Dividend Policy

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

KUMAR

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

 Is it true that companies dont distribute dividends would not command a

good price? Microsoft, the worlds 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)

Where

Po=D +Ke

Po = Current market price;

Ke

Ke

D = dividend per share;

E = earnings per share;

r = Rate of Return;

Assumptions

Ke= Cost of equity

The firm is all equity firm.

The firm has indefinite life.

Earnings and dividends dont 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.

GORDONS 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 Ke-g

Where 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 firms 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;

Assumptions

E = EPS

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. LINTERS 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;

Findings

AF = Adjustment Factor

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.

5.

The adjustment factor is an arbitrary number. 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 companys 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;

Assumptions

Ke = Cost of equity;

Perfect Market

There are large no. of buyers and sellers.

All investors are equally knowledgeable

 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.

 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.

 Indias richest man just got richer.Wipros 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.

 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 companys 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 companys 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

 No uncertainty about amount

Could put

Constant

A fixed dividend rate

of dividend

pressure on firms

Dividend

maintained each

Increase in dividends sends

liquidity

Model

year

positive signals about the

Once established

company

difficult to go

 Ideal for those seeking steady

back on the policy

income

Gives impression of a strong

and healthy company Ratio of dividend per Constant No strain on companys share to earnings Payout liquidity since dividends linked per share is Approach to profits constant Market speculation due to anticipation of profits and dividends

Fixed low dividend Constant always paid plus Dividend additional dividend Plus in years of good Approach profit Dividends are paid out of profits after Residual providing for Approach upcoming capital expenditure

Minimum return is guaranteed Dividends are also linked to profits. Hence best of both plans

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! Its 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 companys 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 companys future cash flows.

Pricing

S x Po (S N) back

where

S= No. of shares outstanding before buy

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. Source : -