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PAYOUT DECISION Dr.P. D. Das CIME, BHUBANESWAR

Introduction • A profitable company regularly face three important questions: 1. How much of its free cash flow should it pass on to shareholders? 2. Should it provide this cash to stockholders by raising the dividend or by repurchasing stocks? 3. Should it maintain a stable, consistent payment policy, or should it let the payment vary as conditions change?

DIVIDENDS Dividend is a portion of the profits distributed to shareholders in a company and is usually expressed as a percentage of nominal value of shares. Dividends are often paid in cash, though in theory other forms also exit.

FORMS OF DIVIDEND • Mostly dividends are paid in cash, but there are also other forms such as Scrip dividends, Debenture dividends, Stock dividends, and, in unusual circumstances, Property dividends. • These are briefly described :

Scrip Dividends • Dividends can be paid only out of profits earned in the particular year or in the past reflected in the company's accumulated reserves. • Profits do not necessarily mean adequate cash to enable payment of cash dividends. • In case the company does not have a comfortable cash position it may issue promissory notes payable in a few months. It may also issue convertible dividend warrants redeemable in a few years.

Debenture Dividends • Companies may also issue debentures in lieu of dividends to their shareholders. These debentures bear interest and are payable after a prescribed period. • It is just like creating a long-term debt. Such a practice is not common.

Bonus Shares or Stock Dividends • Instead of paying dividends out of accumulated reserves, the latter may be capitalized by issue of bonus shares to the shareholders. Thus, while the funds continue to remain with the company; the shareholders acquire the right and this way their market-able equity increases. • They can either retain their bonus shares and thus be entitled to increased total dividend or can sell their bonus shares and realize cash. • Ordinarily, bonus shares are not issued in lieu of dividends. They are periodically issued by prosperous companies in addition to usual dividends, Certain guidelines, as laid down by the government, are applicable for issue of bonus shares in India.

Property Dividends • This form of dividend is unusual. Such dividend may be in the form of inventory or securities in lieu of cash payment. A company sometimes may hold shares of other companies, e.g., its subsidiaries that it may like to distribute among its own shareholders, instead of paying dividend in cash. • In case the company sells these shares it may have to pay capital gains, which may be subject to taxation. If these shares are transferred to its shareholders, there is no tax liability.

TYPES OF DIVIDEND • Interim Dividend - An interim dividend is one which is declared before the declaration of the final dividend. It is a dividend declared between two annual general meetings. • Final Dividend - at the end of the accounting period, the accounts of the company are prepared to ascertain the amount of profit earned by the company. The directors take into account the final position of the company’s future prospects and decide to recommend to the shareholders at the AGM the dividend to be paid to shareholders.

DIFFERENT WAYS OF PAYING DIVIDENDS.

• Cash Dividend: It takes various forms: 1. Regular cash dividend – cash payments made directly to stockholders, usually each quarter 2. Extra cash dividend – indication that the “extra” amount may not be repeated in the future 3. Special cash dividend – similar to extra dividend, but definitely won’t be repeated 4. Liquidating dividend – some or all of the business has been sold

• Stock Dividends: 1. Pay additional shares of stock instead of cash. 2. Increases the number of outstanding shares. 3. Small stock dividend – a. Less than 20 to 25% – b. If you own 100 shares and the company declared a 10% stock dividend, you would receive an additional 10 shares

4. Large stock dividend – more than 20 to 25%

Some important dates in paying dividends • Declaration date - the board of directors declare the dividends. • Ex-Dividend date - The date from which the stock begins to trade without the right to receive dividend declared. – a. Occurs two business days before date of record – b. If you buy stock on or after this date, you will not receive the dividend – c. Stock price generally drops by about the amount of the dividend

• Record Date - The dividend payment will be made to the members whose names appear in the registrar of members on a particular date. • Payment date - The date on which the company actually mails the dividend warrants.

Example: • For every share you hold. Suppose you hold a share worth Rs.10. • Dates: |_________|___________|__________|____ 1/15 1/26 Declaration Ex-dividend Date Date

1/30 Record Date

2/15 Payment Date

• Are you eligible for the dividend? • Yes. If you hold the share prior to the ex-dividend date you will receive the dividend.

• Should the price of your share be affected after you have received the dividend? • The stock price will fall by the amount of the dividend on the ex-date (Time 0). • If you get dividend of Re1 per share and the stock price is Rs.10 per price of your share on ex-date will be Rs. 9 per share (10-1)

Can you tell me the important components of shareholders return? • Dividends (Payout). Anything else that comes to your mind. • What if the firm does not pay dividend? • Yes, it is the capital gains from the investment of that retained money (Retained earnings). You know that either decision will affect the value of the firm. Therefore the most crucial issues for a firm in paying dividends contribute the following elements: • 1. High or low payout? • 2. How frequent? • 3. Do we announce the policy? • 4. Amount in near future & long term • 5. Stable or irregular dividends?

• I hope you agree that the most important aspect of dividend policy is to determine the amount of earnings to be distributed to shareholders and the amount to be retained in the firm with an objective to maximize shareholder’s return. • Lets try to analyze the above statement with the help of a practical example.

• Before taking the example you should know that: • Growth rate is the product of ROE & Retention ratio

g = ROE * b Ex: Now, let’s assume that there are two companies A & B. Both have ROE of 20% and the worth of one share is Rs 10. Company A has a high payout policy of 80% and Company B has a low payout policy of 20%. Now, we will see the consequence of both the policies of companies A & B:

Company A (High payout) Year

Equity

Earnings @ 20%

Dividends

1 2 3 4 5 10 15 20

100 104 108.16 112.48 116.98 142.33 173.17 210.68

20 20.8 21.63 22.5 23.4 28.47 34.63 42.14

16 16.64 17.31 18 18.72 22.77 27.71 33.71

Retained Earnings

4 4.16 4.32 4.5 4.68 5.69 6.92 8.43

Company B (Low payout) Year

Equity

1 2 3 4 5 10 15 20

100 116 134.56 156.09 181.07 380.30 798.75 1677.65

Earnings @ 20%

20 23.2 26.91 31.22 36.21 76.06 159.75 335.53

Dividends

4 4.64 5.38 6.24 7.24 15.21 31.95 67.11

Retained Earnings

16 18.56 21.53 24.98 28.97 60.85 127.8 268.42

You can examine from the above table that over a long period of time, Low payout is overtaking high payout company. Company B retains much more (Rs 268.42) than Company A (Rs 8.43). Company A’s dividends and equity investments are growing @ 16 % per annum while that of Company A at 4% only.

• Can we say that a higher payout policy means more current dividends & less retained earnings, which may consequently result in slower growth and perhaps lower market price/ share. • On the other hand, low payout policy means less current dividends, more retained earnings & higher capital gains and perhaps higher market price per share. • Capital gains are future earnings while dividends are current earnings.

• How do we define dividend policy? • It’s the decision for the firm to pay out earnings versus retaining and reinvesting them. • Now that you know that there exists a relationship between dividend policy and value of the firm. • Being an investor, what would you prefer high payouts or low payouts.

• You would prefer a high payout! Why? • • • •

• •

•

Because, you want to enjoy all the benefits today and you don’t trust future. So you don’t want to take the risk. What about others! I heard ‘low payout’ from someone. Why would you prefer low payout! Because you want your firm to grow with new investment opportunities using your money since you know that retained earnings are comparatively cheaper. It is very difficult specify. We have different theories bases on differing opinions of the analysts; some consider dividend decision to be irrelevant and some believe dividend decision to be an active variable influencing the value of the firm. Lets study these theories one by one…

Dividend and Valuation • There are conflicting opinion as far as the impact of dividend decision on the value of the firm. According to one school of thought, dividends are relevant to the value of the firm. • Others opine that dividends does not affect the value of the firm and market price per share of the company. Dividends are irrelevant so that the amount of dividends paid has no effect on the valuation of a firm.

Dividend Relevance Theory Walter’s Model

Relevance Theory • If the choice of the dividend policy affects the value of a firm, it is considered as relevant. • In that case a change in the dividend payout ratio will be followed by a change in the market value of the firm. If the dividend is relevant, there must be an optimum payout ratio. • OPTIMUM PAYOUT RATIO is that ratio which gives highest market value per share.

Walter’s Model (Relevant Theory) • Prof. James E. Walter argues that the choice of dividend policies almost always affect the value of the firm. His model is based on the following assumptions: • 1. Internal financing: The firm finances all investment through retained earnings; i.e. debt or new equity is not issued. • 2. Constant return and cost of capital: the firm’s rate of return, r , and its cost of capital, k , are constant. • 3. 100% payout or retention: All earnings are either distributed as dividends or reinvested internally immediately. • 4. Infinite time: the firm has infinite life

Valuation Formula: Based on the above assumptions, Walter put forward the following formula:

P = DIV + (EPS-DIV) r/Ke Ke P = market price per share DIV= dividend per share EPS = earnings per share DIV-EPS= retained earnings per share r = firm’s average rate of return Ke= firm’s cost of capital or capitalisation rate

The above equation is reveals that the market price per share is the sum of two components: a. The first component DIV is the present value of an infinite stream of dividends. b. The second component (EPS-DIV) r/ke ke is the present value of an infinite stream of returns from retained earnings.

Example: Dividend Policy: Application of Walter’s Model

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Interpretation-1 1. When the firm is able to earn a return on investments exceeding the required rate of return that is, r>Ke, the value of shares is inversely related to the D/P ratio: as the payout ratio increases, the market value of shares declines. Its value is the highest (Rs.150) when the D/P ratio is zero. If the firm retains its entire earnings (D/P=0%), it will maximize the market value of shares (Rs.150). When all earning are distributed, its value is the lowest. In other words, the optimum payout ratio is zero.

Interpretation-2 2. When r K - The value per share P, increases with an increase in the retention ratio, b, that is, P increases with a decrease in the dividend payout ratio (D/E). In other words, when r > K, the firm should distribute lesser dividend and retain higher amount from earnings. • Normal Firms, r = K - The market value of the firm is not affected by the dividend policy. • Declining Firms, r < K - the value of the share decreases with the increase in the retention ratio.

Example: Application of Gordon’s Dividend Model

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It is revealed that under Gordon’s model:

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DIVIDEND IRRELEVANCE: THE MILLER–MODIGLIANI (MM) HYPOTHESIS

• Now we will turn attention to the other side where Miller & Modigliani (MM) who advanced their view that the value of the firm depends solely on its earnings power and is not influenced by the manner in which they are split. • According to M-M, under a perfect market situation, the dividend policy of a firm is irrelevant, as it does not affect the value of the firm. • They argue that the value of the firm depends on the firm’s earnings, which results from its investment policy. Thus, when investment decision of the firm is given, dividend decision –the split of earnings between dividends and retained earnings- is of no significance in determining the value of the firm.

Assumptions

• Perfect capital markets: The firm operates in perfect capital markets where investors behave rationally, information is freely available to all and transactions and flotation costs do no exist. Perfect capita; markets also imply that no investor is large enough to affect the market price of a share. • No taxes: taxes do no exist or there are no differences in the tax rates applicable to capital gains and dividends. This means that investors value a rupee of dividend as much as a rupee of capital gains. • Investment opportunities are known: the firm is certain with its investment opportunities and future profits. • No risk: Risk of uncertainty does not exist i.e. investors are able to forecast future prices and dividends with certainty, and one discount rate is appropriate for all securities and all time periods. Thus, r=k for all t

• According to M-M, r should be equal for all shares. If it is not so, the low return yielding shares will be sold by the investors who will purchase the high- return yielding shares. This process will tend to reduce the price of the low-return shares and increase the prices of the high-return shares. This switching or arbitrage will continue until the differentials in rates of return are eliminated. The discount rate will also be equal for all firms under M-M assumptions since there are no risk differences. • Thus the rate of return for a share held for one year may be calculated as follows:

Step-1: THE MARKET PRICE OF A SHARE IN THE BEGINNING OF THE PERIOD IS EQUAL TO THE PRESENT VALUE OF DIVIDENDS PAID AT THE END OF THE PERIOD PLUS THE MARKET PRICE OF SHARE AT THE END OF THE PERIOD. Symbolically,

Po =

(D1 + P1)

Where, Po = Prevailing market price of a share Ke=Cost of Equity capital D1= Dividend to be received at the end of period 1, and P1= Market Price of a share at the end of the period 1.

Step-2:

ASSUMING NO EXTERNAL FINANCING, THE TOTAL CAPITALISED VALUE OF THE FIRM WOULD BE SIMPLY BE THE NUMBER OF SHARES (n) TIMES THE PRICE OF EACH SHARE (Po). Thus,

nPo =

(nD1 + nP1)

Step-3: If the firms internal source of financing its investment opportunities fall short of the funds required, and n is the number of new shares issued at the end of year 1at price P1, the above equation can be written as:

nPo =

[(nD1 + (n + n) P1 -

nP1)]

Step-4: If the firm were to finance all investment proposals, the total amount raised through new shares issued would be given as: nP1 = I – (E – nD1) = I –E + nD1 Where, n P1 = amount obtained from the sale of new shares of finance capital budget. I = Total amount / requirement of capital budget E = earnings of the firm during the period nD1 = Total dividend paid (E-nD1) = Retained Earnings According to the above equation, whatever investment needs (I) are not financed by retained earnings, must be financed through the sale of additional equity shares.

Step-5: if we substitute equation in step-4 and

equation in step-3, we derive : nPo = { there is a +ve nD1 and –ve nD1. therefore, nD1 cancels}

Step-6: Conclusion: Since dividends (D) are not found in the above equation, M-M conclude that dividend do not count and that dividend policy has no effect on the share price.

Example

• A company belongs to a risk class for which the appropriate capitalization rate is 10%. It currently has outstanding 25,000 shares selling at Rs.100 each. The firm is contemplating the declaration of dividend of Rs.5 per share at the end of the current financial year. It expects to have a net income of Rs. 2,50,000 and has a proposal for making new investments of Rs.5,00,000. Show that under the MM assumptions, the payment of dividend does not affect the value of the firm.

RATIONAL EXPECTATIONS MODEL • According to the rational expectations model, there would be no impact of the dividend declaration on the market price of the share as long as it is at expected rate. • However it may show some adjustments in case dividends declared are higher or lower than expected level. If the results are higher than expected than there would be a upward movement and vice versa.

BIRD IN HAND THEORY • Graham, Dodd and Cottle(1962) state that one dollar of dividends is worth opportunity three dollars of retained cash flows. • According to their view that dividends are more worth to investors than retained earnings. It is again assumed that the purchaser of a share buys share in expectation of future dividends.

RESIDUAL THEORY • According to this theory of dividends, the firm should follow its investment policy of accepting all positive NPV projects, and paying out dividends if and only if funds are payable. • if the firm treats dividends as residual, the dividends can vary from period to period, depending on investment plans and operating results of the firm. The residual dividend policy is used by most firms to set a long run target payout.

100 PERCENT PAYOUT THEORY • Rubner (1966) argued that shareholders prefer dividends and directors requiring additional finance would have to convince investors that proposed new investments offer positive increases in wealth. • This would encourage the rejection of the projects which serve mainly to enhance the status and job security of managers and company can adopt a policy of 100 percent payout.

100 percent retention theory • Clarkson and Elliot (1969) put forth their argument that given taxation and transaction costs, dividends are a luxury that neither shareholders nor companies can afford and hence the firm can follow a dividend policy of 100 percent retention. They further argue that successful investment opportunities are open to the firm and there is no point in paying dividends and raising additional capital.

SPAN OF CONTROL THEORY • Managers in an organisation look at cash flows generated from the operations as an important and convenient source of new capital. The professional managers prefer to have a large span of control as measured by the number of employees, sales, market value, total assets or expenditure. • In pursuit to the managerial objective of increasing span of control, directors are expected to prefer retention's to distributions.

DIVIDEND POLICY

Important considerations in dividend policy • Transaction costs • Shareholder’s Income tax • Dividend clientele • Dividend payout ratio • Dividend signaling hypothesis • Divisible profits • Liquidity

• Rate of expan...