Topic 3 Dividend Policy 1
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Transcript of Topic 3 Dividend Policy 1
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Dividend PolicyDividend Policy
Topic 3
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Dividend is Financing orDividend is Financing or
Investment Decision?Investment Decision?
Dividend decision is part of Financing
decision, because the earnings available
may be retained in the business for Re-investment. If the funds are not required,
they may distributed as dividends.
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Affects:Affects:
Dividend policy of the firm affect both the
long-term financing and wealth of the
shareholders. Therefore, the firm
distribute;- reasonable amount as dividend to its
members,
- retain the rest for its growth & survival.
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Do investors prefer high or lowDo investors prefer high or low
payouts? There are threepayouts? There are threetheories:theories:
Dividends are irrelevant: Investorsdont care about payout.
Bird-in-the-hand: Investors prefer ahigh payout.
Tax preference: Investors prefer alow payout, hence growth.
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Dividend Irrelevance TheoryDividend Irrelevance Theory
Investors are indifferent betweendividends and retention-generated capitalgains. If they want cash, they can sell
stock. If they dont want cash, they canuse dividends to buy stock.
Modigliani-Miller support irrelevance.
Theory is based on unrealisticassumptions (no taxes or brokeragecosts), hence may not be true. Needempirical test.
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BirdBird--inin--thethe--Hand TheoryHand Theory
Investors think dividends are less
risky than potential future capital
gains, hence they like dividends. If so, investors would value high
payout firms more highly, i.e., a high
payout would result in a high stockprice.
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Tax Preference TheoryTax Preference Theory
Low payouts mean higher capital
gains. Capital gains taxes are
deferred. This could cause investors to prefer
firms with low payouts, i.e., a high
payout results in a low stock price.
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Implications of 3 Theories forImplications of 3 Theories forManagersManagers
Theory Implication
Irrelevance Any payout OK
Bird-in-the-hand Set high payout
Tax preference Set low payout
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Which theory is most correct?Which theory is most correct?
Empirical testing has not been ableto determine which theory, if any, is
correct. Thus, managers use judgment whensetting policy.
Analysis is used, but it must beapplied with judgment.
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Dividend Decision:Dividend Decision:
Acc. to one school of thoughtdividend decision does not affect the
shareholders wealth.
A
cc. to another school of thought,dividend decision affect the
shareholders wealth.
Based on these two thoughts, it can be
classified into two theories.
1. Irrelevance Theory
2. Relevance Theory
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1. The Irrelevance Theory1. The Irrelevance Theory
Modigliani & Miller (MM) approach:Acc. to this dividend policy has no affect on the
market price of the share and value of thefirm, is determined by the earning capacityof the firm.
Assumptions:
- There are perfect capital market
- Investors are rational
- No taxes or no difference in the tax rate todividends and capital gains.
- No risk or uncertainty in future.
- Investment and dividend decisions areindependent.
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MM argument:MM argument:
If a co. retains earnings instead of giving it out as dividends, the
shareholder enjoys capital
appreciation equal to the amount of
earnings retained.
If it distributes earnings by way of
dividend - the shareholder enjoys
dividends instead of appreciation in
the retained earnings.
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Criticisms of MM position:Criticisms of MM position:
Uncertainty and Fluctuations
Offering of additional equity at lower
prices Higher dividend Greatervolume of under priced equity issue Greater dilution of control
Issue cost
Transaction cost
Differential rates of taxes
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(n+m) P(n+m) P11 (I(I E)E)npnpoo == ----------------------------------------------
1 + K1 + Kee
I - (E nD1) m = no. of sharesm = -------------- issued
p1 I = New Invt. required
E = EarningsP1= p0 (1+ke) D1 P1 = Mkt. price per share at
the endKe = cost of equity n = no. of shares at
the beginning
D1 = dividend paid at the endnp0 = Value of the firm (present)
Illustration: Refer worksheet case 4
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1. Walters approach:1. Walters approach:
Acc. to this dividend decisions are
relevant and affect the value of the
firm. It is significant based on Return on
Investment (R) and Cost of Capital (K).
He has made three different firm;
(a)Growth firm : R > K
(b)Normal firm : R = K
(c) Declining firm : R < K
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Assumptions :Assumptions :
The investment of the firm are financed
through retained earnings only and the
firm does not use external funds.
Investment decision is dependent on the
dividend decision. The IRR and K of the firm are constant.
Earnings and dividends do not change
while determining the value. The firm has very long life.
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D r (ED r (E D) / KD) / KeeP =P = ---------- ++ ------------------------------------
KKee KKee
P = Mkt. price per share
D = Dividend per sharer = Internal rate of return
E = EPS
Ke =Cost of equity capital
Illustrn.: pp 547
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Criticism.Criticism.
Firms depends on external funds aswell as retained earnings;
IRR & cost of capital does not remainconstant.
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(b) Gordons Approach(b) Gordons Approach
Acc. to him dividends are relevant and itaffects firm value.
Assumptions:
- The firm is an all equity firm;- No external financing is available;
- The IRR & cost of capital is constant;
- The cost of capital is greater than growthrate i.e, rate of return on investment of allequity firm.
- The firm has perpetual life.
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Implications..Implications..
When r > k, the share price increasesas the dividend payout ratio decrease;
W
hen r = k, share price remainunchanged, dividend payout is variant
When r < k, the share price increases,as the dividend payout increases.
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Gordons Revised model:Gordons Revised model:
Considered risk & return even when r=k dividendpolicy affects the value of shares on account of
uncertainty of future;
Investors are risk averse and avoid risk;
They prefer near dividends rather than futuredividends;
Bird-in-hand argument the value of rupee of
dividend income is more than the value of rupee of
capital gain. uncertainty, the cost of capital cannot be constant
and so firm should high payout ratio.
Illustration : Refer worksheet
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Dividend Policy:Dividend Policy:
1. Stable dividend policy: Acc. to this,the percentage of earnings paid out
as dividends remains constant. Sothat, dividends fluctuate in line withearnings.
Earnings
Time
Dividend
Earnings
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2. Steadily changing dividend:2. Steadily changing dividend:
As per this policy, the rupee levelof dividends remains stable or
gradually increase or decreases.Earnings
Time
Dividend
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Dividend policies in practice:Dividend policies in practice:
Nature of Industry Dividend practices
Electrical 10% (Govt. expects)
Chemical Depends on earning position
Tea No fixed (may be 30-50%)
Toothpaste Both dividends and bonus
shares usually high
Aluminium When performance is good
more dividend or vice versa
Pharmaceuticals Around 30% or maintain min.
18% dividend every year
Textiles No fixed, depends on profit
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End