FM II

Term II PGP 18 Batch

Pankaj Baag
Faculty Block 01, Room No 21
Mob: 8943716269
Ph (O): 0495-2809121
Ext. 121
Email: baagpankaj@iimk.ac.in

Case: Dividend Policy at FPL Group Inc (A)

1. Why do firms pay dividends? What, in general, are the advantages and
disadvantages of paying cash dividends?
2. What are the most important issues confronting the FPL Group in May
1994?
3. From FPLs perspective, is the current payout ratio appropriate? Would
a higher payout ratio be more appropriate? a lower payout ratio?
4. From an investors perspective, is FPLs payout ratio appropriate?
5. As Kate Stark, what would you recommend regarding investment in
FPLs stock buy, sell, or hold?

. Enrollment key for FM II in VC is

FM2AB

Chapter 16

Payout
Policy

Enrollment key for FM II in VC is

FM2AB
McGraw-Hill/Irwin

Chapter overview

This chapter starts by describing different types of cash payouts.

There are two ways in which a firm can distribute cash to the
shareholdersdividend and stock repurchase.
The information content in dividends and share repurchases is
explained.
It covers the dividend controversy by discussing the three
schools of thoughtthe rightists, the radical left, and the middleof-the-roaders associated with the issue.
Miller and Modiglianis Proposition on dividend irrelevance is
illustrated using examples.
The chapter ends with a discussion on tax systems of other
countries including imputation tax system.

LEARNING OBJECTIVES

Enable you to explain how companies decide on

their dividend payouts and also the mechanism of
payouts.
Understand the mechanisms and implications of
share repurchases
Discuss and analyze the issues surrounding the
payout controversy the right, taxes and the left,
and the middle-of-the-roaders.
Understand different tax systems.

Payout policies
There are two payout policiescash dividends and stock
repurchases
Cash Dividend
Dividends are rarely cut back, managers do not increase dividends

unless confident that dividend can be maintained

Stock Repurchase
Repurchases are more flexible and repurchases are tax-advantaged

Stock repurchases also give shareholders cash.

DIVIDEND AND STOCK REPURCHASES

The histogram shows data on dividends and repurchases over the years .

Firms pay out cash to their shareholders in two ways. They can pay
a cash dividend or, using cash, buy back some of the outstanding
shares
Total repurchases made by Indian companies have increased at an
annual 30% rate over the last decade
Dividends still are the pre-dominant form of cash distribution even
after share buybacks were legalized in India with effect from 31 Oct
1998
In US, some companies like : do not pay any dividend and
invest their total profits in business
BOD approves companies decision to buyback shares, SEBI is
informed but sometimes/actually may not buyback any shares.
Reliance Energy case in 2004: 525 ps worth 350 crores on 16 Jun
2004 but on 27 Jun 2005 it said that it had not buyback any share

How firms pay dividends

Firms dividend is set by the BOD
The announcement of the dividend (declaration date) states that the
payment will be made to all stockholders who are registered as of the
record date.
Then dividend checks are mailed for credit on a given date
(payment date)
Stocks are traded with dividends (cum dividend) until two days
before the record date, and then they trade ex-dividend.
The stock price falls by the amount of the dividend on the exdividend date
If you buy on ex-dividend date, it will not be entered in companys
book before the record date and you will not be entitled for dividend.

TATA STEEL DIVIDEND

23 May,
2013
Tata Steel
declares
quarterly
dividend
of Rs. 8 per
share

Declaration
date

15 July, 2013

17 July, 2013

Shares start
to
trade exdividend

Dividend will be
paid
to shareholders
registered
on this date

Ex-dividend
date

Record
date

01 August,
2013
Dividend
checks
mailed
to
shareholders

Payment
date

16-10

Procedure for Cash Dividend

Payment
25 Oct.

1 Nov.

2 Nov.

4 Nov.

7 Dec.

Declaration
Date

ExCumdividend dividend
Date
Date

Record
Date

Payment
Date

Declaration Date: The Board of Directors declares a payment

of dividends.
Cum-Dividend Date: The last day that the buyer of a stock is
entitled to the dividend.
Ex-Dividend Date: The first day that the seller of a stock is
entitled to the dividend.
Record Date: The corporation prepares a list of all individuals
believed to be stockholders as of 4 November.

Price Behavior around the ExDividend Date

In a perfect world, the stock price will fall by

the amount of the dividend on the ex-dividend
date. -t -2 -1 0 +1 +2
Rs.P
Rs.P - div
The price drops
Exby the amount of
dividend
Date
the cash
dividend Taxes complicate things a bit. Empirically, the
price drop is less than the dividend and occurs
within the first few minutes of the ex-date.

Share Price Drop

On the ex-dividend date, the share price starts trading at
the previous day's closing price minus the amount of the
dividend.
For example, if a stock paying a 50-cent dividend closed
the day before at $50, the share price opens on the exdividend day at $49.50.
Investors who owned the shares before the ex-dividend
date maintain the value of their investment.
The investment that was worth $50 is now worth $49.50
plus the 50-cent dividend to be paid later

The amount paid out in dividends no

longer belongs to the company and this
is reflected by a
reduction in the company's market cap.
Those purchasing shares after the exdividend date, they no longer have a
claim to the dividend, so the exchange
adjusts the price downward to reflect
this fact.

Implications for Companies

Dividend payments, whether they are cash or stock,

reduce retained earnings by the total amount of the
dividend.
In the case of a cash dividend, the money is transferred
to a liability account called dividends payable.
This liability is removed when the company actually
makes the payment on the dividend payment date,
usually a few weeks after the ex-dividend date.
For instance, if the dividend was $0.025 per share and
there are 100 million shares outstanding, retained
earnings will be reduced by $2.5 million and that money
eventually makes its way to the shareholders.

In the case of a stock dividend, however, the amount

removed from retained earnings is added to the equity
account, common stock at par value, and brand new
shares are issued to the shareholders.
The value of each share's par value does not change.
For instance, for a 10% stock dividend where the par
value is 25 cents per share and there are 100 million
shares outstanding, retained earnings are reduced by
$2.5 million, common stock at par value is increased by
that amount and the total number of shares outstanding
is increased to 110 million.

This is different from a stock split, although it looks

the same from a shareholder's point of view. In a
stock split, all the old shares are called in, new
shares are issued and the par value is reduced by
the inverse of the ratio of the split.
For instance, if instead of a 10% stock dividend,
the above company declares an 11-to-10 stock
split, the 100 million shares are called in and 110
million new shares are issued, each with a par
value of $0.22727.
This leaves the common stock at par value
account's total unchanged. The retained earnings
account is not reduced either.

Implications for Investors

Cash dividends, the most common sort, are taxed at either the normal tax
rate or at a reduced rate of 5% or 15%
There may be some tax advantage accounts
The dividing line between the normal tax rate and the reduced or
"qualified" rate is how long the underlying security has been owned.
Sometimes, especially in the case of a special, large dividend, part of the
dividend is actually declared by the company to be a return of capital.
In this case, instead of being taxed at the time of distribution, the return
of capital is used to reduce the basis of the stock, making for a larger
capital gain down the road, assuming the selling price is higher than the
basis.
For instance, if you buy shares with a basis of $10 each and you get a $1
special dividend, 55 cents of which is return of capital, the taxable
dividend is 45 cents, the new basis is $9.45 and you will pay capital
gains tax on that 55 cents when you
sell your shares sometime in the future.

knowledge1
Firms are not allowed to pay a dividend out of legal capital,
which is generally defined as the par value of outstanding
shares.
Companies are not free to declare whatever dividend it
chooses,
Regulated by Sec 123 of CA, 2013
Can pay dividends only out of free reserves
Cannot pay any dividends in case of inadequate profits
CA, 2013 also imposes certain restrictions on the interim
dividends,
If the cumulative profit of the company that is profit for all the
quarters of the fiscal year before the dividend declaration date
is negative then the rate cannot be higher than the average
dividend rate of the previous three financial years

Cash Dividend Payment

Cash Dividend - Payment of cash by the firm
to its shareholders.
Ex-Dividend Date - Date that determines
whether a stockholder is entitled to a dividend
payment; anyone holding stock before this
date is entitled to a dividend.
Record Date - Person who owns stock on this
date received the dividend.

Most companies pay regular dividends each year

Sometimes this is supplemented by a special
dividend
Some US companies offer automatic dividend
reinvestment plan (DRIP) and often at discounts
say 5% from the market price; sometimes 10% or
more of dividend will be reinvested
A 5% stock dividend means that the firm will
send five extra shares to each shareholder for
every 100 shares currently owned.

Dividend are not always in the form of cash

Sec 205(3) of the CA in India prohibits from paying dividends
in any form other than cash
The same section however allows companies to capitalize
profit and reserves as fully paid up bonus shares
So frequently companies also declare stock dividend
This is same as issue of bonus share. If a company
announces a 1:2 bonus issue (it means 50% stock dividend)
It sends the shareholder 1 extra share for every 2 shares
currently held
It is therefore : a bonus issue is equivalent to a stock split
Bonus issue is a transfer from RE to Share capital where as
Split is a reduction in the par value of each share
Both increase the number of shares but no effect on assets,
profit or total value. So both reduce value per share

Bonus issues (stock dividend) used to

play a vital role in India
Before Apr 2009, Indian companies
declared dividend as a percentage of the
face value per share
Eg: 100% dividend Rs 2 per share on a
face value of Rs 2
After Apr 2009, SEBI made it mandatory
to announce the dividend on a per share
basis

Stock Dividends Vs. Stock

Splits
Stock dividend: Firm issues new shares in

lieu of paying a cash dividend.

10% stock dividend

100 owned.

get 10 shares for each

Stock split: Firm increases the number of

shares outstanding.
2:1 split

owned.

get 1 new share for each share

Stock Dividends Vs. Stock

Splits,
continued

Both stock dividends and stock splits increase

the number of shares outstanding, so the pie
is divided into smaller pieces.

Unless the stock dividend or split conveys

information, or is accompanied by another

event like higher dividends, the stock price falls
so as to keep each investors wealth
unchanged.

 When should a firm consider declaring a

stock dividend?

Hard to come up with a good argument for small

stock dividends such as 5% or 10%.
Administrative costs hurt, and there are few if
any benefits.

When should a firm consider splitting its

stock?

There is a widespread belief that the optimal

price range for stocks is $20 to $80.
Stock splits can be used to keep the price in the
optimal range.
Stock splits generally occur when management
is confident, so are interpreted as positive
signals.

 liquidating dividend
A type of payment made by a
corporation to its shareholders during its
partial or full liquidation.
For the most part, such a distribution is
made from the company's capital base,
and as a return of capital, is typically not
taxable for shareholders.
This distinguishes a liquidating
dividend from regular dividends, which
are issued from the company's operating
profits or retained earnings.

Different Types of Dividends

Many companies pay a regular cash dividend.

Often companies will declare stock dividends.

Public companies often pay quarterly.

Sometimes firms will throw in an extra cash dividend.
The extreme case would be a liquidating dividend.
No cash leaves the firm.
The firm increases the number of shares outstanding.

Some companies declare a dividend in kind.

Wrigleys Gum sends around a box of chewing gum.

Dundee Crematoria offers shareholders discounted
cremations.

 Dividend Payments
Stock Dividend
Distribution of additional shares to firms stockholders

Stock Splits
Issue of additional shares to firms stockholders
Stock Repurchase
Firm buys back stock from its shareholders

16-29

 Types of Dividends
Cash Dividend
Regular Cash Dividend
Special Cash Dividend
Stock Dividend
Stock Repurchase (4 methods)
Buy Shares on Market
Tender Offer to Shareholders
Dutch Auction
Private Negotiation (greenmail)

16-30

How firms repurchase (buyback) stock

Instead of paying a dividend to its stockholders, firm can use the
cash to repurchase stock
The reacquired shares are kept in the companys treasury and may
be resold if the company needs money (US)
Where a company buys-back its own securities, it shall extinguish
and physically destroy the securities so bought-back within seven
days of the last date of completion of buy-back.(India)
There are four main ways to repurchase stock, common is through
open market, second is tender offer
SEBI (buyback of securities) Regulations 1998 allows a company to
buyback its share by the tender offer on a proportionate basis (stated
number of shares at a fixed price say 20% above the current market
level), from the open market either through the book building process
or stock exchanges or from odd lot holders
Third is to employ a Dutch auction and the fourth by direct
negotiation with a major shareholder.

Issue of further shares after Buy back (India)

Every buy-back shall be completed within twelve
months from the date of passing the special
resolution or Board resolution as the case may be.
A company which has bought back any security
cannot make any issue of the same kind of
securities in any manner whether by way of public
issue, rights issue up to six months from the date
of completion of buy back.
Globally, Earlier there was severe restriction/ban
on repurchase
Companies with large cash rather than hand it
back to shareholders invested in low rate of
returns. Why?

 Objectives of Buy Back: (CA)

Shares may be bought back by the company on
account of one or more of the following reasons
i. To increase promoters holding
ii. Increase earning per share
iii. Rationalise the capital structure by writing
off capital not represented by available assets.
iv. Support share value
v. To thwart takeover bid
vi. To pay surplus cash not required by business
Infact the best strategy to maintain the share
price in a bear run is to buy back the shares
from the open market at a premium over the
prevailing market price.

 Resources of Buy Back (CA)

A Company can purchase its own shares from
(i) free reserves; Where a company purchases its
own shares out of free reserves, then a sum equal
to the nominal value of the share so purchased
shall be transferred to the capital redemption
reserve and details of such transfer shall be
disclosed in the balance-sheet or
(ii) securities premium account; or
(iii) proceeds of any shares or other specified
securities.
A Company cannot buyback its shares or other
specified securities out of the proceeds of an
earlier issue of the same kind of shares or
specified securities.

DIVIDEND POLICY

survey of financial executives.

16-35

INFORMATION CONTENT OF
DIVIDEND
Payout Decision
Managers are reluctant to make dividend
changes that may be reversed
Managers worry about rescinding dividend
increases and raising new funds to maintain
payout

16-36

INFORMATION CONTENT OF
DIVIDEND
Payout Decision
To avoid risk of reduction in payout, managers
smooth dividends
Dividend changes follow shifts in long-run
sustainable earnings
Transitory earnings changes unlikely to affect
dividend payouts

16-37

INFORMATION CONTENT OF
DIVIDEND
Payout Decisions
Managers focus on dividend changes over
absolute levels
Paying a dividend of $2.00 per share is
important if last year's dividend was $1.50
Paying a dividend of $2.00 is not important if
last year's dividend was $2.00

16-38

So why announcement of a dividend

increase is a good news?
Managers are reluctant to reduce
dividend
Managers will not increase dividends
unless they are confident that the
payment can be maintained
Signals: confidence in future profits
Hence investors refers to information
content of dividends

 Investors dont get excited over the level

of the dividend
They worry about the change: view it as
an indicator of the sustainability of
earnings
But a dividend cut is not always a bad
news
EG: 2009: JP Morgan: saved $5 billion a
year to prepare for a recession-pay the
$25 billion under the troubled asset
relief programme- a signal of confidence
not distress

Similarly a dividend announcement can be a bad news

the market reacted differently.
the decline in the price of Microsoft in the aftermath of its firstever dividend

Generally, firms buy back stock when they have

accumulated excess cash or wish to change their
capital structure by replacing equity with debt.??

INFORMATION CONTENT OF
DIVIDEND
Dividend stock repurchase decisions

contain information
Information contained in decisions vary
Asymmetric information may be conveyed
Dividend increases could mean overpriced
stock or increased future profits
Signal varies based on prior information
about company

16-42

INFORMATION CONTENT OF
REPURCHASE
Announcement
of share repurchase in not a commitment

to

continue in future
So the news is less positive compared to dividend (higher)
4% , vs .it is 2% price rise
Applaud repurchase if they feel that managers would otherwise
fritter away the money on perks/unprofitable empire building
Repurchase also reflect management optimism with the view
that share price is underpriced
Confidence in future, if undervalued, you offer to buy back at
20% over the current market price, but if you are not going to
sell it, conclusion stock is good value even at 20% above the
current price
Usually this happens when management hold on to their
shares resulting in an average rise of about 11%

John Lintner had developed a simple model

which is consistent with the above observations
and explains dividend payments well.
This model suggests that the dividend depends
partly on the firms current earnings and partly
on the dividend for the previous year.
Current dividends are related to a weighted
average of current earnings and past earnings.