Amity School Of Business

DIVIDEND DECISIONS
MODULE 5

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WHAT ARE DIVIDENDS?

Dividends refer to the corporate net profits distributed among shareholders. There is inverse relationship between retained earnings and cash dividends. Dividend decision is an important decision and hinges on the effect of the decision on the maximization of shareholders wealth.

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FACTORS DETERMINING DIVIDEND POLICY OF A FIRM

Dividend payout ratio Stability of dividends Legal, contractual and internal constraints and restrictions Owners considerations Capital market considerations Inflation

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(a) Dividend payout Ratio

It is the percentage of the net earnings distributed to the shareholders as dividends. It involves decision to payout earnings or to retain them for re-investment. Indicates the percentage earnings distributed to shareholders in cash, calculated by dividing the cash dividend per share by its earnings per share.

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(b)Stability of dividends
Dividend stability refers to the payment of a certain minimum amount of dividend regularly. (i) Constant dividend per share: is a policy of paying certain fixed amount per share as dividend. (ii) Constant payout ratio: is a policy to pay a constant percentage of net earnings as dividend to shareholders in each dividend period.

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Why investors prefer stable dividend policy? Desire for current income Informational contenets Requirements of institutional investors

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(c)Legal ,Contractual and internal constraints and restrictions

Legal requirements Capital Impairment rules Net profits Insolvency Contractual requirements Internal constraints Liquid assets Growth prospects

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Continued..
Financial requirements Availability of funds Earnings stability Control (d) Owners' Considerations Taxes Opportunities Dilution of ownership

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Continued..
(e) Capital market considerations (f) Inflation

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Forms of Dividend
Cash Dividend. Bonus Shares

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Advantages of bonus shares

To Shareholders
Tax Benefit Indication of higher future profits Future dividends may increase Psychological Value

To Company
Conservation of cash Only means under financial crisis More attractive share Price

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TWO SCHOOLS OF THOUGHT

According to one, dividends are irrelevant so that amount of dividends paid have no effect on the value of the firm. The other one considers the dividend decision as relevant to the value of the firm .

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RELEVANCE OF DIVIDENDS
Dividend relevance implies that shareholders prefer current dividends and there is no direct relationship between dividend policy and market value of a firm. Two theories representing this notion are: (i) Walters model (ii) Gordons model

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WALTERS MODEL
The choice of an appropriate dividend policy affects the value of an enterprise. The key argument in support is the relationship between the return on a firms investment (r ) and its cost of capital(k). Three types of firms: (a) Growth firms (b) Decline firms (c) Normal firms

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Continued
Type of firm Growth firm Normal firm Decline firm

Relation r>k between r and k D/P ratio Zero

r=k

r<k

Market price of the share

Maximized by retained earnings

Anything between 0 to 100 Constant

100%

Maximized by distribution of dividends

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ASSUMPTIONS
All financing through retained earnings, no external sources of funds No change in Business risk No change in key variables like D and E Firm has a perpetual life

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LIMITATIONS
Model applicable to all equity firms. Assumes that r is constant.

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Walters Model
P = DIV+(r / k)(EPS-DIV) k

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GORDONS MODEL
Assumptions Firm is an all equity firm r and k are constant Firm has perpetual life Retention ratio once decided is constant. Thus, growth rate(g= br) is also constant. ke > br

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ARGUMENTS
The crux of Gordon's arguments is a two fold assumption: (i) Investors are risk averse (ii) They put a premium on certain return and discount /penalize uncertain returns

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Continued
As investors are rational, so they avoid risk. Payments of current dividends completely removes the chances of any risk. Investors discount future dividend i.e. They would place less importance to it than the current dividends. The above model underlying Gordon's model of dividend relevance is also described as the bird-in hand argument.

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Continued..
Investors would like to avoid uncertainty and would be inclined to pay higher price for those shares on which current dividends are paid. The omission of dividends or payment of low dividends would lower the value of the shares. The value of market price of the share( P) increases with the increase in the D/P ratio, and is maximum when there are no retentions.

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Gordons Model
P0 = DIV1 / (ke - gn)

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IRRELEVANCE OF DIVIDENDS
Dividend policy of a firm is a part of the financing decision. Dividend policy of a firm is a residual decision and dividends are a passive residual. It implies that when firm has sufficient investment opportunities ,it will retain the earnings to finance them.

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MM HYPOTHESIS
The argument in support of the irrelevance of dividends is provided by MM hypothesis. Dividend irrelevance implies that the value of the firm is unaffected by the distribution of dividends and is determined solely by the earning power and risk of its assets.

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ASSUMPTIONS OF MM HYPOTHESIS
Perfect capital markets No taxes Investment policy which does not change Investors are able to forecast future prices with certainty

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CRUX OF THE ARGUMENT

The crux of the MM position on the irrelevance of dividend is the arbitrage argument. Arbitrage implies the distribution of earnings to shareholders and raising an equal amount externally, the effect of dividend payment would be offset by the effect of raising additional funds.

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CRITICISIMS OF MM APPROACH

(A)

The validity of MM approach is open to question on two counts: Market Imperfection Tax effect Flotation costs Transaction and inconvenience costs Institutional restrictions

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Continued.
(B) Resolution of uncertainty
Near Vs Distant Dividend Informational content of dividends Preference for current income Under pricing The arguments in support of MM do not stand the test of scrutiny under real world/business situations

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WHAT ARE STOCK SPLITS?

A stock split is a corporate action which splits the existing shares of a particular face value into smaller denominations so that the number of shares increase, however, the market capitalization or the value of shares held by the investors post split remains the same as that before the split. As the price of a security gets higher and higher, some investors may feel the price is too high for them to buy, or small investors may feel it is unaffordable. Splitting the stock brings the share price down to a more "attractive" level

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Reserve stock split

A reduction in the number of a corporation's shares outstanding that increases the par value of its stock or its earnings per share. The market value of the total number of shares (market capitalization) remains the same. For example, a 1-for-2 reverse split means you get half as many shares, but at twice the price.

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BUYBACK OF SHARES
A buyback can be seen as a method for company to invest in itself by buying shares from other investors in the market. Buybacks reduce the number of shares outstanding in the market. Buy back is done by the company with the purpose to improve the liquidity in its shares and enhance the shareholders wealth.

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BONUS SHARES
Bonus shares involve payment to existing owners of dividend in the form of shares. New shares are issued to shareholders in proportion to their holdings ie. Shares are issued on pro rata basis to the current shareholders while the firms assets, its earnings ,risk being assumed and investors percentage ownership in the company remains unchanged. For example, the company may give one bonus share for every five shares held.