Section_D

DIVIDEND POLICY

UNIT: D

Syllabus

Dividend Decisions: Meaning and Types of Dividend, Issues in Dividend Policy, Traditional Model, Walter Model, Gordon Model, Miller and Modigliani Model, Bonus Shares and Stock Splits.

Meaning and Types of Dividend

The word dividend is derived from the word “dividendum” which means total divisible sum. It is that share of profit which is distributed among shareholders. It provides information about company. As “In an uncertain world in which verbal statements can be ignored or misinterpreted, dividend action does provide a clear cut means of ‘making a statement’ that speaks louder than a thousand words”.

— Solomon Types:1. Cash Dividend2. Stock Dividend3. Scrip or Bond Dividend4. Property Dividend

Dividend Policy

Dividend Policy is the policy which concerns quantum of profits to be distributed by way of dividend. It determines the division of earnings between payments to shareholders and retained earnings”

Types of Dividend Policy:1. Conservative or Strict Dividend Policy2. Liberal Dividend Policy3. Irregular Dividend Policy4. Sound or Stable Dividend Policy

Sound or Stable Dividend PolicyPatterns:1. Constant Dividend per share2. Constant Pay-out ratio3. Constant Dividend per share plus extra dividendAdvantages:4. Sign of continued normal operations of company.5. Stablise the market value of shares.6. Creates confidence among shareholders.7. Improves credit standing of company.8. Resolutions of investors uncertainty.9. Institutional Investors’ Requirement.Limitations:10. Difficult to make changes in the policy.11. Difficult to be followed in case of insufficient profits.

Issues in Dividend Policy

Earnings to be Distributed – High Vs. Low Payout (it depends upon some determinants).

Objective – Maximize Shareholders Return.

Effects – Taxes, Investment and Financing Decision.

Determinants of Dividend Policy

1. Financial Need of company2. Magnitude and trend of earning3. Liquidity position 4. Shareholders Expectations5. Nature of the industry6. Cyclical Variation7. Age of the company8. Structure of ownership (Closely / Widely Held

Company)9. Legal Restrictions10. Restriction by lending institutions11. State of Capital Market12. Taxation Policy

Relevance Vs. Irrelevance

Relevance concept of Dividend: this hold that there is a direct relationship between dividend policy and the value in terms of market price of shares. It is represented by following two theories:

a. Walter's Modelb. Gordon's Model Irrelevance concept of Dividend: According to

this concept dividend are irrelevant or are a passive residual. As per this concept, investors are indifferent between capital; gains and dividend. The ultimate desire of investor is to earn higher return. It is explained through Modigliani and Miller approach.

Walters Model

Valuation: If firm’s average rate of return is r and k is the cost of capital i.e. capitalization rate.

( / )(DIV / ) (EPS – DIV)

r kP k

k

Assumptions:1. Internal Financing2. Constant Return and Cost of Capital3. Fixed Payout or Retention4. Constant EPS and DIV5. Infinite Time

Example0.15, 0.10, 0.08

0.10

EPS Rs 10

DPS 40%

(0.15 / 0.1)(4 / 0.1) (10 4) Rs 130

0.1(0.10 / 0.1)

(4 / 0.1) (10 4) Rs 1000.1

(0.08 / 0.1)(4 / 0.1) (10 4) Rs 88

0.1

r

k

P

P

P

Gordon's Model

Valuation:Market value of a share is equal to the present value of

an infinite stream of dividends to be received by shareholders

P =EPS (1- b) / (k-b*r)Assumptions:1. All Equity Firm2. No External Financing3. Constant Return and Cost of Capital4. Perpetual Earnings5. No Taxes6. Constant Retention7. Cost of Capital greater than Growth Rate

Example 0.15, 0.10, 0.08

0.10

EPS Rs 10

60%

(1 – 0.6) / 0.10 – (0.15 * 0.6) = Rs 400

10(1 – 6) / 0.10 – (0.10 * 0.6) = Rs 100

10(1 – 0.6) / 0.10 – (0.08 * 0.6) = Rs 77

r

k

b

P

P

P

Cont.

Optimum Payout Ratio: Growth Firms – Retain all earnings Normal Firms – Distribute all earnings Declining Firms – No effectThe Bird in the Hand: Argument put forward that

investors are risk averters. They consider distant dividends as less certain than near dividends. Rate at which an investor discounts his dividend stream from a given firm increases with the futurity of dividend stream and hence lowering share prices.

Criticism: Unrealistic assumptions (like No external Financing, Constant Rate of Return, Constant opportunity cost of capital etc.)

Modigliani and Miller

According to M-M, under a perfect market situation, the dividend policy of a firm is irrelevant as it does not affect the value of the firm. They argue that the value of the firm depends on firm earnings which results from its investment policy. Thus when investment decision of the firm is given, dividend decision is of no significance.

Market Imperfections

Tax Differential – Low Payout Clientele Flotation Cost Transaction and Agency Cost Information Asymmetry Diversification Uncertainty – High Payout Clientele Desire for Steady Income No or Low Tax on Dividends

Stock Split

A corporate action in which a company's existing shares are divided into multiple shares. Although the number of shares outstanding increases by a specific multiple, the total dollar value of the shares remains the same compared to pre-split amounts, because no real value has been added as a result of the split. One reason as to why stock splits are performed is that a company's share price has grown so high that to many investors, the shares are too expensive to buy in round lots.

Bonus Share

An offer of free additional shares to existing shareholders. A company may decide to distribute further shares as an alternative to increasing the dividend payout. New shares are issued to shareholders in proportion to their holdings. For example, the company may give one bonus share for every five shares held.

Effect of Bonus Issue: Increase the number of shares Net worth remains unaffected Reduction in EPS and DPS Conservation of cash Remedy for undercapitalisation Tax saving to shareholders Increases the marketability of shares

CORPORATE RESTRUCTURINGUnit: D

Corporate Restructuring

Any change in a company’s operations, capital structure or ownership that is outside its ordinary course of business.

Motives: Sales enhancement Operating economies Improved management Information effect Wealth transfers Tax reasons Leverage gains Management’s personal agenda

Forms

A. Operational restructuringB. Financial (or Debt or

Ownership) restructuring

Operational restructuring

Outright or partial sale of companies or product lines or to downsize by closing unprofitable or non-strategic facilities. It is also known as divestiture. (i.e. The divestment of a portion of the enterprise or the firm as a whole). It removes non-core assets so that company could better focus on core activities.It may be through the following: Liquidation -- The sale of assets of a firm,

either voluntarily or in bankruptcy.

Continued

Sell-off -- The sale of a division of a company, known as a partial sell-off, or the company as a whole, known as a voluntary liquidation.

Spin-off -- A form of divestiture resulting in a subsidiary or division becoming an independent company. Ordinarily, shares in the new company are distributed to the parent company’s shareholders on a pro rata basis.

Equity Carve-out -- The public sale of stock in a subsidiary in which the parent usually retains majority control.

Financial Restructuring

Actions by the firm to change its total debt and equity structure, (i.e., share repurchase, adding debt or lower overall cost of capital) is known as financial restructuring.

It may be through any of the following ways:1. Making a public company private through the

repurchase of stock by current management and/or outside private investors. It is treated as an asset sale rather than a merger.

2. Leverage Buyout (LBO) i.e. debt financed purchase of all the stock or assets of a company, subsidiary, or division by an investor group. In LBO a large fraction of the purchase price is debt financed. Further it goes private i.e. the shares are no longer traded in open market.

Joining of CompaniesWhen two companies join to form one new firm, it can be:

Merger: The combination of two firms into a new legal entity A new company is created Both sets of shareholders have to approve the transaction. Voluntary.

Takeover The transfer of control from one ownership group to another. Forced.

Amalgamation A genuine merger in which both sets of shareholders must

approve the transaction Requires a fairness opinion by an independent expert on the

true value of the firm’s shares when a public minority exists.Acquisition:

The purchase of one firm by another.

Continued

Strategic alliances: An agreement between two or more independent firms to cooperate in order to achieve some specific commercial objective. It is usually occur between (1) suppliers and their customers, (2) competitors in the same business, (3) non-competitors with complementary strengths.

Joint venture: It is a business jointly owned and controlled by two or more independent firms. Each venture partner continues to exist as a separate firm, and the joint venture represents a new business enterprise.

Types of Merger

1. Horizontal• A merger in which two firms in the same industry combine.• Often in an attempt to achieve economies of scale and/or

scope.2. Vertical

• A merger in which one firm acquires a supplier or another firm that is closer to its existing customers.

• Often in an attempt to control supply or distribution channels.

3. Conglomerate• A merger in which two firms in unrelated businesses

combine.• Purpose is often to ‘diversify’ the company by combining

uncorrelated assets and income streams4. Cross-border (International) M & A

• A merger or acquisition involving a Canadian and a foreign firm a either the acquiring or target company.

Motive and Advantages

M & A is done to have synergy (the amount by which the value of the combined firm exceeds the sum value of the two individual firms). Its possible advantages are as follows: Economies of Scope Complementary Strengths Efficiency Increase Better Rating Tax Benefits Reduction in risk through diversification Economies of Scale which may be

Technical economies, Managerial economies, Financial economies, Marketing economies and Research and development economies.

Diseconomies

There are sometimes problems that can affect integrated firms. These are known as ‘diseconomies of scale’

firms are too big to operate effectively

decisions take too long to make poor communication occurs

Types of Takeover

Friendly Takeover: In friendly takeovers, both parties have the opportunity to structure the deal to their mutual satisfaction.

Hostile Takeover: A takeover in which the target has no desire to be acquired. In the typical hostile takeover process acquirer Slowly acquire a toehold by open market purchase of shares at market prices without attracting attention. Then it Files statement at the 10% early warning stage. It accumulates 20% of the outstanding shares through open market purchase over a longer period of time. Thereafter it make a tender offer to bring ownership percentage to the desired level (either the control (50.1%) or amalgamation level (67%)).

Takeover Defenses

Defensive tactics includes (1) persuasion by management that the offer is not in their best interests, (2) taking legal actions, (3)increasing the cash dividend or declaring a stock split to gain shareholder support, and (4) White knight. Some defensive tactics may be discussed as follows:

Shark Repellent - Amendments to a company charter made to forestall takeover attempts.

White Knight - Friendly potential acquirer sought by a target company threatened by an unwelcome suitor. In this the target seeks out another acquirer considered friendly to make a counter offer and thereby rescue the target from a hostile takeover.

Continued

Shareholders Rights Plan It is also known as poison pill or deal killer. In this measure taken by a target firm to avoid acquisition; for example, the right for existing non-acquiring shareholders to buy 50 percent more shares shareholders at an attractive price (at a discount price) if a bidder acquires a large holding. Selling the Crown Jewels•The selling of a target company’s key assets that the acquiring company is most interested in to make it less attractive for takeover. It Can involve a large dividend to remove excess cash from the target’s balance sheet.

CAPITAL BUDGETING

Section: D

Capital Budgeting (CB)

CB is the long-term planning for making and financing proposed capital outlays. [ Horngren]

CB consists in planning, the development of available capital for the purpose of maximising the long term profitability of the firm. [Lynch]

Procedure:1. Origination of Investment Proposals2. Screening the proposal3. Evaluation of project4. Establishing Priorities5. Final Approval6. Evaluation

Significance Methods1. Long term

Implications2. Irreversible

Decisions3. Cash Forecast4. Affects Future cost

structure5. Bearing on

competitive position

6. Wealth Maximisation

1. Degree of urgency Method

2. Pay back Method3. Unadjusted Rate of

Return Method4. Discounted Cash

Flow MethodA. Net Present Value

methodB. Internal Rate of

return method

Pay-back Method

Simple and easy calculation

Snap answer Suitable where

precision of profitability is not crucial

Suitable for organisation facing cash deficiency

Ignores pattern of cash flow

Overlook cost of capital

Rigid Over emphasis over

liquidity Ignores time value of

money

Merits Demerits

Unadjusted Rate of return

Simple Consideration of

profitability, investment

Ignores time value of money

Ignores cash inflow

Does not consider length of project

Does not consider scrap value of assets

Merits Demerits

Discounted Cash Flow Method

Considers economic life of project

Considers time value of money

Suitable even in case of uneven cash inflow

Considers scrap value of assets

Complicated Difficulty in forecasting

economic life of asset Problem in determining

cash inflow Problem in

determination of discount rate

Merits Demerits