Session 08-09 - Dividend Policy & Firm Value

Dividend Decisions

Session No. 8 & 9

Dividend Policy and Firm value

1 Manish Parmar

Key Concepts

2

Understand dividend types and how they

are paid

Understand the difference between cash

and stock dividends

Understand why share repurchases are an

alternative to dividends

Understand the issues surrounding

dividend policy decisions

Dividend payments can be made in

either of the following ways:-

3

Cash Dividend - Payment of cash by the firm to its

shareholders. (Normally companies pay regular

dividends and sometimes it pays special dividend)

Public Ltd companies often pay quarterly or semi

annually i.e. regular Dividend.

Sometimes firms will pay an extra cash dividend,

i.e. Special Dividend.

The extreme case would be a liquidating

dividend.

Dividend payments can be made

in either of the following ways:-

4

Stock Dividend - Distribution of additional shares to

a firm’s Shareholders. (Bonus shares)

Stock Splits – The par value per share is reduced

and the number of shares is increased

proportionately. In both the above cases:-

No cash leaves the firm

The firm increases the number of shares

outstanding

5

TABLE 1 Effect of Bonus Shares and Share Splits

(I) Equity portion before the bonus issue:

Equity share capital (30,000 share of Rs 100 each) Rs 30,00,000

Share premium (@ Rs 25 per share) 7,50,000

Retained earnings 62,50,000

Total equity 1,00,00,000

(II) Equity portion after the bonus issue (1 : 2 ratio):

Equity share capital (45,000 shares of Rs 100 each) 45,00,000

Share premium (45,000 shares × Rs 25) 11,25,000

Retained earnings (Rs 62,50,000 – 15,000 shares × Rs 125) 43,75,000


(III) Equity portion after the share splits (10 : 1 ratio):

Equity share capital (3,00,000 shares of Rs 10 each) 30,00,000

Share premium 7,50,000

Retained earnings 62,50,000


Standard Method of Cash

Dividend

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Record Date – Date on which company

determines existing shareholders.

Ex-Dividend Date - Date that determines

whether a stockholder is entitled to a dividend

payment; anyone holding stock immediately

before this date is entitled to a dividend.

Cash Dividend - Payment of cash by the firm

to its shareholders.

Procedure for Cash Dividend

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25 Oct. 1 Nov. 2 Nov. 4 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.

Cum-Dividend Date: Buyer of stock still receives the dividend.

Ex-Dividend Date: Seller of the stock retains the dividend.

Record Date: The corporation prepares a list of all individuals

believed to be stockholders as of 4 November.

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Price Behavior

In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date.

$P

$P - div

Ex-

dividend

Date

The price drops

by the amount of

the cash

dividend.

-t … -2 -1 0 +1 +2 …

Assumptions: No tax on dividend payments

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The Irrelevance of Dividend Policy

A compelling case can be made that dividend policy

is irrelevant.

Since investors do not need dividends to convert

shares to cash; they will not pay higher prices for

firms with higher dividends.

In other words, dividend policy will have no impact

on the value of the firm because investors can

create whatever income stream they prefer by using

homemade dividends.

10

Homemade Dividends Bianchi Inc. is a $42 stock about to pay a $2

cash dividend.

Bob Investor owns 80 shares and prefers a $3 dividend.

Bob’s homemade dividend strategy: Sell 2 shares ex-dividend

homemade dividends

Cash from dividend $160

Cash from selling stock $80

Total Cash $240

Value of Stock Holdings $40 × 78 =

$3,120

$3 Dividend

$240

$0

$240

$39 × 80 =

$3,120

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Dividend Policy is Irrelevant

In the above example, Bob Investor began with

a total wealth of $3,360:

share

42$shares 80360,3$

240$share

39$shares 80360,3$

80$160$share

40$shares 78360,3$

After a $3 dividend, his total wealth is still $3,360:

After a $2 dividend and sale of 2 ex-dividend shares, his total wealth is still $3,360:

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Dividends and Investment Policy

Firms should never forgo positive NPV projects to

increase a dividend (or to pay a dividend for the first

time).

Recall that one of the assumptions underlying the

dividend-irrelevance argument is: “The investment

policy of the firm is set ahead of time and is not

altered by changes in dividend policy.”

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Repurchase of Shares

In India, repurchase of shares is commonly known as

buyback of shares.

Instead of declaring cash dividends, firms can get rid

of excess cash through buying shares of their own

stock.

Recently, share repurchase has become an important

way of distributing earnings to shareholders.

Buyback of shares is allowed in India from 1998 (Sec

77A of companies act)

Concept Question

How does share buyback impact companies

financial condition vis-à-vis paying cash

dividends?

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15

Stock Repurchase versus Dividend

100,000=outstandingShares

1,000,000Value of Firm1,000,000Value of Firm

1,000,000Equity850,000AssetsOther

0Debt$150,000Cash

sheetbalanceOriginalA.

Equity&LiabilitiesAssets

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

shareholders.

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900,000FirmofValue900,000FirmofValue

900,000Equity850,000AssetsOther

0Debt$50,000Cash

dividendcash shareper $1After B.

Equity&sLiabilitieAssets

If they distribute the $100,000 as a cash dividend, the balance

sheet will look like this:

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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

If they distribute the $100,000 through a stock repurchase, the

balance sheet will look like this:

Concept Question

If the Board of directors hold ESOPS in the

company and they are about to choose

dividend vs buyback decision, what will they

choose?

Let us have a re-look at the balance sheets we

just saw!!

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19




0Debt$50,000Cash





20




Cash $50,000 Debt 0





21


$9=00,000$900,000/1=shareper Price

100,000=goutstandinShares



0Debt$50,000Cash





22




Cash $50,000 Debt 0



Shares outstanding= 90,000

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



Methods of Share Buybacks in

India

• Open market offer purchase. E.g. HUL, Madras

cements.

• Tender offer. E.g.Bajaj Auto. [Check NSE & BSE

websites for announcements].

• Targeted buybacks. E.g. GESCO.

http://www.rediff.com/money/2001/jan/12inter.htm

• Book Building process to buyback shares.23

Regulation of buybacks (Sec

77A)

A company can buyback 10 percent of its

shares annually with board resolution.

Beyond that a special resolution is required.

The buyback should not exceed 25 percent of

the total paid up capital and free reserves.

The post-buyback debt-equity ratio should

not exceed 2:124

Regulation of buybacks…Contd

The shares bought should be extinguished &

physically destroyed.

A declaration of solvency has to be filed with

SEBI & registrar of companies.

The company should not make further issue

within a prescribed time limit.

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SEBI'S PROPOSALS

(BT article* as on 25/01/2013)

Buy-back period to be reduced to three

months from 12.

Minimum buy-back to be 50 per cent of the

proposed size.

25 per cent of the amount earmarked for buy-

back to be kept in an escrow account

Capital raising from equity markets to be

prohibited for two years after a buy-back

* Will SEBI's proposals help in checking misuse of the share buy-back

route by companies _ Business Today.pdf

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Will SEBI's proposals help in checking misuse of the share buy-back route by companies _ Business Today.pdf

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Dividend Vs Buyback: Real world

considerations

Flexibility.

Keeps stock price higher, good for insiders who hold

stock options (Previous Example)

Undervaluation-(Signaling theory)

Taxation (Discussed in detailed after few slides)

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Personal Taxes and Dividends

To get the result that dividend policy is irrelevant, we needed three assumptions:

No taxes

No transactions costs

No uncertainty

In the United States, both cash dividends and capital gains are taxed at a maximum rate of 15 percent. (In India-?)

Section 46A of Income Tax

Act.Capital Gains on buyback of its own shares:-

The difference between the cost of acquisition

and the value of consideration received by the

shareholder shall be deemed to be the capital gains

arising to such shareholder

Are all capital gains taxable? LTCG on transfer of

equity shares listed on a stock exchange in India,

where STT has been paid, is tax exempt, while STCG

in the same situation is taxed at a rate of 15% Dividends : Companies pay DDT @15% & Dividends are

exempt in investors hand.

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Firms without Sufficient Cash

In a world of personal taxes,

firms should not issue stock

to pay a dividend.

FirmStock

Holders

Cash: stock issue

Cash: dividends

Gov.

Taxes

Investment Bankers The direct costs of stock issuance will add to this effect.

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Firms with Sufficient Cash

The above argument does not necessarily apply to

firms with excess cash.

Consider a firm that has $1 million in cash after

selecting all available positive NPV projects.

Select additional capital budgeting projects (by

assumption, these are negative NPV).

Acquire other companies

Purchase financial assets

Repurchase shares

32

The Clientele Effect

Clienteles for various dividend payout policies are

likely to form in the following way:

Stock Type

Zero-to-Low payout (Prefer Capital gains)

Low-to-Medium payout

Medium payout

High payout (Prefer Stable income)

Once the clienteles have been satisfied, a corporation is

unlikely to create value by changing its dividend policy.

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DIVIDEND POLICY : STABILITY

Steadily Changing Dividends

Earnings/Dividends

Earnings

Dividends

Time

34

What We Know and Do Not Know Corporations “smooth” dividends.

Dividends provide information to the market.

(Signaling)

Firms should follow a sensible policy:

Do not forgo positive NPV projects just to pay a

dividend.

Avoid issuing stock & debt to pay dividends.

Consider share repurchase when there are few better

uses for the cash.

35

Stock Dividends & Stock Splits• Stock Dividends: Pay additional shares of stock

instead of cash

• Increases the number of outstanding shares

• Stock splits – essentially the same as a stock dividend

except it is expressed as a ratio

• For example, a 2 for 1 stock split is the same as a

100% stock dividend.

• Stock price is reduced when the stock splits.

• Common explanation for split is to return price to a

“more desirable trading range.”

Other factors affecting dividend

policy Legal constraints

The companies are not allowed to declare

dividends when they have overdue liabilities or

are bankrupt.

Contractual constraints

Restrictive provisions in loan agreements & bond

indentures.

Internal constraints; like liquidity problems.

*Fresh loans can be taken…but its not advisable.36

We had a good discussion on

theoretical concepts….lets do a

practical case

….next session….case is FPL

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Documents

Session 08-09 - Dividend Policy & Firm Value