Financial Management UNIT V

UNIT-V
Unit V: Dividend Policy: Stable Dividend Dividend Theories - Factors Influencing Dividend Policy Issues in Dividend Policy - Bonus Shares
Dividend Policy:
A Dividend policy is the company's stance on how it will dispense its earnings.. It will include in its description the amount paid to shareholders ( if any) or if the company will retain the profits.. It will also outline when the dividends will be paid out , how much, and how frequent.. The profit, which is any positive gain, from any investment, or business venture, will be either dispersed to investors or shareholders, or it may be re-invested back into the company. The Dividend policy will explain exactly if the profit earnings will go the shareholders in full, or a portion may be obtained by the company for re-investment.
Dividend policy is the policy used by a company to decide how much it will pay out to shareholders in dividends. In your financial accounting course, you learn that after deducting expense from the revenue, a company generates profit. Part of the profit is Kept in the company as retained earnings and the other part is distributed as dividends to shareholders. From the share valuation model, the value of a share depends very much on the amount of dividend distributed to shareholders. Dividends are usually distributed in the form of cash (cash dividends) or share (share dividends which are beyond the remit of this article). When a company distributes a cash dividend, it must have sufficient cash to do so. This creates a cash flow issue. Profit generated may not be in the form of cash. You may verify this by looking at the cash flow statement of a company. A company may have profit of $400 million but the cash only increase by $190 million in a financial year. This is a concern to the management as insufficient cash may mean the company is unable to distribute a dividend. Investors earn returns from their shares in the form of capital gains and dividend yield. Dividend yield is an important ratio in evaluating investment. For example, Hang Seng Bank distributed a $6.30 dividend per share in 2008. If you purchased shares in Hang Seng Bank at
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$87 per share, the companys dividend yield was 7.2% ($6.30/$87) which is much higher than the bank deposit rate. Dividend payout ratio is another important indicator: Dividend payout ratio = Dividend per share Earnings per share This ratio indicates how much of the profit is distributed as dividend to shareholders. The higher the dividend payout ratio, the more attractive the share is to shareholders.
Stability Dividends:
Stability Dividends is considered a desirable policy by the management of most companies in practice. Shareholders also seem generally to favor this policy and value stable dividends higher than the fluctuating ones. All other things being the same, the stable dividend policy may have a positive impact on the market price of the share. Stability of dividends also means regularity in paying some dividend annually, even though the amount of dividend may fluctuate over years, and may not be related with earnings. There are a number of companies, which have records of paying dividends for a long, unbroken period. More precisely, stability of dividends refers to the amounts paid out regularly. Three forms of such stability may be distinguished:
Constant dividend per share or dividend rate Constant payout Constant dividend per share plus extra dividend. Constant Dividend per Share or Dividend Rate: In India, companies announce dividend as a per cent of the paid-up capital per share. A number of companies follow the policy of paying a fixed amount per share or a fixed rate on paid-up capital as dividend every year, irrespective of fluctuations in the earnings. This policy does not imply that the dividend per share or dividend rate will never be increased. When the
company reaches new level of earnings and expects to maintain them, the annual dividend per share or dividend rate may be increased. The earnings per share and the dividend per share relationship under this policy.
EPS
EPS and DPS (Rs.) Constant dividend per share policy Time (Years) DPS
It is easy to follow this policy when earnings are stable. However, if the earnings pattern of a company shows wide fluctuations, it is difficult to maintain such a policy. With earnings fluctuating from year to year, it is essential for a company, which wants to follow this policy to build up surpluses in years of higher than average earnings to maintain dividends in years of below average earnings. In practice, when a company retains earnings in good years for this purpose, it earmarks this surplus as dividend equalization reserve. These funds are invested in current assets like tradable (markable) securities, so that they may easily be converted into cash at the time of paying dividends in bad years.
A constant dividend per share policy puts ordinary shareholders at par with preference shareholders irrespective of the firms investment opportunities or the preferences of shareholders. Those investor who have dividends as the only source of their income may prefer the constant dividend policy. They do not accord much importance to the changes in share prices. In the long run, this may help to stabilize the market price of the share.
Constant Payout:
The ratio of dividend to earnings is known as payout ratio. Some companies may follow a policy of constant payout ratio i.e., paying s fixed percentage of net earnings every year. With this policy the amount of dividend will fluctuate in direct proportion to earnings. If a company adopts a 40 per cent payout ratio, then 40 per cent of every rupee of net earnings Rs 2 per share, the dividend per share will be Re 0.80 and if it earns Rs.1.50 per share the dividend per share will be Re 0.60. the relation between the earnings per share and the dividend per share under this policy.
EPS
EPS and DPS (Rs)
DPS
Time (Years) Dividend policy of constant payout ratio This policy is related to a companys ability to pay dividends. If the company incurs losses, no dividends shall be paid regardless of the desires of shareholders. Internal financing with retained earnings is automatic when this policy is followed. At any given payout ratio, the amount of dividends and the additions to retained earnings increase with increasing earnings and decrease with decreasing earnings. This policy does not put
any pressure on a companys liquidity since dividends are distributed only when the company has profits.
Constant Dividend per Share plus Extra Dividend: For companies with fluctuating earnings, the policy to pay a minimum dividend per share with a step-up feature is desirable. The small amount of dividend per share is fixed to reduce the possibility of ever missing a dividend payment. By paying extra dividend (a number of companies in India pay an interim dividend followed by a regular, final dividend) in periods of prosperity, an attempt is made to prevent investors from expecting that the dividend amount. This type of policy enables a company to pay constant amount of dividend regularly without a default and allows a great deal of flexibility for supplementing the income of shareholders only when the companys earnings are higher than the usual, without committing itself to make larger payments as a part of the future itself to make larger payments as a part of the future fixed dividend. Certain shareholders like this policy because of the certain cash flow in the form of regular dividend and the option of earning extra dividend occasionally.
We have discussed three forms of stability of dividends. Generally, when we refer to a stable dividend policy, we refer to the first form of paying constant dividend per share. A firm pursuing a policy of stable dividend may command a higher price for its shares than a firm, which varies dividend amount with cyclical fluctuations in the earnings.
Merits of stability of Dividends:

The stability of dividends has several advantages as discussed below: Resolution investors uncertainty. of
Investors desire for current income. Institutional investors requirements. Raising finances. additional
Resolution of investors uncertainty: When a company follows a policy of stable dividends, it will not change the amount of dividends if there are temporary changes in its earnings. Thus, when the earnings of a company fall and it continues to pay same amount of dividend as in the past, it conveys to investors that the future of the company is brighter than suggested by the drop in earnings. Similarly, the amount of dividends is increased with earnings level only when it is possible to maintain it in future. On the other hand, if a company follows a policy of changing dividends with cyclical changes in the earnings, shareholders would not be certain about the amount of dividends.
Investors desire for current Income There are many investors, such as old and retired persons, women etc., who desire to receive regular periodic income. They invest their savings in the shares with a view to use dividends as a source of income to meet their living expenses. Dividends are like wages and salaries for them. These investors will prefer a company with stable dividends to the one with fluctuating dividends.
Institutional investors requirements:
Financial, educational and social institutions and unit trusts also invest funds in shares of companies. In India, financial institutions such as IFCI, IDBI, LIC and UTI are some of the largest investors in corporate securities. Every company is interested to have these financial institutions in the shares of those companies, which have a record of paying regular dividends. These institutional investors may not prefer a company, which has a history of adopting an erratic dividend policy. Thus, to cater the requirement of institutional investors, a company prefers to follow a stable dividend policy.
Raising additional finances: A stable dividend policy is also advantages to the company in its efforts to raise external finances. Stable and regular dividend policy tends to make the share of a company as quality investment rather than a speculation. Investors purchasing these shares intend to hold them for a long period of time. The loyalty and goodwill of shareholders towards a company increases with stable dividend policy. They would be more receptive to an offer by the company for further issues of shares. A history of stable dividends serves to spread ownership of outstanding shares more widely among small investors, and thereby reduces the chance of loss of control. The persons with small means, in the hope of supplementing their income, usually purchase shares of the companies with a history of paying regular dividends. A stable dividend policy also helps the sale of debentures and preference shares. The fact that the company has been paying dividend regularly in the past is a sufficient assurance to the purchasers of these securities that no default will be made by the company in paying their interest or preference dividend and returning the principal sum. The financial institutions are the largest purchasers of these securities. They purchase debentures and preference shares of those companies, which have a history of paying stable dividends.
Danger of Stability of Dividends:

The greatest danger in adopting a stable dividend policy is that once it is established, it cannot be changed without seriously affecting investors attitude and the financial standing of the company. If a company, with a pattern of stable dividends, misses investors more severe than the failure to pay dividend by a company with unstable dividend policy. The companies with dividend income to meet their living and operating expenses. A cut in dividend is considered as a cut in salary. Because of the serious depressing effect on investors due to a dividend cut, directors have to maintain stability of dividends during lean years even though financial prudence would indicate elimination of dividends or a cut in it. Consequently, to be on the safe side, the dividend rate should be fixed at a conservative figure so that it may be possible to maintain it even in lean periods of several years. To give the benefit of the companys prosperity extra or interim dividend, can be declared. When a company fails to pay extra dividend, it does not have a depressing effect on the investors as the failure to pay a regular dividend does.
Theories of Dividend Policy:

i) ii) Dividend Relevance Theories Dividend Irrelevance Theories
Dividend Relevance Theory: The dividend is a relevant variable in determining the value of the firm, it implies that there exists an optimal dividend policy, which the managers should seek to determine, that maximizes the value of the firm. There are three models, which have been developed under this approach. These are: a) b) c) d) e) Traditional Model Walters Model Gordons Dividend Capitalisation Model Bird-in-hand Theory Dividend Signaling Theory
f) Agency Cost Theory
a)
TRADITIONAL MODEL: MP is positively related to higher dividends. Thus MP would increase if dividends are higher and decline if dividends are lower. P = m (D + E/3) Where,
P = Market price m = Multiplier D = Dividend per share E = Earnings per share
b) GORDONS DIVIDEND CAPITALISATION MODEL Assumptions : Firm is all-equity, RE are used to finance projects, r and k are constant, there are no taxes, b once decided is constant. Gordon put forward the following valuation model: P0 = E 1+ (1 b) k - br where, P0 = Price per share at the end of the year 0 E1 = Earnings per share at the end of year 1 (1 b) = Fraction of earnings the firm distributes by way of earnings b = Fraction of earnings the firms ploughs back k = Rate of return required by the shareholders r = Rate of return earned on investments made by the firm br = Growth rate of earnings and dividends
c) BIRD-IN-HAND THEORY
John Lintner propounded this theory in 1962 and Myron Gordon in 1963. The shareholders are not entitled to any fixed return. The return to the shareholders is in the form of dividends and capital gains. Current dividends are relatively certain compared to future capital gains. According to this theory shareholders are risk averse and prefer to receive dividends in the present time period to future capital gains. Modigliani and Miller termed this argument as bird-in-hand fallacy.
d) DIVIDEND SIGNALLING THEORY Managers have greater access to inside information about the company. They may share this information with the shareholders through an appropriate dividend policy. Constant or increasing dividends convey positive signals about the future prospects of the company resulting in an increase in share price. Similarly, absence of dividends or decreasing dividends convey negative signal resulting in decline in share price. A liberal dividend policy by reducing the agency costs may lead to enhancement of the shareholder value.
2. DIVIDEND IRRELEVANCE THEORY: These theories contend that there are two components of shareholder returns a) Dividend Yield (D / P0) b ) Capital Yield (P1/ P 0 ) / P 0 Suppose a firm issues a Rs.10 par value share at a premium of Rs.90. In other words, the issue price is Rs.100. If the firm declares a dividend of Rs.3 (the dividend yield is 3%) price at the end of next year is s Rs.115, the
capital yield is (115 100) / 100 = 15 per cent. The total return to the shareholders is 18 per cent. These theories, which argue that dividends are not relevant in determining the value of the firm, are: i. Residual Theory ii. Modigliani and Miller (M&M) Model iii. Dividend Clientele Effect iv. Rational Expectations Model i. RESIDUAL THEORY: According to this theory a firm will only pay dividends from residual earnings, that is, from earnings left over after all the suitable investment opportunities have been financed.
ii. MODIGILANI AND MILLER (M&M) Model: According to the model, it is only the firms investment policy that will have an impact on the share value of the firm and hence should be given more importance. The current market price of the share is equal to the discounted value of the dividend paid and the market price at the end of the period. P0 = _ 1___(D1+ P 1) (1 + k e) Where, P0 = Current market price of the share (t = 0) P1 = Market price of the share at the end of the period (t = 1) D1 = Dividends to be paid at the end of the period (t=1) ke = Cost of equity capital With no external financing the total value of the firm will be as follows: nP0 = _ 1___(nD1+ nP 1) (1 + ke ) Simplifying the above equation, we get
n1 1P = I E + nD1 Where, I = Total investment required nD1 = Total dividends paid E = Earnings during the period (E - nD1 ) = Retained earnings Substituting this value of the new shares in the above equation, we get nP0 = 1 ___ [nD1 + (n + n1)P1 - I + E - nD1 ] (1 + ke ) = nD1 + (n + n1 )P1 - I + E - nD1] (1 + ke ) nP0 = (n + n1 )P1 - I + E (1 + ke ) Thus, according to the M&M model, the market value of the share is not affected by the dividend policy and this is clear from the last equation above. iii. DIVIDEND CLIENTELE EFFECT: According to this theory, dividend policy is irrelevant in determining the firms value. Different firms may follow different dividend policies depending upon their own needs and circumstances. One firm may decide on a higher payout ratio whereas others may decide on lower dividend payout. Similarly, different shareholders may have different needs some may prefer current dividends whereas current dividends whereas others may be more interested in capital gains. Those investors who prefer current dividends would like to become shareholders in companies which declare generous dividends whereas those investors who are more interested in capital gains would folk to companies having relatively lower payout ratios.
iv. RATIONAL EXPECTATIONS MODEL: According to this model there would be no effect of dividend declaration on the market price as long as the dividend declared is in line with the expected dividends. If dividend <expected dividend MP will decline and vice versa. Thus, so far as dividend declared ratifies the market expectation the dividend policy is not relevant in determining the MP.
Factors influencing Dividend Policy:

A number of considerations affect the dividend policy of company. The major factors are 1. Stability of Earnings. The nature of business has an important bearing on the dividend policy. Industrial units having stability of earnings may formulate a more consistent dividend policy than those having an uneven flow of incomes because they can predict easily their savings and earnings. Usually, enterprises dealing in necessities suffer less from oscillating earnings than those dealing in luxuries or fancy goods. 2. Age of corporation. Age of the corporation counts much in deciding the dividend policy. A newly established company may require much of its earnings for expansion and plant improvement and may adopt a rigid dividend policy while, on the other hand, an older company can formulate a clear cut and more consistent policy regarding dividend. 3. Liquidity of Funds. Availability of cash and sound financial position is also an important factor in dividend decisions. A dividend represents a cash outflow, the greater the funds and the liquidity of the firm the better
the ability to pay dividend. The liquidity of a firm depends very much on the investment and financial decisions of the firm which in turn determines the rate of expansion and the manner of financing. If cash position is weak, stock dividend will be distributed and if cash position is good, company candistributethecashdividend. 4. Extent of share Distribution. Nature of ownership also affects the dividend decisions. A closely held company is likely to get the assent of the shareholders for the suspension of dividend or for following a conservative dividend policy. On the other hand, a company having a good number of shareholders widely distributed and forming low or medium income group, would face a great difficulty in securing such assent because they willemphasisetodistributehigherdividend.
5. Needs for Additional Capital. Companies retain a part of their profits for strengthening their financial position. The income may be conserved for meeting the increased requirements of working capital or of future expansion. Small companies usually find difficulties in raising finance for their needs of increased working capital for expansion programmes. They having no other alternative, use their ploughed back profits. Thus, such Companies distribute dividend at low rates and retain a big part of profits.
6. Trade Cycles. Business cycles also exercise influence upon dividend Policy. Dividend policy is adjusted according to the business oscillations. During the boom, prudent management creates food reserves for contingencies which follow the inflationary period. Higher rates of dividend can be used as a tool for marketing the securities in an otherwise depressed market. The financial solvency can be proved and maintained by the companies in dull years if the adequate reserves have been built up. 7. Government Policies. The earnings capacity of the enterprise is widely affected by the change in fiscal, industrial, labour, control and other government policies. Sometimes government restricts the distribution of dividend beyond a certain percentage in a particular industry or in all spheres of business activity as was done in emergency. The dividend policy has to be modified or formulated accordingly in those enterprises.
8. Taxation Policy. High taxation reduces the earnings of he companies and consequently the rate of dividend is lowered down. Sometimes government levies dividend-tax of distribution of dividend beyond a certain limit. It also affects the capital formation. N India, dividends beyond 10 % of paid-up capital are subject to dividend tax at 7.5 %. 9. Legal Requirements. In deciding on the dividend, the directors take the legal requirements too into consideration. In order to protect the interests of creditors an outsiders, the companies Act 1956 prescribes certain guidelines in respect of the distribution and payment of dividend. Moreover, a company is required to provide for depreciation on its fixed and tangible assets before declaring dividend on shares. It proposes that Dividend should not be distributed out of capita, in any case. Likewise, contractual obligation should also be fulfilled, for example, payment of dividend on preference shares in priority over ordinary dividend.
10. Past dividend Rates. While formulating the Dividend Policy, the directors must keep in mind the dividend paid in past years. The current rate should be around the average past rat. If it has been abnormally increased the shares will be subjected to speculation. In a new concern, the company should consider the dividend policy of the rival organization. 11. Ability to Borrow. Well established and large firms have better access to the capital market than the new Companies and may borrow funds from the external sources if there arises any need. Such Companies may have a better dividend pay-out ratio. Whereas smaller firms have to depend on their internal sources and therefore they will have to built up good reserves by reducing the dividend payout ratio for meeting any obligation requiring heavyfunds.
12. Policy of Control. Policy of control is another determining factor is so far as dividends are concerned. If the directors want to have control on company, they would not like to add new shareholders and therefore, declare a dividend at low rate. Because by adding new shareholders they
fear dilution of control and diversion of policies and programmes of the existing management. So they prefer to meet the needs through retained earing. If the directors do not bother about the control of affairs they will follow a liberal dividend policy. Thus control is an influencing factor in framingthe dividend policy. 13. Repayments of Loan. A company having loan indebtedness are vowed to a high rate of retention earnings, unless one other arrangements are made for the redemption of debt on maturity. It will naturally lower down the rate of dividend. Sometimes, the lenders (mostly institutional lenders) put restrictions on the dividend distribution still such time their loan is outstanding. Formal loan contracts generally provide a certain standard of liquidity and solvency to be maintained. Management is bound to hour such restrictions and to limit the rate of dividend payout.
14. Time for Payment of Dividend. When should the dividend be paid is another consideration. Payment of dividend means outflow of cash. It is, therefore, desirable to distribute dividend at a time when is least needed by the company because there are peak times as well as lean periods of expenditure. Wise management should plan the payment of dividend in such a manner that there is no cash outflow at a time when the undertaking isalreadyinneed ofurgentfinances.
15. Regularity and stability in Dividend Payment. Dividends should be paid regularly because each investor is interested in the regular payment of dividend. The management should, in spite of regular payment of dividend, consider that the rate of dividend should be all the most constant. For this purpose sometimes companies maintain dividend equalization Fund.
Bonus shares:
Shares issued by a "healthy" company to existing shareholders without any cost. They are issued in proportion to the existing holding of a shareholder. Only if a company has accumulated a surplus in free reserves (retained
profits) it can issue bonus shares. As bonus issues add to the number of total shares of the company, the Earnings Per Share ratio decreases. A company issue shares in lieu for cash or sometimes against transfer of physical or intellectual property to the company's hands. But bonus shares are issued to the existing shareholders by converting free reserves or share premium account to equity capital without taking any consideration from investors. Bonus shares do not directly affect a company's performance. Bonus issue has following major effects. 1. Share capital gets increased according to the bonus issue ratio. 2. Liquidity in the stock increases. 3. Effective Earnings per share, Book Value and other per share values stand reduced. 4. Markets take the action usually as a favorable act. 5. Market price gets adjusted on issue of bonus shares. 6. Accumulated profits get reduced.
Issue of bonus shares: Bonus shares are issued by converting the reserves of the company into share capital. It is nothing but capitalization of the reserves of the company. There are some conditions which need to be satisfied before issuing Bonus shares: 1) Bonus shares can be issued by a company only if the Articles of Association of the company authorizes a bonus issue. Where there is no provision in this regard in the articles, they must be amended by passing special resolution act at the general meeting of the company. 2) It must be sanctioned by shareholders in general meeting on recommendationsofBOD ofcompany. 3) Guidelines issue by SEBI must be complied with. Care must be taken that issue of bonus shares does not lead to total share capital in excess of the authorized share capital. Otherwise, the authorized capital must be increased by amending the capital clause of the Memorandum of
association. If the company has availed of any loan from the financial institutions, prior permission is to be obtained from the institutions for issue of bonus shares. If the company is listed on the stock exchange, the stock exchange must be informed of the decision of the board to issue bonus shares immediately after the board meeting. Where the bonus shares are to be issued to the non-resident members, prior consent of the Reserve Bank should be obtained. Only fully paid up bonus share can be issued. Partly paid up bonus shares cannot be issued since the shareholders become liable to pay the uncalled amount on those shares. It is important to note here that Issue of bonus shares does not entail release of companys assets. When bonus shares are issued/credited as fully paid up out of capitalized accumulated profits, there is distribution of capitalized accumulated profits but such distribution does not entail release of assets of the company. Issue ofBonusSharesby PublicSector Undertakings It has come to the notice of the Government that a number of Central Government Public Sector Undertakings are carrying substantial reserves in their balance sheets against a relatively small paid up capital base. The question of the need for these enterprises to capitalize a portion of their reserves by issuing Bonus Shares to the existing shareholders has been under consideration of the Government. The issue of Bonus Shares helps in bringing about at proper balance between paid up capital and accumulated reserves, elicit good public response to equity issues of the public enterprises and helps in improving the market image of the company. Therefore, the Government has decided that the public enterprises, which are carrying substantial reserves in comparison to their paid up capital sold issue Bonus Shares to capitalize the reserves for which the certain norms/conditions and criteria may be followed and fulfilled. There are some SEBI guidelines for Bonus issue which are contained in Chapter XV of SEBI( Disclosure & Investor Protection) Guidelines, 2000 which should be followed in deciding the correct proportion of reserves to be capitalized by issuing Bonus Shares.
Private sector banks, whether listed or unlisted, can also issue bonus and rights shares without prior approval from the Reserve Bank of India. Liberalising the norms for issue and pricing of shares by private sector banks, the RBI said that the bonus issue would be delinked from the rights issue. However, central bank approval will be required for Initial Public Offerings (IPOs) and preferential shares. These measures are seen as part of the RBI's attempt to confine itself to banking sector regulation and leave the capital market entirely to the SEBI. Under the guidelines, private sector banks have also been given the freedom to price their subsequent issues once their shares are listed on the stock exchanges. The issue price should be based on merchant bankers' recommendation, the RBI has said. It means though RBI approval is not required but pricing should be as per SEBI guidelines. The RBI, however, clarified that banks will have to meet SEBI's requirements on issue of bonus shares. As per current regulations, private sector banks whose shares are not listed on the stock exchange are required to obtain prior approval of the RBI for issue of all types of shares such as public, preferential, rights or special allotment to employees and bonus. Banks whose shares are listed on the stock exchanges need not seek prior approval of the RBI for issue of shares except bonus shares, which was to be linked with rights or public issues by all private sector banks.

Financial Management UNIT V

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Financial Management UNIT V

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UNIT-V

EPS and DPS (Rs)

Merits of stability of Dividends:

Institutional investors requirements:

Danger of Stability of Dividends:

Theories of Dividend Policy:

f) Agency Cost Theory

P = Market price m = Multiplier D = Dividend per share E = Earnings per share

Factors influencing Dividend Policy:

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