Dividend Decisions

Prof. Prashant Sharma

Let’s Revisit: Key Decisions Under Financial
Management
Working
Day to Day Capital
Management Management
of Capital Decisions

Long-term Long-term Capital Capital

Financial Financial
Arrangement Investment Structure Budgeting
Management Management
of Capital of Capital Decisions Decisions

Management Dividend
of Profits Decisions
Dividend Decisions: Key Questions
• Should a company pay dividend?
• Are dividend decisions relevant for wealth maximization?
• How much?
• How frequent?
• In what form?
• What’s the process?
Dividend Yield
Dividend Theories

Relevance Irrelevance
Theory Theory
Miller-
Walter’s Modigliani
Hypothesis

Gordon’s
model
 Dividend 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.
• Theory is based on unrealistic assumptions (no
taxes or brokerage costs), hence may not be true.
Need empirical test.
Bird-in-the-Hand Theory
(Dividend preference theory)
• Investors think dividends are less risky than potential future
capital gains, hence they like dividends.
• Risk-averse investors will therefore prefer dividend.
• If so, investors would value high payout firms more highly, i.e.,
a high payout would result in a high P0.
Tax Preference Theory
• Retained earnings lead to long-term capital
gains, which are taxed at lower rates than
dividends: 12.5% capital gain text versus 30% tax
bracket, Capital gains taxes are also deferred.
• According to time value of money, a dollar of
taxes paid in the future has a lower effective
cost than a dollar paid today.
• This could cause investors to prefer firms with
low payouts, i.e., a high payout results in a low
P0.
Implications of 3 Theories for
Managers

Theory Implication
Irrelevance Any payout OK
Bird in the hand Set high payout
Tax preference Set low payout

But which, if any, is correct???

 Possible Stock Price Effects
Stock Price (Rs.)

Bird-in-Hand
40

30 Irrelevance

20
Tax preference

10

0 50% 100% Payout

 Possible Cost of Equity Effects
Cost of equity (%)
Tax Preference
20

15 Irrelevance

10 Bird-in-Hand

0 50% 100% Payout

Which theory is most correct?

• Empirical testing has not been able to

determine which theory, if any, is correct.
• Thus, managers use judgment when setting
policy.
• Analysis is used, but it must be applied with
judgment.
 Clientele Effect
• This clustering of stockholders in companies with dividend policies that match
their preferences in called the clientele effect.
• Despite the tax disadvantages of dividends, some different groups, or clienteles,
of stockholders prefer different dividend payout policies.
• Stockholders in their peak earning years might prefer reinvestment, because
they have less need for current investment income.
• Therefore, investors who want current investment income should own shares in
high–dividend payout firms, while investors with no need for current investment
income should own shares in low–dividend payout firms.
• Firms get the investors they deserve, because the dividend policy of a firm
attracts investors who like it. Firms will have a difficult time changing an
established dividend policy.
• If investors migrate to firms that pay the dividends that most closely match their
needs no firm’s value should be affected by its dividend policy.
What’s the “residual dividend model”?

• Find the retained earnings needed for the

capital budget.
• Pay out any leftover earnings (the residual) as
dividends.
• This policy minimizes flotation and equity
signaling costs, hence minimizes the WACC.
Using the Residual Model to
Calculate Dividends Paid

Net
Dividends =Income –
[( )( )]
Target
equity
ratio
Total
capital
.
budget
Data for SSC

• Capital budget: Rs. 800,000. Given.

• Target capital structure: 40% debt, 60%
equity. Want to maintain.
• Forecasted net income: Rs. 600,000.
• How much of the Rs. 600,000 should we pay
out as dividends?
Setting Dividend Policy
• Forecast capital needs over a planning horizon,
often 5 years.
• Set a target capital structure.
• Estimate annual equity needs.
• Set target payout based on the residual model.
• Generally, some dividend growth rate emerges.
Maintain target growth rate if possible, varying
capital structure somewhat if necessary.
 Important Dates
Declaration Date
The date on which the board of directors' board of directors passes a resolution to pay
a dividend

Ex-Dividend Date
At this point of time investors must have bought the stock to receive the dividend

Record Date
Makes up a list of shareholders till date. These shareholders will receive dividend

Payment Date
Dividend got credited in the account
Forms of Dividends
• Cash
• Stocks
• Bonus
• Stock Repurchase
• Stock Split
Stock Dividends
• Non-cash form of dividends
• Also known as bonus issue of shares - Company distributes
additional shares to shareholders instead of cash.
• Each shareholders end up with more shares, which did not have to
paid for (free of cost).
• Stock dividends are generally not taxable because it merely divide
the pie into smaller slices.
• It does not affect the shareholder’s proportionate ownership.
Stock Dividends
• Share capital gets increased according to the bonus issue ratio.
• Retained earning decreases but total share holders’ equity
remains same.
• Liquidity in the stock increases.
• Increase in number of share offset decrease in earnings per
share, and other measures of value per share.
• Stock dividends used on a regular annual basis will keep the
stock price more or less constrained.
Stock Repurchase
https://www.youtube.com/watch?v=EDyvkbwR6Uw
• Investor tax argument
• Uncertainty about the ability to continue generating these cash
flows in future periods - Allow to maintain flexibility for future
periods.
• A repurchase is a signal that stock is underpriced.
• Executive compensation is often affected by share buybacks.
• Increasing insider control in firms.
• Supporting stock prices when they are declining.
Repurchase
• ABC currently has 30000 shares outstanding. Each share has a
market value of Rs. 20. If the firm repurchases Rs. 150000 worth of
shares, what will the value of each share be after the repurchase?
Ignore taxes.
• Total value = 30000*20 = 600000
• After repurchase value = 450000
• Per share value = Rs. 450000 / (30000 – 7500)
Advantages of stock repurchases
• Stockholders can tender or not.
• Helps avoid setting a high dividend that cannot be maintained.
• Repurchased stock can be used in takeovers or resold to raise
cash as needed.
• Income received is capital gains rather than higher-taxed
dividends.
• Stockholders may take as a positive signal—management
thinks stock is undervalued.
Disadvantages of stock repurchases
• May be viewed as a negative signal (firm has poor investment
opportunities).
• Selling stockholders may not be well informed, hence may be
treated unfairly.
• Firm may have to bid up price to complete purchase, thus
paying too much for its own stock.
Choosing between dividends &
repurchases
• Sustainability and stability of excess cash flow.
• Stockholder tax preferences
• Predictability of future investment needs
• Undervaluation of the stock
• Management compensation
Stock Split
• A firm has just declared a 2-for-1 share split. If you own 12000
shares before the split, how many shares do you own after the
split?