DIVIDEND POLICY AND FIRM VALUE

OUTLINE Models in Which Investment and Dividend Decisions are Related

Traditional Position
Miller and Modigliani Position Rational Expectations Hypothesis Radical Position Overall Picture Dividend Policy

MODELS IN WHICH INVESTMENT AND DIVIDEND DECISIONS ARE RELATED

Walter Model

Gordon Model

WALTER MODEL
D + (E D) r/k P= k where: P = price per equity share E = earnings per share D = dividend per share r = rate of return on investments k = cost of equity capital Example E = Rs.4, D = Rs.2, r = 0.20, k = 0.15 2 + 2 x 0.20/0.15 P= 0.15 = 31.11

IMPLICATIONS OF THE WALTER MODEL The optimal payout ratio for a growth firm (r > k) is nil

The optimal payout ratio for a normal firm (r = k) is

irrelevant The optimal payout ratio for a declining firm (r < k) is 100 percent

GORDON MODEL
E1 (1 b)
P0 = where k br P0 = price per share at the end of year 0 E1 = earnings per share at the end of year 1 (1 b) = dividend payout ratio b = ploughback ratio k = shareholders required rate of return r = rate of return earned on investments made by the firm br = growth rate of earnings / dividends Example

r = 0.20, k = 0.15, E1 = 4.0, b = 0.25

4.0 (1 0.25) P0 = = Rs.30 0.15 (0.25) (0.20)

IMPLICATIONS The optimal payout ratio for a growth firm (r > k) is nil

The payout ratio for a normal firm is irrelevant

The optimal payout ratio for a declining firm (r < k) is 100 percent

TRADITIONAL POSITION 4D P=m + R

where P = market price per share

D = dividend per share

R = retained earnings per share

m = a multiplier

MILLER AND MODIGLIANI (MM) POSITION

MM have argued that the value of a firm depends solely on its earning power and is not influenced by the manner in which earnings are split between dividends and retained earnings
Current Income

Dividends

Earnings

Retained Earnings

Capital Apprecn

MM ASSUMPTIONS There is no tax advantage or disadvantage associated with dividends. Investment and dividend decisions are independent.

Firms can issue stock without incurring any floatation or

transaction costs.

CRITICISMS OF MM POSITION Critics of MM agree that, under the assumptions made by

MM, dividends are irrelevant. However, they dispute the

validity of the dividend irrelevance theorem by

challenging the assumptions used by MM.

CRITICISMS OF MM POSITION

Information about Prospects

Uncertainty and Fluctuations

Offering of Additional Equity at Lower Prices

Issue Cost

Transaction Costs
Differential Rates of Taxes Rationing Unwise Investments

RATIONAL EXPECTATIONS HYPOTHESIS

What matters in economics is not what actually happens

but the difference between what actually happens and

what was supposed to happen.

RATIONAL EXPECTATIONS

HYPOTHESIS
In a world of rational expectations, unexpected dividend announcements would transmit messages about changes in earnings potential which were not incorporated in the market price earlier.

The reappraisal that occurs as a result of these signals leads to price movements which look like responses to the dividends themselves, though they are actually caused by an underlying revision of the estimate of earnings potential.

RATIONAL EXPECTATIONS

HYPOTHESIS
The above analysis is helpful in reconciling the

practitioners view that dividends matter very much and

the academic view that dividends do not matter. As Merton

Miller said: Both views are correct in their own way. The
academic is thinking of the expected dividend; the

practitioner of the unexpected

RADICAL POSITION Directly or indirectly dividends are generally taxed more heavily than capital gains. So radicalists argue that firms should pay as little dividends as they can get away with so that investors earn more by way of capital gains and less by way of dividends

EFFECT OF DIVIDEND POLICY ON REQUIRED RETURN

Firm A (No Dividend) 1. Next years price 2. Dividend 3. Total pre-tax payoff 4. Current price 5. Capital gain 6. Pre-tax rate of return [(2) + (5)]/ (4) 7. Tax on dividend at 20 percent 8. Tax on capital gains at 10 percent 9. Total post-tax income Rs 120 0 Rs 120 Rs 102.86 Rs 17.14 16.67% Rs 1.714 Rs 15.426 Firm B (High Dividend) Rs 105 Rs 15 Rs 120 Rs 101.43 Rs 3.57 18.31% Rs 3 Rs 0.357 Rs 15.213

10. Post-tax rate of return

15.426 = 15% 102.86

15.213 = 15% 101.43

DIVIDEND DECISION

OUTLINE

Why Firms Pay Dividends

Dividend Policy : Payout Ratio

Dividend Policy : Stability

Dividend as a Residual Payment Corporate Dividend Behaviour Legal and Procedural Aspects of Dividends Bonus Shares and Stock Splits Share Buyback Dividend Policy in Practice

WHY FIRMS PAY DIVIDENDS Plausible Reasons Investor preference for dividends Information signaling

Dubious Reasons for Paying Dividends

Bird-in-hand fallacy

Temporary excess cash

DIVIDEND POLICY : PAYOUT RATIO

The considerations relevant for determining the dividend payout ratio are: Funds requirement Liquidity Access to external sources of financing

Shareholder preferences
Difference in the cost of external equity and retained earnings Control Taxes

DIVIDEND POLICY : STABILITY Stable Dividend Payout Ratio

Earnings/Dividends

Earnings

Dividends

Time

DIVIDEND POLICY : STABILITY Steadily Changing Dividends

Earnings/Dividends Earnings

Dividends

Time

KEY CONSIDERATIONS IN FORMULATING

THE DIVIDEND POLICY

Investment decisions have the greatest impact on value creation.

External equity is more expensive than internal equity (retained earnings) because of issue costs and underpricing.
Most promoters are averse to dilute their stake in equity and hence are reluctant to issue external equity. There is a limit beyond which a firm would have real difficulty in raising debt financing.

The dividend decision of the firm is an important means by which the management conveys information about the prospects of the firm.

GUIDELINES FOR DIVIDEND POLICY

Dont pay dividends at the expense of positive NPV projects. Minimise the need to sell external equity.

Define a target dividend payout ratio along with a target debt-equity ratio, taking into account the investment needs, managerial preferences, capital market norms, and tax code. Accept temporary departures from the target dividend payout ratio and the target debt-equity ratio.
Avoid dividend cuts. In essence, the above guidelines imply that a firm should pursue a smoothed residual dividend policy and not a pure residual dividend policy or a fixed dividend payout policy.

DIVIDEND STREAM UNDER DIFFERENT POLICIES

Earnings Et Investment budget Equity investment Ite Pure residual dividends Dt Fixed dividend payout ratio Dt (pt = 0.55) Smoothed residual dividends

1 150.0 137.0 68.5 81.5 82.5

2 3 4 5 6 Total 190.0 140.0 220.0 280.0 250.0 1230.0 160.0 180.0 200.0 210.0 220.0 1107.0 80.0 90.0 100.0 105.0 110.0 553.5 110.0 50.0 120.0 175.0 140.0 676.5 104.0 77.0 121.0 154.0 137.5 676.5 676.5

105.0 105.0 106.5 120.0 120.0 120.0

CONFERENCE BOARD SURVEY

A survey of dividend policies and practice, conducted by the Conference Board in the U.S., revealed that five considerations or guidelines were dominant in the minds of dividend decision makers:
The companys earnings record and its future prospects. The companys record of continuity or regularity of dividend payments. The need to maintain a stable rate of dividends per share of stock.

The companys cash flow, present cash position, and the anticipated need for funds.
The needs and expectation of the owners of the common stock.

CORPORATE DIVIDEND BEHAVIOUR

Lintners survey of corporate dividend behaviour showed that:
Firms set long-run target payout ratios. Managers are concerned more about the change in the dividend than the absolute level.

Dividends tend to follow earnings, but dividends follow a smoother path than earnings.
Dividends are sticky in nature because managers have a reluctance to effect dividend changes that may have to be reversed.

LINTNERS MODEL
Lintner expressed corporate dividend behaviour in the form of the following model:

Dt = cr EPSt + (1-c) Dt-1

where Dt = dividend per share for year t c r = adjustment rate = target payout rate

EPSt = earnings per share for year t Dt-1 = dividend per share for year t-1

EXAMPLE OF LINTNERS MODEL Kinematics Ltd. has earnings per share of Rs 4.00 for year t. Its dividend per share for year t 1 was Rs 1.50. Assume that the target payout ratio and the adjustment rate for this firm are 0.6 and 0.5, respectively. What would be the dividend per share for Kinematics Ltd. for year t, if the Lintner model applies to it? Kinematics dividend per share for year t would be: 0.5 x 0.6 x Rs 4.00 + 0.5 x Rs 1.5 = 1.95

LEGAL ASPECTS
The key provisions of company law pertaining to dividends are:
Companies can pay only cash dividends (with the exception of bonus shares). Dividends can be declared for any financial year only out of the profits of the company for that year arrived at after providing for depreciation in accordance with the provisions of Section 205 or out of the profits of the company for any previous financial year or years arrived at after. The Companies (Transfer to Reserves) Rules, 1975, provide that before dividend declaration a specified percentage of profit should be transferred to the reserves of the company.

BONUS SHARES A bonus issue represents capitalisation of free reserves built out of the genuine profits or share premium collected in cash only In the wake of a bonus issue: (a) The shareholders proportional ownership remains unchanged. (a) The book value per share, the earnings per share,

and the market price per share decrease, but the

number of shares increases.

STOCK SPLITS
In a stock split the par value per share is reduced and the number of shares is increased proportionately
A comparison between a bonus issue and a stock split is given below:

Bonus Issue
The par value of the share is unchanged A part of reserves is capitalised

Stock Split
The par value of the share is reduced There is no capitalisation of reserves

The shareholders proportional ownership remains unchanged

The shareholders proportional ownership remains unchanged

The book value per share, the The book value per share, the earnings per share, and the earnings per share, and the market market price per share decline price per share decline The market price per share is The market price per share is brought within a more popular brought within a popular trading trading range. range.

SHARE BUYBACKS Share buybacks, referred to as equity repurchases or stock repurchases in the US, have become possible since

1998 in India.
In India, corporates generally choose the open market

purchase method. Under this method, a company buys

shares from the secondary market over a period of one year subject to a maximum price fixed by the board/shareholders

RATIONALE FOR BUYBACKS Efficient allocation of resources Price stability Tax advantage

Control
Voluntary Character No implied commitment

OBJECTIONS TO BUYBACKS

Unfair advantage

Manipulation

SURVEY FINDINGS A survey of equity repurchases in the US, conducted by S.G.Badrinath and Nikhil Varaiya, suggested five basic reasons for equity repurchases: To boost stock price. To rationalise the companys capital structure. To substitute for cash dividends. To prevent dilution from stock market grants. To give excessive cash back to shareholders.

REGULATION OF BUYBACKS
.

A company can buyback 10 percent of its shares annually with board resolution. Beyond that a special resolution of shareholders is required. The post-buyback debt-equity ratio should not exceed 2:1
The buyback should not exceed 25 percent of the total paid up capital and free reserves.

After completing a buyback programme, a company should not make a further issue of equity securities within a period of 6 months, except in certain cases. A buyback cannot be done through negotiated deals.
The buyback process has to be handled by a merchant banker/s duly appointed by the company.

DIVIDEND POLICIES IN PRACTICE

Generous dividend and bonus policy

More or less fixed dividend policy

Erratic dividend policy

SUMMING UP
There are several views on the relationship between dividend policy and share valuation. According to the Walter model and the Gordon model the effect of dividend policy depends on the relationship between the rate of return on investments and the cost of capital. According to the traditional position the stock market places more weight on dividends than on retained earnings. Miller and Modigliani have advanced the view that the value of a firm is independent of its dividend policy. According to the critics of Miller and Modigliani, dividends matter because of uncertainty characterising the future, imperfections in the capital market, and presence of taxes. In a world of rational expectations, unexpected dividend announcements would transmit messages about changes in earnings potential which were not incorporated in the market price earlier. The radical position argues that a lower dividend payout ratio promotes the welfare of shareholders.

SUMMING UP
There are several reasons for paying dividends, some plausible and some dubious.
The two important dimensions of a firms dividend policy are: what should be the average payout ratio? How stable should the dividends be over time? The smoothed residual dividend approach, which produces a stable and steadily growing stream of dividend, often appears to be the most sensible approach in practice. Lintners classic study of corporate dividend behaviour showed that firms think primarily in terms of the proportion of earnings that should be ploughed back in the firm and firms try to reach the target payout ratio gradually over time.

 The amount of dividend that can be legally distributed is governed by company law. The important events and dates in the dividend payment procedure are: board resolution, shareholder approval, record date, and dividend payment. Bonus shares are shares issued to existing shareholders as a result of capitalisation of reserves.

In a stock split the par value per share is reduced and the number of share is increased proportionately.
In a share buyback a company purchases its own shares from the stock market.