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Dividend Policy 11 -1 Dividend Policy 11 -1

Dividend Policy. • Determining how much of a company’s profit is to be paid Dividend Policy. • Determining how much of a company’s profit is to be paid to shareholders as dividends and how much is to be retained 11 -2

Institutional Features of Dividends • Dividend declaration procedures – Interim and final: § In Institutional Features of Dividends • Dividend declaration procedures – Interim and final: § In Sri Lanka, if dividends are paid, we typically find two types: • A final dividend is paid after the end of the accounting or reporting year. • An interim dividend can be paid any time before the final report is released, usually after the half-yearly accounts are released. – Cum-dividend period: § Period during which the share holder is qualified to receive a previously announced dividend. – Ex-dividend date: § Shares purchased on or after the ex-dividend date do not include a right to the forthcoming dividend payment. 11 -3

Institutional Features of Dividends (cont. ) • Example of cum-dividend and ex-dividend date: Cum-Dividend Institutional Features of Dividends (cont. ) • Example of cum-dividend and ex-dividend date: Cum-Dividend Period time 0 4 days Book Closing Date announcement date Ex-dividend date Payment date 11 -4

Institutional Features of Dividends (cont. ) • Declaration date – Date Board of Directors Institutional Features of Dividends (cont. ) • Declaration date – Date Board of Directors pass a resolution to pay a dividend. • Record (books closing) date – The date on which shareholders listed in the register of shareholders are designated to receive a dividend. – This is 4 days after the ex-dividend date. – The idea is that if shares are traded cum-dividend, brokers have time to notify the share register to ensure the new shareholder receives the dividend. • Date of payment – Date dividend cheques are mailed or dividends are paid electronically. 11 -5

The Importance of Payout Policy to Shareholders • A company’s business decisions involve investment, The Importance of Payout Policy to Shareholders • A company’s business decisions involve investment, financing and payout policies. • Directors of companies must decide how much cash, if any, to pay to shareholders and whether the payment should be in the form of dividends or repurchase shares. • The amount of money involved in payment suggests payout decision is a significant issue in many companies operation. • Retained earnings are the most significant internal source of financing. Dividend is a cash outflow to the company. On the other hand, dividend increase shareholders’ current income. • The decision on the company’s payout policy should be consistent with the overall financial objective of maximising shareholders’ wealth. 11 -6

Dividend Payout and Value of the Company • Payout ratio: which is dividend as Dividend Payout and Value of the Company • Payout ratio: which is dividend as a percentage to earnings • Retention ratio: How much earnings are retained in the business (1 -payout ratio) • Growth = ROE x Retention ratio • Suppose two companies Low payout company and High payout company. Both have a ROE of 20%. Value of the share is Rs 100 for both companies. High payout company payout ratio is 80% and low payout company payout ratio is 20% 11 -7

Equity Rs. Earnings high payout company Year 1 Year 2 Year 3 Year 4 Equity Rs. Earnings high payout company Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Low payout copany Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Dividend Retained Earnings 100. 0 104. 0 108. 2 112. 5 117. 0 121. 7 126. 5 131. 6 136. 9 142. 3 20. 0 20. 8 21. 6 22. 5 23. 4 24. 3 25. 3 26. 3 27. 4 28. 5 16. 0 16. 6 17. 3 18. 0 18. 7 19. 5 20. 2 21. 1 21. 9 22. 8 4. 0 4. 2 4. 3 4. 5 4. 7 4. 9 5. 1 5. 3 5. 5 5. 7 100. 0 116. 0 134. 6 156. 1 181. 1 210. 0 243. 6 282. 6 327. 8 380. 3 20. 0 23. 2 26. 9 31. 2 36. 2 42. 0 48. 7 56. 5 65. 6 76. 1 4. 0 4. 6 5. 4 6. 2 7. 2 8. 4 9. 7 11. 3 13. 1 15. 2 16. 0 18. 6 21. 5 25. 0 29. 0 33. 6 39. 0 45. 2 52. 5 60. 8 11 -8

 • Low payout company have the higher return in the long-run than high • Low payout company have the higher return in the long-run than high payout company. • But future has a uncertainty and the share price is determined by so many factors than payout. • Therefore some investors may prefer high payout companies and other low payout companies. 11 -9

 • Dividend policy is not a isolated decision. paying dividends means outflow of • Dividend policy is not a isolated decision. paying dividends means outflow of cash. Hence it may affect on the investment and financing decisions. • It is difficult to isolate the effect of dividend policy on the share price. Therefore number of theories have been developed. – Theories that consider dividend decisions to be irrelevant – Theories that consider dividend decisions to be relevant 11 -10

Dividend Relevance- Walter’s Model • James Walter argues that the choice of dividend policies Dividend Relevance- Walter’s Model • James Walter argues that the choice of dividend policies affect value of the firm under following assumption. – – – The firm finances all investment through retained earnings All earnings are either distributed as dividends or reinvested Firm’s rate of return , r, and its cost of capital, k, are constant. Beginning earnings and dividends never change The firm has a very long or infinite life 11 -11

Dividend Policy and Value of Share Growth Firm r>k Normal Firm, r = k Dividend Policy and Value of Share Growth Firm r>k Normal Firm, r = k Declining firm, r

Dividend Relevance- Gordon’s Model • According to Myron Gordon dividend policies affect value of Dividend Relevance- Gordon’s Model • According to Myron Gordon dividend policies affect value of the firm under following assumption. – – – The firm finances all investment through internal equity The firm and its stream of earnings are perpetual Firm’s rate of return , r, and its cost of capital, k, are constant. Taxes do not exist The retention ratio, b, once decided opun, is constant. Thus the growth rate, g =br, is constant forever. – Cost of capital greater than growth rate (k>g) 11 -13

Dividend Policy and Value of Share Growth Firm r>k Normal Firm, r = k Dividend Policy and Value of Share Growth Firm r>k Normal Firm, r = k Declining firm, r

Irrelevance Theory — Modigliani and Miller (1961) • Value of firm is determined solely Irrelevance Theory — Modigliani and Miller (1961) • Value of firm is determined solely by the earning power of the firm’s assets and the manner in which the earnings stream is split between dividends; and retained earnings does not affect shareholders’ wealth. • Modigliani and Miller (MM): Given the investment decision of the firm, the dividend payout ratio is a mere detail. It does not affect the wealth of shareholders. • Assumptions – Company has a fixed investment or capital budgeting program. – No taxes, transaction costs, or other market imperfections. – Investors are rational so always prefer more wealth to less wealth — investors are indifferent between receiving dividends or capital gains. 11 -15

 • X Ltd currently has 20000 shares selling at a Mkt price of • X Ltd currently has 20000 shares selling at a Mkt price of Rs. 100 per share. The firm has no borrowing but has capital reserve of Rs. 300000 which is expected to invest on a project resulting with NPV of Rs. 200000. The firm also want to pay a dividend per share of Rs. 15. How does the firm value be affected (i) if it does not pay any dividend, (ii) if it pays dividend per share of Rs. 15. 11 -16

 • The firms current value is =2000, 000 • After the investment the • The firms current value is =2000, 000 • After the investment the value will increase to 2000, 000+200000 =2200, 000. If the firm does not pay dividends, the value per share = 2200000/20000 = Rs. 110 • If the firm pay dividends it will use all its reserves(15*20000 =300000) and it has to issue new share to raise these funds. • The value of a share after the dividend (110 -15 =95) • The firm will issue (300000/95=3158 share to raise Rs. 300000. and the total number of shares is 23158 at 95 a share. Thus the total value is 23158*95=220000 11 -17

Relevance of dividend policy under market imperfections Uncertainty and Shareholders' Preference for Dividend Many Relevance of dividend policy under market imperfections Uncertainty and Shareholders' Preference for Dividend Many believe that dividend are relevant under condition of uncertainty as the bird-in-the-hand argument. Investors prefer dividends than capital gains. Investors prefer near dividends than future dividends. Near dividends are discounted at lower discount rates than future dividends because discount rates increase with uncertainty. This implies that there exists a high payout clientele who value shares of dividend paying more than those who do not pay dividends. 11 -18

Relevance of dividend policy under market imperfections Transaction Cost Issue of new share involve Relevance of dividend policy under market imperfections Transaction Cost Issue of new share involve flotation or issue costs, including cost of preparing and issuing prospectus, underwriting fee, brokers’ commission etc. no flotation costs are involved if the earnings are retained. Thus if flotation costs are considered, the equivalence between retained earnings and new share capital is disturbed and the retention of earnings would be favored over the payment of dividends 11 -19

Relevance of dividend policy under market imperfections Tax Differential From tax point of view. Relevance of dividend policy under market imperfections Tax Differential From tax point of view. A shareholder in high tax bracket should prefer capital gains over current dividends for two reasons. 1. A 10 percent withholding tax applies on the dividends paid to either a resident or a nonresident company. 2. Capital Gain tax is not applicable in Sri Lanka. As a result of tax advantage of capital gains over dividends strongly favours a low-dividend payout policy. 11 -20

Relevance of dividend policy under market imperfections Informational Content of Dividends The cash payment Relevance of dividend policy under market imperfections Informational Content of Dividends The cash payment for dividends conveys to shareholders that the company is profitable and financially strong. When a firm changes its dividend policy in a significant manner, investors assume that it is in response to an expected change in the firm’s profitability which will last long. An increase in payout ratio signals to shareholders a permanent or long term increase in firm’s expected earnings. It is argued that the announcement of changes in dividend policy influences share prices, and the managers use the dividend changes to convey information the future earnings of their companies. 11 -21

Dividend Stability -- maintaining the position of the firm’s dividend payments in relation to Dividend Stability -- maintaining the position of the firm’s dividend payments in relation to a trend line. Rs Per Share 4 50% of earnings paid out as dividends Earnings per share 3 2 Dividends per share 1 Time

Dividend Stability Dividends begin at 50% of earnings, but are stable and increase only Dividend Stability Dividends begin at 50% of earnings, but are stable and increase only when supported by growth in earnings. Rs Per Share 4 50% dividend-payout rate with stability Earnings per share 3 2 1 Dividends per share Time

Merits of Dividend Stability • Information content -- management may be able to affect Merits of Dividend Stability • Information content -- management may be able to affect the expectations of investors through the informational content of dividends. A stable dividend suggests that the company expects stable or growing dividends in the future. • Current income desires -- some investors who desire a specific periodic income will prefer a company with stable dividends to one with unstable dividends. • Institutional considerations -- a stable dividend may permit certain institutional investors to buy the common stock as they meet the requirements to be placed on the organizations “approved list. ”

Factors Affecting Dividend Policy Firm’s Investment Opportunities and Financial Needs Growth firms have a Factors Affecting Dividend Policy Firm’s Investment Opportunities and Financial Needs Growth firms have a large number of investment opportunities requiring substantial amount of funds. Hence growth firms would like to retain earnings over payment of dividends. For mature firms investment opportunities occur infrequently. These firms may distribute most of their earnings. Theoretically, when the company has an IRR greater than the return required by shareholders, it would be to the advantage of shareholders to allow the reinvestment of earnings by the company. 11 -25

Factors Affecting Dividend Policy Shareholders Expectations Shareholders’ preference for dividends or capital gains may Factors Affecting Dividend Policy Shareholders Expectations Shareholders’ preference for dividends or capital gains may depend on their economic status and the tax treatment on dividends and capital gains. • Retired and old persons prefer to invest in companies with regular dividend • Wealthy investors prefer capital gains to minimize tax Legal considerations: – Dividends can only be paid out of profit and are not to be paid out of capital. – A dividend cannot be paid if it would make the company insolvent. 11 -26

Factors Affecting Dividend Policy Liquidity Greater the Cash position and overall liquidity of a Factors Affecting Dividend Policy Liquidity Greater the Cash position and overall liquidity of a company, the greater will be its ability to pay dividends. Financial condition and borrowing capacity A highly levered company may expect to retain earnings to strengths its equity base. Access to the Capital Market A company that is not sufficiently liquid can still pay dividends if it is able to raise debt and equity in the capital market. Inflation In an inflationary environment, funds generated by depreciation often are not sufficient to replace a firm’s assets as they become obsolete. Hence a firm may be forced to retain a higher percentage of earnings to maintain the asset base. 11 -27

Factors Affecting Dividend Policy Control when a company pays large dividends, its cash position Factors Affecting Dividend Policy Control when a company pays large dividends, its cash position is affected. As a result, the company will have to issue new shares to raise funds to influence its investment programs. If the existing shareholders don't buy additional shares their control will be diluted. Hence the shareholders may prefer to retain earnings to finance the firm’s investment opportunities. 11 -28

Forms of dividend • Cash Dividend Both the total assets and net worth of Forms of dividend • Cash Dividend Both the total assets and net worth of the company are reduced when the cash dividend is distributed. The market price of the share drops in most cases by the amount of the cash dividend distributed • Bonus Shares Issue of bonus shares is the distribution of shares free of cost to the existing shareholders. Bonus issue represents a recapitalization of reserves. The earnings per share and market price per share falls proportionately to the bonus issue. 11 -29

Bonus share • Ex: Equity of the X is as follows Rs. Mn Paid Bonus share • Ex: Equity of the X is as follows Rs. Mn Paid up Share Capital ( 1 mn shares , Rs. 10 each) Share premium Reserve and surplus 10 15 8 Total Equity 33 • The company decided to offer a 1: 10 bonus issue that is 100000 new shares. At a price of Rs 30 per share the total value of new share issued will be 3 Mn. This amount is transferred from reserves to share capital and share premium account Rs. Mn Paid up Share Capital ( 1. 1 mn shares , Rs. 10 each) Share premium Reserve and surplus 11 17 5 Total Equity 33 11 -30

 • Lets suppose that net earnings of the company are Rs. 2. 20 • Lets suppose that net earnings of the company are Rs. 2. 20 Mn. Therefore the EPS is Rs 2. 20. • EPS has dropped to Rs. 2 after the bonus issue (Rs. 2. 2 Mn/1. 1 Mn shares). • Similarly MPS to Rs 27. 27 (30(1 -1/1. 1) • However the bonus issue has no impact on the wealth of the share holders (27. 27*1. 1) 11 -31

Advantages of Bonus Shares • Tax benefits • Indication of higher future profits • Advantages of Bonus Shares • Tax benefits • Indication of higher future profits • Future dividends may increase (if the company pays a fixed dividend rate) 11 -32

Stock Splits Stock Split -- An increase in the number of shares outstanding by Stock Splits Stock Split -- An increase in the number of shares outstanding by reducing the par value of the stock. • Primarily used to move the stock into a more popular trading range and increase share demand. • Assume a company with 200, 000 shares of Rs. 10 par common stock splits 2 -for-1. How does this impact the shareholders’ equity accounts?

Stock Splits Before 2 -for-1 Stock Split Common stock (Rs 10 par; 200, 000 Stock Splits Before 2 -for-1 Stock Split Common stock (Rs 10 par; 200, 000 shares) Rs 2, 000 shares Share premium 1, 000 Retained earnings 7, 000 Total shareholders’ equity Rs 10, 000 After 2 -for-1 Stock Split Common stock (Rs. 5 par; 400, 000 shares) Rs. 2, 000 shares Share premium 1, 000 Retained earnings 7, 000 Total shareholders’ equity Rs.

Value to Investors of Stock Splits • • Indication of higher future profits Effect Value to Investors of Stock Splits • • Indication of higher future profits Effect on cash dividends More popular trading range Informational content