Topic 3

Dividend Policy

Dividend is Financing or Investment Decision?

Dividend decision is part of Financing decision, because the earnings available may be retained in the business for Reinvestment. If the funds are not required, they may distributed as dividends.

Affects:
Dividend policy of the firm affect both the long-term financing and wealth of the shareholders. Therefore, the firm distribute; - reasonable amount as dividend to its members, - retain the rest for its growth & survival.

Do investors prefer high or low payouts? There are three theories:

Dividends are irrelevant: Investors dont care about payout. Bird-in-the-hand: Investors prefer a high payout. Tax preference: Investors prefer a low payout, hence growth.

Dividend Irrelevance Theory

Investors are indifferent between dividends and retention-generated capital gains. If they want cash, they can sell stock. If they dont want cash, they can use dividends to buy stock. Modigliani-Miller support irrelevance. Theory is based on unrealistic assumptions (no taxes or brokerage costs), hence may not be true. Need empirical test.

Bird-in-theBird-in-the-Hand Theory
Investors think dividends are less risky than potential future capital gains, hence they like dividends. If so, investors would value high payout firms more highly, i.e., a high payout would result in a high stock price.

Tax Preference Theory

Low payouts mean higher capital gains. Capital gains taxes are deferred. This could cause investors to prefer firms with low payouts, i.e., a high payout results in a low stock price.

Implications of 3 Theories for Managers

Theory Irrelevance Bird-in-the-hand Tax preference Implication Any payout OK Set high payout Set low payout

Which theory is most correct?

Empirical testing has not been able to determine which theory, if any, is correct. Thus, managers use judgment when setting policy. Analysis is used, but it must be applied with judgment.

Dividend Decision: Acc. to one school of thought dividend decision does not affect the shareholders wealth. Acc. to another school of thought, dividend decision affect the shareholders wealth. Based on these two thoughts, it can be classified into two theories. 1. Irrelevance Theory 2. Relevance Theory

1. The Irrelevance Theory

Modigliani & Miller (MM) approach: Acc. to this dividend policy has no affect on the market price of the share and value of the firm, is determined by the earning capacity of the firm. Assumptions: - There are perfect capital market - Investors are rational - No taxes or no difference in the tax rate to dividends and capital gains. - No risk or uncertainty in future. - Investment and dividend decisions are independent.

MM argument:
If a co. retains earnings instead of giving it out as dividends, the shareholder enjoys capital appreciation equal to the amount of earnings retained. If it distributes earnings by way of dividend - the shareholder enjoys dividends instead of appreciation in the retained earnings.

Criticisms of MM position:
Uncertainty and Fluctuations Offering of additional equity at lower prices Higher dividend Greater volume of under priced equity issue Greater dilution of control Issue cost Transaction cost Differential rates of taxes

(n+m) P1 (I E) npo = ----------------------1 + Ke

m = no. of shares issued I = New Invt. required E = Earnings P1= p0 (1+ke) D1 P1 = Mkt. price per share at the end Ke = cost of equity n = no. of shares at the beginning D1 = dividend paid at the end np0 = Value of the firm (present)
Illustration: Refer worksheet case 4

I - (E nD1) m = -------------p1

2. Relevance Theory
Acc. to this those firms which pay higher dividends, will have greater value as compared to those which do not pay dividends or have a lower dividend pay ratio. There are two approach; 1. Walters Approach 2. Gordens approach

1. Walters approach:
Acc. to this dividend decisions are relevant and affect the value of the firm. It is significant based on Return on Investment (R) and Cost of Capital (K). He has made three different firm;

(a) Growth firm (b) Normal firm (c) Declining firm

:R>K :R=K :R<K

Assumptions :
The investment of the firm are financed through retained earnings only and the firm does not use external funds. Investment decision is dependent on the dividend decision. The IRR and K of the firm are constant. Earnings and dividends do not change while determining the value. The firm has very long life.

D r (E D) / Ke P = ----- + -----------------Ke Ke
P = Mkt. price per share D = Dividend per share r = Internal rate of return E = EPS Ke =Cost of equity capital

Illustrn.: pp 547

Criticism.
Firms depends on external funds as well as retained earnings; IRR & cost of capital does not remain constant.

(b) Gordons Approach

Acc. to him dividends are relevant and it affects firm value. Assumptions: - The firm is an all equity firm; - No external financing is available; - The IRR & cost of capital is constant; - The cost of capital is greater than growth rate i.e, rate of return on investment of all equity firm. - The firm has perpetual life.

Valuation model.
P0 E1(1 b) = ------------k br

Where, P0 = price per share at the end of year 0 E1 = EPS at the end of year 0 b = retention ratio K = required return or cost of capital br=g=growth rate of earnings & dividends r = rate of return earned on investments made by the firm. Illustration: pp 549

Implications..
When r > k, the share price increases as the dividend payout ratio decrease; When r = k, share price remain unchanged, dividend payout is variant When r < k, the share price increases, as the dividend payout increases.

Gordons Revised model:

Considered risk & return even when r=k dividend policy affects the value of shares on account of uncertainty of future; Investors are risk averse and avoid risk; They prefer near dividends rather than future dividends; Bird-in-hand argument the value of rupee of dividend income is more than the value of rupee of capital gain. uncertainty, the cost of capital cannot be constant and so firm should high payout ratio. Illustration : Refer worksheet

Determinants of Dividend policy:

1. 2. 3. 4. 5. 6. 7. 8. Legal restrictions Desire and type of shareholders Nature of Industry Age of the company Future financial requirements Taxation policy Control objectives Requirements of institutional investors. 9. Liquidity position of the firm 10.Cost of external equity and retained earnings.

Dividend Policy: 1. Stable dividend policy: Acc. to this, the percentage of earnings paid out as dividends remains constant. So that, dividends fluctuate in line with Earnings earnings.
Earnings
Dividend

Time

2. Steadily changing dividend: As per this policy, the rupee level of dividends remains stable or gradually increase or decreases.
Earnings

Dividend

Time

Dividend policies in practice:

Nature of Industry Electrical Chemical Tea Toothpaste Dividend practices 10% (Govt. expects) Depends on earning position No fixed (may be 30-50%) Both dividends and bonus shares usually high Aluminium When performance is good more dividend or vice versa Pharmaceuticals Around 30% or maintain min. 18% dividend every year Textiles No fixed, depends on profit

End