Distribution Policy 1
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Transcript of Distribution Policy 1
SOUTH EASTERN STEEL COMPANY
• GROUP 3• ASHWATH.G.HEGDE• NAVIN GUPTA• PRIYA RICHHARIYA• PRGATI SAXENA• SAILAJA AKELLA
Introduction • Established in 1945• Annual revenue of $10 to 20 million• Employees: 100 to 250• Business activity: Manufacturer of fabricated
metal products, exporter / importer• Products and services: carbon-cold finished bars
carbon-expanded steel carbon-grating carbon-hollow structurals.
Distribution policy
• It is the decision about how much of earnings to pay out as dividends versus retaining and reinvesting earnings in the firm.
IRRELEVANCE THEORY
• Investors are indifferent between dividends and retention-generated capital gains. If they want cash, they can sell stock. If they don’t want cash, they can use dividends to buy stock.
• Modigliani-Miller support irrelevance but their theory is based on unrealistic assumptions (no taxes or brokerage costs), and hence may not be true.
Bird-in-the-Hand Theory
• Investors think dividends are less risky than potential future capital gains, hence they like dividends.
• If so, a high payout would result in a low risk, hence a high P0.
Tax Preference Theory
• Retained earnings lead to capital gains, which are taxed at lower rates than dividends: 28% maximum vs. up to 39.6%. Capital gains taxes are also deferred.
• This could cause investors to prefer firms with low payouts, i.e. low payout results in a low ks, hence a high P0.
Implications of the three theories for managers
Theory • Irrelevance• Bird -in-the –hand• Tax preference
Implication • Any payout is suitable• Sets high payout• Sets low payout
Have empirical tests proved which theory is most correct
• No. Empirical testing has not been able to determine which theory, if any, is correct.
• Thus, managers must use judgment when setting policy.
• Analysis is used, but it must be applied with judgment.
What is the “information content,” or “signaling,” hypothesis and how does it affect
dividend policy?
• Managers hate to cut dividends, so they won’t raise dividends unless they think the increase is sustainable.
• Thus, investors view dividend increases as signals of manage-ment’s positive view of the future.
Cont….
• Therefore, if a company’s stock price increases at the time it announces a dividend increase, this could reflect expectations for higher future EPS, not a preference for dividends over retentions and capital gains.
• Conversely, a dividend cut would be a signal that managers are worried about future earnings.
• The signaling impact constrains dividend decisions by imposing a large cost on a dividend cut and by discouraging managers from raising dividends until they are sure about future earnings.
• Managers tend to raise dividends only when they believe future earnings can comfortably support a higher dividend level and they cut dividends only as a last resort.
What is the “clientele effect” and how does it affect dividend policy?
• Different groups of investors, or clienteles, prefer different policies, e.g. retirees need dividends for income.
• A firms’ past dividend policy deter-mines its current clientele of investors.
• Clientele effects impede changing policy. Taxes and brokerage costs hurt investors who switch companies.
Problem
• Capital budget: $800,000 • Target capital structure: 40% debt, 60%
equity. Plans to maintain. • Forecasted net income: $600,000. • How much of the $600,000 should be paid
out as dividends?
Cont…
• Of the $800,000 capital budget, 0.60($800,000) = $480,000 must be equity to keep at target capital structure. 0.40($800,000) = $320,000 will be debt.
• With $600,000 of net income, the residual is:$600,000 - $480,000 = $120,000= dividends paid.
• Payout ratio = $120/$600 = 0.20 = 20%.
What if Net Income dropped to $400,00? A rise to $800,000 Net Income $8,00,000
• Distribution = Net Income - [(Target equity ratio) * (Total capital budget)]
• = $8,00,000 - 60% * $8,00,000 = $3,20,000 • Resulting Payout = 40.0%
How would a change in investment opportunities affect the dividend under the
residual dividend policy?
• Fewer good investments would lead to a smaller capital budget, hence a higher dividend payout.
• More good investments would lead to a lower dividend payout.
What are the advantages and disadvantages of the residual dividend model?
• Advantages: Minimizes new stock issues, hence flotation costs and negative signals associated with new stock.
• Disadvantages: Variable dividends send conflicting signals, increase risk, and do not appeal to any specific clientele. Results in higher required return.
Stock Repurchases
• Repurchases: When a firm buys its own stock back.
• Reasons for repurchases: – An alternative to distributing cash as dividends. – To dispose of one-time cash from an asset sale. – To make a large capital structure change.
Advantages of Repurchases
• Stockholders can tender . • Distribute cash without setting high dividend
that cannot be maintained. • Treasury stock can be used in take-overs or
resold to raise cash. • Stockholders get capital gains rather than
higher-taxed dividends. • May signal that managers think stock is under-
valued.
Disadvantages of Repurchases
• May be seen as a negative signal of poor investment opportunities.
• Theoretically, IRS could impose penalties if repurchases were solely to avoid taxes on dividends.
• Selling stockholders may not be well informed, hence unfair to them.
• Firm may have to bid up the price to complete repurchase.
SEBI (BUY BACK OF SECURITIES) REGULATIONS, 1998 & Section 77A of The Companies Act, 1956
• Buy-back of equity shares in any financial year shall not exceed twenty-five per cent of its total paid-up equity capital in that financial year.• Ratio of the debt owed by the company is not more than twice the capital and its free reserves after such buy-back • The promoter shall not deal in the securities of the company in the stock exchange during the period the buy-back offer is open
Cont…
• The company shall nominate a compliance officer and investors service centre for compliance with the buy-back regulations and to redress the grievances of the investors.
• Every buy-back shall be completed within twelve months from the date of passing the special resolution passed in general meeting authorizing the buyback
Steps in Setting Dividend Policy
• Identify target capital structure. • Forecast capital needs over planning horizon,
often 5 years. • Estimate annual debt and equity needs. • Set long-run target payout ratio based on the
residual model. • Generally, some growth rate emerges. Aim for
growth at target rate if possible, varying capital structure as necessary.
Stock Dividends vs. Stock Splits
• Stock dividend: Firm issues new shares in lieu of paying cash dividend. If 10% stock dividend, get 10 shares for each 100 owned.
• Stock split: Firm increases the number of shares outstanding. If 2:1, gives stockholders twice as many shares. (Can have reverse split.)
• Different accounting treatment.
• Both stock dividends and stock splits increase the number of shares outstanding, “smaller pieces of pie.”
• Unless the stock dividend or split conveys information, or is accom-panied by another event like higher dividends, stock price generally falls so as to keep each investor's wealth unchanged.
• Splits/stock dividends may get the stock to an “optimal price range.”
What is a dividend reinvestment plan (DRIP)?
• Shareholders can automatically reinvest their dividends in shares of the company's common stock. Get more shares rather than cash.
• There are two types of plans: – Open market purchase plan. – New stock plan.
Open Market Purchase Plan
• Dividends to be reinvested are turned over to a trustee, who buys shares on the open market and holds them for participating stockholders.
• Brokerage costs are low because of volume purchases.
• Convenient and easy way to invest systematically.
• Company pays administrative costs.
New Stock Plan
• Firm issues new stock to DRIP participants, then keeps money otherwise used for dividends and uses it for other purposes.
• No fees charged. Stock is sometimes sold at discount from market price set about equal to flotation costs of underwritten stock offering.