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Main Ideas from this chapter

This chapter describes the clear picture of different forms of dividend and dividend policies. The core ideas of this chapter are to make one clear about the different forms of dividend, dividend payment procedures, dividend payout policies, stock dividend, stock split, reverse stock split and repurchase of stock.

MEANING OF DIVIDEND POLICYDividends refers to that portion of a firm's net earnings which are paid to shareholders. Dividend are paid either in cash or stock. Since dividends are distributed out of the profits, the alternative to the payment of dividends is the retention of earnings. The retained earnings constitute an important source of financing the investment requirements of the firm. There is inverse relationship between retained earnings and cash dividends. More dividends result in smaller retentions where as lesser dividend results in larger retentions. Thus, dividends and retained earnings are competitive and conflicting.

Dividend decisions refers to the decisions regarding the division of net earnings to the dividend and retained earnings. A firm can distribute all of its earnings to the shareholders as dividends or can retain all of its earnings for re investment as retained earnings or can distribute a part of earnings as dividend and retain the balance for re-investment purpose.

Dividend decision is a major financial decision in the sense that a firm has to choose between distributing profits to the shareholders and ploughing back them into the business. The selection would be influenced by the effect on the objective of financial management of maximizing shareholder's wealth.

Given the objective of financial management of maximizing shareholder's wealth, the firm should be guided by the consideration as which alternative use of net earnings is consistent with the goal of wealth maximization. If paying dividends to shareholders will maximize the wealth of shareholder, the firm would be advised to use earnings for paying dividends to shareholders. The firm would be advised to retain the earnings if retaining earning will end to the maximization of wealth. Thus,

optimal dividend policy is one which leads to maximization of wealth of owners.

However, there are conflicting opinions regarding the impact of dividends on the valuation of a firm. According to one school of thought, called irrelevance theory of dividend, dividends are irrelevant so that amount of dividends paid has no effect on the valuation of a firm. This thought is led by Modigiliani and Miller. According to MM Hypothesis, dividend policy has no effect on the value of the firm.

On the other hand, certain theories consider the dividend decision as relevant to the value of the firm. The dividend decision has effect on the value of the firm. This view is led by J.E. Walter, M.J. Gordon and others.

The arguments given are support of irrelevance theory of dividend seems not to be hold true. Therefore, it should be concluded that dividend policy is relevant. A firm should try to follow an optimum dividend policy which maximizes the shareholder's wealth in long run. An optimum dividend policy will vary from firm to firm as it is determined by a number of factors.

DIVIDEND PAYOUT RATIO AND RETENTION RATIO

Dividend policy decision refers to the decision to pay out earnings or to retain them for reinvestment in the firm Dividend refers to the portion of net income paid out to the shareholders. The percentage of earnings paid out in form of cash dividend is known as dividend payout ratio. Dividend payout ratio can be calculated as under.

Divide Payout ratio =

Or

Where,

Dividend Per Share =

Corporate Finance – Risal et all

Earnings Per Share =

A firm may retain same portion of its earnings for reinvestment purpose. The percentage of earnings retained in the firm is called retention ratio. High dividend payout ratio means low retention ratio and vice versa.

Retention ratio is calculated as under :

Retention ratio= 1 - Dividend Paid out ratio

Or

=

Example

A company has net income of Rs 4,00,000 this year. It retained Rs 1,60,000 of those earning for investment purpose. It has 40,000 shares outstanding.

Required : (i) Earning per share

(ii) Dividend per share

(iii) Total dividend

(iv) Dividend payout ratio

(v) Retention ratio

Solution

Given,

Net income = Rs 4,00,000

Retained earnings = Rs 1,60,000

No. of shares = 40,000

(i) Earning per share =

=

= Rs 10

(ii) Dividend Paid = Net income - Retained earnings

= 4,00,000 - 1,60,000

= Rs 2,40,000

(iii) Dividend per share =

=

= Rs 6

(iv) Dividend payout ratio =

=

= 0.60 or 60%

(v) Retention ratio= 1 - dividend payout ratio

= 1 - 0.60

= 0.40 or 40%

DIVIDEND PAYMENT PROCEDURES

Cash dividend refers to the portion of net income paid out to shareholders in cash. The dividend payment procedures of a company can be described as under:

1. Declaration date

The date at which board of directors meet and issue a statement declaring dividend is called declaration date. The board of directors set the amount of dividend to be paid, the holder - of - record date and the payment date on this date. Generally, dividend is announced as a percentage of the per value of stock. However, it can be the absolute amount like Rs 5 per share in some cases.

2. Holder - of - record date

The date on which the company opens the ownership books to make a list of shareholders who are entitled to receive the dividend is called holder - of - record date. All the stockholders of the record date are


entitled to receive the dividend declared by the board of directors. The new stockholders would receive dividend if the name of shareholders is recorded in the ownership book on or before the date of record. However, if the notification about the transfer was received after the date of record, the old owner of the stock would receive the dividends.

3. Ex - dividend date

Ex-dividend date is two business days prior to the record date. Shares purchased after the ex-dividend date are not entitled to the dividend. The transaction must take place before the ex-dividend date to entitle the new holder to receive dividend. Thus, the date when the right to the dividend leaves the stock for new owner is called ex-dividend date.

4. Payment date

The date on which the company actually pays dividends or mails the cheques to the stockholders is called payment date. On this date, the company actually pays the dividend to all the stockholders of the date of record.

Example 2

On July 31, 2009, Khushi Company Limited declared a dividend of Rs 5 per share, payable on October 1 to the holders of record on September 1. Show the Khushi's dividend payment procedure.

Solution

1. Declaration date : July 31, 2009 on which Khushi Company's board of directors declared a dividend of Rs 5 per share.

2. Holder - of - record date : September 1, 2009 on which company makes a list of shareholders who are entitled to receive dividend.

3. Ex-dividend date : August 30, 2009 after which dividends are entitled with the seller of the stock.

4. Payment date : October 1, 2009 on which Khushi Company mails the cheque of dividends to the shareholder.

2 days

31-7-2009 30-8-2009 1-19-2009 1-10-2009

Declaration date Ex-dividend date Holder-of-record date Payment date

FACTORS AFFECTING DIVIDEND POLICYDividend policy is concerned with determining the proportion of firm's net income to be distributed in the form of dividend and the proportion of earnings to be retained for investment purpose. A firm's dividend policy is influenced by a number of factors. Some of the major factors influencing the firm's dividend policy are as under :

(1) Legal rules

There are certain legal rules that may limit the amount of dividends a firm may pay. Following are the rules relating to dividend payment:

(a) Net profit rule : According to this rule, dividends can be paid out of present or past earnings. Amount of dividends can not exceed the accumulated profits. If there is accumulated loss, it must be set off out of the current earnings before paying out any dividends.

(b) Insolvency rule :- According to this rule, a firm can not pay the dividends when its liabilities exceed assets. When the firm's liabilities exceed its assets, the firm is considered to be financially insolvent. The firm, financially insolvent, is prohibited by law to pay dividends.

(c) Capital impairment rule :- According to this rule, a firm can not pay dividend out of its paid up capital. The dividend payout that impairs capital is considered illegal.

2. Desire of shareholders

Dividend policy is affected by the desire of shareholders Shareholders may be interested either in dividend income or capital gain. Wealthy shareholders may be interested in capital gain as against dividend income because of low tax rate on capital gain. Where as the


shareholders, whose sources of income is dividend only, are interested in dividend income and would not be interested in capital gain.

3. Liquidity position

In order to pay dividend, a company requires cash, and, therefore, the availability of cash resources within the company will be a factor in determining dividend payments. Generally, the greater the cash position and overall liquidity of a company, the greater is the ability to pay dividends. A company must have adequate cash available as well as retained earnings to pay dividends. The liquidity position of the company will influence the dividend payout of a particular year.

4. Rate of expansion of business

The rate of asset expansion needs to be taken into account. The more rapid the rate at which the firm is growing, the greater will be its needs for financing assets expansion. The greater the future need for funds, the more likely the firm is to retain earnings rather than pay them out.

5. Cost of external financing

The cost of external financing will have impact on the dividend payout of a company. In situations, where the external funds are costlier, a firm may resort to low dividend payout and use the internal funds for financing its business.

6. Need to repay debt

The need to repay debt also influence the availability of cash flow to pay dividend. If a firm has to repay debt in a particular year, firm may decide to low dividend payout and use the funds to repay the debt.

7. Contractual constraints

When the company obtained loan funds from debenture holders or term lending institutions, the terms of issue or contract of loan may contain restrictions on dividend payments. Debt contracts often stipulate that no dividends can be paid unless the current ratio, times interest earned ratio and other safety ratios exceed stated minimums.

8. Access to the capital market

The company, which has a good access to capital market, can follow a liberal dividend policy because this type of the company can raise the required funds from the capital market.

9. Degree of control

One of the important influencing factor on dividend policy is the objective of maintaining control over the company by the existing management or shareholders. The management who wish to maintain close control over the company will not much depend on the external sources of finance, and they maintain a low dividend payout policy and the funds generated from operations would be used for working capital and capital investment needs of the firm.

10. Tax position of shareholders

The tax position of shareholders also influences dividend policy. The company owned by wealthy shareholders having high income tax bracket tend toward lower dividend payout where as the company owned by small investors tend toward higher dividend payout.

11. Stability of earnings

The stability of earnings also effects the dividend policy decision. If the earnings of a firm are relatively stable, the firm is more likely to payout a higher percentage of earnings than the firm which has fluctuating earnings.

12. General state of economy

When state of economy is uncertain, both political and economic, the firm may maintain a low dividend payout policy, to withstand to the business risks.

Example 3

For each of the companies described below, would you expect it to have a low, or high dividend payout ratio? Explain why?

(a) A company with a large proportion of inside ownership, all of whom are high income individuals.


(b) A growth company with an abundance of good investment opportunities.

(c) A company with volatile earnings and high business risk.

(d) A company that has high liquidity and is experiencing ordinary growth.

Solution

(a) Low payout ratio : Highly taxed owners generally prefer capital gains rather dividend income.

(b) Low payout ratio : Earning are retained in business to support investment opportunities and there will be less residual funds to pay dividends.

(c) Low payout ratio : The company will retain earnings to build its financial strength and to offset high business risk.

(d) High payout ratio : The firm having high liquidity and no more assets expansion tend to pay higher dividend.

Example 4

How would each of the following changes tend to affect dividend payout ratio, other things held constant?

(a) An increase in personal income tax rate.

(b) A decline in investment opportunities.

(c) An increase in corporate profit.

(d) A rise in interest rate.

Solution :

(a) An increase in the personal income tax rate would lower the dividend payout ratio because shareholders with high income tax bracket prefer capital gain rather than dividend income.

(b) A decline in investment opportunities would lead to high dividend payout ratio because less retention is required to support investment opportunities.

(c) A permanent increase in corporate profit would lead to increase in dividend payout because the firm has more earnings to distribute dividend.

(d) An increase in interest rate would lead to low dividend pay out because retained earnings may be a relatively attractive way of financing new investment.

DIVIDEND PAYOUT SCHEMESA firm can pay dividends using either residual dividend policy or stable dividend policy.

1. Residual dividend policy

Residual dividend policy is based on the assumption that investors prefer to have a firm retain and reinvest earnings rather than pay our them in dividends. Under residual dividend policy, a firm pays dividend only after meeting its investment need at desired debt - equity ratio. This policy is based on the following assumption:

(a) The firm wishes to minimize the need of external equity.

(b) The firm wishes to maintain its current capital structure.

Under residual dividend policy, if the net income exceeds the portion of equity financing, then the excess of net income over equity need is paid as dividend. The company does not pay any dividend when net income is less than or equal to equity need for financing the investment proposals. In case, net income is not sufficient to meet equity need, the company should raise deficit amount by external equity. Following steps should be followed to determine amount of dividend under residual dividend policy :

(a) Determine the optimal capital budget.

(b) Find out target equity ratio in capital structure

Target equity ratio = 1 - Debt ratio.

(c) Determine the amount of equity required to finance the optimal capital budget.


Equity financing required = Optimal Capital Budget Target equity ratio

(d) Pay dividends if earnings are more than equity financing required.

Dividends = Net income - (Capital budget Target equity ratio)

Example 5

National Corporation has a target capital structure that consists of 60% debt and 40% equity. The company anticipates that its capital budget for the upcoming year will be Rs 3,00,000. If the company reports net income of Rs 2,00,000 and it follows a residual dividend policy, what will be its dividend payout ratio?

Solution

Target debt ratio = 60%

Target equity ratio = 40%

Capital Budget = Rs 300,000

Net income - Rs 2,00,000

Under residual dividend policy,

Dividend = Net income - (Capital budget Target equity ratio)

= 200000 - (300000 0.40)

= 200000 - 120000

= Rs 80,000

Dividend payout ratio =

=

= 0.4 or 40%

2. Stable dividend policy :-

Stability or regularity of dividend is considered as a desirable policy by the management of most companies because stable dividends have

a positive impact on the market price of the share. Following are the most commonly used constant dividend policies :

(a) Constant dividend per share :- Under this policy, a fixed amount of dividend per share is paid on annual basis irrespective of earnings of the company. The earnings may fluctuate from year to year but dividend per share remains unchanged. However, it does not mean that dividend per share never be increased. Dividend per share can be increased when the firm can sustain the higher level. The relationship between earning per share and dividend per share under this policy can be shown by following figure :

(b) Constant payout ratio :- Under this policy, a fixed percentage of the net earnings is paid as dividends every year. If earnings vary, the amount of dividend also varies from year to year. If earnings increase, dividends also increase and if earnings decrease, dividends also decrease. Dividends are paid when profits are earned. No dividend is paid when the firm suffers loss in any year. The relation between earning per share and dividend per share is shown as under :

(c) Regular dividend plus extra dividend policy :- Under this policy, a minimum constant dividend per share is fixed and additional dividend is paid over the regular low dividends in the years of relatively high earnings. This policy is a compromise between constant dividend per share and constant payout ratio policy. The low regular dividend is maintained even when earnings decline and extra dividends can be paid when earnings are more.

Example 6

City corporation has the following earning per share over the last 5 years.

Year EPS (Rs)

1 12

2 12

3 20

4 20


5 24

Determine dividend per share under the following policies:

(a) A constant dividend per share of Rs 8

(b) A constant dividend pay out ratio of 40%

(c) Rs 5 regular dividend per share and extra dividend to bring the pay out ratio to 40%.

Solution

(a) Constant dividend per share

Year 1 2 3 4 5

EPS 12 12 20 20 24

DPS 8 8 8 8 8

(b) Constant dividend payout ratio of 40%

Year 1 2 3 4 5

EPS 12 12 20 20 24

D/P Ratio 0.40 0.40 0.40 0.4 0.4

DPS 4.80 4.80 8 8 9.60

(c) Regular dividend plus extra dividend

Year 1 2 3 4 5

EPS 12 12 20 20 24

Minimum dividend 5 5 5 5 5

Extra - - 3 3 4.60

Total dividend 5 5 8 8 9.60

FORMS OF DIVIDENDCASH DIVIDEND

When dividend is distributed to shareholders in cash out of the earnings of the company, it is called cash dividend. When cash dividend is distributed, both total assets and net worth of the company decrease. Total assets decrease as cash decreases and net wath decreases as retained earnings decrease. The market price per share also decreases in most cases by the amount of cash dividend distributed.

Marker price per share after cash dividend = Marker price per share before cash dividend - dividend per share.

Example 7

The Neha Corporation's balance sheet as of 31st Dec. 2009 before the dividend is as follows :

Balance Sheet

Liabilities Rs Assets Rs

Common stock (20000 shares of Rs 10)

200000 Cash & bank 100000

Retained earnings 100000 Other current assets 100000

Paid in Capital 50000 Fixed assets 300000

Debt 150000

500000 500000

Market price per share of common stock is Rs 17.5

(a) Construct a profroma balance sheet if company pays Rs 2.5 per share cash dividend.

(b) Determine the marker price per share after cash dividend.

Solution :-

(a) Balance Sheet

after cash dividend


Liabilities Rs Assets Rs

Common stock (20000 shares of Rs 10)

200000 Cash & bank 50000

Retained earnings 50000 Other current assets 100000

Paid in Capital 50000 Fixed assets 300000

Debt 150000

450000 450000

W. Notes :

Dividend Paid = 20000 2.5 = Rs 50000

Cash & bank balance = 100000 - 50000

= Rs 50000

Retained earnings = 100000 - 50000

= Rs 50000

(b) Marker price per share after cash dividend = Market price per share before cash dividend - dividend per share

= 17.5 - 2.50

= Rs 15

STOCK DIVIDEND/BONUS SHARESStock dividend refers to the dividends paid to the existing stockholders in the form of additional shares of common stock. It represents a distribution of additional shares to existing shareholder. Stock dividend increases the number of outstanding shares of the firm's stock. It involves simply an accounting entry transfer from retained earnings account to the common stock and paid in capital accounts. Due to stock dividend, retained earnings decrease, common stock and paid in capital increase. The stock dividend does not affect the equity position of stockholders. Market price per share and earning per share after stock dividend will decrease.

No. of bonus shares = No. of shares outstanding % of stock dividend.

Decrease in Retained earnings = No. of bonus shares Market price per share.

Increase in common stock = No. of bonus shares par value per share.

Increase in paid in capital = No. of bonus shares paid in capital per share.

Marker price per share after stock dividend =

AdvantagesThe important benefits derived from stock dividend or issue of bonus shares are as follows :

1. It preserves the company's liquidity as no cash leaves the company.

2. The shareholders receive a dividend which can be converted into cash whenever he wishes through selling the additional shares.

3. It broadens the capital base and improves image of the company.

4. It reduces the marker price of the shares, rendering the shares more marketable.

5. It is an indication to the prospective investors about the financial soundness of the company.

6. The shareholders can take the advantage of tax saving from stock dividend.

Disadvantages1. The future rate of dividend will decline.

2. The future market price of share falls sharply after bonus issue.

3. Issue of bonus shares involve lengthy legal procedures and approvals.

Example 8

The Janaki Rice Mills has the following shareholder's equity account :

Common stock (Rs 10 par value) 2,00,000

Additional Paid in Capital 2,00,000


Retained earnings 4,00,000

Shareholder' equity 8,00,000

Market price of the stock is Rs 40 per share

(a) Reformulate the shareholders equity account if the company declares 20% stock dividend

(b) What will be the share price after 20% stock dividend?

Solution

(a)

Common stock (24000 shares of Rs 10) 2,40,000




Working Notes :

Addition bonus shares= 20,000 20% = 4,000

Increase in common stock = 4,000 10 = Rs 40,000

Increase in paid in capital = 4000 30 = Rs 1,20,000

Decrease in retained earnings = 4000 40 = Rs 1,60,000

(b)

Market price per share after stock dividend =

=

=

= Rs 33.33

STOCK SPLITA stock split is a method to reduce the marker price per share by giving certain number of share for one old share. Due to stock split, number of outstanding shares increase and par value and marker price of the stock decrease. A stock split affects only the par value, market value and the number of outstanding shares. However, net worth of the company remains unaltered.

With a stock split, shareholder's equity account does not change, but the par value per share changes. The earnings per share will be diluted and marker price per share fall propotionately with a stock split. But, the total value of the holdings of a shareholder remains unaffected by a stock split. Following ate the reasons for splitting a firm's ordinary shares :

1. Stock split results in reduction in market price of the share. It helps in increasing the marketability and liquidity of a company's shares.

2. Stock splits are used by the company management to communicate to investors that the company is expected to earn higher profits in future.

3. Stock split is used to give higher dividends to shareholders.

Example 9

XZY Company has the following shareholder's equity account.

Common stock (10000 shares of Rs 100 each) 10,00,000




The current marker price per share is Rs 400 each.

(a) Reformulate the shareholder's equity account if the company split their shares two - for - one

(b) What will the marker price per share after stock split?

Solution


(a) Shareholder's equity after stock split





(b) Marker price per share after stock split = Rs 400 1/2 = Rs 200.

REVERSE STOCK SPLITReverse stock split is method used to raise marker price of a firm's stock by exchanging certain number of outstanding shares for one new share of stock. Due to reverse stock split, number of outstanding shares decreases, par value of the shares increases and marker price per share also increases. However, total net worth of the company remains unchanged. Reverse stock split is used to stop the marker price per share below a certain level. The reverse split is generally an indication of financial difficulty and is, therefore, intended to increase the marker price per share.

Example 10

XYZ company has the following shareholder's equity account





What will happens to this account and no. of shares outstanding with a 1-for-2 reverse stock split?

Solution :

Shareholder's equity Account

Common stock (10000 shares of Rs 100) Rs. 10,00,000

Additional Paid in Capital Rs. 5,00,000

Retained earnings Rs. 5,00,000

Shareholder' equity Rs. 20,00,000

No. of Shares Rs. 10,000

REPURCHASE OF STOCK

Stock repurchase is method in which a firm buys back shares of its own stock, there by decreasing shares outstanding, increasing earning per share, and, often increasing the stock price. It is an alternative to cash dividends. In a stock repurchase, the company pays cash to repurchase shares from its shareholders. These shares are usually kept in the company's treasury and then resold when the company needs money.

If a firm has excess cash, it may purchase its own stock leaving fewer shares outstanding, increasing the earning per share and increasing the stock price. It may be an alternative to paying cash dividends. The benefits to the shareholders are the same under cash dividend and stock repurchase. In the absence of personal income taxes and transaction costs, both cash dividend and stock repurchase have no any difference to shareholders. Capital gain arising from repurchase should equal the dividend otherwise would have been paid.

Repurchase price or equilibrium price is the price that brings capital gain equal to the cash dividend. Share price for repurchase or the equilibrium price is calculated from the following equation:

Repurchase Price (P*) =

Where,

S = Total number of shares outstanding

Pc = Current marker price per share

n = Number of shares to be repurchased.

Share can be repurchased in different ways. A company can repurchase its shares through authorized brokers on the open market. Shares can be also repurchased by making a tender offer which will specify the purchases


price, the total amount and the period within which shares will be bought back. Similarly, a company can purchase a block of shares from one large holder on a negotiated basis.

Advantages of repurchase of stock1. A firm an use idle cash to repurchase stock if it has less investment

opportunities.

2. Dividend and earning per share will be increased through stock repurchase.

3. Stock repurchase will result in increase in the share value.

4. The buying shareholders will benefit since the company generally offer a price higher than the current market price of the share.

5. When shares are under valued in the market, a company can buy back shares at higher price to move up the current share price.

6. If a company has high proportion of equity in its capital structure, if can reduce equity capital by buying back its shares to achieve target capital structure.

7. The promoters of the company benefit by consolidating their ownership and control over companies through stock repurchase. They do not sell their shares to the company rather make the share repurchase attractive for others.

8. Repurchase of stock can remove a large block of stock that is overhanging the market and keeping the price per share down.

9. In a hostile takeover, a company may buy back its shares to reduce the availability of shares and make take over difficult.

10. Stockholder are given a choice of whether or not to sell their stock to the firm.

Disadvantages of stock repurchase1. Shareholders may not be indifferent between dividends and capital

gains, and the price of stock might benefit more from cash dividends than from repurchase.

2. The remaining shareholder may lose if the company pays excessive price for the shares under the stock repurchase scheme.

3. Stock repurchase may signal to investors that the company does not have long - term growth opportunities to utilize the cash.

4. The buyback of shares may be useful as a defense against hostile takeover only in case of cash rich companies.

Example 11 :-

A company has Rs 16,00,000 in excess funds. The company wishes to distribute these funds to repurchase the stock.

Presently, it has 4,00,000 shares outstanding and the market price per share is Rs. 36. It wishes to repurchase 10% of its stock or 40000 shares.

a. Assuming no signaling effect, at what price should the company offer to repurchase?

b. In total, how much will the company be distributing through share repurchase?

c. If the company were to pay out the funds through cash dividend instead, what will be the market price per share after the distribution?

Solution

(a) Current marker price (Pc) = Rs 36

No. of shares outstanding (S) = 4,00,000

No. of shares repurchased (n) = 40,000

Required repurchase price (P*) = ?

Now,

P* =

=

= Rs 40

Assuming no signaling effect, the company should offer to repurchase its stock at Rs. 40.


(b) The company will be distributing Rs 16,00,000 (40,000 Rs 40) through share repurchase.

(c) Cash dividend per share =

=

= Rs 4

Marker price per share after cash dividend = Rs 36-4= Rs 32.

Illustrative Problems1. MN Company expects to generate following net income during next

years.

Year Net income

1 4,00,000

2 6,00,000

3 8,00,000

The company currently has 100000 shares outstanding.

(a) Determine earning per share in each year.

(b) Determine total dividend and dividend per share if a dividend pay out ratio of 50% is maintained.

(c) Determine dividend per share if company declares Rs 2 regular dividend per share and extra dividend in order to bring the payout ratio to 50% if it otherwise would fall below.

Solution

(a) Earning Per Share

Year 1 2 3

Net income 4,00,000 6,00,000 8,00,000

No. of shares 1,00,000 1,00,000 1,00,000

*Earning Per Share

4 6 8

* Earning Per Share =

(b) Dividend per share & total dividend

Year 1 2 3

Net income 4,00,000 6,00,000 8,00,000

D/P Ratio 50% 50% 50%

* Total dividend 2,00,000 3,00,000 4,00,000

No. of Shares 1,00,000 1,00,000 1,00,000

Dividend Per Share 2 3 4

* Total dividend = Net income dividend payout ratio

** Dividend Per Share =

(c) Dividend Per Share

Year 1 2 3

Net income 4,00,000 6,00,000 8,00,000

No. of shares 1,00,000 1,00,000 1,00,000

Earning Per Share 4 6 8

Regular Dividend 2 2 2

Extra Dividend - 1 2

Total dividend per share 2 3 4


2. Janakpur Rice Mill expects next year's net income to be Rs 12,00,000. Its debt to equity ratio is currently 60%. It has Rs 9,60,000 of profitable investment opportunities, and its wishes to maintain its existing debt ratio. According to residual dividend model, how large should the company's dividend payout ratio be next year?

Solution,

Debt to equity ratio = 60%

Let, Amount of equity = 100

Amount of Debt = 60

Total assets = 100+60

= 160

Debt ratio =

=

= 0.375

Equity ratio = 1 - Debt ratio

= 1 - 0.375

= 0.625

= 62.5%

Dividend Paid = Net income - (Capital budget equity ratio)

= 12,00,000 - (96,00,000 0.625)

= 12,00,000 - 6,00,000

= Rs 6,00,000

Dividend payout ratio =

=

= 0.50 or 50%

3. Nepal Industrial Bank has the following shareholder's equity account

Common Stock (20,000 shares of Rs 10 per) 2,00,000

Paid in Capital 1,00,000


Shareholder's equity 5,00,000

Current Marker price of the stock is Rs 30 per share.

(a) What happen to these accounts if the company declared 10% stock dividend?

(b) What would happen to these accounts if the company declared a 2 - for - 1 stock split?

(c) What would happen if there was a reverse stock of 1 - for - 4?

Solution

(a) Shareholder's equity after stock dividend

Common Stock (22000 shares of Rs 10 per) 2,20,000




Working Notes :

Extra shares for stock dividend = 20,000 10%

= 2,000 shares.

Increase in common stock = 2,000 Rs 10 = Rs 20,000

Increase in paid up capital = 2,000 Rs 30 = Rs 60,000

Decrease in retained earnings = 2,000 Rs 40

= Rs 80,000


(b) Shareholder's equity after stock split

Common Stock (40,000 shares of Rs 5) 2,00,000




Working Notes :

No. of shares after split = 20,000 2/1

= 40,000 shares.

Par value after split = 10 1/2

= Rs 5

(c) Shareholder's equity after Reverse stock split

Common Stock (5,000 shares of Rs 40) 2,00,000




Working Notes :

No. of shares after reverse stock split = 20,000 1/4

= 5,000 shares

Par share after reverse stock split = 10 4/1

= Rs 40

4. After a 4 - for - 1 stock split, Spice Nepal Limited paid a dividend of R 3 per new share, which represents a 20% increase over last year's pre - split dividend. What was last year's dividend per share?

Solution :

After stock split dividend per shares (D1) = Rs 3

Before stock split dividend per share (D1) = Rs 3 4/1

= Rs 12

growth rate (g) = 20%

Last year's dividend (Do) = ?

We know,

D1 = Do (1+g)

or, 12 = Do (1 + 0.20)

or, Do =

= Rs 10.

Hence, last year's dividend per share was Rs 10.

5. Khushi Compnay treats dividend as a residual decision. It expects to generate Rs 5 million in net earnings after tax in the coming year. The company has an all - equity capital structure and its cost of equity capital is 20%. The company treats this cost as the opportunities cost of retained earnings. Cost of external equity is 21%.

(a) How much in dividends should be paid if the company has Rs 3 million in projects whose expected return exceeds 20% percent?

(b) How much in dividends should be paid if it was Rs 5 million in projects whose expected return exceeds 20%?

(c) How much in dividends should be paid if it has Rs 6 million in projects whose expected return exceeds 21%.

Solution

(a) Dividends to be paid = Net income - (Capital budget equity ratio)

= 5 - 3 1

= Rs 2 million.

(b) Dividends to be paid

= Net income - (Capital budget equity ratio)

= 5 - 5 1


= Nil

(c) Dividend to be paid (external financing) = Net income - (Capital budget equity ratio)

= 5 - 6 1

= (Rs 1 million)

Hence, the company will not pay any dividend rather it should raise Rs 1 million in additional new common stock externally to satisfy the financing need.

6. ABC corporation has Rs 6 million in excess funds. The corporation wishes to distribute these funds via the repurchase of stock. Presently, it has 24,00,000 shares outstanding, and the marker price per share is Rs 25. It wishes to repurchase 10% of its stock, or 2,40,000 shares.

(a) Assuming no signaling effect, at what price should the company offer to repurchase?

(b) In total, how much will the company be distributing through share repurchase?

(c) If the company were to pay out the funds through cash dividends in stead, what would be the marker price per share after the distribution?

Solution

(a) Current Marker Price (Pc) = Rs 25


No. of shares repurchased (n) = 2,40,000

Repurchase Price (P*) = ?

We know,

P* =

=

= Rs 27.78

(b) Total distribution through stock repurchase = 2,40,000 Rs 27.78

= Rs 66,67,200

(c) Divident Per Share =

=

= Rs 2.78

Market price after cash dividend = 25 - 2.78

= Rs 22.22

7. Sharda Company repurchased 50,000 shares of its 5,00,000 shares outstanding at a price of Rs 55 per share. Immediately prior to the share repurchase announcement, share price was Rs 45. However, 2,00,000 shares were tendered by stockholders wanting to sell. The company had to repurchase the 50,000 shares on a pro - rata basis according to the number of shares tendered.

(a) Why did so many shareholders tender their shares? At what price should the company have made its repurchase offer?

(b) Who gained from the offer? Who lost?

Solution

(a) Current marker price (Pc) = Rs 45


No. of shares repurchased (n) = 5,00,00 shares

Equilibrium price or repurchase price (P*) = ?

P* =

=

= Rs 50


Since the offer price (Rs 55) is more than the equilibrium repurchase price, many shareholders tendered their shares to sell. The company should have made its offer at Rs 50 instead of Rs 55.

(b) The holder of shares whose shares were repurchased gained from the tender offer and remaining shareholder suffered loss.

SUMMARYDividend Policy is concerned with the decisions regarding division of net income to the dividend and retained earnings. The firm should determine optimum dividend policy which leads the firm to stockholders wealth maximization. A company can adopt either residual dividend policy or stable dividend policy. Three alternative stable dividend policies are constant dividend per share, constant dividend pay out and regular plus extra dividend policy.

A firm's dividend payment procedures start with determining the declaration date on which board of directors declare dividends to be paid, the holders of record date and payment date.

A firm's dividend policy is influenced by a large no. of factors like legal requirements, desire of shareholders, liquidity position; need to repay debt, desire of control, rate of business expansion, access to capital market, tax position of shareholders, restrictions in debt contracts etc.

Cash dividend is the dividend, which is distributed to shareholders in cash. Due to cash dividend, total assets as well as net worth decrease as cash and retained earnings decrease. The market price of share also decreases by the amount of cash dividend distributed.

A stock dividend refers to the dividend distributed to existing shareholders in the form of additional shares rather than in cash. Due to stock dividend, no. of outstanding shares increases, Common stock and paid in capital increases and retained earnings decrease. However, net worth remains unchanged.

Stock split increases the number of outstanding shares with a proportionate decrease in par value. Reverse stock split decreases the number of shares outstanding with a proportionate increase in par value.

With a stock split and reverse stock split, shareholder's equity remains unchanged.

In a stock repurchase, a firm buys back some of its outstanding shares, thereby decreasing number of shares, increasing earning per share and marker price. It is an alternative to paying cash dividend.


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