4- Introduction to Topic

7/30/2019 4- Introduction to Topic

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INTRODUCTION TO TOPIC

A business

organisation always aims

at earning profits. The

utilisation of profits

earned is a significant

financial decision. The

main issue here is

whether the profits

should be used by the

owner(s) or retained and

reinvested in thebusiness itself. This

decision does not

involve any problem is

so far as the sole

proprietary business is

concerned. In case of a partnership the agreement often provides for the basis of

distribution of profits among partners. The decision-making is somewhat complex in the

case of joint stock companies.

Since company is an artificial person, the decision regarding utilisation ofprofits

rests with a group of people, namely the board of directors. As in any other types of

organisation, the disposal of net earnings of a company involves either their retention in

the business or their distribution to the owners (i.e., shareholders) in the form of dividend,

or both. Yet the decision regarding distribution of disposable earnings to the shareholders

is a significant one. The decision may mean a higher income, lower income or no

income at all to the shareholders. Besides affecting the mood of the present shareholders,

dividend may also influence the mood, behaviour and responses of prospective

investors, stock exchanges and financial institutions because of its relationship with

the worth of the company, which in turn affects the

market value of its shares. The decision regarding

dividend is taken by the Board of Directors and is

then recommended to the shareholders for their

formal approval in the annual general meeting of the

company. Disposal of profits in the form of

dividends can become a controversial-issue because


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of conflicting interests of various parties like the directors, employees, shareholders,

debenture holders, lending institutions, etc. Even among the shareholders there may be

conflicts as they may belong to different income groups. While some may be interested

in regular income, others may be interested in capital appreciation and capital gains.

Hence, formulation of dividend policy is a complex decision. It needs careful

consideration of various factors. One thing, however, standsout. Instead of an ad hoc

approach, it is more desirable to follow a reasonably long-term policy regarding

dividends.

CONCEPT OF DIVIDEND

Dividends are

payments made by

a corporation to its

shareholder members. It

is the portion of

corporate profits paid

out to stockholders.

When a corporation

earns a profit or surplus, that money can be put to two uses: it can either be re-invested in

the business (called retained earnings), or it can be distributed to shareholders. There are

two ways to distribute cash to shareholders: share repurchases or dividends. Many

corporations retain a portion of their earnings and pay the remainder as a dividend.

A dividend is allocated as a fixed amount per share. Therefore, a shareholder

receives a dividend in proportion to their shareholding. For the joint stock company,

paying dividends is not an expense; rather, it is the division of after tax profits among

shareholders. Retained earnings (profits that have not been distributed as dividends) are

shown in the shareholder equity section in the company's balance sheet - the same as its

issued share capital. Public usually pay dividends on a fixed schedule, but may declare a

dividend at any time, sometimes called a special dividend to distinguish it from the fixed

schedule dividends.

Cooperatives, on the other hand, allocate dividends according to members'

activity, so their dividends are often considered to be a pre-tax expense.
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Dividends are usually paid in the form of cash, store credits (common among

retail consumers' cooperatives) and shares in the company (either newly created shares or

existing shares bought in the market.) Further, many public companies offerdividend

reinvestment plans, which automatically use the cash dividend to purchase additional

shares for the shareholder.

DIVIDEND DEFINITION

A dividend is a payment made by a company to its shareholders. A company can

retain its profit for the purpose of re-investment in the business operations (known as

retained earnings), or it can distribute the profit among its shareholders in the form of

dividends.

A dividend is not regarded as expenditure; rather, it is considered a distribution of

assets among shareholders. The majority of companies keep a component of their profits

as retained earnings and distribute the rest as dividend.

FORMS OF PAYMENT
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Cash dividends (most common) are those paid out in currency, usually

via electronic funds transferor a printed papercheck. Such dividends are a form of

investment income and are usually taxable to the recipient in the year they are paid. This

is the most common method of sharing corporate profits with the shareholders of the

company. For each share owned, a declared amount of money is distributed. Thus, if a

person owns 100 shares and the cash dividend is USD $0.50 per share, the holder of the

stock will be paid USD $50.

Stock or scrip dividends are those paid out in the form of additional stock shares

of the issuing corporation, or another corporation (such as its subsidiary corporation).

They are usually issued in proportion to shares owned (for example, for every 100 shares

of stock owned, a 5% stock dividend will yield 5 extra shares). If the payment involves

the issue of new shares, it is similar to astock split in that it increases the total number of

shares while lowering the price of each share without changing the market capitalization,

or total value, of the shares held. (See also Stock dilution.)

Property dividends or dividends in specie(Latin for"in kind") are those paid out

in the form of assets from the issuing corporation or another corporation, such as a

subsidiary corporation. They are relatively rare and most frequently are securities of other

FORMS OFPAYMENT

Cashdividends

Stock or scrip

dividends

Propertydividends

Interimdividends

Otherdividends
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companies owned by the issuer, however they can take other forms, such as products and

services.

Interim dividends are dividend payments made before a company's annual

general meeting (AGM) and final financial statements. This declared dividend usually

accompanies the company's interim financial statements.

Scrip dividend. A company may not have sufficient funds to issue dividends in the nearfuture, so instead it issues a scrip dividend, which is essentially a promissory note (which

may or may not include interest) to pay shareholders at a later date. This dividend creates

a note payable.

Liquidating dividend. When the board of directors wishes to return the capital originallycontributed by shareholders as a dividend, it is called a liquidating dividend, and may be a

precursor to shutting down the business. The accounting for a liquidating dividend is

similar to the entries for a cash dividend, except that the funds are considered to come

from the additional paid-in capital account.

Other dividends can be used in structured finance. Financial assets with a known

market value can be distributed as dividends; warrants are sometimes distributed in this

way. For large companies with subsidiaries, dividends can take the form of shares in a

subsidiary company. A common technique for "spinning off" a company from its parent

is to distribute shares in the new company to the old company's shareholders. The new

shares can then be traded independently.

DIVIDEND POLICY : INTRODUCTION

The objective of corporate management usually is the maximisation of the market

value of the enterprise i.e., its wealth. The market value of common stock of a company is

influenced by its policy regarding allocation of net earnings into `plough back' and

`payout'. While maximising the market value of shares, the dividend policy should be so

oriented as to satisfy the interests of the existing shareholders as well as to attract the

potential investors. Thus, the aim should be to maximise the present value of future

dividends and the appreciation in the market price of shares.
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Dividend policy is concerned with taking a decision regarding paying cash

dividend in the present or paying an increased dividend at a later stage. The firm could

also pay in the form ofstock dividends which unlike cash dividends do not provide

liquidity to the investors; however, it ensures capital gains to the stockholders. The

expectations of dividends by shareholders helps them determine the share value,

therefore, dividend policy is a significant decision taken by the financial managers of any

company.

BACKGROUND OF CORPORATE DIVIDEND POLICY

The issue of corporate dividends has a long history and, as Frankfurter and Wood

(1997) observed, is bound up with the development of the corporate form itself.

Corporate dividends date back at least to the early sixteenth century in Holland and

Great Britain when the captains of sixteenth century sailing ships started selling

financial claims to investors, which entitled them to share in the proceeds, if any, of the

voyages3. At the end of each voyage, the profits and the capital were distributed to

investors, liquidating and ending the ventures life. By the end of the sixteenth century,

these financial claims began to be traded on open markets in Amsterdam and were

gradually replaced by shares of ownership. It is worth mentioning that even then many

investors would buy shares from more than one captain to diversify the risk associated

with this type of business.

At the end of each voyage, the enterprise liquidation of the venture ensured a

distribution of the profits to owners and helped to reduce the possibilities of fraudulent

practice by captains (Baskin, 1988). However, as the profitability of these ventures was

established and became more regular, the process of liquidation of the assets at the

conclusion of each voyage became increasingly inconvenient and costly. The successes

of the ventures increased their credibility and shareholders became more confident in

their management (captains), and this was accomplished by, among other things, the

payment of generous dividends (Baskin, 1988). As a result, these companies began

trading as going concern entities, and distributing only the profits rather than the entire

invested capital. The emergence of firms as a going concern initiated the fundamentalpractice of firms to decide what proportion of the firms income (rather than assets) to

return to investors and produced the first dividend payment regulations (Frankfurter and

Wood, 1997). Gradually, corporate charters began to restrict the payments of dividends
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to the profits only.

The ownership structure of shipping firms gradually evolved into a joint

stock company form of business. But it was chartered trading firms more generally that

adopted the joint stock form. In 1613, the British East India Company issued its first

joint stock shares with a nominal value. No distinction was made, however, between

capital and profit (Walker, 1931, p.102). In the seventeenth century, the success of this

type of trading company seemed poised to allow the spread of this form of business

organization to include other activities such as mining, banking, clothing, and utilities.

Indeed, in the early 1700s, excitement about the possibilities of expanded trade and the

corporate form saw a speculative bubble form, which collapsed spectacularly when the

South Sea Company went into bankruptcy. The Bubble Act of 1711 effectively slowed,

but did not stop, the development of the corporate form in Britain for almost a century

(Walker, 1931).

In the early stages of corporate history, managers realized the importance of

high and stable dividend payments. In some ways, this was due to the analogy investors

made with the other form of financial security then traded, namely government bonds.

Bonds paid a regular and stable interest payment, and corporate managers found that

investors preferred shares that performed like bonds (i.e. paid a regular and stable

dividend). For example, Bank of North America in 1781 paid dividends after only six

months of operation, and the bank charter entitled the board of directors to distribute

dividends regularly out of profits. Paying consistent dividends remained of paramount

importance to managers during the first half of the 19th century (Frankfurter and

Wood, 1997, p.24)

In addition to the importance placed by investors on dividend stability, another

issue of modern corporate dividend policy to emerge early in the nineteenth century

was that dividends came to be seen as an important form of information. The scarcity

and unreliability of financial data often resulted in investors making their assessments

of corporations through their dividend payments rather than reported earnings. In

short, investors were often faced with inaccurate information about the

performance of a firm, and used dividend policy as a way of gauging what

managements views about future performance might be. Consequently, an increase in

divided payments tended to be reflected in rising stock prices. As corporations becameaware of this phenomenon, it raised the possibility that managers of companies could

use dividends to signal strong earnings prospects and/or to support a companys share

price because investors may read dividend announcements as a proxy for earnings


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growth.

To summarise, the development of dividend payments to shareholders has been

tied up with the development of the corporate form itself. Corporate managers realized

early the importance of dividend payments in satisfying shareholders expectations.

They often smoothed dividends over time believing that dividend reductions might have

unfavourable effects on share price and therefore, used dividends as a device to signal

information to the market. Moreover, dividend policy is believed to have an impact on

share price. Since the 1950s, the effect of dividend policy on firm value and other

issues of corporate dividend policy have been subjected to a great debate among finance

scholars. The next section considers these developments from both a theoretical and an

empirical point of view.


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Types of Dividend Policies

The following are various types of dividend policies (1) Policy of No Immediate

Dividend (2) Stable Dividend Policy. (3) Regular Dividend plus Extra Dividend Policy.

(4) Irregular Dividend Policy. (5) Regular Stock Dividend Policy. (6) Regular Dividend

plus Stock Dividend Policy. (7) Liberal Dividend Policy.

We discuss these policies in detail:

(1) Policy of No Immediate Dividend: Generally, management follows a policy of

paying no immediate dividend in the beginning of its life, as it requires funds for growth

and expansion. In case, when the outside funds are costlier or when the access to capital

market is difficult for the company and shareholders are ready to wait for dividend for

some time, this policy is justified, provided the company is growing fast and it requires a

good deal of amount for expansion. But such a policy is not justified for a long time, as

the shareholders are deprived of the dividend and the retained earnings built up which

will attract attention of laborers, consumers etc. It would be better if the period of

dividend is followed by issue of bonus shares, so that later on rate of dividend is

maintained at a reasonable level.

(2) Regular or Stable Dividend Policy: When a company pays dividend regularly at a

fixed rate, and maintains it for a considerably long time even though the profits may

fluctuate, it is said to follow regular or stable dividend policy. Thus stable dividend policy

means a policy of paying a minimum amount of dividend every year regularly. It raises

the prestige of the company in the eyes of the investors. A firm paying stable dividend

can satisfy its shareholders and can enhance its credit standing in the market. Not only

that the dividend must be regularly paid but the dividend must be stable. It may be fixed

amount per share or a fixed percentage of net profits or it may be total fixed amount of

dividend on all the shares etc. The benefits of stable dividend policy are (i) it helps in

raising long-term finance. When the company tries to raise finance in future, the investors

would examine the dividend record of the company. The investors would not hesitate to

invest in company with stable dividend policy. (2) As it will enhance the prestige of the

company, the price of its shares would remain at a high level. (3) The shareholders

develop confidence in management. (4) It makes long-term planning easier. (The detailed

discussion of this policy follows in the next paragraph.

(3) Regular Dividend plus Extra Dividend Policy. A firm paying regular dividends

would continue with its pay out ratio. But when the earnings exceed the normal level, the

directors would pay extra dividend in addition to the regular dividend. But it would be

named 'Extra dividend', as it should not give an impression that the company has

enhanced rate of regular dividend, This would give an impression to shareholders that the

company has given extra dividend because it has earned extra profits and would not be


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repeated when the business earnings become normal. Because of this policy, the

company's prestige and its share values will not be adversely affected. Only when the

earnings of the company have permanently increased, the extra dividend should be

merged with regular normal dividend and thus rate of normal dividend should be raised.

Besides, the extra dividend should not be abruptly declared, but the shareholders should

have some idea in advance, so that they may sell their shares, if they like. This system is

not found in India.

(4) Irregular Dividend Policy: When the firm does not pay out fixed dividend regularly,

it is irregular dividend policy. It changes from year to year according to changes in

earnings level. This policy is based on the management belief that dividend should be

paid only when the earnings and liquid position of the firm warrant it. This policy is

followed by firms having unstable earnings, particularly engaged in luxury goods.

(5) Regular Stock Dividend Policy: When a firm pays dividend in the form of shares

instead of cash regularly for some years continuously, it is said to follow this policy. We

know stock dividend as bonus shares. When a company is short of cash or is facing

liquidity crunch, because a large part of its earnings are blocked in high level of

receivables or when the company is need of cash for its modernization and expansion

program, it follows this policy. It is not advisable to follow this policy for a long time, as

the number of shares will go on increasing, which would result in fall in earnings per

share. This would adversely affect the credit standing of the firm and its share values willgo down.

(6) Regular Dividend plus Stock Dividend Policy: A firm may pay certain amount of

dividend in cash and some dividend is paid in the form of shares (stock). Thus, the

dividend is split in to two parts. This policy is justified when (1) The company wants to

maintain its policy of regular dividend and yet (2) It wants to retain some part of its

divisible profit with it for expansion. (3) It wants to give benefit of its earnings to

shareholders but has not enough liquidity to give full dividend in cash. All the limitations

of paying regular stock dividends apply to this policy.

(7) Liberal Dividend Policy: It is a policy of distributing a major part of its earnings to

its shareholders as dividend and retains a minimum amount as retained earnings. Thus,

the ratio of dividend distribution is very large as compared to retained earnings. The rate

of dividend or the amount of dividend is not fixed. It varies according to earnings. The

higher is the profit, the higher will be the rate of dividend. In years of poor earnings, the

rate of dividend will be lower. In fact, it is the policy of Irregular Dividend.


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Dividend Policy Goals

There are several factors, which influence the determination of the dividend

policy. As such no two companies may follow exactly similar dividend policies. The

dividend policy has to be tailored to the particular circumstances of the company.However, the following aspects have general applicability:

Dividend policy should be analysed in terms of its effect on the value of the company.

Investment by the company in new profitable opportunities creates value and when a

company foregoes an attractive investment, shareholders incur an opportunity loss.

Dividend, investment and financing decisions are interdependent and there is often a

tradeoff.

Dividend decision should not be treated as a short run residual decision because '

variability of annual earnings may cause even a zero dividend in a particular year. This

m a y have serious repercussions for the company and m a y result in the delisting of

its share for the purpose of dealings on any approved stock exchange.

A workable compromise is to treat dividends as a long-run residual to avoid

undesirable variations in payout. This needs financial planning over a fairly long time

horizon.

Whatever dividend policy is adopted by the company, the general principles

guiding the dividend policy should, as far as possible, be communicated clearly to

investors who m a y then take their decisions in terms of their own preferences and

needs.

Erratic and frequent changes in dividends should be avoided. Reduction in the rate of

dividend is a painful thing for the shareholders to bear. The management will find it hard

to convince the shareholders of the desirability of a lower dividend for the sake of

preserving their future interests.

FACTORS AFFECTING DIVIDEND DECISION


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1. Stability of Earnings. The nature of business has an important bearing on the

dividend policy. Industrial units having stability of earnings may formulate a more

consistent dividend policy than those having an uneven flow of incomes because they can

predict easily their savings and earnings. Usually, enterprises dealing in necessities suffer

less from oscillating earnings than those dealing in luxuries or fancy goods.

2. Age of corporation. Age of the corporation counts much in deciding the dividend

policy. A newly established company may require much of its earnings for expansion and

plant improvement and may adopt a rigid dividend policy while, on the other hand, an

older company can formulate a clear cut and more consistent policy regarding dividend.

3. Liquidity of Funds. Availability of cash and sound financial position is also an

important factor in dividend decisions. A dividend represents a cash outflow, the greater

the funds and the liquidity of the firm the better the ability to pay dividend. The liquidity

of a firm depends very much on the investment and financial decisions of the firm which

in turn determines the rate of expansion and the manner of financing. If cash position is

weak, stock dividend will be distributed and if cash position is good, company can

distribute the cash dividend.

4. Extent of share Distribution.Nature of ownership also affects the dividend decisions.

A closely held company is likely to get the assent of the shareholders for the suspension

of dividend or for following a conservative dividend policy. On the other hand, a

company having a good number of shareholders widely distributed and forming low or

medium income group, would face a great difficulty in securing such assent because they

will emphasise to distribute higher dividend.

5. Needs for Additional Capital. Companies retain a part of their profits for

strengthening their financial position. The income may be conserved for meeting the

increased requirements of working capital or of future expansion. Small companies

usually find difficulties in raising finance for their needs of increased working capital for

expansion programmes. They having no other alternative, use their ploughed back profits.

Thus, such Companies distribute dividend at low rates and retain a big part of profits.

6. Trade Cycles. Business cycles also exercise influence upon dividend Policy. Dividend

policy is adjusted according to the business oscillations. During the boom, prudent

management creates food reserves for contingencies which follow the inflationary period.

Higher rates of dividend can be used as a tool for marketing the securities in an otherwise

depressed market. The financial solvency can be proved and maintained by the companies

in dull years if the adequate reserves have been built up.


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7. Government Policies. The earnings capacity of the enterprise is widely affected by the

change in fiscal, industrial, labour, control and other government policies. Sometimes

government restricts the distribution of dividend beyond a certain percentage in a

particular industry or in all spheres of business activity as was done in emergency. The

dividend policy has to be modified or formulated accordingly in those enterprises.

8. Taxation Policy. High taxation reduces the earnings of he companies and

consequently the rate of dividend is lowered down. Sometimes government levies

dividend-tax of distribution of dividend beyond a certain limit. It also affects the capital

formation. N India, dividends beyond 10 % of paid-up capital are subject to dividend tax

at 7.5 %.

9. Legal Requirements. In deciding on the dividend, the directors take the legal

requirements too into consideration. In order to protect the interests of creditors an

outsiders, the companies Act 1956 prescribes certain guidelines in respect of the

distribution and payment of dividend. Moreover, a company is required to provide for

depreciation on its fixed and tangible assets before declaring dividend on shares. It

proposes that Dividend should not be distributed out of capita, in any case. Likewise,

contractual obligation should also be fulfilled, for example, payment of dividend on

preference shares in priority over ordinary dividend.

10. Past dividend Rates. While formulating the Dividend Policy, the directors must keep

in mind the dividend paid in past years. The current rate should be around the average

past rat. If it has been abnormally increased the shares will be subjected to speculation. In

a new concern, the company should consider the dividend policy of the rival organisation.

11. Ability to Borrow. Well established and large firms have better access to the capital

market than the new Companies and may borrow funds from the external sources if there

arises any need. Such Companies may have a better dividend pay-out ratio. Whereas

smaller firms have to depend on their internal sources and therefore they will have to built

up good reserves by reducing the dividend pay out ratio for meeting any obligation

requiring heavy funds.

12. Policy of Control. Policy of control is another determining factor is so far as

dividends are concerned. If the directors want to have control on company, they would

not like to add new shareholders and therefore, declare a dividend at low rate. Because by

adding new shareholders they fear dilution of control and diversion of policies and

programmes of the existing management. So they prefer to meet the needs through

retained earing. If the directors do not bother about the control of affairs they will follow


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a liberal dividend policy. Thus control is an influencing factor in framing the dividend

policy.

13. Repayments of Loan. A company having loan indebtedness are vowed to a high rate

of retention earnings, unless one other arrangements are made for the redemption of debt

on maturity. It will naturally lower down the rate of dividend. Sometimes, the lenders

(mostly institutional lenders) put restrictions on the dividend distribution still such time

their loan is outstanding. Formal loan contracts generally provide a certain standard of

liquidity and solvency to be maintained. Management is bound to hour such restrictions

and to limit the rate of dividend payout.

14. Time for Payment of Dividend. When should the dividend be paid is another

consideration. Payment of dividend means outflow of cash. It is, therefore, desirable to

distribute dividend at a time when is least needed by the company because there are peak

times as well as lean periods of expenditure. Wise management should plan the payment

of dividend in such a manner that there is no cash outflow at a time when the undertaking

is already in need of urgent finances.

15. Regularity and stability in Dividend Payment. Dividends should be paid regularly

because each investor is interested in the regular payment of dividend. The management

should, inspite of regular payment of dividend, consider that the rate of dividend should

be all the most constant. For this purpose sometimes companies maintain dividend

equalization Fund.


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PROCEDURE FOR DECLARATION AND PAYMENT OF DIVIDENDS

Step 1 : Recommendation by the Board

Dividend can be declared only on the recommendation of the board of directors ("Board")

Dividend Distribution Tax (DDT)

Declaration of Interim Dividend

Permission of RBI

Unpaid dividend

Payment within 42 days of declaration

Payment from profits of the Company

Resolution at the annual general meeting

Recommendation by the Board


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of the company. The members cannot on their own declare any dividend. The Board, after

consideration and approval of the financial statements of the company, determines the

rate of dividend to be declared and recommends the same to the shareholders.

Step 2 : Resolution at the annual general meeting

Dividend is declared by a company by a resolution passed at its AGM after sanctioning

the rate of dividend recommended by the Board. The members may declare a lower rate

of dividend than what is recommended by the Board but they have no power to increase

the amount or rate so recommended by the Board.

Step 3 : Payment from profits of the Company

It has to be ensured that dividend is paid out of the profits of the company after providing

for depreciation and if no depreciation is provided, ensure that approval was obtained

from the Central Government before declaring the dividend.

Step 4 : Payment within 42 days of declaration

(a) The amount of dividend including interim dividend shall be deposited in a

separate bank account within 5 days from the date of declaration of such dividend.

(b) Dividend should be paid out of such bank account within 42 days of declaration of

such dividend.

(c) Failure to comply with this requirement subjects the company to penalty under the

Act unless such failure is because of the reason excepted under the Act.

Step 5 : Unpaid dividend

(a) Unpaid Dividend Account

The amount of dividend which remains unpaid or unclaimed after 30 days from the date

of declaration should be transferred to a special dividend account, to be calle d Unpaid

Dividend Account' of the company within 7 days from the expiry of the 30 days period

provided for payment of dividend.


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The company in default of this provision shall pay, from the date of such default, 12%

interest on the amount not transferred to the said account, which interest shall ensure to

the benefit of the members, in proportion to the amount remaining unpaid to them.

(b) Investor Education and Protection Fund

Any amount in the Unpaid Dividend Account of the company which remains unclaimed

and unpaid for a period of 7 years from the date of transfer of such amount to the Unpaid

Dividend Account should be transferred to the Investor Education and Protection Fund,

within 30 days of the expiry of 7 years from the date of transfer to the Unpaid Dividend

Account. But prior to such transfer the company must have given individual intimation to

the concerned members of the amount of dividend remaining unclaimed which is liable to

be transferred to such fund at least 6 months before the due date of such transfer.

Step 6 : Permission of RBI

The permission of RBI is required in case of payment of dividend to non- resident

shareholders.

Step 7 : Declaration of Interim Dividend

(a) Interim dividend can be declared by the Board without requiring the approval of

the members of the company. However interim dividend can be paid only if authorized by

the articles of association of the company.

(b) A mere resolution declaring interim dividend does not create any liability and may

be rescinded at any time before actual payment. (distinction between interim and final

dividend)

Step 8 : Dividend Distribution Tax (DDT)

The DDT is liable to be paid by the company at the rate of 15.0% (plus a surcharge of

10% and education cess at the rate of 3% on dividend distribution tax and surcharge) on

the total amount distributed as a dividend. Thus the effective rate of dividend distribution

tax is 16.995%.

In addition it is pertinent to note that dividends are not taxable in India in the hands of the


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shareholders.

DIVIDEND POLICY

Dividend policy is concerned with taking a decision regarding paying cashdividend in the present or paying an increased dividend at a later stage. The firm could

also pay in the form of stock dividends which unlike cash dividends do not provide

liquidity to the investors, however, it ensures capital gains to the stockholders. The

expectations of dividends by shareholders helps them determine the share value,

therefore, dividend policy is a significant decision taken by the financial managers of any

company.

RELEVANCE MODEL OF DIVIDEND POLICY

Dividendpolicy

Relevance modelof dividend policy

(direct effect on

the value of the

firm)

Walter'smodel

Gordon'sModel

Irrelevancemodel of

dividend policy

( does not affect

the firm's value)

Traditionaltheorem

Modigliani-Miller

theorem


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Dividends paid by the firms are viewed positively both by the investors and the

firms. The firms which do not pay dividends are rated in oppositely by investors thus

affecting the share price. The people who support relevance of dividends clearly state that

regular dividends reduce uncertainty of the shareholders i.e. the earnings of the firm is

discounted at a lower rate, ke thereby increasing the market value. However, its exactly

opposite in the case of increased uncertainty due to non-payment of dividends.

Two important models supporting dividend relevance are given by Walter and Gordon.

WALTER'S MODEL

James E. Walter's model shows the relevance of dividend policy and its bearing on the

value of the share.

Assumptions of the Walter model

1. Retained earnings are the only source of financing investments in the firm, there isno external finance involved.

2. The cost of capital, ke and the rate of return on investment, r are constant i.e. evenif new investments decisions are taken, the risks of the business remains same.

3. The firm's life is endless i.e. there is no closing down.Basically, the firm's decision to give or not give out dividends depends on whether it has

enough opportunities to invest the retain earnings i.e. a strong relationship between

investment and dividend decisions is considered.

Model description

Dividends paid to the shareholders are re-invested by the shareholder further, to

get higher returns. This is referred to as the opportunity cost of the firm or the cost of

capital, ke for the firm. Another situation where the firms do not pay out dividends, is

when they invest the profits or retained earnings in profitable opportunities to earn returns

on such investments. This rate of return r, for the firm must at least be equal to ke. If this

happens then the returns of the firm is equal to the earnings of the shareholders if the

dividends were paid. Thus, its clear that if r, is more than the cost of capital ke, then the

returns from investments is more than returns shareholders receive from further

investments.


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Walter's model says that if rke then the

investment opportunities reap better returns for the firm and thus, the firm should invest

the retained earnings. The relationship between r and k are extremely important to

determine the dividend policy. It decides whether the firm should have zero payout or

100% payout.

In a nutshell :

If r>ke, the firm should have zero payout and make investments. If r


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Although the model provides a simple framework to explain the relationship

between the market value of the share and the dividend policy, it has some unrealistic

assumptions.

1. The assumption of no external financing apart from retained earnings, for the firmmake further investments is not really followed in the real world.

2. The constant r and ke are seldom found in real life, because as and when a firminvests more the business risks change.

GORDON'S MODEL

Myron J. Gordon has also supported dividend relevance and believes in regular

dividends affecting the share price of the firm.

Assumptions of the Gordon model

Gordon's assumptions are similar to the ones given by Walter. However, there are two

additional assumptions proposed by him :

1. The product of retention ratio b and the rate of return r gives us the growth rate ofthe firm g.

2. The cost of capital ke, is not only constant but greater than the growth rate i.e.ke>g.

Model description

Investor's are risk averse and believe that incomes from dividends are certain rather than

incomes from future capital gains, therefore they predict future capital gains to be risky

propositions. They discount the future capital gains at a higher rate than the firm's

earnings thereby, evaluating a higher value of the share. In short, when retention rate

increases, they require a higher discounting rate. Gordon has given a model similar to

Walter's where he has given a mathematical formula to determine price of the share.

Mathematical representation

The market price of the share is calculated as follows:
http://en.wikipedia.org/wiki/Myron_J._Gordonhttp://en.wikipedia.org/wiki/Myron_J._Gordon


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where,

P = Market price of the share E = Earnings per share b = Retention ratio (1 - payout ratio) r = Rate of return on the firm's investments ke = Cost of equity br = Growth rate of the firm (g) Therefore the model shows a relationship between the payout ratio, rate of return, cost of

capital and the market price of the share.

IRRELEVANCE MODEL OF DIVIDEND POLICY

TRADITIONAL APPROACH

Many finance and economics specialists believe that cash dividend

policy is unimportant because it is not relevant and does not affect the owners wealth.

The source of this belief is a study conducted by Miller and Modigliani (1961). This

study concludes that dividend policy has no effect on a companys value, and therefore

managers will not be able to maximize owners wealth through a dividend policy.

The irrelevance proposition concept for dividend policy on the owners

wealth stems from the fundamental idea that companies which distribute continuous high

cash dividends to shareholders therefore secure a higher share price (Lumby and Jones,

1999). As a result, investors capital gains are very limited in such a company as they

receive the same returns as other investors holding another companys shares with low

dividends while its prices become high because of the retained earnings. These investors

obtain high capital gains which compensates the limited cash dividends. In both cases, the

shareholders wealth is the profits obtained by cash dividend plus capital gains realizedfrom rising share prices. In case there are no taxes or where taxes on capital gains are

equal to dividends taxes, the investor will not be affected, whether or not the company

has paid cash dividends or kept the profit in retained earnings and the investor has


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obtained capital gains when selling his/her shares as a result of the rise in the price of the

companys shares through undistributed profits and with no change in the other effective

factors.

According to the irrelevance proposition, dividend policy affects only the level of

external financing required to finance future projects with a positive net present value.

This means that each dollar distributed to shareholders represents a capital loss of a

dollar. According to this hypothesis, the only constraint on the companys market

value is the companys investment policy, not which dividend policy the company

follows. This is because the investment policy is responsible for future profits (Miller

and Modigliani, 1961). Accordingly, the companys decision on the distribution of

cash or non-profit distribution would not affect the market value of the company and

therefore would not affect the owners wealth. This hypothesis recommends that

managers should give greater importance to the investment policy and let the dividend

policy follow the investment policy; which is known the Residual Dividend Policy.

The advocates of the irrelevance proposition hypothesis (Black and Scholes, 1974,

Miller and Scholes, 1978, Merton and Myron, 1982, Merton, 1986, Peter, 1996) adopt

the idea that an investor can build his/her own cash dividend policy regardless of

the companys dividend policy. This is known as the Homemade Dividend (Miller and

Modigliani, 1961) where investors can obtain income through selling part of his/her

shares equal to the value of cash profits that could have been distributed by the

company if the company does not have cash dividends and the investor himself

wishes to receive cash dividends to meet his consumer needs. The investor may wish also

to reinvest cash dividends distributed by the company if he/she shows no desire for cash

dividends. By following this method, the investor will not be affected by the companys

dividend policy, and therefore would not be compelled to abandon the stocks of

companies following a dividend policy which is not consistent with his/her wishes.

One of the criticisms of the irrelevance proposition hypothesis is that it cannot be

practically acceptable. The theory of building a dividend policy for each investor based

on an efficient market, with no transaction costs for buying and selling, is not practical

(Dempsey and Laber, 1992). In addition, the investor will pay taxes on cash dividends or

capital gains, making the adoption of a specific dividend policy for each investor a costly

process. In addition, investment in companies whose cash dividend policy is consistent

with investors needs is less expensive than building a special dividend policy.

Irrelevance proposition hypothesis is built on the basis that the investor is rational when


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taking his/her decisions. However, psychological tests prove that human beings are not

one hundred per cent rational with regard to decision-making. Shefrin and Statman (1984)

in their study argue that investors have an unreasonable preference regarding profit

dividends; this is not consistent with irrelevance proposition hypothesis. Irrelevance

proposition hypothesis is also criticised for assuming equality between cash dividends

and capital gains. The two are not equal as a cash dividend is cash in the hand without

any uncertainty risk, while a capital gain is cash in the future with considerable risk. So,

how can they be equal?

The irrelevance proposition hypothesis has been built on a set of assumptions that

have already been indicated. It is understood here that any change in these

assumptions would naturally lead to a change in the basic hypothesis and therefore

to a change in the results. Accordingly, and in practical terms, financial markets in

general do not agree with these assumptions


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MODIGLIANI AND MILLER

APPROACH:

Franco Modigliani was awarded Nobel prize in 1985 and Merton Miller in 1990

(along with Markowitz and Sharpe). M&M have theorised on the irrelevance of the

capital structure, and a corollary, irrelevance of the dividend payout ratio to the value of

the firm. Like several financial theories, M&M hypothesis is based on the argument of

efficient capital markets. In addition, we believe that a firm has two options:

(a) It retains earnings and finances its new investment plans with such retained

earnings; (b) It distributes dividends, and finances its new investment plans by

issuing new shares.

The intuitive background of the M&M approach is extremely simple, and in fact,

almost self- explanatory. It is based on the following propositions:

Why would a company retain earnings? Only tenable reason is that the

company has investment opportunities. If the company does not retain earnings,

where does it finance those investment opportunities from? We may assume a

.

Value of the firm (i.e wealth of shareholders)

Depends on Firm's earnings.

Depends on

Firm's investment policy and not on

dividend policy.


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debt issuance, but then as M&M otherwise propounded irrelevance of the capital

structure, they see a parity between debt and equity, and hence, it does not make

a difference whether the new investments are funded by equity or debt. So, let

us assume that the new growth plans are funded by equity.

Shareholders price the equity shares of the company to take into account the

earnings and the retentions of the company. If the company distributes dividends,

the shareholders take into account that fact in pricing of the shares; if the

company does not distribute dividends, that is also reflected in the pricing of the

shares.

If dividends are distributed, the financing needs of the company will be funded by

issuing new shares. The issue price of these shares will compensate for the fact

that the dividends have been distributed. That is to say, the market price of the

share will remain unaffected by whether the dividends have been distributed or

not.

Let us take a one year time horizon to understand the indifference argument of M&M. We

use the following new notations:

Po : Price of the equity share at point 0

P1 : Price of the equity share at point 1, that is, end of period 1D1 : Dividend per share being paid in period 1n : existing number of issued sharesm : new shares to be issuedI : Investment needs of the company in year 1X : Profits of the firm year in 1

The relation between the price at the beginning of the year (Po), and that at the end of

the year (P1) is the simple question of discounted value at the shareholders expected

rate of return (KE). Hence,

Po = (P1 +D1) / (1+(KE) (1)

Equation (1) is quite easy to understand. Shareholders have got a cash return equal to

D1 at the end of Year 1, and the share is still worth P1. Hence, discounted at the

cost of equity, the discounted value is the price at the beginning of the period.

Alternatively, it may also be stated that the


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P1 = (P0 )* (1+(KE) - D1 (2)

That is to say, if the company declares dividends, the price the end of year 1 comes

down to the effect of the distribution.

Equation (1) can be manipulated. By multiplying both sides by n, and adding a self-

cancelling number m, we may write (1) as follows:

nPo = [(n+m)P1 -mP1 +nD1)]/(1+(KE) (3)

Note that we have multiplied both sides by n, and the added number m along with m is

cancelled by deducting the same outside the brackets.

mP1 represents the new share capital raised by the company to finance its investment

needs. How much share capital would the company need to raise? Given the

investment needs I and the profits X, the new capital issued will be given by the

following:

mP1 = I(X - nD1) (4)

Again, this is not difficult to understand, as the total amount of profit of the company is

X, and the total amount distributed as dividends is nD1. Hence, the company is left with a

funding gap as shown by equation (4).

If the value of mP1 is substituted in Equation (3), we have the

following:

nPo = [(n+m)P1 {I(X - nD1)}+nD1)]/(1+(KE) (5)

As nD1 would cancel out, we will be left with the following:

nPo = [(n+m)P1 I + X] /(1+(KE) (6)

Since nPo is total value of the stock at point 0, it is seen from Equation (6) that dividend

is not a factor in that valuation at all.

assumptions:


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Perfect capital markets: The firm operates in perfect capital markets where investors

behave rationally, information is freely available to all and transactions and flotation costs

do no exist. Perfect capita; markets also imply that no investor is large enough to affect

the market price of a share.

No taxes: taxes do no exist or there are no differences in the tax rates applicable to

capital gains and dividends. This means that investors value a rupee of dividend as much

as a rupee of capital gains.

Investment opportunities are known: the firm is certain with its investment opportunities

and future profits.

No risk: Risk of uncertainty does not exist i.e. investors are able to forecast future prices

and dividends with certainty, and one discount rate is appropriate for all securities and all

time periods. Thus, r=k for all t

According to M-M, r should be equal for all shares. If it is not so, the low return yielding

return shares will be sold by the investors who will purchase the high- return yieldingshares. This process will tend to reduce the price of the low-return shares and increase the

prices of the high-return shares. This switching or arbitrage will continue until the

differentials in rates of return are eliminated. The discount rate will also be equal for all

firms under M-M assumptions since there are no risk differences.

Drawbacks :

There are some critics who argue that the assumptions made by MM dividends are

irrelevant. According to them dividends matter because of the uncertainty characterising the

future, the imperfections in the capital market, and the existence of taxes. We will discuss

the implications of these as follows:


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1. Information About Prospects :In a world of uncertainty the dividends paid bythe company, based as they are on the judgment of the management about

future, convey information about the prospects of the company. A higher

dividend payout ratio may suggest that the future of the company, as judged

by management, is promising. A lower dividend payout ratio may suggest

that the future of the company as considered by management is uncertain.

Gordon has eloquently expressed this view. An allied argument is that

dividends reduce uncertainty perceived by investors. Hence investors prefer

dividends to capital gains. So shares with higher current dividends, other

things being equal, command a high in the market.

2. Uncertainty and Fluctuations: Due to uncertainty, share prices tend tofluctuate, sometimes rather widely. When share prices fluctuate, conditions

for conversion of current income into capital value and vice versa may not be

regarded as satisfactory by investors. Some investors who wish to enjoy

more current income may be reluctant to sell a portion of their shareholding

in a fluctuating market. Such investors would naturally prefer, and value

more, a higher payout ratio. Some investors who wish to get less current

income may be hesitant to buy shares in a fluctuating market. Such investorswould prefer, and value a lower payout ratio.

3. Offering of Additional Equity at Lower Prices: MM assume that a firm cansell additional equity at the current market price. In practice, firms following

the advice and suggestions of merchant bankers offer additional equity at a

price lower than the current market price. This practice of 'underpricing'

mostly due to market compulsions, ceteris paribus, makes a rupee of retained

earnings more valuable than a rupee of dividends. This is because of the

following chain of causation:

4. Issue cost: The MM irrelevance proposition is based on the premise that arupee of dividends be replaced by a rupee of external financing. This is

passib1e when there is no issue cost. In the real world where issue cost is

incurred, the amount of external financing has to be greater than the amount


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of dividend paid. Due to this, other things being equal, it advantageous to

retain earnings rather than pays dividends and resort to external finance.

5. Transaction Costs: In the absence of transaction costs, current income(dividends) and Capital gains are alike-a rupee of capital value can be

converted into a rupee of current income and vice versa. In such a situation if

a shareholder desires current income (from shares) greater than the dividends

received, he can sell a portion of his capital equal in value to the additional

current income sought. Likewise, if he wishes to enjoy current income less

than the dividends paid, he can buy additional shares equal in value to the

difference between dividends received and the current income desired. In the

real world, however, transaction costs are incurred. Due to this, capital value

cannot be converted into an equal current income and vice versa. For

example, a share worth Rs 100 may fetch a net amount of Rs 99 after

transaction costs and Rs 101 may be required to. buy a share worth Rs 100.

Due to. transaction costs, shareholders who have preference Higher dividend

payout Greater dilution of the value of equity Greater volume of under priced

equity issue to financea given level of investment far current income, would

prefer a higher payout ratio and shareholders who have preference for

deferred income would prefer a lower payout ratio.

6. Differential Rates of Taxes: MM have assumed that the investors areindifferent between a rupee of dividends and a rupee of capital appreciation,

This assumption is true when the taxation is the same for current income and

capital gains. In the real world, the effective tax on capital gains is lower

than that for current income. Due to this difference, investors would prefer

capital gains to current income.


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4- Introduction to Topic

Documents

Transcript of 4- Introduction to Topic