Dividend policy and firm value with theories

Dividend policy and firm value with theories

1. DIVIDEND POLICY & FIRM VALUE

2. In this session we shall look at What is an ‘Optimal DPR’? Various theories of dividend Walter model Gordon model MM Model Dividend as a residual What do investors prefer? Practical considerations in determining a dividend policy Forms of dividend

3. Dividend policy and firm value While deciding on how much of earnings to distribute in form of dividends amongst shareholders, the underlying objective is ‘ maximization of shareholders wealth’ The proportion of earnings which get paid out in form of dividend is known as DPR (Dividend payout ratio) Optimal DPR: that % of earnings (EPS) which when paid out in form of dividend shall maximize the value of the firm Various theories have been developed putting forth “What should be the optimal DPR?”

4. Theories of ‘Dividend’ Some theories suggest that by changing the DPR, firm’s value can be impacted and hence ‘Dividend decision’ is relevant Other theories suggest that no matter what be the DPR, value of the firm shall remain same thereby making ‘Dividend decision’ irrelevant Different theories of dividend: Walter’s Model Gordon Model MM Model Dividend as a passive residual

5. Walter’s Model – Dividend decision is relevant Assumptions: The firm is an all equity financed entity It relies only on ‘retained earnings’ to finance its future investments ROI is constant Walter’s formula: P = D + (E – D) r / k k Here, ‘D’ – DPS; ‘E’ – EPS; r – ROI; k – cost of equity

6. The objective of the firm is to “maximize P” i.e. that DPR would be considered ‘optimal’ one that leads to maximum ‘P’ Implications of Walter’s model: When r < k, As DPR increases: ‘P’ increases Optimal DPR: 100% When r > k, As DPR increases: ‘P’ decreases Optimal DPR: 0% When r = k, As DPR increases / decreases : ‘P’ remains unchanged Optimal DPR: no one ‘optimal DPR’, dividend policy irrelevant Walter’s Model – Dividend decision is relevant

7. Walter’s Model - Example A company has a total investment of Rs 10,00,000 and 1,00,000 shares outstanding of face value of Rs 10 each. It earns a rate of return of 11% on its investment and has a policy of paying 60% of its earnings as dividend. Is it optimum dividend policy as per ‘Walter’s model’? What is the optimal policy and why? Assume that the required rate of return is 12%.

8. Amount of investment = Rs 10,00,000 No. of equity shares = 1,00,000 Face value / share = Rs 10 ROI = 11% Thus, EPS = 10% of Rs 10 = Re 1.1 Given DPR = 60% DPS = 60% of Rs 1.1 = Rs 0.66 k e = 12% Walter’s Model - Example

9. As per the present policy, using Walter’s model, P = = D + (E – D) r / k k P = 0.66 + (1.1 – 0.66) )0.11/ 0.12 = Rs 8.86 0.12 As k e > r, DPR of 100% shall be optimal At DPR = 100%, P = 1.1 + (1.1 – 1.1) (0.11/0.12) = Rs 9.16 0.12 Walter’s Model - Example

10. Gordon’s Model – Dividend decision is relevant Gordon gave the following formula for determining firm’s value : P = E (1-b) k – br Here, ‘b’ is the retention ratio Implications For a growth firm (i.e. r>k): Optimal DPR is 0% For a declining firm (i.e. r<k): Optimal DPR is 100%

11. Gordon’s model - Example A company has a total equity capital of Rs 50,00,000 comprising of equity shares of Rs 10 each. It earns a return of 12% on its investments of Rs 50,00,000. The appropriate discount rate for the firm is 10%. Using Gordon’s Model, compute the share price of the company if the company has a policy of declaring 50% dividend. What would be your answer if the company earns a return of 8% on its investment?

12. When r = 12% EPS = 1.2 k e = 10% DPR = 50% b = 0.5 P = 1.2 (1-0.5) (0.10-0.5*0.12) = Rs 15 Gordon’s model - Example

13. When r = 12% EPS = 1.2 k e = 10% DPR = 50% b = 0.5 P = 1.2 (1-0.5) (0.10-0.5*0.12) = Rs 15 When r = 8% EPS = 0.8 k e = 10% DPR = 50% b = 0.5 P = 0.8 (1-0.5) ( 0.10-0.5*0.08) = Rs 6.67 Gordon’s model - Example

14. MM Model – Dividend irrelevance model As per MM, the value of the firm depends on its earnings power and is not influenced by the manner in which its earnings are split between dividend and retained earnings. It postulates that the investors’ would be indifferent towards the alternate dividend policies being followed by firms , as they can construct their own dividend policy If the company retains earnings and the shareholder wants dividend, he can create it by selling stock If the company pays higher dividend than what the investor desires, he would use the excess dividend to buy additional shares This is referred to as HOMEMADE DIVIDEND

15. Also the investor shall be indifferent between payment or non-payment of dividend by the company as: If the company retains earnings, the shareholder enjoys capital appreciation equal to the amount of earnings retained If it distributes earnings, the shareholder enjoys dividend equal in value to the amount by which his capital would have appreciated had the company chosen to retain earnings MM Model – Dividend irrelevance model

16. MM model explains the irrelevance of dividend policy through the ‘Process of Arbitrage’ Process of arbitrage: With respect to dividend, it involves ‘two’ simultaneous actions: Payment of dividend by the firm Raising of fresh capital MM Model – Dividend irrelevance model

17. Value of the share today : P = (D 1 + P 1 ) ( 1 + ke ) Value of the firm with ‘n’ shares : V = (nD 1 + nP 1 ) ( 1 + ke ) Value of firm after raising ‘m’ new shares, the total shares now being ‘ n+m ’: V = [ ( n+m )P 1 – I + E ] ( 1 + k e ) MM Model – Dividend irrelevance model

18. Example – MM Model Mint enterprises has 1,00,000 shares outstanding and is planning to declare a dividend of Rs 5 / share at the end of the current year. The present market price = Rs 100 and k e = 10%. What is the expected MP at the end of year 1 if: Dividend of Rs 5 is paid? Dividend is not paid? Assume that this firm has total profits of Rs 10,00,000 during year 1 and is planning to make an investment of Rs 20,00,000 at the end of the current year. Calculate the value of Mint Enterprises under the 2 dividend options.

19. Example – MM Model Calculation of ‘Price’ at the end of the year If D = Rs 5 P = (D 1 + P 1 ) (1 + ke ) 100 = 5 + P 1 (1 + 0.1) P 1 = Rs 105

20. Example – MM Model Calculation of ‘Price’ at the end of the year If D = Rs 5 P = (D 1 + P 1 ) (1 + ke ) 100 = 5 + P 1 (1 + 0.1) P 1 = Rs 105 If D = Rs 0 P = (D 1 + P 1 ) (1 + ke ) 100 = + P 1 (1 + 0.1) P 1 = Rs 110

21. Example – MM Model Calculation of ‘Price’ at the end of the year If D = Rs 5 P = (D 1 + P 1 ) (1 + ke ) 100 = 5 + P 1 (1 + 0.1) P 1 = Rs 105 If D = Rs 0 P = (D 1 + P 1 ) (1 + ke ) 100 = + P 1 (1 + 0.1) P 1 = Rs 110 In form of capital appreciation In form of capital appreciation Dividend Rs 110

22. Example – MM Model Determination of fresh issue of shares When D = Rs 5 Total profits 10,00,000 Dividend (5,00,000) Retained earnings 5,00,000 Total funds required 20,00,000 Retained earnings (5,00,000) Fresh issue 15,00,000 P 1 105 Thus, no. of new shares = 15,00,000 / 105 = 14285.71 n + m = 1,00,000 + 14285.71 = 114285.71 When D = 0 Total profits 10,00,000 Dividend ( 0) Retained earnings 10,00,000 Total funds required 20,00,000 Retained earnings (10,00,000) Fresh issue 10,00,000 P 1 110 Thus, no. of new shares = 10,00,000 / 110 = 9090.90 n + m = 1,00,000 + 9090.90 = 109090.90

23. Example – MM Model Calculation of firm value When D = Rs 5 V = [ ( n+m )P 1 – I + E ] (1 + ke ) = (114285.71*105) – 20,00,000 + 10,00,000 (1+0.1) = Rs 100,00,000 When D = 0 V = [ ( n+m )P 1 – I + E ] (1 + ke ) = (109090.90* 110) – 20,00,000 + 10,00,000 (1+0.1) = Rs 100,00,000

24. Criticism of MM Model Dividend paid by the company may convey information about the prospects of the company in future. A high DPR may reduce uncertainties perceived by investors. MM asserts that a rupee of dividend can be replaced by a rupee of external financing. This is possible if there are no issue costs, which is true in a practical situation. Differential rates of tax for current income and capital gains may exist.

25. Dividends as a passive residual When dividend policy is taken strictly as a financing decision, payment of cash dividend is a ‘passive residual’. The payment of dividend is determined solely by the availability of acceptable investment proposals . If anything out of net income is left after providing for the capital expenditures, the same may be paid out as dividend.

26. Example Earnings (Rs) Capital expenditure proposed(Rs) Dividend (Rs) 10,00,000 10,00,000 10,00,000

27. Example Earnings (Rs) Capital expenditure proposed(Rs) Dividend (Rs) 10,00,000 5,00,000 10,00,000 10,00,000

28. Example Earnings (Rs) Capital expenditure proposed(Rs) Dividend (Rs) 10,00,000 5,00,000 5,00,000 10,00,000 10,00,000

29. Example Earnings (Rs) Capital expenditure proposed(Rs) Dividend (Rs) 10,00,000 5,00,000 5,00,000 10,00,000 10,00,000 10,00,000

30. Example Earnings (Rs) Capital expenditure proposed(Rs) Dividend (Rs) 10,00,000 5,00,000 5,00,000 10,00,000 10,00,000 10,00,000 15,00,000 + external financing of Rs 5,00,000

31. Dividends vs. Capital gains : What do investors prefer? Gordon- Litner : “Bird in the hand” argument Investors value expected dividend more highly than the expected capital gains Tax preference theory: Investors might prefer companies to retain and plough earnings back into business. If dividend is received, it is taxable. Capital gains, if LT, are tax free. Taxes are not paid on gains until the stock is sold. As per TVM concept, tax paid in future will have lower effective cost than paid today.

32. Practical considerations – Factors affecting dividend policy Informational or signaling effect of dividends If a company announces / increases dividends , this increase has a “ signaling effect” about management’s expectation of a future change in earnings. The signaling effect results in an increase in the stock price of the company. Clientele effect When a company pays consistent dividends, it attracts shareholders who are looking for an organization with a predictable dividend-distribution pattern. Stockholders in low-or zero-tax brackets, such as retired individuals, who prefer current income, will prefer consistent dividends. On the other hand, companies that pay no dividends also have satisfied stockholders, perhaps because these high-tax bracket stockholders do not need current income and prefer reinvestment. Liquidity position of the company Companies with greater liquidity will be able to pay larger dividends and companies with greater investment needs and less liquidity will pay smaller dividends . The decision about the amount to be paid as dividends also depends on a company’s ability to raise cost of capital from the market.

33. Practical considerations – Factors affecting dividend policy Investment opportunities available Companies retain earnings if they have profitable investment opportunities and pay dividends if they don’t. Legal considerations Various government bodies prepare a list of securities in which insurance companies, pension funds , savings banks, and other financial institutions can invest their funds . If dividends are not paid even for a single year, it may lead to the company’s removal from these legal lists. Constraints in loan agreements If a company has taken out a loan or borrowed funds from the market, the ability of the company to pay cash dividends may be constrained due to certain restrictions in the loan agreement . Such restrictions are usually included to protect creditors from threats of insolvency of the company.

34. Practical considerations – Factors affecting dividend policy Variability in earnings Keeping in view their earnings, companies generally set a dividend policy that can be maintained over a period of time and are averse to any future reductions in dividend payments. Companies with a high degree of business risk or with unstable earnings prefer a low dividend- payout ratio to guard against possible reduction in dividends at a later stage. Target payout ratios John Lintner's 1956 study provided evidence that when a company’s earnings increase, it will not raise its dividends immediately. A key assumption here is that investors are more sensitive to a reduction in dividend payouts than to an increase . Companies increase dividends as a result of an increase in earnings only if the company is sure that the increase in dividends can be maintained. Dividend stability A stable pattern of dividend payments by a company is an important consideration for both management and investors.

35. Types of Dividend Policy Constant payout ratio Constant dividend per share Small constant dividend per share plus extra dividend

36. Constant Payout Ratio Dividend payout is the ratio of dividend per share to EPS. When companies follow a policy of constant payout ratio, they decide that a specific proportion of the earnings will be paid to the shareholders in each period. As a result, the dividends fluctuate in direct proportion to changes in earnings. Companies that follow a constant payout -ratio dividend policy believe that the investors prefer stocks that pay predictable dividends even though the amount of dividends may fluctuate every year . Companies with volatile earnings generally adopt this policy. In such a case, if there is a drop in the company's earnings or if a loss occurs in a given period, dividends will be low or nonexistent . Consider a company that adopts a policy of paying 35 percent of every dollar of net earnings as dividends . If the company earns $10 per share, the dividend per share ( DPS) will be $3.5.

37. Constant dividend per share With this type of dividend policy, companies pay a fixed amount of dividends in each period . Fluctuations in the earnings of the company do not affect the dividends paid by the company . This policy is generally followed by companies whose earnings are stable. If there are wide fluctuations in the earnings, companies will find it difficult to maintain this policy. Companies following this policy generally maintain sufficient reserves in good years so that in the years when earnings are low, they have sufficient reserves to maintain the dividend policy.

38. Small constant dividend per share plus extra dividend Some companies tend to maintain a policy of low constant dividend per share supplemented by an extra dividend that is determined according to the earnings of the company . By paying a low amount as constant dividends, a company avoids giving the shareholders false hopes about the dividend pattern of the company . The small amount of dividends paid every year sends a positive signal to the investors that the company is profitable and also helps to reduce uncertainty in the minds of investors. This helps build the confidence of the investors. The extra dividend paid allows the company to maintain flexibility in the payment of dividends.

39. Forms of dividends Issue of bonus shares Stock split Stock buyback

40. Bonus issue A bonus issue is a form of dividend through which a company gives additional shares of equity stock to its shareholders without they having to pay for the same. It is a way of capitalizing reserves. Issue of bonus shares only changes the form and not the content/wealth of equity shareholders.

41. Example – Bonus issue Existing structure Paid up capital (Rs 10) 500 lakhs Reserves & Surplus 4500 lakhs Total funds 5000 lakhs The firm announces a bonus issue of 2:1 i.e. Value of bonus shares = 2 * 500 lakhs = 1000 lakhs

42. Example – Bonus issue Existing structure Paid up capital (Rs 10) 500 lakhs Reserves & Surplus 4500 lakhs Total funds 5000 lakhs The firm announces a bonus issue of 2:1 i.e. Value of bonus shares = 2 * 500 lakhs = 1000 lakhs Structure after ‘Bonus Issue’ Paid up share capital 1500 lakhs Reserves & Surplus 3500 lakhs Total funds 5000 lakhs i.e. funds have been transferred from Reserves & Surplus to the paid up capital

43. On “Proportionate holding of investor” Remains the same On “Number of shares” Earlier: 500 lakhs / 10 = 50 lakhs Post issue: 1500 lakhs / 10 = 150 lakhs Example – Bonus issue Effect of bonus issue

44. On “Book value” How many times is ‘total shareholders funds value’ to paid up capital value in per share terms? Earlier: Post issue: 5000/500 = 10*10 5000/1500 = 3.33*10 = Rs 100 = Rs 33.33 Example – Bonus issue Effect of bonus issue

45. Stock split A stock split is similar to a stock dividend because it also increases the number of shares outstanding. The difference between the two is that a stock dividend appears as a transfer from retained earnings to the common stock and is paid in capital account, whereas a stock split is shown as a proportional reduction in the par value of each share.

46. Example – Stock Split Existing structure Paid up capital (Rs 10) 500 lakhs Reserves & Surplus 4500 lakhs Total funds 5000 lakhs The firm announces a bonus issue of 3:1 & a stock split of 4:1

47. Example – Stock Split Existing structure Post issue and split Post ‘bonus issue’ Share capital increases by 3 times i.e. to 2000 lakhs (200 lakh shares of Rs 10 each) Post ‘stock split’ Shares increase in number to 4 times i.e. 200*4= 800 lakh shares And share price becomes = 10/4 = Rs 2.50 / share Paid up capital (Rs 10) 500 lakhs Reserves & Surplus 4500 lakhs Total funds 5000 lakhs The firm announces a bonus issue of 3:1 & a stock split of 4:1

48. Comparing bonus issue and stock split Bonus issue Stock split Share value Increases Remains the same No. of shares Increases Increases Face value / share Remains the same Decreases Transfer from reserves Happens Does not happen Example – Stock Split

49. Shares buyback Here, the firm buys its own shares from whomsoever wants to sell the holding at a specified price during a specified period . This enhances shareholder value and helps to discourage unfriendly takeovers . Stock repurchase is a popular method adopted by many well known companies, such as Coca-Cola , Tandy, Marck , General Motors, and IBM. There are 2 key parameters – No. of shares to be bought back Price at which to buy them

50. Example – Shares buyback Equator Ltd. has 150 lakh shares outstanding at a market price of Rs 550 each. The firm has been paying a modest dividend of Rs 10 / share. Over time, it has accumulated substantial cash of Rs 100 crores, deployed at present, in govt securities. The management believes that about Rs 30 crores would be adequate to meet its expansion plans for foreseeable future. Management wants to return the excess cash back to the shareholders. It has two options- a) Pay a dividend b) Buyback of shares Calculate the DPS that it would pay if it opts for paying dividend. Also explain the process of buyback assuming premium appropriate for buyback is 20%.

51. Given, No. of shares = 150 lakhs Current MP = Rs 550 Surplus cash available = 100 cr – 30 cr = 70 cr DPS = 70 cr / 150 lakhs = 7000 lakhs / 150 lakhs = Rs 46.67 Example – Shares buyback

52. Buyback: Price of buyback = 550 + 20% of 550 = Rs 660 No. of shares that can be bought back = 7000 lakhs / 660 = 10,60,000 No. of shares o/s post buyback = (150 – 10.6) lakhs = 139.40 lakhs Example – Shares buyback

53. To summarise While deciding on how much of earnings to distribute in form of dividends amongst shareholders, the underlying objective is ‘ maximization of shareholders wealth ’ Different opinions (in form of theories) exist w.r.t what an optimal DPR should be While Walter and Gordon model suggest formulae to arrive at a DPR that maximizes price / value MM model asserts that the dividend policy is irrelevant. Apart from these traditional models, various contemporary viewpoints have also developed taking account of practical considerations in defining a dividend policy A firm could be paying dividend in different forms like issuing bonus shares or through stock split etc.