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UNDERPOLICY GUIDENCE: DIVIDEND & VALUE OF PROF. ANUBHA GUPTA FIRM

IMRT BUSINESS SCHOOL VIPUL KHAND GOMTINAGAR LUCKNOW

FROM: BHUPENDRA PT SINGH PGDM-2nd TRIMESTER [email protected]

Topics Covered How Dividends are Paid Share Repurchase How Do Companies Decide on Dividend

Payments Why Dividend Policy Should Not Matter Why Dividends May Increase Firm Value Why Dividends May Reduce Firm Value

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Dividend Payments

 Regular vs. extra dividend  Regular payment is an important issue Cash Dividend - Payment of cash by the firm to its shareholders. Ex-Dividend Date - Date that determines whether a stockholder is entitled to a dividend payment; anyone holding stock before this date is entitled to a dividend. Record Date - Person who owns stock on this date received the dividend. [email protected]

Procedure for Cash Dividend Payment 25 Oct.

1 Nov.

2 Nov.

Cumdividend Date

Exdividend Date

6 Nov.

7 Dec.

… Declaration Date

Record Date

Payment Date

Declaration Date: The Board of Directors declares a payment of dividends. Cum-Dividend Date: The last day that the buyer of a share is entitled to the dividend. Ex-Dividend Date: The first day that the seller of a share is entitled to the dividend. Record Date: The corporation prepares a list of all individuals believed to be shareholders as of 6 November. [email protected]

Payments Some legal limitations on

dividends Bondholders are often against excessive

dividend payments Most state prohibit a company from paying

dividends such that make the company insolvent Sometimes state law prevents a company

from [email protected] a dividend if it cuts into the

Taxes, Issuance Costs, and Dividends In a tax-free world, cash dividends are a wash between the firm and its shareholders.

Firm

Cash: Share Issue Share [email protected] Holders Cash: Dividends Taxes

In a world with taxes, the government gets a cut.

Gov. [email protected]

Payments Stock Dividend - Distribution of additional shares to a firm’s stockholders. Stock Splits - Issue of additional shares to firm’s stockholders.

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Example - Amoeba Products has 2 million shares currently outstanding at a price of $15 per share. The company declares a 50% stock dividend. How many shares will be outstanding after the dividend is paid?

Answer 2 mil x .50 = 1 mil + 2 mil = 3 mil shares [email protected]

Dividend Example - cont - After the stock dividend what is the new price per share and what is the new value of the firm? Answer The value of the firm was 2 mil x $15 per

share, or $30 mil. After the dividend the value will remain the same. Price per share = $30 mil / 3 mil share =

$10 per share [email protected]

Payments Stock Repurchase - Firm buys back stock from its shareholders. (cash dividend vs. share repurchase )  If there are a few investment opportunities, and the companies do not want to commit a regular abundant dividend, then stock repurchase seems to be a good strategy

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Example - Cash dividend versus share repurchase Assets A. Original balance sheet Cash $150,000 Other assets 850,000 Value of Firm 1,000,000

Liabilities & Equity Debt 0 Equity 1,000,000 Value of Firm 1,000,000

Shares outstanding = 100,000 Price per share = $1,000,000 / 100,000 = $10

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Example - Cash dividend versus share repurchase Assets B. After cash dividend Cash Other assets

$50,000 850,000

Value of Firm 900,000

Liabilities & Equity Debt Equity

0 900,000

Value of Firm 900,000

Shares outstanding = 100,000 Price per share = $900,000 / 100,000 = $9

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Example - Cash dividend versus share repurchase Assets C. After stock repurchase Cash

$50,000

Other assets 850,000 Value of Firm 900,000

Liabilities & Equity Debt

0

Equity 900,000 Value of Firm 900,000

Shares outstanding = 90,000 Price per share = $900,000 / 90,000 = $10

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Decision  How Dividends are Determined? 1. Firms have long-term target dividend payout

ratios. 2. Managers focus more on dividend changes than on absolute levels. 3. Dividends changes follow shifts in long-run, sustainable levels of earnings rather than short-run changes in earnings . 4. Managers are reluctant to make dividend changes that might have to be reversed. (They are particularly worried about having to rescind a dividend increase) Level of dividends can be taken as a signal [email protected] about the company’s future prospect

Policy  Three points of view about dividend policy

and the value of firm 1. Dividend policy makes no difference 2. High dividends increase firm value 3. High dividends bring high taxes and

therefore reduce firm value

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Dividend policy  Higher dividend payout means:  More current dividend amount, consequently higher

stock price  But lower retention rate with lower amount available for reinvestment leading to lower growth depressing stock price  Thus needs to strike a balance to maximize stock price  Referred as optimal dividend policy  MM’s proposition: value of a firm depends only on the income produced by its assets  Not on how the income is split between dividends and retained earnings (growth)  Investors more certain of present dividend (bird-in-hand) and prefer present dividend yield, as against capital gain yield (less certain of receiving capital gain in future [email protected]

 Tax rate on capital gains and on dividend income are

usually different for investors (long-term capital gains attract normally lower tax rate)  Again, capital gains tax not payable until stock is sold  Wealthy investors (who own most of the stock and receive most of the dividends) likely to prefer higher retention rate for plough back of profits rather than high dividend rate  Most firms try to follow a policy of paying a constant or steadily increasing dividend  That provides stable income to investors  Any departures from it give investors information about management’s expectations for future earnings (signalling effects)  Other dividend policies may pertain to:  Residual (after capital budgeting) dividend policy  Constant payout ratio policy  Low regular dividend plus extra policy (can be [email protected] in difficult years and then pay extra

 The major issue involved:  At what rate earned inside the organization vs. at

what rate earned in outside opportunities (besides the differential tax impact on dividend and capital gains) from investors’ point of view  Cost of retaining earnings vs. cost of distributing earnings from the company’s point of view.  Clientele effect:  Individuals in high tax bracket likely to prefer either no or less dividends, on the contrary low tax bracket investors would prefer the opposite  This disparity eventually narrowed down, and the market stabilizes  As investors desirous of specific pattern of dividends switch over their investments to those firms where they would get their preferred choice of dividends, known as clientele effect  Linter model:  Managers estimate what portion of firms’ earnings is likely to be permanent and what portion of earnings is likely to be temporary Bhup.manas@gmail. [email protected]

 Dividends likely to be raised following a permanent

(rather than temporary) increase in earnings and firms have a long-run target for their dividends to earnings ratio  Managers need to decide the target payout ratio and the speed of adjustment of current dividend to target  Dividend may be paid by way of cash, or stock dividend depending on company’s cash position and its likely impact on its capital structure  Stock split refers to increasing the number of shares, such as doubling the number of shares outstanding by giving each stockholder two new shares for each one formerly held- to keep the stock prices within the optimal trading range  Stock repurchase plan- firm buys back some of its outstanding stock, thereby decreasing the number of shares and consequently increasing EPS and stock price [email protected]

X & Y ARE TWO FAST GROWING COMPANIES IN THE ENGINEERING INDUSTRY. THEY ARE CLOSE COMPITITORS & THEIR ASSETS COMPOSITION, CAPITAL STRUCTURE & PROFITABILITY RECORDS HAVE BEEN VERY SIMILAR FOR SEVERAL YEARS. THE PRIMARY DIFFERENCE BETWEEN THEM FROM FINANCIAL MANAGEMENT PERSPECTIVE IS THEIR DIVIDEND POLICY. THE COMPANY X TRIES TO MAINTAIN A NON DECREASING DIVIDEND PER SHARE, WHILE THE COMPANY Y MAINTAINS A CONSTANT DIVIDEND PAY OUT RATIO. THEIR RECENT EARNING PER SHARE(EPS), DIVIDEND PER SHARE (DPS), & SHARE PRICE (P) HISTORY ARE AS FOLLOWS:::::

Year EPS

COMPANY X

COMPANY Y

DPS P(RANGE) EPS

DPS

P(RANGE ) Rs 60-80

1

Rs 9.30

Rs 2

Rs 75-90

Rs 9.50

2

7.40

2

55-80

7.00

Rs 1.90 1.40

3

10.50

2

70-110

10.50

2.10

35-80

4

12.75

2.25

85-135

12.25

2.45

80-120

5

20.00

2.50

135-200

20.25

4.05

110-225

6

16.00

2.50

150-190

17.00

3.40

140-180

7

19.00

2.50

155-210

20.00

4.00

130-190

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25-65

QUESTIONS OF EXAMPLE IN ALL CALCULATIONS BELOW THAT REQUIRE A SHARE PRICE, USE THE AVERAGE OF THE TWO PRICES GIVEN IN THE SHARE PRICE RANGE. (A) DETERMINE THE DIVIDEND PAYOUT RATIO (D/P) & PRICE TO EARNINGS(P/E) RATIO FOR BOTH COMPANIES FOR ALL THE YEARS. (B) DETERMINE THE AVERAGE D/P & P/E FOR BOTH THE COMPANIES OVER THE PERIOD 1 THROUGH 7. (C) THE MANAGEMENT OF COMPANY Y IS PUZZLED AS TO WHY THEIR SHARE PRICES ARE LOWER THAN THOSE OF COMPANY X, IN SPITE OF THE BETTER PROFITABILITY RECORD PARTICULARLY OF THE PAST 3 YEARS. AS A FINANCIAL CONSULTANT, HOW WOULD YOU EXPLAIN THE SITUATION ?????????

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SOLUTION D

D/P & P/E RATIOS

(A) & (B)

YE AR

COMPANY X EPS

DPS

D/P RATI O

1

9.30

2.00

21.5

2

7.40

2.00

3

P/E RATIO

EPS

DPS

D/P RATI O

82.50

8.87

9.50

1.90

20

70

7.37

27.5

67.50

9.12

7.00

1.40

20

45

6.43

10.50 2.00

19.0

90.00

8.57

10.50 2.10

20

57.50

5.48

4

12.75 2.25

17.6

8.63

12.25 2.45

20

20.00 2.50

12.5

8.37

20.25 4.05

20

6

16.00 2.50

15.6

10.62

17.00 3.40

20

7

19.00 2.50

13.2

9.6

20.00 4.00

20

9.16

96.50 19.30 20

100.0 0 167.5 0 160.0 0 160.0 0 760.0 0

8.16

5

110.0 0 167.5 0 170.0 0 182.5 0 870.0 0

94.95 15.75 16.6

P

COMPANY Y

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P

P/E RATIO

8.27 9.41 8.00 7.88

(c) COMPANY X IS FOLLOWING A STABLE DIVIDEND POLICY WHEREAS COMPANY Y IS FOLLOWING A STABLE DIVIDEND PAYOUT RATIO. IN THE LATTER TYPE OF POLICY, SPORADIC DIVIDEND PAYMENTS OCCUR WHICH MAKE ITS OWNERS VERY UNCERTAIN ABOUT THE RETURNS THEY CAN EXPECT FROM THEIR INVESTMENT IN THE FIRM &, THEREFORE, GENERALLY DEPRESS THE SHARE PRICES. IT IS PROBABLY FOR THIS REASON THAT THE COMPANY X’S AVERAGE PRICE PER SHARE EXHIBITED A CONSISTENT INCREASE COMPARED TO COMPANY Y, VOLATILE PATTERN OF EARNINGS OF BOTH COMPANIES (DURING THE LAST 3 YEARS) NOTWITHSTANDING. SO COMPANY Y IS ADVISED TO FOLLOW A STABLE DIVIDEND [email protected] POLICY.

om

Irrelevant Since investors do not need dividends to

convert shares to cash (because they can do it themselves), they will not pay higher prices for firms with higher dividend payouts. In other words, dividend policy will have no impact on the value of the firm

★ MM dividend-irrelevance proposition: Under ideal conditions, the value of the firms is unaffected by dividend policy ★ Given the firm’s capital budgeting and borrowing decisions, dividend policy is a trade-off between cash dividends and the issue or repurchase of common stock [email protected]

Dividend Policy is Irrelevant

Example - Assume Rational Semiconductor has no extra cash, but declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend.

Record Date Cash 1,000 Asset Value 9,000 Total Value 10,000 New Proj NPV 2,000 # of Shares 1,000 price/share $12

+

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Irrelevant Example - Assume Rational Semiconductor has no extra cash, but declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend.

Record Date Pmt Date Cash 1,000 0 Asset Value 9,000 9,000 Total Value 10,000 + 9,000 New Proj NPV 2,000 2,000 # of Shares 1,000 1,000 price/share $12 $11 [email protected]

Dividend Policy is Irrelevant Example - Assume Rational Semiconductor has no extra cash, but declares a $1,000 dividend. They also require $1,000 for current investment needs. Using M&M Theory, and given the following balance sheet information, show how the value of the firm is not altered when new shares are issued to pay for the dividend.

Record Date Cash 1,000 $11) Asset Value 9,000 Total Value 10,000 New Proj NPV 2,000 # of Shares 1,000 price/share $12

Pmt Date Post Pmt 0 1,000 (91

+

9,000 9,000 2,000 1,000 $11

NEW SHARES ARE ISSUED [email protected]

sh @

9,000 10,000 2,000 1,091 $11

Dividend Policy is Irrelevant Example - continued - Shareholder Value

Stock Cash Total Value

Record 12,000 0 12,000

Stock = 1,000 sh @ $12 = 12,000 [email protected]

Dividend Policy is Irrelevant Example - continued - Shareholder Value

Stock Cash Total Value

0

Record 12,000 1,000

Pmt 11,000

12,000

12,000

Stock = 1,000sh @ $11 = 11,000 [email protected]

Dividend Policy is Irrelevant Example - continued - Shareholder Value

Stock 12,000 Cash Total Value 12,000

Record 12,000 0

Pmt 11,000

1,000 12,000

Stock = 1,091sh @ $11 = 12,000 [email protected]

Post

0 12,000

Dividends Increase Value Market Imperfections and Clientele Effect There are natural clients for high-payout stocks, but it does not follow that any particular firm can benefit by increasing its dividends. The high dividend clientele already have plenty of high dividend stock to choose from.

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Dividends Increase Value Dividends as Signals Dividend increases send good news about cash flows and earnings. Dividend cuts send bad news. (information content of dividends) Because a high dividend payout policy will be costly to firms that do not have the cash flow to support it, dividend increases signal a company’s good fortune and [email protected] its manager’s confidence in

Dividends Decrease Value Tax Consequences Companies can convert dividends into capital gains by shifting their dividend policies. If dividends are taxed more heavily than capital gains, taxpaying investors should welcome such a move and value the firm more favorably. In such a tax environment, the total cash flow retained by the firm and/or held by shareholders [email protected] will be higher than if dividends

Next years price

Firm A $112.50

Firm B $102.50

Dividend Total pretax payoff

$0 $112.50

$10.00 $112.50

Todays stock price Capital gain

$100 $12.50

$97.78 $4.72

Pretax rate of return (%)

12.5 100

Tax on dividend @ 40%

$0

= 12. 5%

Tax on capital gain @ 20% .20 x $12.50 = $2.50 Total after tax income (0 + 12.50) - 2.50 (dividend plus capital = $10.00 gains less taxes) 10 Aftertax rate of return (%) . 10 = 10% 100 =

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14. 72 97. 78

= 15. 05%

.40 x $10 = $4.00 .20 x $4.72 = $.94 (10.00 + 4.72) - (4.00-.94) = $9.78 9. 78 . 10 = 10% 97. 78 =

Dividends Decrease Value Before 1986, dividends tax was up to

50%, the realized capital gains were taxed only 20% Taxes on dividends have to be paid immediately, but taxes on capital gains can be deferred until shares are sold and capital gains are realized Pension funds are untaxed, so there is no difference for them Corporations have to pay a 35% tax on the full amount of any realized capital gain. However, they pay corporate [email protected] income tax on only 30% of any dividend

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