Dividend Dividend refers to the corporate net profits distributed among shareholders. Dividends can be both preference dividends and equity dividends. Preference dividends are fixed dividends paid as a percentage every year to the preference shareholders if net earnings are positive. After the payment of preference dividends, the remaining net profits are paid or retained or both depending upon the decision taken by the management. Determinants of Dividend Policy The main determinants of dividend policy of a firm can be classified into: 1. 2. 3. 4. 5. 6. Dividend payout ratio Stability of dividends Legal, contractual and internal constraints and restrictions Owner's considerations Capital market considerations and Inflation.
1. Dividend payout ratio Dividend payout ratio refers to the percentage share of the net earnings distributed to the shareholders as dividends. Dividend policy involves the decision to pay out earnings or to retain them for reinvestment in the firm. The retained earnings constitute a source of finance. The optimum dividend policy should strike a balance between current dividends and future growth which maximizes the price of the firm's shares. The dividend payout ratio of a firm should be determined with reference to two basic objectives maximizing the wealth of the firms owners and providing sufficient funds to finance growth. These objectives are interrelated. 2. Stability of dividends Dividend stability refers to the payment of a certain minimum amount of dividend regularly. The stability of dividends can take any of the following three forms:
a. constant dividend per share b. constant dividend payout ratio or c. constant dividend per share plus extra dividend 3. Legal, contractual and internal constraints and restrictions Legal stipulations do not require a dividend declaration but they specify the conditions under which dividends must be paid. Such conditions pertain to capital impairment, net profits and insolvency. Important contractual restrictions may be accepted by the company regarding payment of dividends when the company obtains external funds. These restrictions may cause the firm to restrict the payment of cash dividends until a certain level of earnings has been achieved or limit the amount of dividends paid to a certain amount or percentage of earnings. Internal constraints are unique to a firm and include liquid assets, growth prospects, financial requirements, availability of funds, earnings stability and control. 4. Owner's considerations The dividend policy is also likely to be affected by the owner's considerations of the tax status of the shareholders, their opportunities of investment and the dilution of ownership. 5. Capital market considerations The extent to which the firm has access to the capital markets, also affects the dividend policy. In case the firm has easy access to the capital market, it can follow a liberal dividend policy. If the firm has only limited access to capital markets, it is likely to adopt a low dividend payout ratio. Such companies rely on retained earnings as a major source of financing for future growth. 6. Inflation With rising prices due to inflation, the funds generated from depreciation may not be sufficient to replace obsolete equipments and machinery. So, they may have to rely upon retained earnings as a source of fund to replace those assets. Thus, inflation affects dividend payout ratio in the negative side. Bonus shares and stock splits
Bonus share is referred to as stock dividend. They involve payment to existing owners of dividend in the form of shares. It is an integral part of dividend policy of a firm to use bonus shares and stock splits. A stock split is a method commonly used to lower the market price of shares by increasing the number of shares belonging to each shareholder. Bonus shares may be issued to satisfy the existing shareholders in a situation where cash position has to be maintained.
Dividend Capitalization model: According to Gordon, the market value of a share is equal to the present value of the future streams of dividends. P= E(1 - b) Ke - br
Where: P =Price of a share E =Earnings per share b =Retention ratio 1=Dividend payout ratio b Cost of capital or the Ke = capitalization rate Growth rate (rate or return br =on investment of an all-g equity firm) Example: Determination of value of shares, given the following data: Case Case A B 40 30 60 70
P=
$62.50 =>(Case B)
Gordon's model thus asserts that the dividend decision has a bearing on the market price of the shares and that the market price of the share is favorably affected with more dividends.
P=
D Ke g
Where:P =Price of equity shares D =Initial dividend Ke=Cost of equity capital g =Growth rate expected
After accounting for retained earnings, the model would be:
P=
D Ke rb
Where:r =Expected rate of return on firms investments b =Retention rate (E D)/E Equation showing the value of a share (as present value of all dividends plus the present value of all capital gains) Walter's model: P= D + r/ke(E - D) ke Where:D=Dividend per share and E =Earnings per share Example: A company has the following facts: Cost of capital (ke) = 0.10 Earnings per share (E) = $10 Rate of return on investments ( r) = 8%
Dividend payout ratio: Case A: 50% Case B: 25% Show the effect of the dividend policy on the market price of the shares. Solution: Case A: D/P ratio = 50% When EPS = $10 and D/P ratio is 50%, D = 10 x 50% = $5 5 + [0.08 / 0.10] [10 P= 5] => $90 0.10 Case B: D/P ratio = 25% When EPS = $10 and D/P ratio is 25%, D = 10 x 25% = $2.5 2.5 + [0.08 / 0.10] [10 P= - 2.5] => $85 0.10 Conclusions of Walter's model: 1. When r > ke, the value of shares is inversely related to the D/P ratio. As the D/P ratio increases, the market value of shares decline. Its value is the highest when D/P ratio is 0. So, if the firm retains its earnings entirely, it will maximize the market value of the shares. The optimum payout ratio is zero. 2. When r < ke, the D/P ratio and the value of shares are positively correlated. As the D/P ratio increases, the market price of the shares also increases. The optimum payout ratio is 100%. 3. When r = ke, the market value of shares is constant irrespective of the D/P ratio. In this case, there is no optimum D/P ratio. Limitations of this model:
1. Walter's model assumes that the firm's investments are purely financed by retained earnings. So this model would be applicable only to all-equity firms. 2. The assumption of r as constant is not realistic. 3. The assumption of a constant ke ignores the effect of risk on the value of the firm.
gained by the investors as a result of increased dividends will be neutralized completely by the reduction in the market value of the shares. 3. The cost of capital is independent of leverage and the real cost of debt is the same as the real cost of equity, according to this model. 4. Those investors are indifferent between dividend and retained earnings imply that the dividend decision is irrelevant. With dividends being irrelevant, a firms cost of capital would be independent of its dividendpayout ratio. 5. Arbitrage process will ensure that under conditions of uncertainty also the dividend policy would be irrelevant. MM Model: Market price of the share in the beginning of the period = Present value of dividends paid at the end of the period + Market price of share at the end of the period. P0 = 1/(1 + ke) x (D1 + P1) Prevailing Where:P0 =market price of a share cost of equity ke = capital Dividend to be received at D1= the end of period 1 and Market price of a share at P1 = the end of period 1. (n + Value of n) P1 the = I+E firm, nP0 (1 + ke) Where:n = number of shares outstanding at the beginning of the period change in the number of shares = n outstanding during the period/
additional shares issued. Total amount required for I = investment Earnings of the firm during the E= period. Example: A company whose capitalization rate is 10% has outstanding shares of 25,000 selling at $100 each. The firm is expecting to pay a dividend of $5 per share at the end of the current financial year. The company's expected net earnings are $250,000 and the new proposed investment requires $500,000. Prove that using MM model, the payment of dividend does not affect the value of the firm. Solution: 1. Value of the firm when dividends are paid: i. Price per share at the end of year 1: P0 = 1/(1 + ke) x (D1 + P1) $100 = 1/(1 + 0.10) x ($5 + P1) P1 = $105 Amount required to be raised from the issue of new shares: n P1 = I (E nD1) => $500,000 ($250,000 - $125,000) => $375,000 Number of additional shares to be issued: n = $375,000 / 105 => 3571.42857 shares (unrounded) Value of the firm: => (25,000 + 3571.42857) (105) $500,000 + $250,000 (1 + 0.10) => $2,500,000 2. Value of the firm when dividends are not paid: i. Price per share at the end of year 1: P0 = 1/(1 + ke) x (D1 + P1) $100 = 1/(1 + 0.10) x ($0 + P1) P1 = $110
ii.
iii. iv.
Amount required to be raised from the issue of new shares: => $500,000 ($250,000 -0) = $250,000 Number of additional shares to be issued: => $250,000/$110 = 2272.7273 shares (unrounded) Value of the firm: => (25,000 + 2272.7273) (110) $500,000 + $250,000 (1 + 0.10) => $2,500,000
Thus, according to MM model, the value of the firm remains the same whether dividends are paid or not. This example proves that the shareholders are indifferent between the retention of profits and the payment of dividend. Limitations of MM model: 1. The assumption of perfect capital market is unrealistic. Practically, there are taxes, floatation costs and transaction costs. 2. Investors cannot be indifferent between dividend and retained earnings under conditions of uncertainty. This can be proved at least with the aspects of i) near Vs distant dividends, ii) informational content of dividends, iii) preference for current income and iv) sale of stock at uncertain price.