CHAPTE R 18

DIVIDEND POLICY

LEARNING OBJECTIVES
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Explain

the objectives of dividend policy in practice Understand the factors that influence a firms dividend policy Focus on the importance of the stability of dividend. Discuss the significance and implications of bonus shares and stock splits and the share buyback Explain Lintner's model of corporate behaviour of dividends

OBJECTIVES OF DIVIDEND POLICY

Firms

Need for Funds Shareholders Need for Income

PRACTICAL CONSIDERATIONS IN DIVIDEND POLICY

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Firms

Investment Opportunities and Financial Needs Shareholders Expectations Constraints on Paying Dividends

Legal restrictions Liquidity Financial condition and borrowing capacity Access to the capital market Restrictions in loan agreements Inflation Control

STABILITY OF DIVIDENDS
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Constant

Dividend per Share or Dividend Rate. Constant Payout. Constant Dividend per Share Plus Extra Dividend.

Constant dividend per share policy

Dividend policy of constant payout ratio

Significance of Stability of Dividends

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Resolutions

of investors uncertainty. Investors desire for current income. Institutional Investors Requirement. Raising Additional Finances.

TARGET PAYOUT AND DIVIDEND SMOOTHING: LINTNERS MODEL OF CORPORATE DIVIDEND BEHAVIOUR
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FORMS OF DIVIDENDS
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Cash

Dividends Bonus Shares (Stock Dividend)

Advantages of Bonus Shares

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To

shareholders:

Tax benefit Indication of higher future profits Future dividends may increase Psychological value

To

company:

Conservation of cash Only means to pay dividend under financial difficulty and contractual restrictions More attractive share price

Limitations of Bonus Shares

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Shareholders wealth

remains unaffected

Costly

to administer Problem of adjusting EPS and P/E ratio

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Conditions for the Issue of Bonus Shares

Residual

reserve criterion Profitability criterion

Share split
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share split is a method to increase the number of outstanding shares through a proportional reduction in the par value of the share. A share split affects only the par value and the number of outstanding shares; the shareholders total funds remain unaltered.

Example
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The

following is the capital structure of Walchand Sons & Company:

Walchand

Company split their shares two-for-one. The capitalization of the company after the split is as follows:

Bonus Share vs. Share Split

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The

bonus issue and the share split are similar except for the difference in their accounting treatment. In the case of bonus shares, the balance of the reserves and surpluses account decreases due to a transfer to the paid-up capital and the share premium accounts. The par value per share remains unaffected. With a share split, the balance of the equity accounts does not change, but the par value per share changes.

Reasons for Share Split

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To

make trading in shares attractive To signal the possibility of higher profits in the future To give higher dividends to shareholders

Reverse Split
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Under

the situation of falling price of a companys share, the company may want to reduce the number of outstanding shares to prop up the market price per share. reduction of the number of outstanding shares by increasing per share par value is known as a reverse split. reverse split is generally an indication of financial difficulty, and is, therefore, intended to increase the market price per share.

The

The

BUYBACK OF SHARES
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The

buyback of shares is the repurchase of its own shares by a company. a result of the Companies Act (Amendment) 1999, a company in India can now buyback its own shares.

As

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In India the following conditions apply in case of the buyback shares:

A company

buying back its shares will not issue fresh capital, except bonus issue, for the next 12 months. The company will state the amount to be used for the buyback of shares and seek prior approval of shareholders. The buyback of shares can be affected only by utilizing the free reserves, viz., reserves not specifically earmarked for some purpose. The company will not borrow funds to buy back shares. The shares bought under the buyback schemes will be extinguished and they cannot be reissued.

Methods of Shares Buyback

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First,

a company can buy its shares through authorized brokers on the open market. the company can make a tender offer, which will specify the purchase price, the total amount and the period within which shares will be bought back.

Second,

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Effects of the Shares Buyback

It

is believed that the buyback will be financially beneficial for the company, the buying shareholders and the remaining shareholders.

Increase

in the companys debt-equity ratio due to reduced equity capital.

Advantages of the Buyback

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Return of surplus cash to shareholders Increase in the share value Increase in the temporarily undervalued share price Achieving the target capital structure Consolidating control Tax savings by companies Protection against hostile takeovers

Drawbacks of the Buyback

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Not an effective defence against takeover Shareholders do not like the buyback Loss to the remaining shareholders Signal of low growth opportunities