Dividend decision in financial management and decision making

unit 4

1. FM Unit 4 DIVIDEND DECISIONS

2. Dividend The term dividend refers to that portion of profit (after tax) which is distributed among the owners/shareholders of the firm. The profit which is not distributed is known as retained earnings. A company may have preference share capital as well as equity share capital and dividends may be paid on both types of capital. However, there is as such, no decision involved as far as the dividend payable to preference shareholders is concerned. The reason being that the preference dividend is more or less, a contractual liability and is payable at a fixed rate. On the other hand, a firm has to consider a whole lot of factors before deciding for the equity dividend. The expected level of cash dividend, from the point of view of equity shareholders, is the key variable from which the shareholders and equity investors determine the share value. The establishment and determination of an effective dividend policy is therefore, of significant importance to the firm’s overall objective. However, the development of such a policy is not an easy job. A whole gamut of considerations affecting the dividend decision is there. The dividend decision may seem to be simple enough, but it evokes a surprising amount of controversy.

3. Concept and Significance The dividend decision is one of the three basic decisions which a financial manager may be required to take, the other two being the investment decisions and the financing decisions. In each period any earning that remains after satisfying obligations to the creditors, the Government, and the preference shareholders can either be retained, or paid out as dividends or bifurcated between retained earnings and dividends. The retained earnings can then be invested in assets which will help the firm to increase or at least maintain its present rate of growth. The dividend decision requires a financial manager to decide about the distribution of profits as dividends. The profits may be distributed either in the form of cash dividends to shareholders or in the form of stock dividends (also known as bonus shares).

4. Cont.. In dividend decision, a financial manager is concerned to decide one or more of the following : Should the profits be ploughed back to finance the investment decisions? Whether any dividend be paid? If yes, how much dividends be paid? When these dividends be paid? Interim or Final ? In what form the dividends be paid? Cash dividend or Bonus Shares? All these decisions are inter-related and have bearing on the future growth plans of the firm. If a firm pays dividends, it affects the cash flow position of the firm but earns a goodwill among the investors who therefore, may be willing to provide additional funds for the financing of investment plans of the firm. On the other hand, the profits which are not distributed as dividends become an easily available source of funds at no explicit costs.

5. Cont.. However, in the case of ploughing back of profits, the firm may loose the goodwill and confidence of the investors and may also defy the standards set by other firms. Therefore, in taking the dividend decision, the financial manager has to consider and analyze various factors. Every aspects of dividend decision is to be critically evaluated. The most important of these considerations is to decide as to what portion of profit should be distributed. This is also known as the dividend payout ratio.

6. Dividend Policy and Value of the Firm Dividend policy is basically concerned with deciding whether to pay dividend in cash now, or to pay increased dividends at a later stage or distribution of profits in the form of bonus shares. The current dividend provides liquidity to the investors but the bonus share will bring capital gains to the shareholders. The investor’s preferences between the current cash dividend and the future capital gain have been viewed differently. Some are of the opinion that the future capital gain are more risky than the current dividends while others argue that the investors are indifferent between the current dividend and the future capital gains. The basic question to be resolved while framing the dividend policy may be stated simply : What is sound rationale for dividend payments? In the light of the objective of maximizing the value of the share, the question may be restated as follows : Given the firm’s investments and financing decisions, what is the effect of the firm’s dividend policies on the share price? Does a high dividend payment decrease, increase or does not affect at all the share price. In the first instance, it may be argued that the dividend policy is important. The value of the share is defined to be equal to the present value of expected future dividends. So, how can now be suggested that the dividend is not relevant? The dividend policy has been a controversial issue among the financial managers and is often referred to as a dividend puzzle .

7. Cont.. The management of a firm must therefore, have a dividend policy which helps in lowering its cost of capital and maximizing the market price of the share. A dividend policy may be defined as a guiding principle in determining what portion of earnings be paid out to shareholders as dividends. As firms differ from one another in more than one way, there cannot be an optimal dividend policy which can be adopted by all the firms in order to attain the objective of maximization of shareholders wealth. A firms dividend policy includes two basic dimensions : ( i ) The dividend payout ratio, which indicate the amount of dividends distributed in relation to the earnings, and ( ii ) The stability of dividends which may be as important to any investor as the amount of dividend is. So, in the first instance, the financial manager has to decide as to how much profits be distributed, or to decide the dividend payout ratio (DP ratio). Moreover, in addition to DP ratio, a whole lot of other economic, legal and procedural constraints are also to be considered while framing a dividend policy for the firm. The present chapter attempts to discuss all these factors which have a bearing on the dividend policy of a firm.

8. Dividend Payout Ratio The first and the foremost dimension of a dividend policy is the decision regarding the DP ratio i.e., to decide about the percentage of profits to be distributed by the firm. The DP ratio is the ratio between dividends to equity shareholder and the profits after tax. In other words, it is the percentage of dividend distributed out of total profit after tax. It may be calculated as follows : DP Ratio = Dividend paid to Shareholders / Net Profit after tax For example, if out of the total profits after tax of 50,00,000, the firm distributes dividends amounting to 30,00,000. In this case, the DP ratio is 60% i.e., 30,00,000/50,00,000. The profits which are not distributed are retained and available for financing the investment. So, the decision regarding the DP ratio is a critical decision and be taken after the perusal of the followings:

9. Cont.. Liquidity : The dividend represents distribution of profits and payment of dividend results in decrease in cash. However, the profits need not necessarily assure the availability of liquid funds. A large amount of profit does not, in any way indicate that cash is available for payment of dividends. The firm’s position in liquid cash is basically independent of the earnings. A company with sizable earnings may be generating cash from operations, but these funds are generally either re-invested in the firm itself or are used to pay for maturing the debts. A firm may be profitable but still a cash poor. Thus, the liquidity position of the firm is an important consideration while deciding the dividend payout.

10. Cont.. Growth Plans : A firm having growth plans and profitable and viable investment opportunities, requires funds for financing of these. Such a firm will have a tendency to adopt a low DP ratio. This will ensure availability of more and more funds to the firm and that too at no apparent or explicit cost, as the retained earnings have no explicit cost. Moreover, if the firm does not have access to external financing (either in form of share capital or in form of borrowings), then the firm will have no options but to generate the resources internally by ploughing back the profits. This also requires a low payout ratio to be adopted by the firm. On the other hand, a firm having no immediate growth plans or investment opportunities, may adopt liberal or high DP ratio.

11. Cont.. Control : As stated above, the dividend payout reduces the funds position and results in lower internal accruals. The firm may then have to raise funds externally. If the funds are to be raised by issuing equity share capital (either because of market conditions or because of debt-equity ratio considerations), then the issue of fresh equity share capital may result in dilution of management control. The present shareholders in general and the management of the firm in particular, may not favor higher DP ratio which may ultimately force the firm to raise the funds externally by issuing additional share capital.

12. Cont.. Establishing a dividend policy is walking on a tight rope. On the one hand, paying too much in dividends create several problems : The firm may find itself short of funds for new investment and may have to incur the cost associated with new issues of securities or capital rationing. On the other hand, paying too little in dividends can also create problems. For one, the firm will find itself with a cash balance that increases over time, which can lead to investments in ‘bad’ projects, especially when the interest of the management in the firm are different from those of the shareholders. However, still a firm, while designing the dividend policy must attempt to answer two questions namely : 1. How much cash is available to be paid out as dividend after meeting capital expenditures and working capital requirements needed to sustain future growth ? 2. How good are the proposals that are available before the firm ? In general, the firms that have good proposal will have an easy time with dividend policy, since the shareholders will expect that the cash accumulated in the firm will be invested in these projects and eventually earn high returns. On the other hand, the firms that do not have good proposals may find themselves under pressure to payout all cash profits (of course subject to legal restrictions) to the shareholders.

13. Cont.. Consequences of Low Payout : If a firm pays much less than what is available as cash profits, it may give rise to different consequences as follows : ( a ) When a firm pays out less than it can afford, it accumulates cash. If a firm does not have good proposals (now or in future) to invest this cash, then it may face several possibilities. In the most benign case, such cash gets invested in financial assets. b ) As the cash accumulates, the financial manager may be tempted to take on projects that do not meet the minimum rate of return requirements. These actions will clearly lower the value of the firm. ( c ) Another possibility is that the management may decide to use the cash to finance an acquisition which may result in the transfer of wealth of the shareholders to the shareholders of the acquired firm. However, the result of low payout may be more positive for firms that have a better selection of projects and whose management has a history of earning good returns for the shareholders. The long term effects of cash accumulations for such firms are generally positive for the following reasons : ( i ) The presence of projects that earn returns greater than the hurdle rate increases the likelihood that the cash will be productively invested in the long run. ( ii ) The high returns earned on internal projects reduces both the pressure and the incentive to invest to poor projects.

14. Cont.. Consequences of High Payout: If a firm pays more than what is available as cash profits, it may give rise to different consequences as follows : ( a ) When a firm pays out more in dividends than it has available as cash profits, it is creating a cash deficit which has to be funded by drawing on the firm’s own cash balance or borrowing money or issuing securities. ( b ) The cash that is paid out as dividends could have been used to invest in some of the good projects, leading to a much higher return and much higher price to the shareholders. So, it can be argued that the firm is paying a hefty price for its dividend policy. The cash this firm is paying out as dividend would earn better returns if it is left to accumulate and invested in the firm.

15. Stability of Dividends Another important dimension of a dividend policy is the stability of dividends that is how stable, regular or steady should the dividends stream be over time ? It is generally said that the shareholders favor stable dividends and those dividends which have prospects of steady upward growth. If a firm develops such a pattern of paying stable and steady dividends, then the investors/shareholders may be willing to pay a higher price for the shares. So, while designing a dividend policy for the firm, it is also to be considered as to whether the firm will have a consistency in dividend payments or the dividends will fluctuate from one year to another. In the long run, every firm will like to have a consistent dividend policy, yet fluctuations from one year to another may be unavoidable. The dividend policy, from the point of view of stability may be classified as follows :

16. Cont.. 1. Constant DP Ratio : A firm may have a policy of distributing a fixed percentage of earnings as dividends to its shareholders. The higher profits will result in higher absolute dividends while lower earnings will result in lower absolute amount of dividends. For example, a firm having a DP ratio of 60% will distribute 6,00,000 as dividends if the profits are 10,00,000; and it will distribute 2,40,000 only if the profits are 4,00,000, and so on. Thus, the percentage dividend rate or dividend per share may fluctuate from year to year depending upon the earnings of the firm. The dividend per share will be a fixed percentage of the earning per share.

17. Cont.. 2. Steady Dividend Per Share : Some firms may prefer to pay a steady and fixed dividend per share to the shareholders irrespective of the earnings. Under this policy, the firm pays a fixed amount per share as dividends to its shareholders. However, the earnings may fluctuate from year to year and so the firm has to be careful in setting the dividend amount at a reasonable level. The dividend per share once decided is maintained for few years. Thereafter, it may be reviewed for increase or decrease depending upon the expected earnings. The dividend per share is not increased or decreased for a temporary increase or decrease in earnings but only for maintainable increase or decrease. The steady dividend per share policy is quite popular and investors also favor this type of policy as it will enable them to plan their investments.

18. Cont.. 3. Steady Dividends plus Extra : A firm may also adopt a policy of paying a steady dividends together with paying some extra whenever supported by the earnings of the firms. The extra dividend may be considered as a ‘bonus’ paid to the shareholders as a result of on usually good year for the firm. This extra may be paid in the form of cash or bonus shares, depending upon the firm’s liquidity position. The designation ‘extra’ is used in connection with the payment to tell the shareholder that this is extra and may not be maintained in future. From, the point of view of the management, a constant dividend per share together with an extra dividend when supported by higher earnings will be more flexible. In such a policy, the management will like to said the constant dividend per share lower than what it would have been otherwise. This policy does relate the dividend payment with the firm’s ability to pay, since the extra or special dividend will be paid only if sufficient extra cash profits are generated by the operations. Some companies have come out with a payment of a special dividend on a particular occasion e.g., the silver jubilee year of the firm.

19. Cont.. Relevance of Stability of Dividends : It is already stated that stability of dividend is an important dimension of the dividend policy. Firms which follow a stable dividend policy, command a better goodwill in the market and higher market price of the share. The stable dividend policy may be suggested in view of the following : ( a ) Many individual investors are not interested in future capital gains, rather they want a regular dividend income from the firms. The regular and constant dividend help these investors to plan their expenditures or investment schedule and thus avoiding many of their hardships, ( b ) Dividend in itself is an implied source of information about the present and expected profitability of the firm. The firm can convey lot of information about the prospects of the firm in the form of dividend announcement. A stable and continuous dividend conveys to the shareholder that the firm is in good health. An increase in dividend transmits improved prospects while a decrease in dividends implies a pressure on profitability. If the firm skips or lowers the dividend payment in a given period due to one or the other reason, the shareholders are quite likely to react unfavorably. The non-payment of dividend creates uncertainty which is likely to result in lower share values. Even if current earnings are lower, a firm should continue its dividend payments to avoid conveying negative information to the shareholders.

20. Cont.. ( c ) Stable dividend policy also helps a firm in establishing itself in the capital market and raising required funds externally. Both the institutional and the individual investors prefer investing funds in a firm which has or is expected to have a stable dividend policy. Sometimes, the institutional investors may even regard a stable dividend policy as a precondition to approve fresh financial assistance in a firm. Thus, the firm should attempt and develop a dividend policy that provides the shareholders and prospective investors with positive and correct information and thus reducing the uncertainty about the future of the firm. The firm should change its dividend policy only in response to those changes which are maintainable in future. A stable dividend policy helps in ( i ) stabilizing the market value of the share, (ii) maintaining the firm’s credit rating, (iii) creating the confidence of investors/shareholders in the firm. All these things tend not only to enlarge the number of potential investors but also enhance the shareholders loyalty to the firm and reduces the management’s need for concern over the control of the firm.

21. Dangers of Stability of Dividends The greatest danger in adopting a stable dividend policy is that once it is established, it cannot be changed without seriously affecting investors’ attitude and the financial standing of the company. If a company, with a pattern of stable dividends, misses dividend payment in a year, this break will have an effect on investors more severe than the failure to pay dividend by a company with unstable dividend policy. The companies with stable dividend policy create a ‘clientele’ that depends on dividend income to meet their living and operating expenses. A cut in dividend is considered as a cut in ‘salary.’ Because of the serious depressing effect on investors due to a dividend cut, directors have to maintain stability of dividends during lean years even though financial prudence would indicate elimination of dividends or a cut in it. Consequently, to be on the safe side, the dividend rate should be fixed at a conservative figure so that it may be possible to maintain it even in lean periods of several years. To give the benefit of the company’s prosperity, extra or interim dividend, can be declared. When a company fails to pay extra dividend, it does not have a depressing effect on investors as the failure to pay a regular dividend does.

22. FORMS OF DIVIDENDS The usual practice is to pay dividends in cash. Other options are payment of the bonus shares (referred to as stock dividend in USA) and shares buyback . In this section, we shall also discuss share split . The share(stock) split is not a form of dividend; but its effects are similar to the effects of the bonus shares. Cash Dividend Companies mostly pay dividends in cash. A company should have enough cash in its bank account when cash dividends are declared. If it does not have enough bank balance, arrangement should be made to borrow funds. When the company follows a stable dividend policy, it should prepare a cash budget for the coming period to indicate the necessary funds, which would be needed to meet the regular dividend payments of the company. It is relatively difficult to make cash planning in anticipation of dividend needs when an unstable policy is followed. The cash account and the reserve account of a company will be reduced when the cash dividend is paid. Thus, both the total assets and the net worth of the company are reduced when the cash dividend is distributed. The market price of the share drops in most cases by the amount of the cash dividend distributed

23. Cont.. Bonus Shares (Scrip Dividend) An issue of bonus shares is the distribution of shares free of cost to the existing shareholders. In India, bonus shares are issued in addition to the cash dividend and not in lieu of cash dividend. Hence companies in India may supplement cash dividend by bonus issues. Issuing bonus shares increases the number of outstanding shares of the company. The bonus shares are distributed proportionately to the existing shareholder. Hence there is no dilution of ownership. For example, if a shareholder owns 100 shares at the time when a 10 per cent (i.e., 1:10) bonus issue is made, she will receive 10 additional shares. The declaration of the bonus shares will increase the paid up share capital and reduce the reserves and surplus (retained earnings) of the company. The total net worth (paid-up capital plus reserves and surplus) is not affected by the bonus issue. In fact, a bonus issue represents a recapitalization of reserves and surplus . It is merely an accounting transfer from reserves and surplus to paid up capital.

24. Cont.. Bonus shares and shareholders wealth Does the issue of bonus shares increase the wealth of shareholders? Normatively speaking, the issue of bonus shares does not affect the wealth of shareholders. The earnings per share and market price per share will fall proportionately to the bonus issue. Advantages of Bonus Shares The bonus shares do not affect the wealth of the shareholders. In practice, however, it carries certain advantages both for the shareholders and the company. For Shareholders- Tax benefit One of the advantages to shareholders in the receipt of bonus shares is the beneficial treatment of such dividends with regard to income taxes. When a shareholder receives cash dividend from the company, this is included in his ordinary income and taxed at ordinary income tax rate. But the receipt of bonus shares by the shareholder is not taxable as income. Further, the shareholder can sell the new shares received by way of the bonus issue to satisfy his desire for income and pay capital gain taxes, which are usually less than the income taxes on the cash dividends. Note that in India as per the current law, investors do not pay any taxes on dividends but they have to pay tax on capital gains. Hence, the Indian law makes bonus shares less attractive than dividends.

25. Cont.. Indication of higher future profits The issue of bonus shares is normally interpreted by shareholders as an indication of higher profitability. When the profits of a company do not rise, and it declares a bonus issue, the company will experience a dilution of earnings as a result of the additional shares outstanding. Since a dilution of earnings is not desirable, directors usually declare bonus shares only when they expect rise in earnings to offset the additional outstanding shares. Future dividends may increase If a company has been following a policy of paying a fixed amount of dividend per share and continues it after the declaration of the bonus issue, the total cash dividends of the shareholders will increase in the future. For example, a company may be paying a `1 dividend per share and pays 1:1 bonus shares with the announcement that the cash dividend per share will remain unchanged. If a shareholder originally held 100 shares, he will receive additional 100 shares. His total cash dividend in future will be `200 (`1 × 200) instead of `100 (`1 × 100) received in the past. Psychological value The declaration of the bonus issue may have a favorable psychological effect on shareholders. The receipt of bonus shares gives them a chance to sell the shares to make capital gains without impairing their principal investment.

26. Cont.. Advantages to the Company- Conservation of cash The declaration of a bonus issue allows the company to declare a dividend without using up cash that may be needed to finance the profitable investment opportunities within the company. The company is thus, able to retain earnings and at the same time satisfy the desires of the shareholders to receive dividend. Only means to pay dividend under financial difficulty and contractual restrictions In some situations, even if the company’s intention is not to retain earnings, the bonus issue (with a small amount of dividend) is the only means to pay dividends and satisfy the desires of shareholders. When a company is facing a stringent cash situation, the only way to replace or reduce cash dividend is the issue of bonus shares. The declaration of the bonus issue under such a situation should not convey a message of the company’s profitability, but financial difficulty. More attractive share price Sometimes the intention of a company in issuing bonus shares is to reduce the market price of the share and make it more attractive to investors. If the market price of a company’s share is very high, it may not appeal to small investors. If the price could be brought down to a desired range, the trading activity would increase. Therefore, the bonus issue is used as a means to keep the market price of the share within a desired trading range.

27. Cont.. Limitations of Bonus Shares Bonus shares have the following limitations: Shareholders’ wealth remains unaffected Costly to administer Problem of adjusting EPS and P/E ratio

28. Cont.. Conditions for the Issue of Bonus Shares The issue of bonus shares by companies in India is also regulated by legal provisions. Section 63 of the Companies Act, 2013 contains provisions relating to issue of bonus shares. The Securities and Exchange Board of India has issued the revised guidelines for issue of bonus shares in year 2009. The guidelines for the issue of bonus shares can be summarized as follows : ( i ) These guidelines are applicable to existing listed companies who shall forward a certificate duly signed by the issuer and duly countersigned by its statutory auditor or by a company secretary in practice to the effect that the terms and conditions for issue of bonus shares as laid down in these guidelines have been complied with. ( ii ) Issue of bonus shares after any public/rights issue is subject to the condition that no bonus issue shall be made which will dilute the value or right of the holders of debentures, convertible fully or partly. ( iii ) The bonus issue is made out of free reserves built out of the genuine profits or share premium collected in cash only. ( iv ) Reserves created by revaluation of fixed assets are not capitalized.

29. Cont.. ( v ) The declaration of bonus issue, in lieu of dividend, is not made. ( vi ) The bonus issue is not made unless the partly-paid shares, if any existing, are made fully paid-up. ( vii ) The company has not defaulted in payment of interest or principal in respect of fixed deposits and interest on existing debentures or principal on redemption thereof, and has sufficient reason to believe that it has not defaulted in respect of the payment of statutory dues of the employees such as contribution to provident fund, gratuity, bonus etc. ( viii ) A company which announces its bonus issue after the approval of the Board of Directors must implement the proposals within a period of six months from the date of such approval and shall not have the option of changing the decision. ( ix ) There should be a provision in the Articles of Association of the company for capitalization of reserves, etc ., and if not, the company shall pass a Resolution at its General Body Meeting making provisions in the Article of Association for capitalization. ( x ) Consequent to the issue of bonus shares if the subscribed and paid-up capital exceed the Authorized share capital, a Resolution shall be passed by the company at its General Body Meeting for increasing the Authorized capital.

30. Share Split A share split is a method to increase the number of outstanding shares through a proportional reduction in the par value of the share. A share split affects only the par value and the number of outstanding shares; the shareholders’ total funds remain unaltered. Bonus Share vs Share Split As with the bonus share, the total net worth does not change and the number of outstanding shares increases substantially with the share split. The bonus issue and the share split are similar except for the difference in their accounting treatment. In the case of bonus shares, the balance of the reserves and surpluses account decreases due to a transfer to the paid-up capital and the share premium accounts. The par value per share remains unaffected. With a share split, the balance of the equity accounts does not change, but the par value per share changes. The earnings per share will be diluted and the market price per share will fall proportionately with a share split. But the total value of the holdings of a shareholder remains unaffected with a share split.

31. Reasons for Share Split The following are reasons for splitting of a firm’s ordinary shares: To make trading in shares attractive . The main purpose of a stock split is to reduce the market price of the share in order to make it attractive to investors. With reduction in the market price of the share, the shares of the company are placed in a more popular trading range. To signal the possibility of higher profits in the future . The share splits are used by the company management to communicate to investors that the company is expected to earn higher profits in future. The market price of high-growth firm’s shares increases very fast. If the shares are not split periodically, they fall outside the popular trading range. Therefore, these companies resort to share splits from time to time. To give higher dividends to shareholders . When the share is split, seldom does a company reduce or increase the cash dividend per share proportionately. However, the total dividends of shareholder increase after a share split.

32. BUYBACK OF SHARES (Repurchase of shares) is the repurchase of its own shares by a company. Until recently, the buyback of shares by companies in India was prohibited under Section 77 of the Indian Companies Act. As a result of the Companies Act (Amendment) 1999, a company in India can now buyback its own shares. A number of companies, such as Reliance Industries and Ashok Leyland, took advantage of this change immediately and offered to buy back the equity shares. In India the following conditions apply in case of the buyback shares: A company buying back its shares will not issue fresh capital, except bonus issue, for the next 12 months. The company will state the amount to be used for the buyback of shares and seek prior approval of shareholders. The buyback of shares can be affected only by utilizing the free reserves, viz., reserves not specifically earmarked for some purpose. The company will not borrow funds to buy back shares. The shares bought under the buyback schemes will be extinguished and they cannot be reissued.

33. Cont.. Evaluation of the Shares Buyback The most plausible reason for the buyback seems to be that a company may like to return surplus cash, which it cannot put to any profitable investment, to shareholders. Companies may also like to use surplus cash to buy back shares rather than pay large dividends, which they cannot maintain in the future years. In those countries, where dividends are taxed at a higher rate than the capital gains, companies may like to resort to shares buyback from time to time to reduce shareholders tax burden. Advantages of Buyback Return of surplus cash to shareholders The buying shareholders will benefit since the company generally offers a price higher than the current market price of the share.

34. Cont.. Increase in the share value When the company distributes the surplus cash, its operating efficiency and P/E ratio remains intact. With reduced number of shares, EPS increases and share price also increases. Increase in the temporarily undervalued share price The share price of a number of companies may be undervalued. This may be especially true for the developing capital markets. Companies may buyback shares at higher prices to move up the current share prices. Achieving the target capital structure If a company has high proportion of equity in its capital structure, it can reduce equity capital by buying back its shares. Consolidating control The promoters of the company benefit by consolidating their ownership and control over companies through the buyback arrangement. They do not sell their shares to the company but make the buyback attractive for others. Their proportionate ownership increases. Tax savings by companies Dividend payments are taxable in the hands of companies at 15 per cent. They will avoid paying dividend taxes if they compensate shareholders through the share buyback. This game will be played only if the tax authorities disregard it. Protection against hostile takeovers In a hostile takeover, a company may buyback its shares to reduce the availability of shares and make takeover difficult.

35. Cont.. The following are the drawbacks of the buyback: Not an effective defence against takeover The buyback of shares may be a useful defence mechanism against hostile takeover only in case of the cash rich companies. In India, companies are not allowed to borrow to buy back their shares. Therefore, the buyback is not effective in protecting those companies that do not have cash. Shareholders do not like the buyback Most companies will not offer the buyback schemes frequently; they will buyback shares once in a while. Shareholders may not, therefore, like the buyback of shares; they might prefer increasing dividends over the years. They consider dividends more dependable than the share buyback. Loss to the remaining shareholders The remaining shareholders may lose if the company pays excessive price for the shares under the buyback scheme. Signal of low growth opportunities The buyback of shares utilizes the firm’s cash. It may signal to investors that the company does not have long-term growth opportunities to utilize the cash. It may also weaken competitive position

36. Determinants/ Constraints of Dividend Policy In the company/ organisation , dividend policy is determined by the Board of directors having taken into consideration a number of factors which include legal restrictions imposed by the Government to safeguard the interests of various parties or the constituents of the company. The main considerations are as follows: (1) Legal: As regards cash dividend policy several legal constraints bear upon it – a firm may not pay a dividend which will impair capital. Dividend must be paid out of firm’s earnings/current earnings. Contract/ Agreements for bonds/loans may restrict dividend payments. The purpose of legal restriction is to ensure that the payment of dividend may not cause insolvency. (2) Financial: There are financial constraints to dividend policy. A firm can pay dividend only to the extent that it has sufficient cash to disburse; a firm can’t pay dividend when its earnings are in accounts receivables or firm does not have adequate liquidity.

37. Cont.. ( 3) Economic Constraints: Besides, there are economic constraints also. The question arise, does the value of dividend affects the value of the firm. If the answer to it is yes then there must be some optimum level of dividend, which maximizes the market price of the firm’s stock. (4) Nature of Business Conducted by a Company: A company having a business of the nature which gives regular earnings may like to have a stable and consistent dividend policy. Industries manufacturing consumer/ consumer durable items have a stable dividend policy. (5) Existence of the Company: The length of existence of the company affects dividend policy. With their long standing experience, the company may have a better dividend policy than the new companies. (6) Type of Company Organisation : The type of company organisation whether a private limited company or a public limited company affects dividend decisions. In a closely held company, a view may be taken for acquiescence and conservative dividend policy may be followed but for a public limited company with wide spread of shareholder, a more progressive and promising dividend policy will be the better decision.

38. Cont.. (7) Financial Needs of the Company: Needs of the Company for additional capital affects the dividend policy. The extent to which the profits are required to be invested in the company for business growth is the main consideration in dividend decisions. Working capital position of a company is an important condition that affects the dividend policy as no company would declare a dividend to undermine its financial strength and threaten its solvency and existence. (8) Market Conditions: Business cycles, boom and depression, affects dividend decisions. In a depressed market, higher dividend declaration are used to market securities for creating a better image of the company. During the boom, the company may like to save more, create reserves for growth and expansion or meeting its working capital requirements. (9) Financial Arrangement: In case of financial arrangements being entered into or being planned like merger or amalgamation with another company, liberal policy of dividend distribution is followed to make the share stock more attractive. (10) Change in Government Policies: Changes in Government Policies particularly those affecting earnings of the company are also taken into consideration in settling dividend decisions. For example, higher rate of taxation will definitely affect company earnings and carry impact on dividend decisions. Besides, fiscal, industrial, labour , industrial policies do affect in different magnitude the dividend decisions of individual corporate enterprises.

39. Dividend Theories Relevance of Dividend Policy A) Walter’s Model B) Gordon’s Model Irrelevance of Dividend Policy A) MODIGLIANI AND MILLER APPROACH (MM model)

40. Relevance of Dividend Policy Walter’s Model Professor James E. Walter argues that the choice of dividend policies almost always affect the value of the firm. The model shows the importance of the relationship between the firm’s rate of return, r , and its cost of capital, k , in determining the dividend policy that will maximize the wealth of shareholders. Walter’s model assumptions: 1 .The firm finances all investment through retained earnings; that is debt or new equity is not issued; 2. The firm’s internal rate of return (r), and its cost of equity capital (ke) are constant; 3. All earnings are either distributed as dividend or reinvested internally immediately. 4. Beginning earnings and dividends never change. The values of the earnings per share (E), and the divided per share (D) may be changed in the model to determine results, but any given values of E and D are assumed to remain constant forever in determining a given value. 5. The firm has a very long or infinite life.

41. Cont.

42. Cont..

43. Cont.. Thus, a firm can maximize the market value of its share and the value of the firm by adopting a dividend policy as follows : ( i ) If r > ke, the payout ratio should be zero ( i.e., retention of 100% profit). Higher the retention, higher would be the price . (Growth Firms) The growth firms are assumed to have ample profitable investment opportunities. These firms naturally can earn a return which is more than what shareholders could earn on their own. So optimum payout ratio for growth firm is 0%. ( ii ) If r < ke, the payout ratio should be 100% and the firm should not retain any profit, Higher the dividend, higher would be the price. (Declining Firms) If the company earns a return which is less than what shareholders can earn on their investments, it is known as declining firm. Here it will not make any sense to retain the earnings. So entire earnings should be distributed to the shareholders to maximize price per share. Optimum payout ratio for a declining firm is 100%. ( iii ) If r = ke , the dividend is irrelevant and the dividend policy is not expected to affect the market value of the share. (Normal Firms) These firms earn a rate of return which is equal to that of shareholders. In this case, dividend policy will not have any influence on the price per share. So there is nothing like optimum payout ratio for a normal firm. All the payout ratios are optimum. Thus, the Walter’s formula shows that the market value of a share is the present value of the expected stream of dividends and capital gains.

44. Critical Appraisal/ Criticism of Walter’s Model The Walter’s model provides a theoretical and simple frame work to explain the relationship between dividend policy and value of the firm. As far as the assumptions underlying the model hold good, the behavior of the market price of the share in response to the dividend policy of the firm can be explained with the help of this model. However, the limitation of this model is that these underlying assumptions are unrealistic. The financing of investment proposals only by retained earnings and no external financing is seldom found in real life. The assumption of constant ‘r’ and constant ‘ke’, is also unrealistic and does not hold good. As more and more investment are made, the risk complexion of the firm will change and consequently the ke may not remain constant.

45. Relevance of Dividend Policy Gordon’s Model Myron Gordon has also proposed a model suggesting that the dividend policy is relevant and can affect the value of the share and that of the firm. This model is also based on the assumptions similar to that made in Walter’s model. Gordon ’s model assumptions: All-equity firm The firm is an all-equity firm, and it has no debt. No external financing No external financing is available. Consequently, retained earnings would be used to finance any expansion. Thus, just as Walter’s model, Gordon’s model too confounds dividend and investment policies. Constant return The internal rate of return, r , of the firm is constant. Constant cost of capital The appropriate discount rate, k for the firm remains constant. Thus, Gordon’s model also ignores the effect of a change in the firm’s risk class and its effect on k . Perpetual earnings The firm and its stream of earnings are perpetual. No taxes Corporate taxes do not exist. Constant retention The retention ratio, b , once decided upon, is constant. Thus, the growth rate, g = br , is constant forever. Cost of capital greater than growth rate ( ke>g) . Retention ratio is always less than 1 , i.e. b < 1

46. Cont..

47. Cont.. The capitalization model projects that the dividend division has a bearing on the market price of the shares. According to Gordon, when r>ke, the price per share increases as the dividend payout ratio decreases. The market value of the share, P , increases with the retention ratio, b , for firms with growth opportunities, i.e., when r > k . When r< ke, the price per share increases as the dividend payout ratio increases. The market value of the share, P , increases with the payout ratio, (1 – b ), for declining firms with r < k . When r=ke the price per share remains unchanged in response to the change in the payout ratio. The market value of the share is not affected by dividend policy when r = k . Thus Gordon’s view on the optimum dividend payout ratio can be summarized as below: (1) The optimum payout ratio for a growth firm (r>ke) is zero. However, if the firm adopts a zero payout then the investor may not be willing to offer any price. (2) There no optimum ratio for a normal firm (r=ke). (3) Optimum payout ratio for a declining firm r<ke is 100%. Thus the Gordon’s Model’s conclusions about dividend policy are similar to that of Walter. This similarity is due to the similarities of assumptions of both the models.

48. Cont.. Gordon argues that the investor do have a preference for current dividends and there is a direct relationship between the dividend policy and the market value of the share. He has built the model on the basic premise that the investors are basically risk averse and they evaluate the future dividends/ capital gains as a risky and uncertain proposition. Dividends are more predictable than capital gains; management can control dividends but it cannot dictate the market price of the share. Investors are certain of receiving incomes from dividends than from future capital gains. The incremental risk associated with capital gains implies a higher required rate of return for discounting the capital gains than for discounting the current dividends. In other words, an investor values, current dividends more highly than an expected future capital gain. So, the “bird-in-the-hand” argument of this model suggests that the dividend policy is relevant as the investors prefer current dividends as against the future uncertain capital gains. When the investors are certain about their returns, they discount the firm’s earnings at a lower rate and therefore, placing a higher value for the share and that of the firm. So, the investors require a higher rate of return as retention rate increases and this would adversely affect the share price.

49. Critical Appraisal/ Criticism of Gordon’s Model Gordon’s model’s conclusions about dividend policy are similar to that of Walter’s model. This similarity is due to the resemblance of assumptions that underlie both the models. Thus the Gordon model suffers from the same limitations as the Walter model.

50. Irrelevance of Dividend Policy MODIGLIANI AND MILLER APPROACH (MM model) They have argued that the market price of a share is affected by the earnings of the firm and is not influenced by the pattern of income distribution. The dividend policy is immaterial and is of no consequence to the value of the firm. What matters, on the other hand, is the investment decisions which determine the earnings of the firm and thus affect the value of the firm. They argue that subject to a number of assumptions, the split of earnings between dividends and retained earnings—is of no significance in determining the value of the firm.

51. Cont.. Assumptions of MM model ( i ) The capital markets are perfect and the investors behave rationally. ( ii ) All informations are freely available to all the investors. ( iii ) There is no transaction cost and no time lag. ( iv ) Securities are divisible and can be split into any fraction. ( v ) There are no taxes and no flotation cost. ( vi ) The firm has a defined investment policy and the future profits are known with certainty. The implication is that the investment decisions are unaffected by the dividend decision and operating cash flows are same no matter which dividend policy is adopted.

52. Cont.. Under the assumptions stated above, MM argue that neither the firm paying dividends nor the shareholders receiving the dividends will be adversely affected by firms paying either too little or too much dividends. They have used the arbitrage process to show that the division of profits between dividends and retained earnings is irrelevant from the point of view of the shareholders. The Model shows that given the investment opportunities, a firm will finance these either by ploughing back profits or if pays dividends, then will raise an equal amount of new share capital externally by selling new shares. The amount of dividends paid to existing shareholders will be replaced by new share capital raised externally. The benefit of increase in market value as a result of dividend payment will be offset completely by the decrease in terminal value of the share. The shareholders therefore, would be indifferent between the dividend payments or retaining the profits. In order to testify their argument, MM have presented the following valuation model :

53. Cont..

54. Cont.. Equation 10.4 simply states that the firm must issue fresh capital of an amount equal to total requirement for investment as reduced by the profit retained. And, the profits retained depends upon the amount of dividends paid i.e., nD1. So, whatever of capital funds needs is not financed by retained earnings ( i.e., E–nD1) must be financed by the issue of fresh share capital. Substituting the Equation 10.4 into Equation 10.3, m = I – (E- nD 1 ) / P 1

55. Cont.. P 1 = P (1+ k e ) – D 1 (1) m = I – (E- nD 1 ) / P 1 (2) nP = [(n+m) P 1 – (I – E)] / (1+ k e ) (3) Where, n = Number of outstanding/ existing equity shares m = Number of shares to be issued I = Investment required E = Total earnings of the firm P 1 = Expected market price at the end of year 1 P = Present or current market price of the share k e = Cost of equity share capital or cost of equity D 1 = Expected dividend at the end of year 1 nP = Value of the firm

56. Cont.. The success of the MM model depends upon the arbitrage process i.e., replacement of amount paid as dividend by the issue of fresh capital. The arbitrage process involves two simultaneous actions. With reference to dividend policy, these two actions are : ( i ) Payment of dividend by the firm, and ( ii ) Raising of fresh capital. With the help of arbitrage process, MM have shown that the dividend payment will not have any effect on the value of the firm. Even if the firm pays dividends, resulting in a increase in market value of the share, the effect on the value of the firm will be neutralized by the decrease in terminal value of the share.

57. Critical Appraisal of MM model Under the assumptions set by MM, this model testifies that dividend is irrelevant and the investors are indifferent between the current dividends and the future capital gains. Given these assumptions, the effect of a dividend decision may be stated as : That there is no relationship between dividend policy and value of the share. One dividend policy is as good as another. Investors are concerned only with total returns and are indifferent whether these returns are coming as dividend income or from capital gains. In particular, the MM model may be criticized as follows : ( i ) The assumption of perfect capital market is theoretical in nature as the perfect capital market is never found in practice. ( ii ) No flotation cost and no time lag assumptions are also unrealistic. In reality, the fact is otherwise and companies have to incur expenses in raising fresh equity capital from the market and that too requires a time gap to fulfil a lot of legal formalities for raising capital, etc. ( iii ) Similarly, the assumption of no transaction costs is imaginary. Some brokerage or commission etc. is payable by the investors whenever they decide in future to encash future capital gain arising out of bonus shares. Hence, the investors may prefer current dividend.

58. Cont.. ( iv ) Assumption of no tax is also questionable. There is generally a difference in tax rate applicable to dividend incomes and capital gains in the hands of the shareholders. ( v ) MM have assumed that the investment policy of the firm is independent of the financing policy. But, some of the firms may undertake only limited investment projects which can be financed by retained earnings only Some companies, even if they are willing, may not find conducive conditions to raise capital from the market. There may be legal constraints in raising capital or the investors may be less willing to subscribe to the fresh capital. In such situations, the firm will have a tendency to retain as much profits as possible by lowering the payout ratio. ( vi ) The MM model may not hold good if the firm is not able to issue additional equity share capital at the then prevailing current market price when dividends are paid and are to be replaced by fresh funds. These new shares would possibly be offered in the capital market and can be sold at a price lower than the then prevailing current market price. Consequently, the firm would be required to sell more shares. Thus, the firm may find the retention of profits as a better option than paying dividends to shareholders and simultaneously raising fresh capital. Thus, the MM model is not a practical proposition. The dividend irrelevance argument does not seem to be feasible when the assumptions underlying the MM model are relaxed.