Download 04.06.2016Dividend policy

Dividend Policy
11-1
Dividend Policy
.
• Determining
how much of a company’s
profit is to be paid to shareholders as
dividends and how much is to
be
retained
11-2
Institutional Features of Dividends
• Dividend declaration procedures
– Interim and final:
 In Sri Lanka, if dividends are paid, we typically find two types:
• A final dividend is paid after the end of the accounting or reporting
year.
• An interim dividend can be paid any time before the final report is
released, usually after the half-yearly accounts are released.
– Cum-dividend period:
 Period during which the share holder is qualified to receive a
previously announced dividend.
– Ex-dividend date:
 Shares purchased on or after the ex-dividend date do not include a
right to the forthcoming dividend payment.
11-3
Institutional Features of Dividends (cont.)
• Example of cum-dividend and ex-dividend date:
Cum-Dividend
Period
time 0
4 days
Book Closing
Date
announcement
date
Ex-dividend
date
Payment
date
11-4
Institutional Features of Dividends (cont.)
• Declaration date
– Date Board of Directors pass a resolution to pay a dividend.
• Record (books closing) date
– The date on which shareholders listed in the register of
shareholders are designated to receive a dividend.
– This is 4 days after the ex-dividend date.
– The idea is that if shares are traded cum-dividend, brokers
have time to notify the share register to ensure the new
shareholder receives the dividend.
• Date of payment
– Date dividend cheques are mailed or dividends are paid
electronically.
11-5
The Importance of Payout Policy to
Shareholders
• A company’s business decisions involve investment, financing and
payout policies.
• Directors of companies must decide how much cash, if any, to pay to
shareholders and whether the payment should be in the form of
dividends or repurchase shares.
• The amount of money involved in payment suggests payout decision
is a significant issue in many companies operation.
• Retained earnings are the most significant internal source of financing.
Dividend is a cash outflow to the company. On the other hand,
dividend increase shareholders’ current income.
• The decision on the company’s payout policy should be consistent
with the overall financial objective of maximising shareholders’ wealth.
11-6
Dividend Payout and Value of the Company
• Payout ratio: which is dividend as a percentage to
earnings
• Retention ratio: How much earnings are retained in
the business (1-payout ratio)
• Growth = ROE x Retention ratio
• Suppose two companies Low payout company and
High payout company. Both have a ROE of 20%.
Value of the share is Rs 100 for both companies.
High payout company payout ratio is 80% and low
payout company payout ratio is 20%
11-7
Equity Rs. Earnings
high payout company
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
Low payout copany
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
Dividend
Retained
Earnings
100.0
104.0
108.2
112.5
117.0
121.7
126.5
131.6
136.9
142.3
20.0
20.8
21.6
22.5
23.4
24.3
25.3
26.3
27.4
28.5
16.0
16.6
17.3
18.0
18.7
19.5
20.2
21.1
21.9
22.8
4.0
4.2
4.3
4.5
4.7
4.9
5.1
5.3
5.5
5.7
100.0
116.0
134.6
156.1
181.1
210.0
243.6
282.6
327.8
380.3
20.0
23.2
26.9
31.2
36.2
42.0
48.7
56.5
65.6
76.1
4.0
4.6
5.4
6.2
7.2
8.4
9.7
11.3
13.1
15.2
16.0
18.6
21.5
25.0
29.0
33.6
39.0
45.2
52.5
60.8
11-8
• Low payout company have the higher return in the
long-run than high payout company.
• But future has a uncertainty and the share price is
determined by so many factors than payout.
• Therefore some investors may prefer high payout
companies and other low payout companies.
11-9
• Dividend policy is not a isolated decision. paying
dividends means outflow of cash. Hence it may
affect on the investment and financing decisions.
• It is difficult to isolate the effect of dividend policy on
the share price. Therefore number of theories have
been developed.
– Theories that consider dividend decisions to be irrelevant
– Theories that consider dividend decisions to be relevant
11-10
Dividend Relevance- Walter’s Model
• James Walter argues that the choice of dividend policies
affect value of the firm under following assumption.
–
–
–
–
–
The firm finances all investment through retained earnings
All earnings are either distributed as dividends or reinvested
Firm’s rate of return ,r, and its cost of capital, k, are constant.
Beginning earnings and dividends never change
The firm has a very long or infinite life
DIV r ( ESP  DIV ) / k
P

k
k
11-11
Dividend Policy and Value of Share
Growth Firm r>k
Normal Firm, r = k
Declining firm, r<k
r=0.15, k=0.1, EPS= Rs.10
r=0.1, k=0.1, EPS= Rs. 10
r=0.08, k=0.1, EPS= Rs. 10
Payout Ratio 0%
P= Rs. 100
P= Rs. 80
P= Rs. 100
P= Rs. 88
P= Rs. 100
P= Rs. 96
P= Rs. 100
P= Rs. 100
P = Rs. 150
Payout Ratio 40%
P = Rs. 130
Payout Ratio 80%
P=Rs. 110
Payout Ratio 100%
P=Rs. 100
11-12
Dividend Relevance- Gordon’s Model
• According to Myron Gordon dividend policies affect value
of the firm under following assumption.
–
–
–
–
–
The firm finances all investment through internal equity
The firm and its stream of earnings are perpetual
Firm’s rate of return ,r, and its cost of capital, k, are constant.
Taxes do not exist
The retention ratio,b, once decided opun, is constant. Thus the
growth rate, g =br, is constant forever.
– Cost of capital greater than growth rate (k>g)
DIV1
P0 
kg
11-13
Dividend Policy and Value of Share
Growth Firm r>k
Normal Firm, r = k
Declining firm, r<k
r=0.15, k=0.1, EPS= Rs.10
r=0.1, k=0.1, EPS= Rs. 10
r=0.08, k=0.1, EPS= Rs. 10
Payout Ratio 40%
P= Rs. 100
P= Rs. 77
P= Rs. 100
P= Rs. 88
P= Rs. 100
P= Rs. 98
P = Rs. 400
Payout Ratio 60%
P=Rs. 150
Payout Ratio 90%
P=Rs. 106
11-14
Irrelevance Theory — Modigliani
and Miller (1961)
• Value of firm is determined solely by the earning power of the
firm’s assets and the manner in which the earnings stream is
split between dividends; and retained earnings does not affect
shareholders’ wealth.
•
Modigliani and Miller (MM): Given the investment decision of
the firm, the dividend payout ratio is a mere detail. It does not
affect the wealth of shareholders.
• Assumptions
– Company has a fixed investment or capital budgeting
program.
– No taxes, transaction costs, or other market imperfections.
– Investors are rational so always prefer more wealth to less
wealth — investors are indifferent between receiving
dividends or capital gains.
11-15
• X Ltd currently has 20000 shares selling at a Mkt
price of Rs. 100 per share. The firm has no
borrowing but has capital reserve of Rs. 300000
which is expected to invest on a project resulting with
NPV of Rs. 200000. The firm also want to pay a
dividend per share of Rs. 15. How does the firm
value be affected (i) if it does not pay any dividend,
(ii) if it pays dividend per share of Rs. 15.
11-16
• The firms current value is =2000,000
• After the investment the value will increase to
2000,000+200000 =2200,000. If the firm does not
pay dividends, the value per share = 2200000/20000
= Rs. 110
• If the firm pay dividends it will use all its
reserves(15*20000 =300000) and it has to issue new
share to raise these funds.
• The value of a share after the dividend (110-15 =95)
• The firm will issue (300000/95=3158 share to raise
Rs. 300000. and the total number of shares is
23158at 95 a share. Thus the total value is
23158*95=220000
11-17
Relevance of dividend policy under
market imperfections
Uncertainty and Shareholders' Preference for Dividend
Many believe that dividend are relevant under condition of
uncertainty as the bird-in-the-hand argument. Investors prefer
dividends than capital gains. Investors prefer near dividends
than future dividends. Near dividends are discounted at lower
discount rates than future dividends because discount rates
increase with uncertainty. This implies that there exists a high
payout clientele who value shares of dividend paying more
than those who do not pay dividends.
11-18
Relevance of dividend policy under
market imperfections
Transaction Cost
Issue of new share involve flotation or issue costs, including
cost of preparing and issuing prospectus, underwriting fee,
brokers’ commission etc. no flotation costs are involved if the
earnings are retained. Thus if flotation costs are considered,
the equivalence between retained earnings and new share
capital is disturbed and the retention of earnings would be
favored over the payment of dividends
11-19
Relevance of dividend policy under
market imperfections
Tax Differential
From tax point of view. A shareholder in high tax bracket
should prefer capital gains over current dividends for two
reasons.
1. A 10 percent withholding tax applies on the dividends paid to
either a resident or a nonresident company.
2. Capital Gain tax is not applicable in Sri Lanka.
As a result of tax advantage of capital gains over dividends strongly
favours a low-dividend payout policy.
11-20
Relevance of dividend policy under
market imperfections
Informational Content of Dividends
The cash payment for dividends conveys to shareholders that
the company is profitable and financially strong. When a firm
changes its dividend policy in a significant manner, investors
assume that it is in response to an expected change in the
firm’s profitability which will last long. An increase in payout
ratio signals to shareholders a permanent or long term
increase in firm’s expected earnings. It is argued that the
announcement of changes in dividend policy influences share
prices, and the managers use the dividend changes to
convey information the future earnings of their companies.
11-21
Dividend Stability
Stability -- maintaining the position of the firm’s
dividend payments in relation to a trend line.
Rs Per Share
4
50% of earnings
paid out as dividends
Earnings per share
3
2
Dividends
per share
1
Time
Dividend Stability
Dividends begin at 50% of earnings, but are stable and
increase only when supported by growth in earnings.
Rs Per Share
4
50% dividend-payout
rate with stability
Earnings per share
3
2
1
Dividends per share
Time
Merits of Dividend Stability
• Information content -- management may be able to affect
the expectations of investors through the informational
content of dividends. A stable dividend suggests that the
company expects stable or growing dividends in the
future.
• Current income desires -- some investors who desire a
specific periodic income will prefer a company with stable
dividends to one with unstable dividends.
• Institutional considerations -- a stable dividend may
permit certain institutional investors to buy the common
stock as they meet the requirements to be placed on the
organizations “approved list.”
Factors Affecting Dividend Policy
Firm’s Investment Opportunities and Financial Needs
Growth firms have a large number of investment
opportunities requiring substantial amount of funds. Hence
growth firms would like to retain earnings over payment of
dividends.
For mature firms investment opportunities occur infrequently.
These firms may distribute most of their earnings.
Theoretically, when the company has an IRR greater than the
return required by shareholders, it would be to the advantage
of shareholders to allow the reinvestment of earnings by the
company.
11-25
Factors Affecting Dividend Policy
Shareholders Expectations
Shareholders’ preference for dividends or capital gains may
depend on their economic status and the tax treatment on
dividends and capital gains.
• Retired and old persons prefer to invest in companies with
regular dividend
• Wealthy investors prefer capital gains to minimize tax
Legal considerations:
– Dividends can only be paid out of profit and are not to be
paid out of capital.
– A dividend cannot be paid if it would make the company
insolvent.
11-26
Factors Affecting Dividend Policy
Liquidity
Greater the Cash position and overall liquidity of a company, the greater
will be its ability to pay dividends.
Financial condition and borrowing capacity
A highly levered company may expect to retain earnings to strengths its
equity base.
Access to the Capital Market
A company that is not sufficiently liquid can still pay dividends if it is able to
raise debt and equity in the capital market.
Inflation
In an inflationary environment, funds generated by depreciation often are
not sufficient to replace a firm’s assets as they become obsolete. Hence a
firm may be forced to retain a higher percentage of earnings to maintain
the asset base.
11-27
Factors Affecting Dividend Policy
Control
when a company pays large dividends, its cash position is
affected. As a result, the company will have to issue new
shares to raise funds to influence its investment programs. If
the existing shareholders don't buy additional shares their
control will be diluted. Hence the shareholders may prefer to
retain earnings to finance the firm’s investment opportunities.
11-28
Forms of dividend
• Cash Dividend
Both the total assets and net worth of the
company are reduced when the cash dividend is
distributed. The market price of the share drops in most
cases by the amount of the cash dividend distributed
• Bonus Shares
Issue of bonus shares is the distribution of
shares free of cost to the existing shareholders. Bonus
issue represents a recapitalization of reserves. The
earnings per share and market price per share falls
proportionately to the bonus issue.
11-29
Bonus share
• Ex: Equity of the X is as follows
Rs. Mn
Paid up Share Capital ( 1 mn shares , Rs. 10 each)
Share premium
Reserve and surplus
10
15
8
Total Equity
33
•
The company decided to offer a 1:10 bonus issue that is 100000 new
shares. At a price of Rs 30 per share the total value of new share
issued will be 3 Mn. This amount is transferred from reserves to share
capital and share premium account
Rs. Mn
Paid up Share Capital ( 1.1 mn shares , Rs. 10 each)
Share premium
Reserve and surplus
11
17
5
Total Equity
33
11-30
• Lets suppose that net earnings of the company are Rs. 2.20 Mn.
Therefore the EPS is Rs 2.20.
• EPS has dropped to Rs. 2 after the bonus issue (Rs. 2.2 Mn/1.1
Mn shares).
• Similarly MPS to Rs 27.27 (30(1-1/1.1)
• However the bonus issue has no impact on the wealth of the
share holders (27.27*1.1)
11-31
Advantages of Bonus Shares
• Tax benefits
• Indication of higher future profits
• Future dividends may increase (if the company pays
a fixed dividend rate)
11-32
Stock Splits
Stock Split -- An increase in the number of
shares outstanding by reducing the par value of
the stock.
• Primarily used to move the stock into a more popular
trading range and increase share demand.
• Assume a company with 200,000 shares of Rs. 10 par
common stock splits 2-for-1. How does this impact the
shareholders’ equity accounts?
Stock Splits
Before 2-for-1 Stock Split
Common stock
(Rs 10 par; 200,000 shares)
Rs 2,000,000
Share premium
1,000,000
Retained earnings
7,000,000
Total shareholders’ equity
Rs10,000,000
After 2-for-1 Stock Split
Common stock
(Rs.5 par; 400,000 shares)
Rs. 2,000,000
Share premium
1,000,000
Retained earnings
7,000,000
Total shareholders’ equity
Rs. 10,000,000
Value to Investors of Stock Splits
•
•
•
•
Indication of higher future profits
Effect on cash dividends
More popular trading range
Informational content