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Dividend Policy

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     on  05 February 2009    

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CA.KUNAL KUMAR AGRAWAL;ERO0096386; ca.kunalag@gmail.com; 9832128128

BASICS

 

RELEVANCE OF VARIOUS DATES

 

1.       Declaration date - The date when dividend is announced.

 

2.       Record date - The date on which register of members is closed to find out the names of the members who will be eligible to receive dividends. The company fixes it.

 

3.       Last cum - dividend date - The date upto which shares can be bought in the stock market and be eligible to receive dividend is called the last cum-dividend date. This is fixed by the stock exchange.

 

4.       Ex-dividend date - The date from which shares can be brought in the stock market without being eligible for dividend is called ex-dividend date.

 

5.       Payment date - The date on which dividend is actually paid out is called the payment date.

 

DIVIDEND PAYOUT

 

Over the next few years, companies cannot afford to ignore dividends. Investors are looking for higher payouts and need the assurance of a stated dividend policy.

 

AS an investor, you would definitely savor this statistic if this stock were in your portfolio. General Electric, the American conglomerate, has paid quarterly dividends without interruption since 1899. Dividends at General Electric have been rising for 29 consecutive years now.

 

A news report quoting the company's spokesman says that the policy followed by the company is for `dividend growth in line with earnings growth'. In India, though, there are few companies that are as consistent in dividend payments, even over the past five years.

 

Dividend indifference: The best that can be said about Indian companies is that they have been indifferent to dividends. The investment literature supports this attitude. Theory says valuations are not influenced by dividend policy. Historically, too, dividends have not been important. Even for strategies based on dividend yields, the contribution of dividends to total returns has not been significant.

 

Going forward, however, it may be different. The average price-to-earnings multiple is now well above 15 times and is almost equal to the average return on equity of 16 per cent. The contribution of dividends to total returns will only increase in the days ahead.

 

The argument that cash reinvested in the business can earn higher returns than what the investor can manage on his own no longer holds water. Practically, it does not work that way. Cash in the balance sheet often pulls down returns. Managements, therefore, cannot afford to retain cash in the balance sheet that they do not need, though many of them still do. Cash as a proportion of balance sheet had gone up to 17 per cent at the end of the FY 2005 from 10 per cent the previous year.

 

The dividend yield, though, has steadily declined and is now at an average of 1.1 per cent for a set of 800 companies. These companies form part of the various BSE and NSE indices. Not only has the dividend yield gone down, there is not one company in this list that has increased dividends in line with profit growth in each of the past five years.

 

This is poor advertisement for Corporate India. Barring a few public sector banks, none of them even has a stated dividend policy. The number of companies in which dividend growth has lagged profit growth is overwhelming.



 

Set the standard: Among companies in the set, those that have steadily increased the payout over the years include a number of multinational companies that also earn a high return on net worth. Companies such as Nestle India, Hindustan Lever, Pfizer, GlaxoSmithKline Consumer and Cummins India have enhanced dividends to deliver value to shareholders. These companies do not seem to be constrained for growth, either. Some Indian companies that have also shown the way forward include Ranbaxy Labs, Hero Honda Motors, Asian Paints, Thermax and a number of banking and non-banking finance companies. These companies, too, are growing fast, and the declaration of dividends has not dampened prospects.



Companies that have held on to profits and not declared dividends include e-Serve, Cranes Software, Sesa Goa, Tata Motors, Moser Baer, ABB, MICO, Havells India, Amtek India and Sterlite Industries. This is only an indicative list and includes many more. The dividend payout ratio in the case of the indicated companies is less than 20 per cent. Investors, however, need dividends to rise and they also need a stated dividend policy.

 

Nature of the firm

Relationship

Payout

Growth Company

Ke < r

0%

Declining Company

Ke > r

100%

Normal Company

Ke = r

Indifference

 

Ø  Is it true that companies don’t distribute dividends would not command a good price? Microsoft, the world’s most happening software company, has not declared a penny of dividend till date. Yet Microsoft is the darling of Wall Street. The rationale is simple. Investors made investments on the basis of actual dividends received but on the basis of expectations of future dividends. The money retained some day in the future be handed back to the shareholders either in the form of cash dividends or buy back.

 


 

DIVIDEND MODELS

 

1.       WALTER MODEL:-

 

Walter argues that the market price of a share is the sum of the present value of the following two cash streams:

 

·         Infinite stream of constant future dividends.

·         Infinite stream of capital gains (Retained earnings).

 

               r  (E-D)

Po=D  +Ke      

      Ke       Ke

Where

Po = Current market price;

D = dividend per share;

E = earnings per share;

r = Rate of Return;

Ke= Cost of equity

Assumptions

 

·         The firm is all equity firm.

·         The firm has indefinite life.

·         Earnings and dividends don’t change.

·         All earnings are either distributed or retained internally.

·         The firm will use only retained earnings to finance its investments.

 

Implications

 

This is model in line with all – or – nothing approach.

 

·         The optimal payout ratio for a growth firm is nil.

·         The payout ratio for a normal firm is irrelevant.

·         The optimal payout ratio for a declining firm is 100%.

 

Criticism

 

·         No external financing is taken under this model.

·         Constant rate of return.

·         Constant opportunity cost.

 

2.       GORDON’S MODEL

 

Gordon argued that the market price of a share is the present value of future dividends, under the assumption that dividends are assumed to grow at a uniform rate forever. It suggests that it is present value of growing perpetuity.

 

 Po =      D1                    Where  

            Ke-g                   D1 = DPS next year;

                             Ke = Cost of equity;

                   g = Growth rate in dividends;

Po = Current market price

 

Assumptions

 

·         The firm is an all equity firm.

·         The firm uses only retained earnings to finance its investments.

·         The rate of return on the firm’s investment is constant.

·         The cost of equity is constant.

·         The firm has an infinite life.

·         The retention ratio is constant.

·         The growth rate is constant.

·         Taxes are absent.

·         Ke is greater than growth rate.

 

Implications

 

·         The optimal payout ratio for a growth firm is nil.

·         The payout ratio for a normal firm is irrelevant.

·         The optimal payout ratio for declining firm is 100%.

 

Criticism

 

·         It does not lead to maximization of wealth.

·         Assumptions about constant rate of return and constant opportunity are suspect.

 

3.       GRAHAM & DODD MODEL

 

This model assign, more weight on dividends than on retained earnings. Investors discount distant dividends at a higher rate than they discount nearby dividend. This is because nearby dividends are more certain than distant dividends.

 

P=m x (D + E/3)           Where,

P = Market price/share;

m = multiplier;

D = DPS;

E = EPS

Assumptions

 

·         Investors are rational.

·         Under conditions of uncertainty they turn risk averse.

 

Implications

 

The weight attached to dividends is equal to four times the weight attached to retained earnings.

 

Criticism

 

The weight provided are based on their subjective judgement and not derived from any empirical analysis.

 

4.       LINTER’S MODEL

 

If a firm sticks to its target payout it will have to change its dividend with every change in earnings. Since shareholders do not like a drop or a wild fluctuation in dividends, the company increases the dividend only to the extent it believes is maintainable in the future. A conservative company would have a lower adjustment factor.

 

D1= Do + [(EPS x Target Payout) – Do] x AF    where,

D1 = Dividend in year 1;

                                                                             EPS = Earnings per share;

                                                                            Do = Dividend in current year;

                                                                             AF = Adjustment Factor

Findings

 

·         Firms have a long-term target dividend payout ratio.

·                     Managers are concerned with changes in dividends rather than in dividends per share.

·         Dividends do increase with earnings but not in perfect tandem.

·         Managers are reluctant to effect dividend changes that may have to be reversed.

 

Criticism

 

·         It does not offer a market price for the share.

·         The adjustment factor is an arbitrary number.

 

5.       RADICAL APPROACH

 

If tax on dividend is higher than tax on capital gains a company offering capital gains rather than dividends will be priced better. If tax on dividend is less than tax on capital gains, a company offering dividends rather than capital gains will be priced better.

 

Assumptions

 

·         It considers both corporate tax and personal tax.

·                     It also considers the fact that dividends and capital gains are not taxed at the same rate.

 

Advantages

 

·         This model is more in tune with reality.

 

6.       MODIGILANI-MILLER MODEL

 

M & M argues that declaration of dividend does not affect the market price.The value of a firm depends on its earnings it depends on its investment policy. Thus, when the investment decision is given, the dividend decision cannot affect the value of the firm. In a perfect market, a firm may face one of the following 2 situations regarding the payment of dividends:


Situation 1: It has sufficient cash to pay dividends:

 

When dividends are paid the investors gain but he losses as company’s assets fall. Thus, there is no gain or loss and value of the firm remains unaffected.

 

Situation 2: It does not have enough cash to pay dividends:

 

If the company issues right shares or public issue then the existing shareholders transfer a part of their claim in the form of new shares to the new shareholders in exchange of cash. There is no gain or loss and the value of the firm remains unaffected.

 

nPo=   (n + m) x P1 – I1 + X1         Where,

            1 + K                           Po = Current market price;

                                                          n = Present no. of shares;

                                                          m = Additional shares issued at year end

                                                          market price to finance capital expenditure;

                                                          P1 = Year end market price;

                                                          I1 = Investment made at year end with

                                                          Money being raised at year end MP;

                                                          X1= Earnings in year 1;

                                                          Ke = Cost of equity;

Assumptions

 

·         Perfect Market

ü  There are large no. of buyers and sellers.

ü  All investors are equally knowledgeable

ü  There is free flow of information.

·         No tax

·         Fixed Investment Policy

·         There is no risk of uncertainty

·         No external funds

 

 

ESTABLISHING A DIVIDEND POLICY

 

CONSTANT DIVIDEND MODEL

 

Under this approach fixed rate of dividend is paid each year. Now this does not mean that dividends will never be increased. If earnings increase and finance manager is certain that the new earnings level can be maintained. However if company in unsure about the earnings then it can split the dividend to cash dividend and special dividend.

 

Example:

 

Suppose TVS Ltd can declare Rs.6 dividend in the current year but is unsure about the earnings then in this case it would declare Rs.4 as regular dividend and Rs.2 as special dividend.

 

Ø  In the year 2003-2004 Infosys Technology Ltd. announced a whooping special dividend of 1000%! The message: Do not expect the same bounty next year.

 

 

Ø  India’s richest man just got richer.Wipro’s announcement today of a special one-time dividend of Rs.25 per share (1250%) with an outgo of Rs.582 and a regular cash dividend of  Rs.4 per share (200%) with a payout of Rs.93 crore, has made Chairman Azim Premji richer by Rs.566 crore. (Source: The Economic Times, April 17, 2004)

 

Advantages

 

·         By keeping the dividend prefixed, there will be no speculation on this score in the stock market.

·         When dividends are increased it sends a positive signal as under this approach the company does not generally drop dividends.

·         It gives an impression of a strong and healthy company which helps the company to tap the market for additional money.

·         Those who seek regular stream of income prefer this model.

 

Disadvantages

 

·         Dividends are de-linked from profits. It puts pressure on the liquidity of the company.

 

CONSTANT PAYOUT APPROACH

 

Under this model the company adopts a fixed payout ratio year after year. This means that ratio of dividends per share is constant.

 

Example:

 

Let the ratio be 40% if in the current year the company has an EPS of Rs. 8 it would declare a dividend Rs. 3.2 per share. Next year if it goes to upto Rs. 10 then it would declare dividend of Rs. 4 per share. Next year if it falls to Rs.6 the dividend per share will be dropped to Rs. 2.4.

 

Advantages

 

·         Dividends are linked to profits. The more the profits the more is dividends: the less the profits the less is dividend.

·         This policy does not put pressure on liquidity of the company as dividends are when there is profit in the company.

 

Disadvantages

 

·         Speculation takes place in the market that what would be the earnings of the company.

 

CONSTANT DIVIDEND PLUS APPROACH

 

Under this approach a fixed low dividend per share is always payable. An additional dividend per share in the form of either interim dividend or special dividend is then paid in years of good profits. In years of not so good profits the extra or special dividend is not paid.

 

Ø  Infosys offered its shareholders a one time special dividend of Rs.100 per share (2000%), a final dividend of Rs.15 per share (300%), bonus issue in the ration of 3:1(three additional shares for one held currently). All of which has made Infy shareholders humungously rich, especially the prescient who bought the scrip a decade ago and bought the stock and held on to it. (Source: The Economic Times, April 14, 2004).

 

Advantages

 

·                     A minimum return is guaranteed.

·                     Dividends are linked to profits and it enjoys the advantages of both the plans.

 

Residual approach

 

Under residual approach, dividends are paid out of profits after making provision for money required to meet upcoming capital expenditure commitments. There are 2 options under residual approach: -

 

Option 1: Dividends= Profit after Tax – Capital Expenditure

 

The option would alter the capital structure of the company because the entire capital expenditure is funded by equity and not funded in the proportion of the company’s capital structure.

 

Option 2: Dividend = Profit after Tax – Capital Expenditure funded out of equity

 

In this option capital structure of the company will not change, as capital expenditure would be financed in the ratio of the company’s capital structure ratio.

 

Advantages

 

·         This is validated in real life since companies in growth phase payout less than those     that have reached the maturity phase.

 

Disadvantages

 

·         A strict application of the residual approach would lead to a very unstable dividend    policy.

 


THE COMPROMISE APPROACH

 

Finance managers have following five goals in mind while declaring dividends.

 

Goal 1: Projects with positive NPV are not to be cut to pay dividends.

Goal 2: Avoid dividend cuts.

Goal 3: Avoid the need to raise fresh equity.

Goal 4: Maintain a long-term target debt equity ratio.

Goal 5: Maintain a long-term target dividend payout ratio.

 

Approach

How Computed

Advantages

Disadvantages

Constant Dividend Model

A fixed dividend rate maintained each year

·   No uncertainty about amount of dividend

·   Increase in dividends sends positive signals about the company

·   Ideal for those seeking steady income

·   Gives impression of a strong and healthy company

·      Could put pressure on firm’s liquidity

·      Once established difficult to go back on the policy

Constant Payout Approach

Ratio of dividend per share to earnings per share is constant

·   No strain on company’s liquidity since dividends linked to profits

·      Market speculation due to anticipation of profits and dividends

Constant Dividend Plus Approach

Fixed low dividend always paid plus additional dividend in years of good profit

·   Minimum return is guaranteed

·   Dividends are also linked to profits. Hence best of both plans

 

Residual Approach

Dividends are paid out of profits after providing for upcoming capital expenditure

·   Firms with more investment opportunities have a lower payout than other firms having low investment opportunities

·      Strict application could lead to an unstable dividend policy

 

 

DOES DIVIDEND POLICY MATTER?

 

Will the declaration of dividends affect the value of the firm? The issue is not one of whether we should declare dividends or not. After all, everybody loves some cash. The issue is when we should declare dividends. Now or later.


THE CASE FOR SOME DIVIDEND

 

1.   Signal Effect:

 

A high dividend payout may suggest that the management is gung-ho about the future. A low dividend payout may suggest that the management is not very confident about the future.

 

2.   Differential tax rates:

 

In practice, the effective tax on LTCG is lower than that on dividends and on STCG is higher than that on dividends. The dividend payout decision will, therefore, depend on personal and corporate tax rates. When personal tax rates higher than corporate tax rates, a firm will have an incentive to reduce dividend payouts. If personal tax rates are lower than corporate tax rates, a firm will have an incentive to payout any excess cash as dividends.

 

3.   Transaction costs:

 

In the absence of transaction costs, dividends and capital gains are interchangeable. In such a case, if a shareholder desires current income greater than the dividends received, he can sell some shares equal in value to the additional current income sought. Similarly if he desires current income less than the dividends paid, he can buy additional shares equal in value to the difference between dividends received and the current income desired. In actual practice, transaction costs are incurred.

 

4.   Mental accounting:

 

Consider this example. Option 1:You received Rs 5000/- as dividend and spend it. Option 2: The company does not pay dividend, so you sell a part of your share for Rs 5000/- and spend it. Subsequently the price of the share goes up. In which case do you feel cheated? Most investors feel cheated in the case of option 2 though in both cases the loss is identical! It’s all a frame of the mind.

 

THE CASE FOR HIGH DIVIDEND PAYOUT

 

1.   Agency cost:

 

Managers do not share all available information with shareholders. Hence shareholders set up an independent mechanism to monitor and find out what the managers are upto. This cost of setting up this mechanism is called agency cost. When high dividends are regularly paid the company may be raising capital frequently from the primary markets. Consequently, capital market players such as financial institutions and banks will be monitoring the performance of the managers. In such a case shareholders need not incur agency costs!

 

2.   Prior claim:

 

Lenders have prior claims over a company’s internal cash flows. The payment of dividend changes this pecking order in favor of shareholders as they receive cash flows before the principal is redeemed. The shareholders comes ahead of the lenders.

 

3.   Uncertainty:

 

In uncertain times, investors would prefer current payout to distant payouts. Clearly a bird in the hand is worth two in the bush. In such a situation future dividends may be discounted at a higher rate. Consequently firms paying dividends earlier will command a higher rate.

 

THE CASE FOR LOW DIVIDEND PAYOUT

 

1.   Additional equity at lower price:

 

MM assume that a firm can sell additional equity at prevailing market price. But reality is otherwise. Companies offer additional equity at a discount to current market price to entice more valuable than a rupee of dividend.

 

2.   Issue costs( aka low cost of retained earnings):

 

MM assumes that a rupee of dividends can be perfectly substituted by a rupee of external financing. This is possible if there is no issue cost. But in actual practice, companies have to incur issue expenditure to raise money. Hence the amount of external financing will be greater than the amount of internal financing for a capital expenditure.

 

 

ALTERNATIVES TO PAY DIVIDEND

 

1.       Buy back or Stock repurchase

 

Buy-back of shares means repurchase of shares of the company by the company. This leads to reduction in share capital of the company. Normally buy-back is resorted to when a company has large unutilized surplus cash. Since the cash is surplus, it is assumed that buy-back will not affect the future earnings of the company.

 

Advantages

 

·                     Future dividends per share can be raised.

·                     It brings about a significant change in capital structure.

·                     Signal on company’s future cash flows.

 

Pricing

S x Po                   where

(S – N)        S= No. of shares outstanding before buy back

                   Po= CMP;

N= No. of shares bought back

 

Theoretical Ex buy back price = (S x Po) – Cash     

                                                    (S – N)

 


2.       Stock Splits, Bonus Shares & Reverse Split

 

A stock split represents a reduction in the face value of shares. It does the same function as a bonus share. A stock split is similar to a bonus share. A 2:1 split means 2 shares are issued in exchange of 1 share held. This is also referred to as 50% stock split.

 

A bonus share (stock dividend) involves the capitalization of reserves. What actually happens is that the accountant transfers an amount from reserves to equity by allotting shares at par value.

 

Therefore Post bonus price will be, (S x Po)              where

   (S + N)              S=No. of  Shares outstanding

                                                                                  before bonus issue

                                                                            Po= Current Market Price

                                                                            N= No. of bonus shares issued

A reverse split is the opposite of stock split. It refers to consolidation of shares. For instance, a Rs.5/- share is increased to a face value of Rs. 15. such a split is referred to as 1:3 since you get 1 share in lieu of every three held.

 

 

FACTORS THAT DERIVE DIVIDENDS!

 

1.    Funds Requirement

2.    Liquidity

3.    Access to external financing

4.    What they want

5.    The cost of money

6.    Loss of control

7.    Taxes

8.       Inflation

 

 

TAX ISSUES

 

 

Tax chase you like a shadow- from the cradle to the grave. The key to dividend policy is the rate at which dividends and capital gains are taxed. Indian tax laws are a trifle complex in this regard. For instance, while the dividends are tax free in the hands of the shareholders companies have to pay a distribution tax of  15% plus surcharge @ 10% and education Cess @ 2% and SHEC @ 1% which collectively works out to 16.995% as per current laws.

 

Where shares are held for over a year they attract LTCG of 10% without indexation and 20% with indexation. STCG are taxed the normal rates tax on capital gains is payable only when the shares are sold and is hence deferred. All this does not mean dividends should not be paid. In fact, it all depends on individual tax rate and corporate tax rate.

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