bhupendra016
TRANSCRIPT
WELCOMETO ALL
YOU OF
DIVIDEND POLICY & VALUE OF FIRM
UNDER GUIDENCE:PROF. ANUBHA GUPTA
IMRT BUSINESS SCHOOLVIPUL KHAND GOMTINAGAR
LUCKNOW
FROM: BHUPENDRA PT SINGH
PGDM-2nd TRIMESTER
Topics CoveredHow Dividends are PaidShare RepurchaseHow Do Companies Decide on Dividend
PaymentsWhy Dividend Policy Should Not MatterWhy Dividends May Increase Firm ValueWhy Dividends May Reduce Firm Value
Dividend Payments
Record Date - Person who owns stock on this date received the dividend.
Ex-Dividend Date - Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock before this date is entitled to a dividend.
Cash Dividend - Payment of cash by the firm to its shareholders.
Regular vs. extra dividend Regular payment is an important issue
Procedure for Cash Dividend Payment
25 Oct. 1 Nov. 2 Nov. 6 Nov. 7 Dec.
Declaration Date
Cum-dividend
Date
Ex-dividend
Date
Record Date
Payment Date
…
Declaration Date: The Board of Directors declares a payment of dividends.Cum-Dividend Date: The last day that the buyer of a share is entitled to the dividend.Ex-Dividend Date: The first day that the seller of a share is entitled to the dividend.
Record Date: The corporation prepares a list of all individuals believed to be shareholders as of 6 [email protected]
m
Dividend PaymentsSome legal limitations on dividendsBondholders are often against excessive dividend
paymentsMost state prohibit a company from paying
dividends such that make the company insolventSometimes state law prevents a company from
paying a dividend if it cuts into the company’s legal capital
Taxes, Issuance Costs, and Dividends
In a tax-free world, cash dividends are a wash between the firm and its shareholders.
Share Holders
Cash: Share Issue
Cash: Dividends
In a world with taxes, the government gets a cut.
Gov.
Taxes
Firm [email protected]
Dividend PaymentsStock Dividend - Distribution of additional shares to a firm’s stockholders.
Stock Splits - Issue of additional shares to firm’s stockholders.
Example - Amoeba Products has 2 million shares currently outstanding at a price of $15 per share. The company declares a 50% stock dividend. How many shares will be outstanding after the dividend is paid?
Answer
2 mil x .50 = 1 mil + 2 mil = 3 mil shares
Stock DividendExample - cont - After the stock dividend what
is the new price per share and what is the new value of the firm?
Answer
The value of the firm was 2 mil x $15 per share, or $30 mil. After the dividend the value will remain the same.
Price per share = $30 mil / 3 mil share = $10 per share
Dividend PaymentsStock Repurchase - Firm buys back stock from its shareholders. (cash dividend vs. share repurchase )
If there are a few investment opportunities, and the companies do not want to commit a regular abundant dividend, then stock repurchase seems to be a good strategy
Assets Liabilities & Equity
A. Original balance sheet
Cash $150,000 Debt 0
Other assets 850,000 Equity 1,000,000
Value of Firm 1,000,000 Value of Firm 1,000,000
Shares outstanding = 100,000
Price per share = $1,000,000 / 100,000 = $10
Example - Cash dividend versus share repurchase
Assets Liabilities & Equity
B. After cash dividend
Cash $50,000 Debt 0
Other assets 850,000 Equity 900,000
Value of Firm 900,000 Value of Firm 900,000
Shares outstanding = 100,000
Price per share = $900,000 / 100,000 = $9
Example - Cash dividend versus share repurchase
Assets Liabilities & Equity
C. After stock repurchase
Cash $50,000 Debt 0
Other assets 850,000 Equity 900,000
Value of Firm 900,000 Value of Firm 900,000
Shares outstanding = 90,000
Price per share = $900,000 / 90,000 = $10
Example - Cash dividend versus share repurchase
The Dividend Decision How Dividends are Determined?1. Firms have long-term target dividend payout
ratios.2. Managers focus more on dividend changes
than on absolute levels.3. Dividends changes follow shifts in long-run,
sustainable levels of earnings rather than short-run changes in earnings .
4. Managers are reluctant to make dividend changes that might have to be reversed. (They are particularly worried about having to rescind a dividend increase)
Level of dividends can be taken as a signal about the company’s future prospect
Dividend Policy Three points of view about dividend
policy and the value of firm1. Dividend policy makes no difference
2. High dividends increase firm value
3. High dividends bring high taxes and therefore reduce firm value
Dividend policyHigher dividend payout means: More current dividend amount, consequently higher stock
priceBut lower retention rate with lower amount available for
reinvestment leading to lower growth depressing stock price
Thus needs to strike a balance to maximize stock priceReferred as optimal dividend policyMM’s proposition: value of a firm depends only on the
income produced by its assetsNot on how the income is split between dividends and
retained earnings (growth)Investors more certain of present dividend (bird-in-hand)
and prefer present dividend yield, as against capital gain yield (less certain of receiving capital gain in future resulting from retained earnings)[email protected]
Tax rate on capital gains and on dividend income are usually different for investors (long-term capital gains attract normally lower tax rate)
Again, capital gains tax not payable until stock is soldWealthy investors (who own most of the stock and receive
most of the dividends) likely to prefer higher retention rate for plough back of profits rather than high dividend rate
Most firms try to follow a policy of paying a constant or steadily increasing dividend
That provides stable income to investors Any departures from it give investors information about
management’s expectations for future earnings (signalling effects)
Other dividend policies may pertain to: Residual (after capital budgeting) dividend policyConstant payout ratio policyLow regular dividend plus extra policy (can be maintained
in difficult years and then pay extra dividend in bright years) [email protected]
The major issue involved: At what rate earned inside the organization vs. at what
rate earned in outside opportunities (besides the differential tax impact on dividend and capital gains) from investors’ point of view
Cost of retaining earnings vs. cost of distributing earnings from the company’s point of view.
Clientele effect: Individuals in high tax bracket likely to prefer either no or
less dividends, on the contrary low tax bracket investors would prefer the opposite
This disparity eventually narrowed down, and the market stabilizes
As investors desirous of specific pattern of dividends switch over their investments to those firms where they would get their preferred choice of dividends, known as clientele effect
Linter model: Managers estimate what portion of firms’ earnings is
likely to be permanent and what portion of earnings is likely to be temporary
Dividends likely to be raised following a permanent (rather than temporary) increase in earnings and firms have a long-run target for their dividends to earnings ratio
Managers need to decide the target payout ratio and the speed of adjustment of current dividend to target
Dividend may be paid by way of cash, or stock dividend depending on company’s cash position and its likely impact on its capital structure
Stock split refers to increasing the number of shares, such as doubling the number of shares outstanding by giving each stockholder two new shares for each one formerly held- to keep the stock prices within the optimal trading range
Stock repurchase plan- firm buys back some of its outstanding stock, thereby decreasing the number of shares and consequently increasing EPS and stock price
X & Y ARE TWO FAST GROWING COMPANIES IN THE ENGINEERING INDUSTRY. THEY ARE CLOSE COMPITITORS & THEIR ASSETS COMPOSITION, CAPITAL STRUCTURE & PROFITABILITY RECORDS HAVE BEEN VERY SIMILAR FOR SEVERAL YEARS. THE PRIMARY DIFFERENCE BETWEEN THEM FROM FINANCIAL MANAGEMENT PERSPECTIVE IS THEIR DIVIDEND POLICY. THE COMPANY X TRIES TO MAINTAIN A NON DECREASING DIVIDEND PER SHARE, WHILE THE COMPANY Y MAINTAINS A CONSTANT DIVIDEND PAY OUT RATIO. THEIR RECENT EARNING PER SHARE(EPS), DIVIDEND PER SHARE (DPS), & SHARE PRICE (P) HISTORY ARE AS FOLLOWS:::::
YearYear COMPANY XCOMPANY X COMPANY YCOMPANY Y
EPSEPS DPSDPS P(RANGE)P(RANGE) EPSEPS DPSDPS P(RANGEP(RANGE))
11 Rs 9.30Rs 9.30 Rs 2Rs 2 Rs 75-90Rs 75-90 Rs 9.50Rs 9.50 Rs Rs 1.901.90
Rs 60-80Rs 60-80
22 7.407.40 22 55-8055-80 7.007.00 1.401.40 25-6525-65
33 10.5010.50 22 70-11070-110 10.5010.50 2.102.10 35-8035-80
44 12.7512.75 2.252.25 85-13585-135 12.2512.25 2.452.45 80-12080-120
55 20.0020.00 2.502.50 135-200135-200 20.2520.25 4.054.05 110-225110-225
66 16.0016.00 2.502.50 150-190150-190 17.0017.00 3.403.40 140-180140-180
77 19.0019.00 2.502.50 155-210155-210 20.0020.00 4.004.00 [email protected]
QUESTIONS OF EXAMPLEIN ALL CALCULATIONS BELOW THAT REQUIRE A SHARE PRICE, USE THE
AVERAGE OF THE TWO PRICES GIVEN IN THE SHARE PRICE RANGE.
(A) DETERMINE THE DIVIDEND PAYOUT RATIO (D/P) & PRICE TO EARNINGS(P/E) RATIO FOR BOTH COMPANIES FOR ALL THE YEARS.
(B) DETERMINE THE AVERAGE D/P & P/E FOR BOTH THE COMPANIES OVER THE PERIOD 1 THROUGH 7.
(C) THE MANAGEMENT OF COMPANY Y IS PUZZLED AS TO WHY THEIR SHARE PRICES ARE LOWER THAN THOSE OF COMPANY X, IN SPITE OF THE BETTER PROFITABILITY RECORD PARTICULARLY OF THE PAST 3 YEARS.
AS A FINANCIAL CONSULTANT, HOW WOULD YOU EXPLAIN THE SITUATION ?????????
SOLUTION
YEYEAR AR
COMPANY XCOMPANY X COMPANY YCOMPANY Y
EPSEPS DPS DPS D/P D/P RATIRATIOO
PP P/E P/E RATIORATIO
EPSEPS DPSDPS D/P D/P RATIRATIOO
PP P/E P/E RATIORATIO
11 9.309.30 2.002.00 21.521.5 82.5082.50 8.878.87 9.509.50 1.901.90 2020 7070 7.377.37
22 7.407.40 2.002.00 27.527.5 67.5067.50 9.129.12 7.007.00 1.401.40 2020 4545 6.436.43
33 10.5010.50 2.002.00 19.019.0 90.0090.00 8.578.57 10.5010.50 2.102.10 2020 57.5057.50 5.485.48
44 12.7512.75 2.252.25 17.617.6 110.0110.000
8.638.63 12.2512.25 2.452.45 2020 100.0100.000
8.168.16
55 20.0020.00 2.502.50 12.512.5 167.5167.500
8.378.37 20.2520.25 4.054.05 2020 167.5167.500
8.278.27
66 16.0016.00 2.502.50 15.615.6 170.0170.000
10.6210.62 17.0017.00 3.403.40 2020 160.0160.000
9.419.41
77 19.0019.00 2.502.50 13.213.2 182.5182.500
9.69.6 20.0020.00 4.004.00 2020 160.0160.000
8.008.00
94.9594.95 15.7515.75 16.616.6 870.0870.000
9.169.16 96.5096.50 19.3019.30 2020 760.0760.000
7.887.88
(A) & (B) DD/P & P/E RATIOSD/P & P/E RATIOS
(c) COMPANY X IS FOLLOWING A STABLE DIVIDEND POLICY WHEREAS COMPANY Y IS FOLLOWING A STABLE DIVIDEND PAYOUT RATIO.
IN THE LATTER TYPE OF POLICY, SPORADIC DIVIDEND PAYMENTS OCCUR WHICH MAKE ITS OWNERS VERY UNCERTAIN ABOUT THE RETURNS THEY CAN EXPECT FROM THEIR INVESTMENT IN THE FIRM &, THEREFORE, GENERALLY DEPRESS THE SHARE PRICES.
IT IS PROBABLY FOR THIS REASON THAT THE COMPANY X’S AVERAGE PRICE PER SHARE EXHIBITED A CONSISTENT INCREASE COMPARED TO COMPANY Y, VOLATILE PATTERN OF EARNINGS OF BOTH COMPANIES (DURING THE LAST 3 YEARS) NOTWITHSTANDING.
SO COMPANY Y IS ADVISED TO FOLLOW A STABLE DIVIDEND POLICY. [email protected]
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Dividend Policy is IrrelevantSince investors do not need dividends to
convert shares to cash (because they can do it themselves), they will not pay higher prices for firms with higher dividend payouts. In other words, dividend policy will have no impact on the value of the firm ★ MM dividend-irrelevance proposition: Under ideal conditions, the value of the firms is unaffected by dividend policy ★ Given the firm’s capital budgeting and borrowing decisions, dividend policy is a trade-off between cash dividends and the issue or repurchase of common stock
Dividend Policy is IrrelevantExample - Assume Rational Semiconductor has no extra
cash, but declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend.
Record DateCash 1,000Asset Value 9,000Total Value 10,000 +New Proj NPV 2,000# of Shares 1,000price/share $12
Dividend Policy is IrrelevantExample - Assume Rational Semiconductor has no extra cash,
but declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend.
Record Date Pmt DateCash 1,000 0Asset Value 9,000 9,000Total Value 10,000 + 9,000New Proj NPV 2,000 2,000# of Shares 1,000 1,000price/share $12 $11
Dividend Policy is IrrelevantExample - Assume Rational Semiconductor has no extra cash, but
declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend.
Record Date Pmt Date Post PmtCash 1,000 0 1,000 (91 sh @ $11)Asset Value 9,000 9,000 9,000Total Value 10,000 + 9,000 10,000New Proj NPV 2,000 2,000 2,000# of Shares 1,000 1,000 1,091price/share $12 $11 $11
NEW SHARES ARE ISSUED
Dividend Policy is Irrelevant
Example - continued - Shareholder Value
RecordStock 12,000Cash 0
Total Value 12,000
Stock = 1,000 sh @ $12 = 12,000
Dividend Policy is Irrelevant Example - continued - Shareholder Value
Record Pmt Stock 12,000 11,000Cash 0 1,000
Total Value 12,000 12,000
Stock = 1,000sh @ $11 = 11,000
Dividend Policy is Irrelevant Example - continued - Shareholder Value
Record Pmt PostStock 12,000 11,000
12,000Cash 0 1,000 0
Total Value 12,000 12,00012,000
Stock = 1,091sh @ $11 = 12,000
Dividends Increase ValueMarket Imperfections and Clientele
EffectThere are natural clients for high-payout stocks, but it does not follow that any particular firm can benefit by increasing its dividends. The high dividend clientele already have plenty of high dividend stock to choose from.
Dividends Increase ValueDividends as Signals
Dividend increases send good news about cash flows and earnings. Dividend cuts send bad news. (information content of dividends)
Because a high dividend payout policy will be costly to firms that do not have the cash flow to support it, dividend increases signal a company’s good fortune and its manager’s confidence in future cash flows.
Dividends Decrease ValueTax Consequences
Companies can convert dividends into capital gains by shifting their dividend policies. If dividends are taxed more heavily than capital gains, taxpaying investors should welcome such a move and value the firm more favorably.
In such a tax environment, the total cash flow retained by the firm and/or held by shareholders will be higher than if dividends are paid.
Firm A Firm B
Next years price $112.50 $102.50
Dividend $ 0 $10.00
Total pretax payoff $112.50 $112.50
Todays stock price $100 $97.78
Capital gain $12.50 $4.72
Pretax rate of return (%)
Tax on dividend @ 40% $0 .40 x $10 = $4.00
Tax on capital gain @ 20% .20 x $12.50 = $2.50 .20 x $4.72 = $.94Total after tax income
(dividend plus capital
gains less taxes)
(0 + 12.50) - 2.50
= $10.00
(10.00 + 4.72)
- (4.00-.94)
= $9.78Aftertax rate of return (%)
12.5100
10100
= =
= = = =
12 5 15 05
10 10 10 10
14 7297 78
9 7897 78
. % . %
. % . %
.
.
..
Dividends Decrease ValueBefore 1986, dividends tax was up to 50%,
the realized capital gains were taxed only 20%
Taxes on dividends have to be paid immediately, but taxes on capital gains can be deferred until shares are sold and capital gains are realized
Pension funds are untaxed, so there is no difference for them
Corporations have to pay a 35% tax on the full amount of any realized capital gain. However, they pay corporate income tax on only 30% of any dividend received
