This document discusses various aspects of corporate dividend policies, including theories on dividend relevance and irrelevance, factors that influence dividend policies, types of dividends such as stock dividends and stock splits, and methods of stock repurchase. It covers Modigliani-Miller's argument that dividends are irrelevant, counterarguments that dividends do matter due to taxes and signaling, and factors corporations consider in determining their dividend policies such as funding needs, liquidity, and debt restrictions.

1. DIVIDEND DECISION PRESENTED BY :- VERACIOUS GROUP Leader:- vasantparakhiya

2. COLORS OF RAINBOWS VASANT –Introduction DEEP –Dividend Theories BHAVIKA–Modigliani Miller Hypothesis & Assumptions of Walter’s model MEET -Dividend Policies ASHISH-Dividend Policy & Share Valuation ISHWER -Corporate Dividend Practices in India VASANT –Summary & Conclusion

3. After studying Dividend Decision you should be able to: Understand the dividend retention versus distribution dilemma faced by the firm. Explain the Modigliani and Miller (M&M) argument that dividends are irrelevant. Explain the counterarguments to M&M - that dividends do matter. Identify and discuss the factors affecting a firm's dividend and retention of earnings policy. Define, compare, and justify cash dividends, stock dividends, stock splits, and reverse stock splits. Define “stock repurchase” and explain why (and how) a firm might repurchase stock. Summarize the standard cash dividend payment procedures and critical dates. Define and discuss dividend reinvestment plans (DRIPs).

4. Dividend Policy Passive Versus Active Dividend Policies Factors Influencing Dividend Policy Dividend Stability Stock Dividends and Stock Splits Stock Repurchase Administrative Considerations

5. Dividends as a Passive Residual Can the payment of cash dividends affect shareholder wealth? If so, what dividend-payout ratio will maximize shareholder wealth? The firm uses earnings plus the additional financing that the increased equity can support to finance any expected positive-NPV projects. Any unused earnings are paid out in the form of dividends. This describes a passive dividend policy.

6. Irrelevance of Dividends A. Current dividends versus retention of earnings M&M contend that the effect of dividend payments on shareholder wealth is exactly offset by other means of financing. The dividend plus the “new” stock price after dilution exactly equals the stock price prior to the dividend distribution.

7. Irrelevance of Dividends B. Conservation of value M&M and the total-value principle ensures that the sum of market value plus current dividends of two firms identical in all respects other than dividend-payout ratios will be the same. Investors can “create” any dividend policy they desire by selling shares when the dividend payout is too low or buying shares when the dividend payout is excessive.

8. Relevance of Dividends A. Preference for dividends Uncertainty surrounding future company profitability leads certain investors to prefer the certainty of current dividends. Investors prefer “large” dividends. Investors do not like to manufacture “homemade” dividends, but prefer the company to distribute them directly.

9. Relevance of Dividends B. Taxes on the investor Capital gains taxes are deferred until the actual sale of stock. This creates a timing option. Capital gains are preferred to dividends, everything else equal. Thus, high dividend-yielding stocks should sell at a discount to generate a higher before-tax rate of return. Certain institutional investors pay no tax.

10. Relevance of Dividends B. Taxes on the investor (continued) Corporations can typically exclude 70% of dividend income from taxation. Thus, corporations generally prefer to receive dividends rather than capital gains. The result is clienteles of investors with different dividend preferences. In equilibrium, there will be the proper distribution of firms with differing dividend policies to exactly meet the needs of investors. Thus, dividend-payout decisions are irrelevant.

11. Walters Model Assumptions Valuation Optimum Payout Ratio Criticism

12. Assumptions Internal Financing Constant Return and Cost of Capital 100% Payout or Retention Constant EPS and DIV Infinite Time

13. Market price per share is the sum of the present value of the infinite stream of constant dividends and present value of the infinite stream of capital gains. Valuation

14. Example

15. Optimum Payout Ratio Growth Firms – Retain all earnings Normal Firms – Distribute all earnings Declining Firms – No effect

16. Criticism No external Financing Constant Rate of Return Constant opportunity cost of capital

17. Other Dividend Issues Flotation costs Transaction costs and divisibility of securities Institutional restrictions Financial signaling

18. Empirical Testing of Dividend Policy Tax Effect Dividends are taxed more heavily (in PV terms) than capital gains, so before-tax returns should be higher for high-dividend-paying firms. Empirical results are mixed -- recently the evidence is largely consistent with dividend neutrality. Financial Signaling Expect that increases (decreases) in dividends lead to positive (negative) excess stock returns. Empirical results are consistent with these expectations.

19. Implications for Corporate Policy Establish a policy that will maximize shareholder wealth. Distribute excess funds to shareholders and stabilize the absolute amount of dividends if necessary (passive). Payouts greater than excess funds should occur only in an environment that has a net preference for dividends.

20. Implications for Corporate Policy There is a positive value associated with a modest dividend. Could be due to institutional restrictions or signaling effects. Dividends in excess of the passive policy does not appear to lead to share price improvement because of taxes and flotation costs.

21. Factors Influencing Dividend Policy Legal Rules Capital Impairment Rule-- many states prohibit the payment of dividends if these dividends impair “capital” (usually either par value of common stock or par plus additional paid-in capital). Incorporation in some states (notably Delaware) allows a firm to use the “fair value,” rather than “book value,” of its assets when judging whether a dividend impairs “capital.”

22. Factors Influencing Dividend Policy Legal Rules Insolvency Rule-- some states prohibit the payment of cash dividends if the company is insolvent under either a “fair market valuation” or “equitable” sense. Undue Retention of Earnings Rule-- prohibits the undue retention of earnings in excess of the present and future investment needs of the firm.

23. Factors Influencing Dividend Policy Other Issues to Consider Funding Needs of the Firm Liquidity Ability to Borrow Restrictions in Debt Contracts (protective covenants) Control

24. Dividend Stability Stability -- maintaining the position of the firm’s dividend payments in relation to a trend line. 50% of earnings paid out as dividends 4 Earnings per share 3 Dollars Per Share 2 Dividends per share 1 Time

25. Dividend Stability Dividends begin at 50% of earnings, but are stable and increase only when supported by growth in earnings. 50% dividend-payout rate with stability 4 Earnings per share 3 Dollars Per Share 2 1 Dividends per share Time

26. Valuation of Dividend Stability Information content-- management may be able to affect the expectations of investors through the informational content of dividends. A stable dividend suggests that the company expects stable or growing dividends in the future. Current income desires-- some investors who desire a specific periodic income will prefer a company with stable dividends to one with unstable dividends. Institutional considerations-- a stable dividend may permit certain institutional investors to buy the common stock as they meet the requirements to be placed on the organizations “approved list.”

28. Stock Dividends and Stock Splits Stock Dividend -- A payment of additional shares of stock to shareholders. Often used in place of or in addition to a cash dividend. Small-percentage stock dividends Typically less than 25% of previously outstanding common stock. Assume a company with 400,000 shares of $5 par common stock outstanding pays a 5% stock dividend. The pre-dividend market value is $40. How does this impact the shareholders’ equity accounts?

29. B/S Changes for the Small-Percentage Stock Dividend $800,000 ($5 x 20,000 new shares) transferred (on paper) “out of” retained earnings. $100,000 transferred “into” common stock account. $700,000 ($800,000 - $100,000) transferred “into” additional paid-in-capital. “Total shareholders’ equity” remains unchanged at $10 million.

30. Small-Percentage Stock Dividends Before 5% Stock Dividend Common stock ($5 par; 400,000 shares) $ 2,000,000 Additional paid-in capital 1,000,000 Retained earnings 7,000,000 Total shareholders’ equity $10,000,000 After 5% Stock Dividend Common stock ($5 par; 420,000 shares) $ 2,100,000 Additional paid-in capital 1,700,000 Retained earnings 6,200,000 Total shareholders’ equity $10,000,000

31. Stock Dividends, EPS, and Total Earnings After a small-percentage stock dividend, what happens to EPS and total earnings of individual investors? Assume that investor SP owns 10,000 shares and the firm earned $2.50 per share. Total earnings = $2.50 x 10,000 = $25,000. After the 5% dividend, investor SP owns 10,500 shares and the same proportionate earnings of $25,000. EPS is then reduced to $2.38 per share because of the stock dividend ($25,000 / 10,500 shares = $2.38 EPS).

32. Stock Dividends and Stock Splits Large-percentage stock dividends Typically 25% or greater of previously outstanding common stock. The material effect on the market price per share causes the transaction to be accounted for differently. Reclassification is limited to the par value of additional shares rather than pre-stock-dividend value of additional shares. Assume a company with 400,000 shares of $5 par common stock outstanding pays a 100% stock dividend. The pre-stock-dividend market value per share is $40. How does this impact the shareholders’ equity accounts?

33. B/S Changes for the Large-Percentage Stock Dividend $2 million ($5 x 400,000 new shares) transferred (on paper) “out of” retained earnings. $2 million transferred “into” common stock account.

34. Large-Percentage Stock Dividends Before 100% Stock Dividend Common stock ($5 par; 400,000 shares) $ 2,000,000 Additional paid-in capital 1,000,000 Retained earnings 7,000,000 Total shareholders’ equity $10,000,000 After 100% Stock Dividend Common stock ($5 par; 800,000 shares) $ 4,000,000 Additional paid-in capital 1,000,000 Retained earnings 5,000,000 Total shareholders’ equity $10,000,000

35. Stock Dividends and Stock Splits Stock Split-- An increase in the number of shares outstanding by reducing the par value of the stock. Similar economic consequences as a 100% stock dividend. Primarily used to move the stock into a more popular trading range and increase share demand. Assume a company with 400,000 shares of $5 par common stock splits 2-for-1. How does this impact the shareholders’ equity accounts?

36. Stock Splits Before 2-for-1 Stock Split Common stock ($5 par; 400,000 shares) $ 2,000,000 Additional paid-in capital 1,000,000 Retained earnings 7,000,000 Total shareholders’ equity $10,000,000 After 2-for-1 Stock Split Common stock ($2.50 par; 800,000 shares) $ 2,000,000 Additional paid-in capital 1,000,000 Retained earnings 7,000,000 Total shareholders’ equity $10,000,000

37. Value to Investors of Stock Dividends or Stock Splits Effect on investor total wealth Effect on investor psyche Effect on cash dividends More popular trading range Informational content

38. Stock Dividends and Stock Splits Reverse Stock Split-- A stock split in which the number of shares outstanding is decreased. Used to move the stock into a more popular trading range and increase share demand. Usually signals negative information to the market upon its announcement (consistent with empirical evidence). Assume a company with 400,000 shares of $5 par common stock splits 1-for-4. How does this impact the shareholders’ equity accounts?

39. Reverse Stock Splits Before 1-for-4 Stock Split Common stock ($5 par; 400,000 shares) $ 2,000,000 Additional paid-in capital 1,000,000 Retained earnings 7,000,000 Total shareholders’ equity $10,000,000 After 1-for-4 Stock Split Common stock ($20 par; 100,000 shares) $ 2,000,000 Additional paid-in capital 1,000,000 Retained earnings 7,000,000 Total shareholders’ equity $10,000,000

40. Stock Repurchase Stock Repurchase-- The repurchase (buyback) of stock by the issuing firm, either in the open (secondary) market or by self-tender offer. Reasons for stock repurchase: Available for management stock-option plans Available for the acquisition of other companies “Go private” by repurchasing all shares from outside stockholders To permanently retire the shares

41. Methods of Repurchase Fixed-price self-tender offer-- An offer by a firm to repurchase some of its own shares, typically at a set price. Dutch auction self-tender offer-- A buyer (seller) seeks bids within a specified price range, usually for a large block of stock or bonds. After evaluating the range of bid prices received, the buyer (seller) accepts the lowest price that will allow it to acquire (dispose of) the entire block. Open-market purchase-- A company repurchases its stock through a brokerage house on the secondary market.

42. Repurchasing as Part of Dividend Policy Assume: Earnings after taxes $ 800,000 Number of shares outstanding ¸ 400,000 Earnings per share $ 2 Current market price per share $ 31 Expected dividend per share $ 1 Expected total dividendsto be paid out$ 400,000

43. Repurchasing as Part of Dividend Policy If dividend is paid, shareholders receive: Expected dividend per share $ 1 Market price per share $ 30 Total value $ 31 If shares repurchased, shareholders receive: Dividend per share $ 0 Market price per share* $ 31 Total value $ 31 * Shares repurchased = $400,000 / $31 = 12,903 Original P/E ratio = $30/$2 = 15 “New” EPS = $800,000 / 387,097 = $2.07 “New” market price = $2.07 x 15 = $31

44. Summary of Repurchasing as Part of Dividend Policy The capital gain arising from the repurchase (stock rising from $30 to $31) exactly equals the dividend ($1) that would have otherwise been paid. This result holds in the absence of taxes and transaction costs. To the taxable investor, capital gains (repurchases) are favored to dividend income as the tax on the capital gain is postponed until the actual sale of the common shares.

45. Summary of Repurchasing as Part of Dividend Policy Stock repurchases are most relevant for firms with large amounts of excess cash that might otherwise generate a significant taxable transaction to investors. Firms must be careful not to make regularly occurring repurchases or the IRS may consider the capital gains as dividends for tax purposes.

47. Possible Signaling Effect Repurchases have a positive signaling effect. For example, if the stock is undervalued management may tender for shares at a “premium.” This signals that the share prices are undervalued. Dutch-auction self-tenders have less signaling power likely due to a smaller tender premium. Open-market purchases have only a modest positive signaling effect likely due to many programs being instituted after significant share price declines.

48. Administrative Considerations: Procedural Aspects May 8 May 29 May 31 June 15 Record Date -- The date, set by the board of directors when a dividend is declared, on which an investor must be a shareholder of record to be entitled to the upcoming dividend. The board of directors met on May 8th to declare a dividend payable to shareholders on June 15th to the shareholders of record on May 31st.

49. Administrative Considerations: Procedural Aspects May 8 May 29 May 31 June 15 Ex-dividend Date -- The first date on which a stock purchaser is no longer entitled to the recently declared dividend. The buyer and seller of the shares have several days to settle (pay for the shares or deliver the shares). The brokerage industry has a rule that new shareholders are entitled to dividends only if they purchase the stock at least two business days prior to the record date.

50. Administrative Considerations: Procedural Aspects May 8 May 29 May 31 June 15 Declaration Date -- The date that the board of directors announces the amount and date of the next dividend. Payment Date -- The date when the corporation actually pays the declared dividend.

51. Dividend Reinvestment Plans Dividend Reinvestment Plan (DRIP) -- An optional plan allowing shareholders to automatically reinvest dividend payments in additional shares of the company’s stock. The firm can use existing stock. A trustee (e.g., a bank) purchases the stock on the open market and credits current shareholders with the new shares. The firm can issue new stock. This method raises “new” funds for the firm. The plan essentially reduces the effective dividend-payout ratio. Some plans offer discounts and eliminate brokerage costs for current shareholders.

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