session 08-09 - dividend policy & firm value
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Dividend Decisions
Session No. 8 & 9
Dividend Policy and Firm value
1 Manish Parmar
Key Concepts
2
Understand dividend types and how they
are paid
Understand the difference between cash
and stock dividends
Understand why share repurchases are an
alternative to dividends
Understand the issues surrounding
dividend policy decisions
Dividend payments can be made in
either of the following ways:-
3
Cash Dividend - Payment of cash by the firm to its
shareholders. (Normally companies pay regular
dividends and sometimes it pays special dividend)
Public Ltd companies often pay quarterly or semi
annually i.e. regular Dividend.
Sometimes firms will pay an extra cash dividend,
i.e. Special Dividend.
The extreme case would be a liquidating
dividend.
Dividend payments can be made
in either of the following ways:-
4
Stock Dividend - Distribution of additional shares to
a firm’s Shareholders. (Bonus shares)
Stock Splits – The par value per share is reduced
and the number of shares is increased
proportionately. In both the above cases:-
No cash leaves the firm
The firm increases the number of shares
outstanding
5
TABLE 1 Effect of Bonus Shares and Share Splits
(I) Equity portion before the bonus issue:
Equity share capital (30,000 share of Rs 100 each) Rs 30,00,000
Share premium (@ Rs 25 per share) 7,50,000
Retained earnings 62,50,000
Total equity 1,00,00,000
(II) Equity portion after the bonus issue (1 : 2 ratio):
Equity share capital (45,000 shares of Rs 100 each) 45,00,000
Share premium (45,000 shares × Rs 25) 11,25,000
Retained earnings (Rs 62,50,000 – 15,000 shares × Rs 125) 43,75,000
Total equity 1,00,00,000
(III) Equity portion after the share splits (10 : 1 ratio):
Equity share capital (3,00,000 shares of Rs 10 each) 30,00,000
Share premium 7,50,000
Retained earnings 62,50,000
Total equity 1,00,00,000
Standard Method of Cash
Dividend
6
Record Date – Date on which company
determines existing shareholders.
Ex-Dividend Date - Date that determines
whether a stockholder is entitled to a dividend
payment; anyone holding stock immediately
before this date is entitled to a dividend.
Cash Dividend - Payment of cash by the firm
to its shareholders.
Procedure for Cash Dividend
7
25 Oct. 1 Nov. 2 Nov. 4 Nov. 7 Dec.
Declaration
Date
Cum-
dividend
Date
Ex-
dividend
Date
Record
Date
Payment
Date
…
Declaration Date: The Board of Directors declares a payment
of dividends.
Cum-Dividend Date: Buyer of stock still receives the dividend.
Ex-Dividend Date: Seller of the stock retains the dividend.
Record Date: The corporation prepares a list of all individuals
believed to be stockholders as of 4 November.
8
Price Behavior
In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date.
$P
$P - div
Ex-
dividend
Date
The price drops
by the amount of
the cash
dividend.
-t … -2 -1 0 +1 +2 …
Assumptions: No tax on dividend payments
9
The Irrelevance of Dividend Policy
A compelling case can be made that dividend policy
is irrelevant.
Since investors do not need dividends to convert
shares to cash; they will not pay higher prices for
firms with higher dividends.
In other words, dividend policy will have no impact
on the value of the firm because investors can
create whatever income stream they prefer by using
homemade dividends.
10
Homemade Dividends Bianchi Inc. is a $42 stock about to pay a $2
cash dividend.
Bob Investor owns 80 shares and prefers a $3 dividend.
Bob’s homemade dividend strategy: Sell 2 shares ex-dividend
homemade dividends
Cash from dividend $160
Cash from selling stock $80
Total Cash $240
Value of Stock Holdings $40 × 78 =
$3,120
$3 Dividend
$240
$0
$240
$39 × 80 =
$3,120
11
Dividend Policy is Irrelevant
In the above example, Bob Investor began with
a total wealth of $3,360:
share
42$shares 80360,3$
240$share
39$shares 80360,3$
80$160$share
40$shares 78360,3$
After a $3 dividend, his total wealth is still $3,360:
After a $2 dividend and sale of 2 ex-dividend shares, his total wealth is still $3,360:
12
Dividends and Investment Policy
Firms should never forgo positive NPV projects to
increase a dividend (or to pay a dividend for the first
time).
Recall that one of the assumptions underlying the
dividend-irrelevance argument is: “The investment
policy of the firm is set ahead of time and is not
altered by changes in dividend policy.”
13
Repurchase of Shares
In India, repurchase of shares is commonly known as
buyback of shares.
Instead of declaring cash dividends, firms can get rid
of excess cash through buying shares of their own
stock.
Recently, share repurchase has become an important
way of distributing earnings to shareholders.
Buyback of shares is allowed in India from 1998 (Sec
77A of companies act)
Concept Question
How does share buyback impact companies
financial condition vis-à-vis paying cash
dividends?
14
15
Stock Repurchase versus Dividend
100,000=outstandingShares
1,000,000Value of Firm1,000,000Value of Firm
1,000,000Equity850,000AssetsOther
0Debt$150,000Cash
sheetbalanceOriginalA.
Equity&LiabilitiesAssets
Consider a firm that wishes to distribute $100,000 to its
shareholders.
16
Stock Repurchase versus Dividend
900,000FirmofValue900,000FirmofValue
900,000Equity850,000AssetsOther
0Debt$50,000Cash
dividendcash shareper $1After B.
Equity&sLiabilitieAssets
If they distribute the $100,000 as a cash dividend, the balance
sheet will look like this:
17
Stock Repurchase versus Dividend
Assets Liabilities & Equity
C. After stock repurchase
Cash $50,000 Debt 0
Other Assets 850,000 Equity 900,000
Value of Firm 900,000 Value of Firm 900,000
If they distribute the $100,000 through a stock repurchase, the
balance sheet will look like this:
Concept Question
If the Board of directors hold ESOPS in the
company and they are about to choose
dividend vs buyback decision, what will they
choose?
Let us have a re-look at the balance sheets we
just saw!!
18
19
Stock Repurchase versus Dividend
900,000FirmofValue900,000FirmofValue
900,000Equity850,000AssetsOther
0Debt$50,000Cash
dividendcash shareper $1After B.
Equity&sLiabilitieAssets
If they distribute the $100,000 as a cash dividend, the balance
sheet will look like this:
20
Stock Repurchase versus Dividend
Assets Liabilities & Equity
C. After stock repurchase
Cash $50,000 Debt 0
Other Assets 850,000 Equity 900,000
Value of Firm 900,000 Value of Firm 900,000
If they distribute the $100,000 through a stock repurchase, the
balance sheet will look like this:
21
Stock Repurchase versus Dividend
$9=00,000$900,000/1=shareper Price
100,000=goutstandinShares
900,000FirmofValue900,000FirmofValue
900,000Equity850,000AssetsOther
0Debt$50,000Cash
dividendcash shareper $1After B.
Equity&sLiabilitieAssets
If they distribute the $100,000 as a cash dividend, the balance
sheet will look like this:
22
Stock Repurchase versus Dividend
Assets Liabilities & Equity
C. After stock repurchase
Cash $50,000 Debt 0
Other Assets 850,000 Equity 900,000
Value of Firm 900,000 Value of Firm 900,000
Shares outstanding= 90,000
Price per share = $900,000 / 90,000 = $10
If they distribute the $100,000 through a stock repurchase, the
balance sheet will look like this:
Methods of Share Buybacks in
India
• Open market offer purchase. E.g. HUL, Madras
cements.
• Tender offer. E.g.Bajaj Auto. [Check NSE & BSE
websites for announcements].
• Targeted buybacks. E.g. GESCO.
http://www.rediff.com/money/2001/jan/12inter.htm
• Book Building process to buyback shares.23
Regulation of buybacks (Sec
77A)
A company can buyback 10 percent of its
shares annually with board resolution.
Beyond that a special resolution is required.
The buyback should not exceed 25 percent of
the total paid up capital and free reserves.
The post-buyback debt-equity ratio should
not exceed 2:124
Regulation of buybacks…Contd
The shares bought should be extinguished &
physically destroyed.
A declaration of solvency has to be filed with
SEBI & registrar of companies.
The company should not make further issue
within a prescribed time limit.
25
SEBI'S PROPOSALS
(BT article* as on 25/01/2013)
Buy-back period to be reduced to three
months from 12.
Minimum buy-back to be 50 per cent of the
proposed size.
25 per cent of the amount earmarked for buy-
back to be kept in an escrow account
Capital raising from equity markets to be
prohibited for two years after a buy-back
* Will SEBI's proposals help in checking misuse of the share buy-back
route by companies _ Business Today.pdf
26
27
Dividend Vs Buyback: Real world
considerations
Flexibility.
Keeps stock price higher, good for insiders who hold
stock options (Previous Example)
Undervaluation-(Signaling theory)
Taxation (Discussed in detailed after few slides)
28
Personal Taxes and Dividends
To get the result that dividend policy is irrelevant, we needed three assumptions:
No taxes
No transactions costs
No uncertainty
In the United States, both cash dividends and capital gains are taxed at a maximum rate of 15 percent. (In India-?)
Section 46A of Income Tax
Act.Capital Gains on buyback of its own shares:-
The difference between the cost of acquisition
and the value of consideration received by the
shareholder shall be deemed to be the capital gains
arising to such shareholder
Are all capital gains taxable? LTCG on transfer of
equity shares listed on a stock exchange in India,
where STT has been paid, is tax exempt, while STCG
in the same situation is taxed at a rate of 15% Dividends : Companies pay DDT @15% & Dividends are
exempt in investors hand.
29
30
Firms without Sufficient Cash
In a world of personal taxes,
firms should not issue stock
to pay a dividend.
FirmStock
Holders
Cash: stock issue
Cash: dividends
Gov.
Taxes
Investment Bankers The direct costs of stock issuance will add to this effect.
31
Firms with Sufficient Cash
The above argument does not necessarily apply to
firms with excess cash.
Consider a firm that has $1 million in cash after
selecting all available positive NPV projects.
Select additional capital budgeting projects (by
assumption, these are negative NPV).
Acquire other companies
Purchase financial assets
Repurchase shares
32
The Clientele Effect
Clienteles for various dividend payout policies are
likely to form in the following way:
Stock Type
Zero-to-Low payout (Prefer Capital gains)
Low-to-Medium payout
Medium payout
High payout (Prefer Stable income)
Once the clienteles have been satisfied, a corporation is
unlikely to create value by changing its dividend policy.
33
DIVIDEND POLICY : STABILITY
Steadily Changing Dividends
Earnings/Dividends
Earnings
Dividends
Time
34
What We Know and Do Not Know Corporations “smooth” dividends.
Dividends provide information to the market.
(Signaling)
Firms should follow a sensible policy:
Do not forgo positive NPV projects just to pay a
dividend.
Avoid issuing stock & debt to pay dividends.
Consider share repurchase when there are few better
uses for the cash.
35
Stock Dividends & Stock Splits• Stock Dividends: Pay additional shares of stock
instead of cash
• Increases the number of outstanding shares
• Stock splits – essentially the same as a stock dividend
except it is expressed as a ratio
• For example, a 2 for 1 stock split is the same as a
100% stock dividend.
• Stock price is reduced when the stock splits.
• Common explanation for split is to return price to a
“more desirable trading range.”
Other factors affecting dividend
policy Legal constraints
The companies are not allowed to declare
dividends when they have overdue liabilities or
are bankrupt.
Contractual constraints
Restrictive provisions in loan agreements & bond
indentures.
Internal constraints; like liquidity problems.
*Fresh loans can be taken…but its not advisable.36
We had a good discussion on
theoretical concepts….lets do a
practical case
….next session….case is FPL
37
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