DIVIDEND

The word "dividend" comes from the Latin word "dividendum" ("thing to be divided").
A dividend is a payment made by a corporation to its shareholders, usually as a distribution
of profits. When a corporation earns a profit or surplus, the corporation is able to re-invest
the profit in the business (called retained earnings) and pay a proportion of the profit as a
dividend to shareholders. Distribution to shareholders may be in cash (usually a deposit into
a bank account) or, if the corporation has a dividend reinvestment plan, the amount can be
paid by the issue of further shares or share repurchase.
A dividend is allocated as a fixed amount per share, with shareholders receiving a dividend
in proportion to their shareholding. For the joint-stock company, paying dividends is not
an expense; rather, it is the division of after tax profits among shareholders. Retained
earnings (profits that have not been distributed as dividends) are shown in the shareholders'
equity section on the company's balance sheet the same as its issued share capital. Public
companies usually pay dividends on a fixed schedule, but may declare a dividend at any
time, sometimes called a special dividend to distinguish it from the fixed schedule
dividends. Cooperatives, on the other hand, allocate dividends according to members'
activity, so their dividends are often considered to be a pre-tax expense.

TYPES OF DIVIDEND

A dividend is generally considered to be a cash payment issued to the holders of

company stock. However, there are several types of dividends, some of which do not
involve the payment of cash to shareholders. These dividend types are:

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 Cash dividend: The cash dividend is by far the most common of the dividend types
used. On the date of declaration, the board of directors resolves to pay a certain
dividend amount in cash to those investors holding the company's stock on a specific
date. The date of record is the date on which dividends are assigned to the holders of
the company's stock. On the date of payment, the company issues dividend payments.
Stock dividend: A stock dividend is the issuance by a company of its common stock to
its common shareholders without any consideration. If the company issues less than 25
percent of the total number of previously outstanding shares, you treat the transaction
as a stock dividend. If the transaction is for a greater proportion of the previously
outstanding shares, then treat the transaction as a stock split. To record a stock
dividend, transfer from retained earnings to the capital stock and additional paid -in
capital accounts an amount equal to the fair value of the additional shares issued. The
fair value of the additional shares issued is based on their fair market value when the
dividend is declared.
Property dividend: A company may issue a non-monetary dividend to investors, rather
than making a cash or stock payment. Record this distribution at the fair market value
of the assets distributed. Since the fair market value is likely to vary somewhat from the
book value of the assets, the company will likely record the variance as a gain or loss.
This accounting rule can sometimes lead a business to deliberately issue property
dividends in order to alter their taxable and/or reported income.
Scrip dividend: A company may not have sufficient funds to issue dividends in the near
future, so instead it issues a scrip dividend, which is essentially a promissory note
(which may or may not include interest) to pay shareholders at a later date. This
dividend creates a note payable.
Liquidating dividend: When the board of directors wishes to return the capital
originally contributed by shareholders as a dividend, it is called a liquidating dividend,
and may be a precursor to shutting down the business. The accounting for a liquidating
dividend is similar to the entries for a cash dividend, except that the funds are
considered to come from the additional paid-in capital account.

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 DIVIDEND POLICY

Dividend may be defined as divisible profit which is distributed amongst the members of a
company in proportion to their shares in such a manner as is prescribed by the
Memorandum and Articles of Association of a company. It is the share of profits of a
company divided amongst its shareholders.
In other words, it is a return that a shareholder gets from the company which is distributed
out of its profits on his shareholdings, i.e., dividend is a distribution to shareholders out of
profits or reserves available for this purpose.

Dividend policy is the policy which concerns quantum of profits to be distributed by way of
dividend. This policy implies that the companies introduce a pattern of dividend payment
through their Board of Directors which, no doubt, has an implication on the future activities
although in practice, this procedure is not followed by most of the companies.

Concepts of Dividend Policy:

(1) Irrelevance Concept of Dividend;

(2) Relevance Concept of Dividend.

1. Irrelevance Concept of Dividend:

This concept is supported by Franco Modigliani and Morton H. Miller and E. Solomon
According to E. Solomon, the dividend policy of the firm is a residual decision, Residual
Theory and dividends are a passive residual. In other words, dividend policy has no effect
on the prices of shares of a company and, as such, it has no significance.
According to them, dividends are irrelevant, or are a passive residual, i.e., in their opinion,
investors are indifferent between dividends and capital gains. The ultimate desire of the
investors is to earn higher return on their investment.

If the firm has adequate investment opportunities which yields a higher rate of return in-
comparison with the cost of retained earnings the investors would be content with the firm
for retaining the earnings.

In the opposite case, however, i.e., if the retention is less than the cost of retained earnings,
investors would prefer to receive earnings i.e., dividends. So, it is needless to mention that a
dividend decision is nothing but a financing decision.

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In short, if the firm has profitable investment opportunities, it will retain the earnings for
investment purposes or if not, they said earnings should be distributed by way of dividend
among the shareholder/investors.

2. Relevance Concept of Dividend:

There are some scholars (viz., James, E. Walter, Myron, J. Gordon, John Linter, and
Richardson among others) who consider dividend decisions to be active variables while
determining the firms value, i.e., the dividend decision is assumed to be relevant. According
to them, dividend policy of a firm has a direct effect on the position of a firm in a stock
exchange.

Because, higher dividends increase the value of shares whereas low dividend decreases its
value in the market due to the fact that dividends actually presents information relating to
the profit earning capacity or profitability of a firm to the investors.

OBJECTIVES OF DIVIDEND POLICY

Dividend policy refers to the decision of the board regarding distribution of residual
earnings to its shareholders. The primary objective of a finance manager is the maximization
of wealth of the shareholders. Payment of dividend leads to increase in the price of shares
on the one hand but leads to a crunch in liquid resources for financing of prospective
projects. There is an inverse relationship between dividend payment and retained earnings.

THE MAIN OBJECTIVES OF A DIVIDEND POLICY ARE

i. Wealth Maximization:
According to some schools of thought dividend policy has significant impact on the value of
the firm. Therefore the dividend policy should be developed keeping in mind the wealth
maximization objective of the firm.

ii. Future Prospects:

Dividend policy is a financing decision and leads to cash outflows and also leads to decrease
in availability of cash for financing of profitable projects. If sufficient funds are not available,
a firm has to depend on external financing. Therefore the dividend policy needs to be
devised in such a manner that prospective projects may be financed through retained
earnings.

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iii. Stable Rate of Dividend:
Fluctuation in the rate of return adversely affects the market price of shares. In order to
have a stable rate of dividend, a firm should retain a high proportion of earnings so that the
firm can keep sufficient funds for payment of dividend when it faces loss.

iv. Degree of Control:

Issue of new shares or dependence on external financing will dilute the degree of control of
the existing shareholders. Therefore, a more conservative dividend policy should be
followed in order that the interest of existing shareholders is not hampered.

TYPES OF DIVIDEND POLICY

Three of the more commonly used dividend policies are described in the following sections.
A particular firms cash dividend policy may incorporate elements of each.

Regular Dividend Policy:

Payment of dividend at the usual rate is termed as regular dividend. In this type of dividend
policy the investors get dividend at usual rate. Here the investors are generally retired
persons or weaker section of the society who want to get regular income. This type of
dividend payment can be maintained only if the company has regular earning.y

Merits of Regular dividend policy:

It establishes a profitable record of the company.

It creates confidence amongst the shareholders.

It aids in long-term financing and renders financing easier.

It stabilizes the market value of shares.

The ordinary shareholders view dividends as a source of funds to meet their day-to-day
living expenses.

If profits are not distributed regularly and are retained, the shareholders may have to
pay a higher rate of tax in the year when accumulated proofits are distributed.

It helps in marinating the goodwill of the company.

It helps in giving regular income to the shareholders.

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However, it must be remembered that regular dividends can be maintained only by
companies of long standing and stable earnings, A company should establish the regular
dividend at a lower rate as compared to the average earnings of the company.

Constant-Payout-Ratio Dividend Policy

The dividend payout ratio indicates the percentage of each dollar earned that is distributed
to the owners in the form of cash. It is calculated by dividing the firms cash dividend per
share by its earnings per share. With a constant-payout-ratio dividend policy, the firm
stablishes that a certain percentage of earnings is paid to owners in each dividend period.
The problem with this policy is that if the firms earnings drop or if a loss occurs in a given
period, the dividends may be low or even nonexistent. Because dividends are often
considered an indicator of the firms future condition and status, the firms stock price may
thus be adversely affected.

EXAMPLE
XYZ ltd. has a policy of paying out 40% of earnings in cash dividends. In periods when a loss
occurs, the firms policy is to pay no cash dividends. In years of decreasing dividends, the
firms stock price dropped; when dividends increased, the price of the stock increased.

Low-Regular-and-Extra Dividend Policy

Some firms establish a low-regular-and-extra dividend policy, paying a low regu-lar dividend,
supplemented by an additional dividend when earnings are higherthan normal in a given
period. By calling the additional dividend an extra divi-dend,the firm avoids giving
shareholders false hopes. This policy is especially common among companies that
experience cyclical shifts in earnings. By establishing a low regular dividend that is paid each
period, the firm gives investors the stable income necessary to build confidence in the firm,
and the extradividend permits them to share in the earnings from an especially good
period.Firms using this policy must raise the level of the regular dividend once proven
increases in earnings have been achieved. The extra dividend should not be a regular event;
otherwise, it becomes meaningless. The use of a target dividend-payout ratio in establishing
the regular dividend level is advisable.

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Demerits of regular and extra divided policy:

The policy of regular and extra dividends year after year may give a wrong impression
among the stockholders who may treat extra dividends as part of regular dividends.

The shareholders may react very strongly to omission of extra dividends in future when
earnings of the firm do not warrant distribution of such dividends.

Firm may lose confidence of stockholders and its credit standing in the market.

It is, therefore, pertinent for the management to make it crystal clear in policy
announcement that a regular dividend rate will be paid under normal circumstances with
the possibility of extra dividends only when earnings power and other conditions warrant

. DIVIDEND POLICY AND VALUE OF A COMPANY

Dividend policy and value of a

company:

Dividend policy doesnt affect the value ll

Dividend policy affect the value of a company
of a company

1. Walter model MM model

2. Gordon model

WALTERS MODEL:

Walter's model supports the principle that dividends are relevant. The investment policy of a
firm cannot be separated from its dividend policy and both are inter-related. The choice of an
appropriate dividend policy affects the value of an enterprise.

According to this concept, a dividend decision of the company affects its valuation. The
companies paying higher dividends have more value as compared to the companies that pay

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lower dividends or do not pay at all. Walters theory further explains this concept in a
mathematical model.

Prof. James E Walter formed a model for share valuation that states that the dividend policy of
a company has an effect on its valuation. He categorized two factors that influence the price of
the share viz. dividend payout ratio of the company and the relationship between the internal
rate of return of the company and the cost of capital.

RELATION OF DIVIDEND DECISION AND VALUE OF A FIRM

According to Walters theory, the dividend payout in relation to (Internal Rate of Return) r
and (Cost of Capital) k will impact the value of the firm in the following ways:

When r > ke, the value of shares is inversely related to the D/P ratio. As the D/P ratio increases,
the market value of shares decline. Its value is the highest when D/P ratio is 0. So, if the firm
retains its earnings entirely, it will maximize the market value of the shares. The optimum
payout ratio is zero.

When r < ke, the D/P ratio and the value of shares are positively correlated. As the D/P ratio
increases, the market price of the shares also increases. The optimum payout ratio is 100%.

When r = ke, the market value of shares is constant irrespective of the D/P ratio. In this case,
there is no optimum D/P ratio.

ASSUMPTIONS OF THE MODEL:

1. Retained earnings are the only source of finance. This means that the company does not
rely upon external funds like debt or new equity capital.

2. The firm's business risk does not change with additional investments undertaken. It implies
that r(internal rate of return) and k(cost of capital) are constant.

3. There is no change in the key variables, namely, beginning earnings per share (E), and
dividends per share (D). The values of D and E may be changed in the model to determine
results, but any given value of E and D are assumed to remain constant in determining a given
value.

4. The firm has an indefinite life.

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WALTERS MODEL VALUATION FORMULA AND ITS DENOTATIONS:

Walters formula to calculate the market price per share (P) is:

P = D/k + {r*(E-D)/k}/k,

Where,

P = market price per share

D = dividend per share

E = earnings per share

r = internal rate of return of the firm

k = cost of capital of the firm

Explanation: The mathematical equation indicates that the market price of the companys
share is the total of the present values of:

1) An infinite flow of dividends, and

2) An infinite flow of gains on investments from retained earnings.

The formula can be used to calculate the price of the share if the values of other variables are
available.

A company has an EPS of Rs. 15. The market rate of discount applicable to the company is
12.5%. Retained earnings can be reinvested at IRR of 10%. The company is paying out Rs.5 as a
dividend.

Calculate the market price of the share using Walters model.

Here,

D = 5, E = 15, k = 12.5%, r = 10%

Market price of the share = P = 5/.125 + {.10 * (15-5)/.125} /.125 = 104

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 IMPLICATIONS OF WALTERS MODEL:

Walters model has important implications for firms in various levels of growth as described
below:

1) Growth Firm:

Growth firms are characterized by an internal rate of return > cost of the capital i.e. r > k.
These firms will have surplus profitable opportunities to invest. Because of this, the firms in
growth phase can earn more return for their shareholders in comparison to what the
shareholders can earn if they reinvested the dividends. Hence, for growth firms, the optimum
payout ratio is 0%.

2) Normal Firm:

Normal firms have an internal rate of return = cost of the capital i.e. r = k. The firms in normal
phase will make returns equal to that of a shareholder. Hence, the dividend policy is of no
relevance in such a scenario. It will have no influence on the market price of the share. So,
there is no optimum payout ratio for firms in the normal phase. Any payout is optimum.

3) Declining Firm:

Declining firms have an internal rate of return < cost of the capital i.e. r < k. Declining firms
make returns that are less than what shareholders can make on their investments. So, it is
illogical to retain the companys earnings. In fact, the best scenario to maximize the price of
the share is to distribute entire earnings to their shareholders. The optimum dividend payout
ratio, in such situations, is 100%.

LIMITATIONS OF THIS MODEL:

1) Walter's model assumes that the firm's investments are purely financed by retained
earnings. So this model would be applicable only to all-equity firms.

2) The assumption of r as constant is not realistic.

3) The assumption of a constant ke ignores the effect of risk on the value of the firm.

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SUMMARY WALTERS MODEL:

Though Walters theory has some unrealistic assumptions, it follows the concept that the
dividend policy of a company has an effect on the market price of its share. It explains the
impact in the mathematical terms and finds the value of the share.

GORDONS GROWTH MODEL:

The Gordon Growth Model, also known as the dividend discount model (DDM), is a method for
calculating the intrinsic value of a stock, exclusive of current market conditions. The model
equates this value to the present value of a stock's future dividends.

Gordons Model assumes that the investors are risk averse i.e. not willing to take risks and
prefers certain returns to uncertain returns. Therefore, they put a premium on a certain return
and a discount on the uncertain returns. The investors prefer current dividends to avoid risk;
here the risk is the possibility of not getting the returns from the investments.

But in case, the company retains the earnings; then the investors can expect a dividend in
future. But the future dividends are uncertain with respect to the amount as well as the time,
i.e. how much and when the dividends will be received. Thus, an investor would discount the
future dividends, i.e. puts less importance on it as compared to the current dividends.

According to the Gordons Model, the market value of the share is equal to the present value
of future dividends. It is represented as:

P = [E (1-b)] / Ke-br

Where, P = price of a share

E = Earnings per share

b = retention ratio

1-b = proportion of earnings distributed as dividends

Ke = capitalization rate

Br = growth rate

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 ASSUMPTIONS OF THE MODEL:

1) The firm is an all-equity firm; only the retained earnings are used to finance the investments,
no external source of financing is used.

2) The rate of return (r) and cost of capital (K) are constant.

3) The life of a firm is indefinite.

4) Retention ratio once decided remains constant.

5) Growth rate is constant (g = br).

6) Cost of Capital is greater than br.

CRITICISM OF THE MODEL:

1) It is assumed that firms investment opportunities are financed only through the retained
earnings and no external financing viz. Debt or equity is raised. Thus, the investment policy or
the dividend policy or both can be sub-optimal.

2) The Gordons Model is only applicable to all equity firms. It is assumed that the rate of
returns is constant, but, however, it decreases with more and more investments.

3) It is assumed that the cost of capital (K) remains constant but, however, it is not realistic in
the real life situations, as it ignores the business risk, which has a direct impact on the firms
value.

Thus, Gordon model posits that the dividend plays an important role in determining the share
price of the firm.

M &M PROPOSITION

The ModiglianiMiller theorem (of Franco Modigliani, Merton Miller) is a theorem on capital
structure, arguably forming the basis for modern thinking on capital structure. The basic
theorem states that in the absence of taxes, bankruptcy costs, agency costs, and asymmetric
information, and in an efficient market, the value of a firm is unaffected by how that firm is
financed. Since the value of the firm depends neither on its dividend policy nor its decision
to raise capital by issuing stock or selling debt, the ModiglianiMiller theorem is often called
the capital structure irrelevance principle.

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 M&M Proposition I

M&M Proposition I states that the value of a firm does not depend on its capital structure.
For example, think of 2 firms that have the same business operations, and same kind of
assets. Thus, the left side of their Balance Sheets looks exactly the same. The only thing
different between the 2 firms is the right side of the balance sheet, i.e. the liabilities and
how they finance their business activities.

In the first diagram, stocks make up 70% of the capital structure while bonds (debt) make up
for 30%. In the second diagram, it is the exact opposite. This is the case because the assets
of both capital structures are the exactly same.

M&M Proposition 1 therefore says how the debt and equity is structured in a corporation is
irrelevant. The value of the firm is determined by Real Assets and not its capital structure.

M&M Proposition II

M&M Proposition II states that the value of the firm depends on three things:

1) Required rate of return on the firm's assets (Ra)

2) Cost of debt of the firm (Rd)
3) Debt/Equity ratio of the firm (D/E)

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If you recall the tutorial on Weighted Average Cost of Capital (WACC), the formula for WACC
is:

WACC = [Rd x D/V x (1-5)] + [Re x E/V]

The WACC formula can be manipulated and written in another form:

Ra = (E/V) x Re + (D/V) x Rd

The above formula can also be rewritten as:

Re = Ra + (Ra - Rd) x (D/E)

This formula #3 is what M&M Proposition II is all about.

Analysis of M&M Proposition II Graph

- The above graph tells us that the Required Rate of Return on the firm (Re) is a linear
straight line with a slope of (Ra - Rd)

- Why is Re linear curved and upwards sloping? This is because as a company borrows more
debt (and increases its Debt/Equity ratio), the risk of bankruptcy is even more higher. Since

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adding more debt is risky, the shareholders demand a higher rate of return (Re) from the
firm's business operations. This is why Re is upwards sloping:

- As Debt/Equity Ratio Increases -> Re will Increase (upwards sloping).

- Notice that the Weighted Average Cost of Capital (WACC) in the graph is a straight line
with NO slope. It therefore does not have any relationship with the Debt/Equity ratio. This is
the basic identity of M&M Proposition I and II, that the capital structure of the firm does not
affect its total value.

- WACC therefore remains the same even if the company borrows more debt (and increases
its Debt/Equity ratio).

Types of Bonds - Fixed Rate Bonds, Floating Rate Bonds, Asset-Backed Bonds, Perpetual
Bonds, Bearer Bonds

Every bond selling on the public market has some covenants and specifications to it that
make it different from other bonds. However, we have classified many of the bonds into the
following categories:

1) Fixed Rate Bonds

Fixed rate bonds are what the name implies, they provide a fixed coupon interest payment
at each period (monthly, quarterly, semi-annually or annually) for a certain # of years up
until maturity. Upon maturity, fixed rate bonds pay back the entire original principal
amount. Go here to learn more about bond debt securities.

2) Floating Rate Notes

Floating Rate Notes are different than fixed rate notes because they pay out variable
coupon interest payments at each period (monthly, quarterly, semi-annually or annually).
The amounts of these variable payments are determined by the current market interest
rates such as the LIBOR (London Interbank Offered Rate) or Federal Funds Rate (FFR) + a
"spread." A spread is a percentage point example 0.2 that remains constant.

3) High Yield Bonds

High yield bonds are bonds that pay out higher coupons than normal, however they have a
large chance of defaulting on these coupon payments. They are therefore graded below the
"investment grade." These types of bonds are also known as junk bonds.

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4) Zero Coupon Bonds

Zero coupon bonds do not pay out any coupon interest payments but they are sold for very
cheap. For example, if you buy a $1000 face value bond today for $450 (discounted bond
value), the company might pay you back $1000 in 5 years. You have therefore made: $1000
- $450 = 550 / 5 years = $110 per year. Zero coupon bond maturity dates can range from
long term (10 - 15 years) and short term (less than 1 year).

5) Asset Backed Bonds

Asset backed bonds are bonds available on the debt market that are backed up by a diverse
pool of illiquid assets such as accounts receivable collections, credit card debt or mortgages
and are relatively safe investments. If an issuing company defaults on its bond debt
repayments, bondholders can then legally be entitled to cash flows generated from these
illiquid pools of assets (A/R, mortgages, credit card debt, etc.).

6) Subordinated Bonds

Subordinated bonds are those that have a lower priority when compared to other creditors
and bondholders in case of bankruptcy and liquidation. If the issuing corporation goes
bankrupt, the creditors are paid first. After that, government taxes are paid. After that, the
senior bond holders are paid followed by the subordinated bondholders. As you can make
out from this, subordinated bonds carry a very high risk of non-payment because they are
the last in the hierarchy of creditors.

7) Perpetual Bonds

Perpetual bonds are also known as perpetuities because they have no date when they
become matured. This means the coupon interest payments are paid forever. Examples of
perpetual bonds are "Consuls" issued by the British Government in 1888, which still trade in
the market today. They are also called Undated Treasuries or Treasury Annuities.

Recently, Wheat Shore Railroad issued a bond that matures in the year 2361 (which matures
in 355 years). This kind of a bond is also known as perpetuity.

8) Bearer Bond

Bearer bonds are legal certificates that entitle the bondholder to receive coupon interest
payments and the entire original principle upon maturity. However, they are different in the
sense that no record of the original bondholder is kept. Whoever has the bond physically
must present it for reimbursement during certain bond payment dates and will receive the
coupon payments.

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 FACTORS AFFECTING DIVIDEND POLICY

It is a generally accepted principle that the directors of a company have sole right to declare
dividend and determine its amount out of companys earnings. But, in addition to legal
restrictions, they have to consider many factors while deciding the dividend policy. A
rational distribution of earnings has been very beautifully described in a legal case.
Accordingly, the net earnings that should be distributed among the shareholders depends
largely upon the companys needs for accumulated reserves to strengthen its credit,
increase its working capital, carrying contemplated projects of expansion or provide
contingencies against future hazards. In the light of this statement, the different factors
which determine the dividend policy of a company are explained below.

1. Dividend pay out ratio: The dividend payout ratio is the ratio of the total amount of
dividends paid out to shareholders relative to the net income of the company. It is
the percentage of earnings paid to shareholders in dividends. The amount that is not
paid out to shareholders is retained by the company to pay off debt or to reinvest in
core operations. The dividend payout ratio can be calculated as the yearly dividend
per shareover the earnings per share, or equivalently, the dividends divided by net
income

2. Stability of dividend: The fluctuation of dividends created by the residual policy

significantly contrasts with the certainty of the dividend stability policy. With the
stability policy, quarterly dividends are set at a fraction of yearly earnings. This policy
reduces uncertainty for investors and provides them with income.

3. Stability of Earnings: The nature of business has an important bearing on the

dividend policy. If a firm has relatively stable earnings , it is more likely to pay
relatively larger dividend than a firm with relatively fluctuating earnings . Industrial
units having stability of earnings may formulate a more consistent dividend policy
than those having an uneven flow of incomes because they can predict easily their
savings and earnings usually, enterprises dealing in necessities suffer less from
oscillating earnings than those dealing in luxuries or fancy goods.

4. Age of Corporation: Age of the corporation count much in deciding the dividend
policy. A newly established company may require much of its earnings for expansion
and plant improvement and may adopt a rigid dividend policy while, on the other
hand, an older company can formulate a clear cut and more consistent policy
regarding dividend.

CORPORATE FINANCE PAGE 17

 5. Liquidity of Fund:
Availability of cash and sound financial positions is also an important factor in dividend
decision. A dividend represents a cash outflow, the greater the funds and the liquidity of the
firm the better the ability to pay dividend. The liquidity of the firm depends very much on
the investment and financial decisions of the firm which in turn determines the rate of
expansion and the manner of financing. If cash position is weak, stock dividend will be
distributed and if cash position is good, company can distribute the cash dividend.

6. Extent of share Distribution:

Nature of ownership also affects the dividend. A closely held company is likely to get the
assent of the shareholders for the suspension of dividend or for following a conservative
dividend policy. On the other hand, a company having a good number of shareholders
widely distributed and forming low or medium income group would face a great difficulty in
securing such assent because they will emphasize to distribute higher dividend.

7. Needs for Additional capital:

Companies retain a part of their profits for strengthening their financial positions. The
income may be conserved for meeting the increased requirements of working capital or of
future expansion. Small companies usually find difficulties in raising finance for their needs
of increased working capital for expansion programmers. They having on other alternative,
use their ploughed. Thus, such companies distribute dividend at low rates and retain a big
part of profits.

8. Trade cycles:
Business cycle also exercise influence upon dividend policy. Dividend policy is adjusted to
the business oscillations. During the boom prudent management creates food reserves for
contingencies which follow the inflationary period. Higher rates of contingencies which
follow the inflationary period. Higher rates of dividend can be used as a tool for marketing
the securities in on otherwise depressed market. The financial solvency can be proved and
maintained by the companies in dull years if the adequate reserves have been built up.

9. Government policies:
The earnings capacity of the enterprise is widely affected by the change in fiscal, industrial
labour, control and other government policies. Sometimes government restricts the
distribution of dividend beyond a certain percentage in a particular industry or in all spheres
of business activity as was done in emergency. The dividend policy has to be modified or
formulated accordingly in those enterprises.

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 10. Taxation Policy:
High taxation reduces the earning of the companies and consequently the rate of dividend is
lowered down . Sometimes government levies dividend -tax of distribution of dividend
beyond a certain limit . It also affects the capital formation.

11. Legal Requirements:

In deciding on the dividend, the directors take the legal requirements too into
consideration. In order to protect the interest of creditors an outsider, the companies Act
1956 prescribe certain guidelines in the respect of distribution and the payment of dividend.
Moreover a company is required to provide for depreciation on its fixed and tangible assets
before declaring dividend on shares. It proposes that dividend should not be distributed out
of capital, in any case. Likewise, contractual obligation should also be fulfilled, for example
payment of dividend on preference shares on priority over ordinary dividend.

12. Ability to Borrow:

Well established and large firms have better access to the capital market than the new
companies and may borrow funds from the external source if there arises any need. Such
companies may have a better dividend payout, whereas smaller firms have to depend on
their internal sources and therefore they have to build up good reserves by reducing the
dividend payout ratio for meeting any obligation requiring heavy funds.

13. Policy of Control:

Policy of control is another determining factor is so far as dividend are concerned. If the
directors want to have control on company, they would not like to add new shareholder and
therefore, declare a dividend at lower rates because by adding new shareholder they feared
dilution of control and diversion of policies and the programmers of the existing
management so they preferred to meet the needs through retained earnings. If the
directors do not bother about the control of affairs they will follow a liberal dividend policy.
Thus control is an influencing factor in framing the dividend policy.

14. Inflation: An investor only interested in a high yield may be sacrificing future buying
power. Indeed, a large, but static, dividend payment will be eaten away by inflation, rising
living costs, over time. This is the same problem that bond investors face.

CORPORATE FINANCE PAGE 19

 STOCK DIVIDEND

A stock dividend is a dividend payment to existing owners in the form of stocks rather than
cash. This is a distribution of corporate shares to shareholders based on their ownership
percentage.

Corporations typically issue stock distributions to investors for a variety Of reasons. Many
companies dont have the cash to pay investors cash dividends, but they still want to
encourage shareholders to keep their money invested in the company. Thus, the
corporation gives each shareholders additional shares of stocks based on their current
ownership percentage, instead of cash. This way the shareholder receives a return on their
investment and the corporation doesnt have to part with its cash.

Since no cash is involved in a stock distribution, the assets and equity accounts are not
affected by the transactions. The equity account is simply increased by the amount of shares
issued to investors and decreased by the amount of the dividend given to each shareholder
resulting in net zero effect.

Share dividends are reported two different ways depending on the number of shares being
issued.

1. Small Stock Dividend

A small Stock dividend is a stock dividend that represent less than 20 % to 25 % of the
common stock outstanding when the dividend is declared. Small stock dividends are most
common.

2. Large Stock Dividend

A large stock dividend is stock dividend that represents more than 25% of the common
stocks outstanding when the dividend is declared.

Accounting Aspect

In an accounting sense, the payment of a stock dividend is a shifting of funds between

stockholders equity accounts rather than an outflow of funds. When a firm declares a stock
dividend, the procedures for announcement and the distribution are the same as a cash
dividend. The accounting entries associated with the payment of a stock dividend depending
on its size.
CORPORATE FINANCE PAGE 20
Shareholders Viewpoint

The shareholders receiving a stock dividend typically receiving nothing of value. After the
dividend is paid, the per share value of the shareholders stock decreases in the per potion to
the dividend in such a way that market value of his or her total holdings in the firm remains
unchanged. Therefore, stock dividends are usually non-taxable. The shareholders proportion
of ownership in the firm remains also same and as long as firms earnings remains
unchanged, so does his or her shares of total earnings.

The Companys Viewpoint

Stock dividends are more costly to issue them cash dividends, but certain advantages
outweigh these costs. Firms find the stock dividends to be way to give owners give
something without having to use cash. giverally, when a firm needs to preserve cash to
finance rapid growth, it uses stock dividends when the stockholders recognise that the firm
is investing the cash flow so as to maximize future earnings, the market value of the firm
should at least remain unchanged.

STOCK SPLITS

Stocks splits occur when a company percives its stocks price may be too high. A stock split is
a method commonly used to lower the market price of firm's stock by increasing the
number of shares belongings to each stockholder.

Stock splits increase the number of shares outstanding and reduces per or stated value per
share of the companys stocks. For example a two for one stock split means that the
company stockholders will receive two shares for every share they currently own. The split
will double the number of shares outstanding and reduce by half the per value per share.
Existing shareholders will see their shareholdings double in quantity, but there will no
change in the proportional ownership represented by the shares.

For example, a shareholder owning 2000 shares out of 1,00,000 before stock split would
own 4,000 shares out of 2,00,000 after a stock split.

CORPORATE FINANCE PAGE 21

Reverse Stock split

Sometime a reverse stock split is made. A reverse stock split is a method used to raise the
market price of a firm's stock by exchanging a certain number of outstanding shares for one
new share. For Example, in a 1-for-3 split, one new share is exchanged for 3 old shares.

SHARE REPURCHASE

Share repurchase (or stock buyback) is the re-acquisition by a company of its own stock. It
represents a more flexible way (relative to dividends) of returning money to shareholders.

Stock buyback happens when a company purchases its own stock, either on the open
market, or directly from its shareholders; it's known as a "share buyback", or "stock
repurchase".

In most countries, a corporation can repurchase its own stock by distributing cash to existing
shareholders in exchange for a fraction of the company's outstanding equity; that is, cash is
exchanged for a reduction in the number of shares outstanding. The company either retires
the repurchased shares or keeps them as treasury stock, available for re-issuance.

What happens when companies buy back stock?

Generally when this happens, the company will absorb or retire these repurchased shares,
and re-name them treasury stock.

Share buybacks are commonly used to create or enhance shareholder value in number of
different ways.

Advantage

1. Enhanced dividends and E.P.S.

Following a stock repurchase, the number of shares issued would decrease and therefore in
normal circumstances both D.P.S. and E.P.S. would increase in future. However, the increase
in E.P.S is a bookkeeping increase since total earnings remaining constant.

2. Enhanced Share Price

Companies that undertake share repurchase, experience an increase in market price of the
shares. This is partly explained by increase in total earnings having less and/or market signal
effect that shares are under value.

CORPORATE FINANCE PAGE 22

3. Capital structure

A companys managers may use a share buy back or requirements, as a means of correcting
what they perceive to be an unbalanced capital structure.

If shares are repurchased from cash reserves, equity would be reduced and gearing
increased (assuming debt exists in the capital structure).

Alternatively a company may raise debt to finance a repurchase. Replacing equity with debt
can reduce overall cost of capital due to tax advantage of debt.

4. Employee incentive schemes

Instead of cancelling all shares repurchase, a firm can retain some of the shares for
employees share option or profit sharing schemes.

5. Reduced take over threat

A share repurchase reduced number of share in operation and also number of weak
shareholders i.e shareholders with no strong loyalty to company since repurchase would
induce them to sell.

This helps to reduce threat of a hostile takeover as it makes it difficult for predator company
to gain control. (This is referred as a poison pill) i.e. Co.s value is reduced because of high
repurchase price, huge cash outflow or borrowing huge long term debt to increase gearing

Disadvantages of stock repurchase

1. High price

A company may find it difficult to repurchase shares at their current value and price paid
may be too high to the detriment of remaining shareholders.

2. Market Signaling

Despite directors effort at trying to convince markets otherwise, a share repurchase may be
interpreted as a signal suggesting that the company lacks suitable investment opportunities.
This may be interpreted as a sign of management failure.

3. Loss of investment income

The interest that could have been earned from investment of surplus cash is lost.

CORPORATE FINANCE PAGE 23

 METHODS:

Under US corporate law there are five primary methods of stock repurchase. More than
95% of the buyback programs worldwide are through an open-market method, whereby the
company announces the buyback program, and then repurchases shares in the open market
(stock exchange).

1. Buy in the open market:

The most straightforward way is to buy the shares in the open market. In this method, the
shares will be purchased directly from the market at the current market price. The board of
a company may authorize to buy a number of shares in this manner. This method offers a
lot of flexibility as the company may choose to buy shares at a convenient time. This method
is also cost effective compared to other methods.

2. Repurchase a fixed number of shares at a fixed price:

Under this method, the company will make a fixed price offer to purchase a fixed number of
shares at a fixed price. This price will usually be above the prevailing market price. For
example, a company may make an offer to buy 1 million shares at $20 per share. If
shareholders offer to sell more than this number of shares, the company will buy shares
from different shareholders on a pro-rata basis.

3. Dutch auction:

This works similar to the fixed price purchase, but instead of specifying a fixed price, the
company sets a range of acceptable prices (minimum and maximum). For example, an offer
to buy 1 million shares in a price range of $18 to $22. The different shareholders will then
quote the price at which they are willing to sell their shares. After receiving all the bids, the
company will qualify these bids starting from the minimum price and then moving up until it
has qualified 1 million shares. If the price at which these one million shares were qualified is
$20, then all these shareholders who bid, 18, 19 and 20, will be paid $20 per share for their
shares.

4. Repurchase by direct negotiation:

Under this method, the company will negotiate the price of shares with certain large
shareholders and buy the shares from them. This price will usually be higher than the
current market price. A company may do so in order to keep away any large shareholders
gaining representation, or a possible takeover attempt.

5. Other types

A company may also buy back shares held by or for employees or salaried directors of the
company or a related company. This type of buy-back, referred to as an employee share
scheme buy-back , requires an ordinary resolution. A listed company may also buy back its
CORPORATE FINANCE PAGE 24
shares in on-market trading on the stock exchange, following the passing of an ordinary
resolution if over the 10/12 limit. The stock exchange's rules apply to on-market buy-backs .
A listed company may also buy unmarketable parcels of shares from shareholders (called a
minimum holding buy-back ). This does not require a resolution but the purchased shares
must still be cancelled.

Purposes/ Why Companies Consider Share Buybacks??

With an increasing number of companies announcing buybacks, it appears that directors

believe that buybacks have a positive impact on the business as well as shareholders. Listed
below are some of the most common reasons why a company might repurchase its own
shares:

Take Advantage of Undervalued Share Price:

A common scenario for a share repurchase is when management believes that their own
shares are undervalued. Rather than keeping surplus cash in the bank, management
decides to purchase shares of the company at - what they believe - a cheap price. The
buyback has two effects on the company's stock: On the one hand, the number of shares
outstanding is being reduced (we will go more into detail below) and buying pressure
increases as the company is physically buying its own stock. On the other hand, by buying
(often) millions of dollars of its own stock, management also reassures the market that they
are confident in their own business operations, which encourages investors to buy. The
market thinks that management would only buy their own stock if they believe that the
value per share will increase in the medium to long-term.

Reduce Dilution and Increase Ownership:

Over time companies tend to issue new shares, e.g. via capital raisings or exercise of
options, which implies dilution of existing shareholders. By buying back stock, a company
can reduce the impacts of dilution. Also reducing the number of shares outstanding may
help increase ownership of the companys management.

Enhancing Financial Ratios:

While enhancing a companys ratios might not be the sole reason for repurchasing shares, it
is often an attractive by-product of these transactions.

CORPORATE FINANCE PAGE 25

Reducing the number of shares outstanding can have a positive impact on various ratios
that are tracked closely by the market.

Return on Asset (ROA): This ratio is calculated by dividing a companys net income by total
assets. Reducing the share capital reduces a companys total assets and overall has a
positive impact on the ROA.

Return on Equity (ROE): Return on Equity is expressed as the amount of net income
returned as a percentage of shareholders equity. Hence, if a companys earnings remain
constant, reducing the total equity lifts its ROE.

Earnings Per Share (EPS): This ratio is calculated by (net income dividends on preferred
stock)/ average outstanding shares. Hence reducing the overall outstanding shares boosts
the EPS of a company.

CORPORATE FINANCE PAGE 26