary banking activities-

Loans and Deposits. Legacy of Himalayan lives on in an institution that's known

throughout Nepal for its innovative approaches to merchandising and customer

service. Products such as Premium Savings Account, HBL Proprietary Card and

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Millionaire Deposit Scheme besides services such as ATMs and Tele-banking were

first introduced by HBL.

!All Branches of HBL are integrated into Globus (developed by Temenos), the single

Banking software where the Bank has made substantial investments. This has helped

the Bank provide services like Any Branch Banking Facility, Internet Banking and

SMS Banking. Living up to the expectations and aspirations of the Customers and

other stakeholders of being innovative, HBL very recently introduced several new

products and services. Millionaire Deposit Scheme, Small Business Enterprises Loan,

Pre-paid Visa Card, International Travel Quota Credit Card, Consumer Finance

through Credit Card and online TOEFL, SAT, IELTS, etc. fee payment facility are

some of the products and services. HBL also has a dedicated offsite Disaster

Recovery Management System.

! 8

!1.2 Statements of the Problem

Dividend is desirable for the shareholders, which inspires them for the further

investment on company's shares. But it is found that there is no satisfactory result

about dividend decision of commercial banks in Nepal. Likewise, dividend

distribution does not match with the earnings of the commercial banks, there does not

exist a proper relationship between dividend and quoted market price of share.

Similarly, commercial banks with lower returns record stable (rigid) price of share

and banks making sound returns do not rigid in share price.

!Dividend, the most inspiring factor for the investment on shares of the corporation, is

an important aspect of financial management because the dividend policy determines

the division of earnings between payment to stockholders and reinvestment in the

firm to exploit growth opportunities. It affects the value of firm as well as overall

financing decision such as financial structure, the flow of funds, corporate liquidity

and investors satisfaction.

!The dividend decision, however, is still a crucial as well as controversial area of

managerial finance. There is no consensus among the financial scholars on this

subject matter and its relation with stock price. Some financial scholars say that stock

prices are least influenced by dividend per share while some others believe that its

relevance to the stock prices is quite significant. The idea of relevance is vague as

well. It is rather hard to define whether dividend per share has positive effect or its

effect is negative one.

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!Thus for the study, the following research problems have been raised;

a) What is the situation of earning and dividend distribution of commercial banks

of Nepal?

b) What impacts do DPS and DPR and have on the MPS of the bank?

c) Does the dividend yield and the joint effect of DPS and EPS changes the

MPS?

d) What will be the trend of DPS, DPR and MPS of the commercial banks in

forthcoming years?

!1.3 Objective of the Study

The study primarily focuses on the dividend practices of commercial banks with a

view to suggest ways to maximize the shareholders return, i.e. value of their

investment is maximized. Followings are the specific objectives of the study.

a) To analyze the earnings and the dividend distribution of the commercial banks.

b) To examine the impact of DPS on MPS, and the effect of dividend payout ratio

on the MPS, and the joint effect of EPS and DPS on MPS.

c) To evaluate the relationship of dividend yield on DPS, EPS and MPS of the

corresponding bank.

d) To estimate the value of DPS, MPS and DPR for the forthcoming two fiscal

years.

!

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1.4 Significance of the Study

Due to excess liquidity and lack of investment opportunities in the capital market,

nowadays people are very much interested and attracted to invest in shares for getting

higher returns. When any new company issues (floats) shares through capital markets,

very big congregation gathers to apply for owner's certificate. It reveals that people

have expectation on higher return for investing in shares. So the dividend decision is

one of the most important decisions of financial management. It is an effective tool

(way) to attract new investors, maintain present investors and controlling position of

the firm.

Having lack of adequate knowledge, the people are haphazardly investing in shares. It

shows that there is an extreme necessity to establish clear conception about the return

that yields from investing in securities. In the Nepalese perspective, we find that there

exist almost none of the companies adopting consistent dividend policy. There may be

many reasons behind it. But there is not sufficient study conducted in this regard.

Therefore, considering all these facts, the study is undertaken which will help to meet

deficiency of the literature relating to dividend practice and price of stock. So this

study is of considerable importance.

!So many persons and parties such as shareholders, management of banks, financial

institutions, general public (depositors, prospective customers, investors etc.) and

other policy making bodies which are concerned with banking (especially NABIL

Bank Ltd, Standard Chartered Bank Ltd., Everest Bank Ltd., Bank of Kathmandu and

Himalayan Bank Ltd.) business will be benefited from this study. It is also believed

that it will provide valuable inputs for future research scholars.

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1.5 Limitations of the Study

The limitations of the study are as follows:

a) The accuracy of secondary data depends on the reliability of the annual reports

of the concerned banks.

b) The study is focused only on dividend practice, earning and price of stock only

and does not cover the other financial aspects.

c) Only five banks are taken as samples to fulfill the objectives of the study.

d) This study covers five fiscal year period only, i.e. from 2004/05 to 2008/09.

e) Limited time and resources are also constraints.

!1.6 Chapter Scheme

The study has been organized into five chapters;

!Chapter I: Introduction

It consists of background of the study, statement of the problem, objectives of the

study, significance of the study and limitation of the study.

!Chapter II: Review of Literature

It includes a discussion on the conceptual framework on dividend and its practices. It

also reviews the major studies relating with dividend decision of several authors/

researchers and from the several books, journals and article, and thesis.

!Chapter III: Research Methodology

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It explains the research methodology used to evaluate dividend practices of

commercial banks in Nepal. It consists of research design, population and sample,

source of data collection, method of analysis financial tools and statistical tools used

in the analysis.

!Chapter IV: Data Presentation and Analysis

Chapter four fulfills the objective of the study by presenting data and analyzing them

with the help of various statistical tools as per methodology. It is concluded with the

findings of the study.

!Chapter V: Summary, Conclusion and Recommendations

It states summary, conclusion and recommendation of the study based on the data

presentation and its analysis using the tools used in the analysis.

!Besides these chapters, Bibliography and Appendix are also included at the end of

the study.

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Chapter II: Review of Literature

DIVIDEND DECISION AND VALUE OF FIRM:

The value of the firm can be maximized if the shareholders wealth is maximized.

There are contradictory views about the impact of dividend decision on the value of

the firm.

According to one school of thought dividend decision does not affect the

shareholders wealth and hence the value of the firm. On the other hand, according to

the other school of thought, dividend decision significantly affects the shareholders

wealth and also the value of the firm. There are the views of the two schools of

thought under two groups:

a. The Relevance Concept of Dividend or the Theory of Relevance

b. The Irrelevance Concept of Dividend or the Theory of Irrelevance

The Relevance Concept of Dividends: According to this school of thought,

dividends are relevant and the amount of dividend paid affects the value of the firm.

Walter, Gordon and others advocated that dividend decisions are important in

determining the value of the firm. Walter argues that the choices of dividend policies

almost and always affect the value of the enterprise.

The Irrelevance Concept of Dividend: The other school of thought propounded by

Modigliani and Miller in 1961. According to MM approach, the dividend policy of a

firm is irrelevant and it does not affect the wealth of the shareholders. They advocate

that the value of the firm depends on the market price of the share; the dividend

decision is of no use in determining the value of the firm.

WALTERS MODEL:

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Walters model, clearly indicates that the choice of appropriate dividend policy

always affects the value of the enterprise. Professor James E.

Walter has very scholarly studied the importance of the relationship between the

firms internal rate of return, r, (or actual capitalization rate) and its Cost of Capital,

Ke (normal capitalization rate) in determining such dividend policy as will maximize

the wealth of the stockholders.

Walters model is based on the following premises:

1) The firm finance its entire investments by means of retained earnings. New equity

stock or debenture is not issued to raise funds.

2) Internal rate of return (r) and cost of capital (Ke) of the firm remain constant.

3) The firms earnings are either distributed as dividends or reinvested internally.

4) Earnings and dividends of the firm never change.

5) The firm has long or infinite life.

The formula used by Walter to determine the market price per share is:

!

Where,

P = Market price per share

D = Dividend per share

E = Earnings per share

r = Internal rate of return (Actual capitalization rate)

K = Cost capital (External capitalization rate)

! 15

It may be noted that Walters formula has the same effect as the continuing dividend

growth formula. It seeks to measure the effect of dividends on common stock value

by comparing actual and normal capitalization rates.

Another characteristic of Walters formula is that it provides an added or reduced

Weight to the retained earnings portion of the capitalization earnings formula. The

factors r and k are placed in front of retained earnings to change its weighted value

under different situations as discussed below:

!1. Growth Firms:

In growth firms internal rate of return is greater than the normal rate(r > k). Therefore,

r/k factor will greater than 1.

Such firms must reinvest retained earnings since existing alternative investments offer

a lower return than the firm is able to secure. Each rupee of retained earnings will

have a higher weighting in Walters formula than a comparable rupee of dividends.

Thus, large the firm retains, higher the value of the firm. Optimum dividend payout

ratio for such a firm will be zero.

2. Normal Firm

Normal firms comprise those firms whose internal rate of return is equal to normal

capitalization (r=k). These firms earn on their investments rate of return equal to

market rate of return. For such firms dividend policy will have no effect on the market

value per share in the Walters model. Accordingly, retained earnings will have the

same weighted value as dividends. In this case the market value per share is affected

by the payout ratio.

3. Declining Firms

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Firms which earn on their investments less than the minimum rate required are

designated as declining firms. The management of such firms would like to distribute

its earnings to the stockholders so that they may either spend it or invest elsewhere to

earn higher return than earned by the declining firms. Under such a situation each

rupee of retained earnings will receive lower weight than dividends and market value

of the firm will tend to be maximum when it does not retain earnings at all.

4. Evaluation of the Walters Model

Professor Walter has endeavoured to show in an erudite manner the effects of

dividend policy on value of equity shares under different situations of a firm.

However, the basic premises on which edifice of the theory are laid down are

unrealistic and therefore, conclusions drawn from the Walters model are hardly true

for real life situations.

!Thus, for instance assume that a firm finances its investment opportunities only by

means of internal sources and no external financing is resorted to for this purpose.

Under such a situation, either the value of the firms investment or dividend or both

will be sub-optimum.

In its attempt to maximize the value of the firm, the management should go on

making investments so long as return of investment is equal to the cost of capital.

This is the optimum level of investment; the remaining amount should be raised from

external sources. On the contrary, Walter argues that value of the firm is maximized

by retaining all the profits because magnitude of investments financed by retained

earnings may be less than the optimum level of investment.

! 17

Further, Professor Walter has assumed that r remains constant under all the

situations. As

a matter of fact, r tends to decrease in correspondence with increase in level of

investments.

This is why it is suggested that the management should make investments upto

optimal level where r = k.

Finally, assumption of constant cost of capital k is incorrect. On the contrary, it varies

in tune with change in risk of the firm.

!Illustration 1 : The earnings per share of a company is Rs. 8 and the rate of

capitalisation applicable is 10%. The company has before it an option of adopting (i)

50%, (ii) 75% and (iii)100% dividend payout ratio. Compute the market price of the

companys quoted

shares as per Walters model if it can earn a return of (i) 15%, (ii) 10% and (iii) 5% on

its retained earnings.

Computation of market price of Companys share by applying Walters formula

!

Now, we can calculate the market price per share based on different IRRs and

dividend payout rations.

(i) Market price per share when Ra = 15%

(a) When dividend payout ratio is 50%

Dividend paid = 8 50/100 = Rs. 4

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!

!(b) When dividend payout ratio is 75%

Dividend paid = Rs. 875/100 = Rs. 6

!

!(c) When dividend payout ratio is 100%

i.e., dividend paid = Rs. 8

!

!

! 19

!

GORDONS MODEL:

Myron Gordon has also developed a model on the lines of Prof. Walter suggesting

that dividends are relevant and the dividend decision of the firm affects its value. His

basic valuation model is based on the following assumptions:

1. The firm is an all equity firm.

2. No external financing is available or used. Retained earnings represent the only

source of financing investment programmes.

3. The rate of return on the firms investment r, is constant.

4. The retention ratio, b, once decided upon is constant. Thus, the growth rate of the

firm (g = br), is also constant.

5. The cost of capital for the firm remains constant and it is greater than the growth

rate, i.e. k > br.

6. The firm has perpetual life.

7. Corporate taxes do not exist.

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According to Gordon, the market value of a share is equal to the present value of

future stream of dividends. Thus, Gordons basic valuation formula is as under:

!

OR

!

!Where,

P = Price of shares

E = Earnings per share

b = Retention Ratio

ke = Cost of equity capital

br = g = growth rate in r, i.e., rate of return on investment of an all-equity firm

D = Dividend per share

The implications of Gordons basic valuation model may be summarized as below :

1. When the rate of return of firms investment is greater than the required rate of

return, i.e. when r > k, the price per share increases as the dividend payout ratio

decreases.

Thus, growth firm should distribute smaller dividends and should retain maximum

earnings.

2. When the rate of return is equal to the required rate of return, i.e, when r = k, the

price per share remains unchanged and is not affected by dividend policy. Thus, for a

normal firm there is no optimum dividend payout.

! 21

3. When the rate of return is less than the required rate of return, i.e., when r

MODIGLIANI-MILLERS MODEL (M-MS MODEL) :

Modigliani-Millers (M-Ms) thoughts for irrelevance of dividends are most

comprehensive and logical. According to them, dividend policy does not affect the

value of a firm and is therefore, of no consequence. It is the earning potentiality and

investment policy of the firm rather than its pattern of distribution of earnings that

affects value of the firm.

Basic Assumptions of M-M Approach

(1) There exists perfect capital market where all investors are rational. Information is

available to all at no cost; there are no transaction costs and floatation costs. There is

no such investor as could alone influence market value of shares.

(2) There does not exist taxes. Alternatively, there is no tax differential between

income on dividend and capital gains.

(3) Firm has uncertainty as to future investments and profits of the firm. Thus,

investors are able to predict future prices and dividend with certainty. This assumption

is dropped by M-M later.

M-Ms irrelevance approach is based on arbitrage argument. Arbitrage is the process

of entering into such transactions simultaneously as exactly balance or completely

offset each other. The two transactions in the present case are payment of dividends

and garnering funds to exploit investment opportunities. Suppose, for example, a firm

decides to invest in a project it has alternatives:

(1) Pay out dividends and raise an equal amount of funds from the market;

(2) Retain its entire earnings to finance the investment programme. The arbitrage

process is involved where a firm decides to pay dividends and raise funds from

outside.

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When a firm pays its earnings as dividends, it will have to approach market for

procuring funds to meet a given investment programme. Acquisition of additional

capital will dilute the firms share capital which will result in drop in share values.

Thus, what the stockholders gain in cash dividends they lose in decreased share

values. The market price before and after payment of dividend would be identical and

hence the stockholders would be indifferent between dividend and retention of

earnings. This suggests that dividend decision is irrelevant.

M-Ms argument of irrelevance of dividend remains unchanged whether external

funds are obtained by means of share capital or borrowings. This is for the fact that

investors are indifferent between debt and equity with respect to leverage and cost of

debt is the same as the real cost of equity.

Finally, even under conditions of uncertainty, divided decision will be of no relevance

because of operation of arbitrage. Market value of share of the two firms would be the

same if they identical with respect to business risk, prospective future earnings and

investment policies.

This is because of rational behavior of investor who would prefer more wealth to less

wealth.

Difference in respect of current and future dividend policies cannot influence share

values of the two firms.

M-M approach contains the following mathematical formulations to prove irrelevance

of dividend decision.

The market value of a share in the beginning of the year is equal to the present value

of dividends paid at the year end plus the market price of the share at the end of the

year, this can be expressed as below :

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!

Where,

P0 = Existing price of a share

K = Cost of capital

D1 = Dividend to be received at the year end

P1 = Market value of a share at the year end

If there is no additional financing from external sources, value of the firm (V) will be

number of share (n) multiplied by the price of each share (Po). Symbolically:

!

If the firm issues m number of share to raise funds at the end of year 1 so as to finance

investment and at price P1, value of the firm at time o will be :

!

Thus, the total value of the firm as per equation (3) is equal to the capitalized value of

the dividends to be received during the period, plus the value of the number of share

outstanding at the end of the period, less the value of the newly issued shares.

A firm can finance its investment programme either by ploughing back of its earnings

or by issue of new share or by both. Thus, total amount of new share that the firm will

issue to finance its investment will be :

mP1 = I1 (X1 - nD1)

Where,

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mP1 = Total amount of funds raised by issue of new share to finance investment

projects.

I1 = Total amount of investment during first period

X1 = Total amount of net profit during first period

Criticism of MM Approach

MM hypothesis has been criticised on account of various unrealistic assumptions as

given below.

1. Perfect capital market does not exist in reality.

2. Information about the company is not available to all the persons.

3. The firms have to incur flotation costs while issuing securities.

4. Taxes do exit and there is normally different tax treatment for dividends and capital

gain.

5. The firms do not follow a rigid investment policy.

6. The investors have to pay brokerage, fees etc., while doing any transaction.

7. Shareholders may prefer current income as compared to further gains.

Illustration: Agile Ltd. belongs to a risk class of which the appropriate capitalisation

rate is

10%. It currently has 1,00,000 shares selling at Rs. 100 each. The firm is

contemplating declaration of a dividend of Rs.6 per share at the end of the current

fiscal year which has just begun. Answer the following questions based on Modigliani

and Miller Model and assumption of no taxes:

(i) What will be the price of the shares at the end of the year if a diviend is not

declared?

(ii) What will be the price if dividend is declared?

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(iii) Assuming that the firm pays dividend, has net income of Rs. 10 lakh and new

investments of Rs. 20 lakhs during the period, how many new shares must be issued?

!Solution:

Modigliani and Miller - Dividend Irrelevancy Model

!

!

100 1.10 = P1 + 6

110 = P1 + 6

P1 = 110 - 6

P1 = Rs. 104

! 27

!(ii) Calculation of No. of Shares to be issued

!Alternatively, the number of new shares to be issued is calculated as follows :

!

Where,

n = Number of Shares outstanding at the beginning of the period i.e., 1,00,000 shares

N = Change in the number of Shares outstanding during the period (to be

ascertained)

I = Total investment required for capital budget i.e., Rs. 20,00,000

E = Earning of the firm during the period after payment of dividend.

If dividend declared =10,00,000 - 6,00,000 = Rs. 4,00,000

If no dividend declared = 10,00,000

Now we can calculate the number of new shares to be issued :

(I) If dividend declared:

!

Particulars Dividend Declared

Dividend not declared

Net Income Less: Dividend Paid Retained Earning New investment Amount to be raised by new issue (A) Market Price per share (B) New shares to be issued (A / B)

10,00,000 6,00,000

10,00,000

4,00,000 10,00,000

16,00,000 10,00,000

104 110

15,385 9,091

! 28

(II) If no dividend declared :

!

MM Dividend irrelevance theory

!

Therefore, whether dividends are paid or not, value of the firm remains the same as

per M.M. approach.

!TYPES OF DIVIDEND POLICY:

The various types of dividend policies are discussed as follows:

1. Regular Dividend Policy

Payment of dividend at the usual rate is termed as regular dividend. The investors

such as retired persons, widows and other economically weaker persons prefer to get

regular dividends.

A regular dividend policy offers the following advantages.

a. It establishes a profitable record of the company.

b. It creates confidence amongst the shareholders.

c. It aids in long-term financing and renders financing easier.

d. It stabilizes the market value of shares.

Particulars Dividend Declared

Dividend not declared

Existing shares New shares issued Total No. of shares at the end Market price per share Total market value of shares at the year end

1,00,000 15,385

1,00,000 9,091

1,15,385 1,09,091

104 110

1,20,00,000 1,20,00,000

! 29

e. The ordinary shareholders view dividends as a source of funds to meet their day-

today living expenses.

f. If profits are not distributed regularly and are retained, the shareholders may have to

pay a higher rate of tax in the year when accumulated profits are distributed.

However, it must be remembered that regular dividends can be maintained only by

companies of long standing and stable earnings. A company should establish the

regular dividend at a lower rate as compared to the average earnings of the company.

2. Stable Dividend Policy

Under this policy, stable or almost stable rate of dividend is maintained.

Company maintains reserves in the years of prosperity and uses them in paying

dividend in lean years. If company follows stable dividend policy, the market price

of its shares shall be higher. 'There are several reasons why investors prefer

stable dividend policy. Main reasons are

(a) Confidence among Shareholders: A regular and stable dividend payment

may serve to resolve uncertainty in the minds of shareholders. There are 'many resorts

not to cut the dividend rate even if its profits are declining, it maintains the -rate of

dividend by appropriating its reserves. Stable dividend presents a good

image of the company and thus gains the confidence of the shareholders and the

goodwill of the company increases in the eyes of the investors

(b) Income Conscious Investors: The second factor favoring stable dividend

policy is that some investors are income conscious and favor a stable rate of

dividend. They, too, never favor an unstable rate of dividend. A stable

dividend policy may also satisfy such investors.

! 30

(c) Stability in Market Price of Shares: Other things being equal, the market

price vary with the rate of dividend the company declares on its equity shares.

The value of shares of a company 'laving a stable dividend policy fluctuates

not widely even if the earnings of the company is lower than the previous year.

Thus, this policy buffers the market price of the stock.

(d) Encouragement to Institutional Investors: A stable dividend policy attracts

investments from institutional investors. Such institutional investor generally

prepare a list of securities, mainly incorporating the securities of the companies

having stable dividend policy in which they invest their surpluses or their long-

term funds such as pensions or provident funds etc.

In this way, stability and regularity of dividends not only affects

the market price of shares but also increases the general credit of the

company that benefits the company in the long run. The company with stable

dividend policy can formulate its financial planning very easily because the

financial manager can correctly estimate the future demand and supply of

capital in the firth. Timing of dividend payment can also be forecasted

easily by preparing cash flow statement.

!Stability of dividends can taken three distinct forms:

!(a) Constant dividend per share: Under this policy, the management follows the policy

of paying a fixed amount of dividend per share every year irrespective of the

fluctuations in the earnings. It does not imply that the rate of dividend will never

! 31

be increased. When the earnings of the company increase at a new level and the

management is of the view that it can easily .maintain that level of earnings, it

increases the rate of dividend per share. The policy is easy to follow when company

earnings are stable. lf earnings fluctuate widely, the company can policy by

maintaining a dividend fluctuation fund in surplus years.

!

(b) Constant payout ratio: Some companies follow the policy of paying a fixed per cent

or net profits as dividend every year, i e., policy of constant' payout ratio.

Suppose, a

company adopts a 40 per cent payout ratio, it means, 40 per cent net earnings of

the company will be paid-out to shareholders every year as dividend. In the year of

loss, no dividend is paid. Internal financing under this policy is automatic. For

example, in the above case, 60% of the profits are transferred to reserves. Thus the

policy leaves nothing to the management discretion.

! 32

!

(c) Stable rupee dividend plus extra dividend: Some companies follow a policy of

paying constant low dividend per share plus an extra dividend in the years of high

profits.

Such a policy is most suitable to the firm having fluctuating earnings from year to

year.

Dangers of Stable Dividend Policy

In spite of many advantages, the stable dividend policy suffers from certain

limitations. Once a stable dividend policy is followed by a company, it is not easier to

change it. If the stable dividends are not paid to the shareholders on any account

including insufficient profits, the financial standing of the company in the minds of

the investors is damaged and they may like to dispose off their holdings. It adversely

affects the market price of shares of the company.

And if the company pays stable dividends in spite of its incapacity, it will be suicidal

in the long-run.

!3. Irregular Dividend Policy

! 33

Some companies follow irregular dividend payments on account of the following:

a. Uncertainty of earnings.

b. Unsuccessful business operations.

c. Lack of liquid resources.

d. Fear of adverse effects of regular dividends on the financial standing of the

company.

!4. No Dividend Policy

A company may follow a policy of paying no dividends presently because of its

unfavourable working capital position or on account of requirements of funds for

future expansion and growth.

!5. Residual Dividend Policy

When new equity is raised floatation costs are involved. This makes new equity

costlier than retained earnings. Under the Residual approach, dividends are paid out

of profits after making provision for money required to meet upcoming capital

expenditure commitments.

!STABILITY OF DIVIDEND:

Another important dimension of a dividend policy is the stability of dividends i.e.

how stable, regular or steady should the dividend stream be, over time? It is generally

said that the shareholders favour stable dividends and those dividends, which have

prospects of steady upward growth. If a firm develops such a pattern of paying stable

and steady dividends, then the investors/shareholders may be willing to pay a higher

! 34

price for the shares. So while designing a dividend policy for the firm, it is also to be

considered as to whether the firm will have a consistency in dividend payments or the

dividends will fluctuate from one year to another. In the long run, every firm will like

to have a consistent dividend policy, yet fluctuations from one year to another may be

unfavourable.

Rationale for stability of dividend

Most of the firms follow stable dividends or gradually increasing dividends due to

following reasons

a. Many investors consider dividends as a part of regular income to meet their

expenses.

Hence, they prefer a predictable pattern of dividends rather than fluctuating pattern.

A fall in the dividend income may lead to sale of some shares. On the other hand

when the dividend income increases, an investor may invest some of the proceeds as

reinvestment in shares. Both the cases involve transaction cost and inconvenience for

investor. Hence, they prefer regular dividends.

b. The dividend policy of firms conveys a lot to the investors. Increasing dividends

means better prospects of the company. On the contrary, decreasing dividends suggest

bad earnings expectations. In addition, stable dividends are sings of stable earnings of

the company. On the other hand, varying dividends lead to uncertainty in the mind of

shareholders.

c. Certain investors mainly institutional, consider the stability of dividends as an

important criterion before they decide on the investment in that particular firm.

!

! 35

Illustration 1

A company has following capital :

7% Preference Shares of Rs. 100 each 6,00,000

Ordinary Shares of Rs. 10 each 16,00,000

22,00,000

The following information are available relating to its financial year ending

31-12-2008:

i) Profit, after taxation @ 40%, Rs. 5,42,000

ii) Ordinary dividend paid 20%.

iii) Depreciation Rs. 1,20,000

iv) Market price of Ordinary Shares Rs. 40

v) Capital Commitment Rs. 2,40,000.

You are required to calculate the following:

a) The dividend yield on the Ordinary Shares.

b) The cover for the preference and Ordinary dividends.

c) The earnings yield,

d) The price - earnings ratio,

e) The Net Cash Flow,

f) The reason for the comparison of net cash flow with capital commitment.

Solution:

a) Dividend yield on ordinary shares (or) dividend yield ratio

= (DPS / market price) 100

= (10 20% /40) 100

= 5%

! 36

[Market price = Capitalized value of dividend]

b) Dividend coverage ratio:

Preference = (PAT / Preference dividend)

= 542000 / 42000

= 12.9 times

Equity = (PAT Preference dividend) / equity dividend

= 500000 / 320000

= 1.5625 times

c) Earnings yield ratio = (EPS / market price ) x 100

= (3.125 / 40) x 100

= 7.8125 %

[EPS = 500000 / 160000 = Rs 3.125]

d) Price Earning Ratio = [(40 / 3.125)] = 12.8 times

(Market price / EPS)

e) Net cash flow Rs

PAT 542000

(+) depreciation 120000

662000

(-) preference dividend 42000

(-) equity dividend 320000

Net cash flow 300000

f) Since the cash flow position shows the firms ability to meet the capital expenditure

/ Capital commitment.

!! 37

Illustration 2: ABC Ltd. has a capital of Rs.10 lakhs in equity shares of Rs.100 each.

The shares currently quoted at par. The company proposes declaration of a dividend

of Rs.10 per share at the end of the current financial year. The capitalisation rate for

the risk class to which the company belongs is 12%.

What will be the market price of the share at the end of the year, if

i) A dividend is not declared?

ii) A dividend is declared?

iii) Assuming that the company pays the dividend and has net profits of Rs.5,00,000

and makes new investments of Rs.10 lakhs during the period, how many new shares

must be issued? Use the M.M. model.

!Solution:

Modigliani Miller Approach

n = no of shares = 10000

P0 = market price = Rs100

D1 = Expected dividend = Rs10

Ke = cost of capital = 12%

i. Market price of share ( P1) if dividend not declared

Given D1 = 0

We know,

P0 = (D1+P1)/ (1+Ke)

P1 = 112

ii. P1 if dividend declared

D1 = Rs10

! 38

P0 = (D1+P1) / (1+ Ke )

P1 = Rs.102

iii. No of shares to be issued :

n = (I E + n D1 )/ P1

= (1000000 500000 + 100000) / 102

= 5882 shares

!Illustration 3

A textile company belongs to a risk-class for which the appropriate PE ratio is 10. It

currently has 50,000 outstanding shares selling at Rs.100 each. The firm is

contemplating the declaration of Rs.8 dividend at the end of the current fiscal year

which has just started. Given the assumption of MM, answer the following questions:

i) What will be the price of the share at the end of the year: (a) if a dividend is not

declared, (b) if it is declared?

ii) Assuming that the firm pays the dividend and has a net income of Rs.5,00,000 and

makes new investments of Rs.10,00,000 during the period, how many new shares

must be issued?

iii) What would be the current value of the firm: (a) if a dividend is declared, (b) if a

dividend is not declared?

!Solution:

Given,

P/E ratio = 10

n = 50,000shares

! 39

P0 = Rs. 100

D1 = Rs. 8

E = Rs. 5,00,000

I = Rs. 10,00,000

Ke = 1 / (P/E ratio)

1. Calculation of P1

1. If dividend not declared:

P0 = (D1+ P1) / (1+Ke)

P1 = Rs110

2. if dividend declared:

P0 = (D1+ P1) / (1+Ke)

P1 = Rs.102

3. If the company pay dividend:

P1 = Rs102

n = (I E +nD1) / P1

No of new shares, n = 900000 / 102 = 8823.5294 shares

4. Value of the firm:

a) If the company pay dividend:

V = (n + n) P1 = (58823.5294) 102

= Rs6000000

b) If the company does not pay dividend:

V = (n+n) P1 = 54545.4545 x 110

= Rs6000000

Working notes:

! 40

n = (1000000 - 500000) / 110 = 4545.4545

!Illustration 4

(i) From the following information supplied to you, ascertain whether the firms D/P

ratio is optimal according to Walter. The firm was started a year ago with an equity

capital of Rs. 20 lakh.

Earnings of the firm Rs 2,00,000.00

Dividend paid 1,50,000.00

P/E ratio 12.50

Number of shares outstanding, 20,000 @ Rs.100 each. The firm is expected to

maintain its current rate of earnings on investment.

ii) What should be the P/E ratio at which the dividend payout ratio will have no effect

on the value of the share?

iii) Will your decision change if the P/E ratio is 8, instead of 12.5?

Solution:

i. Ke = (EPS / market price) = 1 /(12.5) = 8 %

r = (200000 / 2000000) x 100 = 10 %

Payout ratio = (150000/200000) x 100 = 75%

It is the growth firm (r > Ke), as per WALTERs model the optimum payout ratio is

Zero.

So in the given case pay out ratio is not optimum.

Proof:

a). Market price at 75% payout ratio

EPS = Rs10

! 41

DPS =Rs7.5

r = 10 % & Ke = 8%

!

!b). Market price at zero payout:

EPS = Rs10

DPS = Rs0

r = 10 % & Ke = 8 %

!

Therefore Zero Payout is optimum.

i. The payment of dividend in case of normal firms(r = Ke) has no effect on the

market value of the share.

Ke = r = 10%

P/E ratio = 10times i.e [ 1 / Ke]

ii. If P/E ratio = 8 , Ke= 12.5 %

r = 10%

When r < Ke the firm is Decline firm as per WALTER and its Optimum payout ratio

is 100%.

So in the given case it is 75% payout only, it is not optimum payout.

!! 42

Proof:

Market price at 75% payout:

!

100% payout

!

!Illustration 5

Excellence Ltd registered earnings of Rs. 800,000 for the year ended 31st March.

They finance all investments out of retained earnings. The opportunities for

investments are many. If such opportunities are not availed their earnings will stay

perpetually at Rs. 800,000. Following figures are relevant.

!

The returns to shareholders are expected to rise if the earnings are retained because of

the risk attached to new investments. As for the current year, dividend payments will

be made with or without retained earnings. What according to you, should be

retained?

!Solution:

!

! 43

Evaluation of different dividend policies:

!

!From the above policies, policy B gives more value to the share holders. Hence it is

advisable to adopt the policy B.

Illustration 6

X Ltd. has 1000 shares of Rs 10 each raised at a premium of Rs. 15 per share. The

companys retained earnings are Rs. 552500. The Companys stock sells for Rs. 20

per share.

a. If a 10% stock dividend is declared how many new shares would be issued?

b. What would be the market price after the stock dividend?

c. How would the equity account change?

d. If a 25% stock dividend is declared what changes will take place?

e. If the company instead declares a 5:1 stock split, how many shares will be

outstanding?

What would be the new par value? What would be the new market price?

! 44

f. If the company declares a 1:4 reverse split, how many shares will be outstanding?

What would be the new par value? What would be the new market price?

g. If the company declares a dividend of Rs. 2 per share and the stock goes ex

dividend tomorrow, what will be the price at which it will sell?

!Solution:

a) If 10% stock dividend declared:

No of new shares issued as bonus = 100

b) Market price after bonus issue = [(1000 x 20) + (100 x 0 )] / 1100

= Rs.18.18

c) Change in equity account

Equity share capital increased by Rs1000

Reserves decreased by Rs1000.

Hence, there is no change in the Net Equity

d) If 25% stock dividend declared

1) No. of new shares issued = 1000 @ 25 % = 250 shares

2) Market price after stock dividend = [(1000 x 20) + (250 x 0)] / 1250

= Rs.16

3) Change in EQUITY account:

Capital increased by Rs. 2500

Reserve decreased Rs.2500

There is no change in Net Equity.

e) If the company declares 5 : 1 stock split i.e. 5 shares issued in exchange of 1 share

each.

! 45

No of shares outstanding = 5000

New face value of share = 10/ 5 = Rs.2

New market price = 20 / 5 = Rs.4

f) If the company declares 1: 4 reverse split i.e 1 share issued in exchange of every 4

shares.

No of shares outstanding = 250

New face value = 4 x 10 = Rs.40

Market price = 20 x 4 = Rs.80

g) Cum dividend market price = Rs. 20

(-) dividend = 2

Ex-dividend market price Rs. 18

Illustration 7

Following is the capital structure of Progressive Co. Ltd. as on 31st March, 2009.

Rs.

Equity Share Capital (1,00,000 shares of Rs. 10 each) 10,00,000

Share premium 15,00,000

Reserves & Surpluses 5,00,000

Net worth 30,00,000

On 1st April, 2007, the company made a bonus issue of two shares for every five held.

The market price at the time of bonus issue was Rs. 40 per share. X holds 100 shares

of the Progressive Co. Ltd. purchased on 1st April, 2003 a market price of Rs. 30. He

sold these shares on 31st March, 2009 at Rs. 50 per share. The income tax rate for X

is 20% and capital gain tax is 15% for him. If the company pays a regular dividend of

10% on par before transferring earnings to reserves and surpluses, state whether X

! 46

was able to earn his required rate of return of 10% on his investment? (The PV at 10%

1st year 0.91; 2nd year 0.83; 3rd year 0.75; 4th year 0.68; 5th year 0.62 and 6th year

0.56)

Solution:

Appraisal of Investment decision: [NPV method ]

1) Initial Investment (out flow): 100 shares @ 30 each = 3000

2) Present value recurring cash inflows

!

!3) Present value of terminal cash inflow:

Sale proceeds 140shares @ 50 each = 7000

(-) capital gain tax 4000@ 15% = 600

6400

Its present value = 6400 x 0.56 = 3584

4) NET PRESENT VALUE:

Present value of cash inflow (407.52+3584) = 3,991.52

(-) outflow 3,000

Net present value 991.52

The investment yields more than 10 % return to the investor.

! 47