Dividend Policy Part II Ernesto S. Nogoy Jr. MBA- FM

Topics to be discussed:  Dividend Policy Theories  Dividend Models  Relevance Theory o Gordon’s Approach o Walter’s Model  Irrelevance Theory o Residual Theory o Modigliani Miller approach  Types of Dividend Policies  Accounting for Cash and Stock Dividends  Steps in setting Dividends  Dividend in Firm Life Cycle  Measures of Dividend Policies  Dividend Payout  Dividend Yield

What is Policy? Deliberate system of principles Assist in both subjective and objective decision making Procedure Protocol

DIVIDEND POLICY THEORIES

 The Residual Theory of Dividend Policy The residual theory of dividend policy holds that the firm will only pay dividend from residual earnings, that is dividends should be paid only if funds remain after the optimum level of capital expenditures is incurred i.e. all suitable investment opportunities have been financed.

DIVIDEND POLICY THEORIES Example ABC Company has a capital structure of 35% of debt and 65% of equity. ABC’s retained earnings in this financial period are Php2,000,000. The new investment required, which were determined by the intersection of IOS and WMCC, is Php2,400,000. Determine if ABC will be able to distribute any dividends.

DIVIDEND POLICY THEORIES Solution The funds required to cover new investment is Php2,400,000. The amount that must come from equity is Php2,400,000*.65=Php1,560,000. Remaining will be available for distribution which is the Php440,000 (2M-1.56M).

DIVIDEND POLICY THEORIES  Dividend Irrelevancy Theory, (Miller & Modigliani, 1961)17 The dividend irrelevancy theory asserts that dividend policy has no effect on either the price of the firm or its cost of capital. Dividend Irrelevance Arguments Dividend policy does not affect share price because the value of the firm is a function of its earning power and the risk of its assets. If dividends do affect value, it is only due to: Information Effect Clientele Effect Signaling Effect

DIVIDEND POLICY THEORIES  The Tax Differential Theory, (B. Graham and D.L. Dodd) This theory simply concludes that since dividends are taxed at higher rates than capital gains, investors require higher rates of return as dividend yields increase. This theory suggests that a low dividend payout ratio will maximize firm value.

DIVIDEND POLICY THEORIES  The Bird in the Hand Theory, (John Lintner 1962 and Myron Gordon, 1963) The essence of this theory is not stockholders are risk averse and prefer current dividends due to their lower level of risk as compared to future dividends. Dividend payments reduce investor uncertainty and thereby increase stock value.

DIVIDEND POLICY THEORIES  The Bird in the Hand Theory

DIVIDEND POLICY THEORIES  Per Cent Retention Theory (Clarkson and Eliot 1969) Clarkson and Eliot (1969) argued that given taxation and transaction costs dividends are a luxury that is not afforded by shareholders as well as by companies and hence a firm can follow a policy of 100 per cent retention. Firms can thus avail of new investment opportunities that would be beneficial to shareholders too.

DIVIDEND MODELS

DIVIDEND MODELS Irrelevance Dividend Policy  Modigliani Miller approach According to them the price of a share of a firm is determined by its earning potentiality and investment policy and not by the pattern of income distribution. The model given by them is as follows: Po = D 1 + P 1 / (1/Ke) Where, Po = Prevailing market price of a share Ke = Cost of equity capital D 1 = Dividend to be received at the end of period one P 1 = Market price of a share at the end of period one

DIVIDEND MODELS Irrelevance Dividend Policy  Residuals theory of dividends One of the assumptions of this theory is that external financing to re-invest is either not available, or that it is too costly to invest in any profitable opportunity. If the firm has good investment opportunity available then, they'll invest the retained earnings and reduce the dividends or give no dividends at all. If no such opportunity exists, the firm will pay out dividends.

DIVIDEND MODELS Relevance Dividend Policy  Walter’s Model According to Prof. James E. Walter, in the long run, share prices reflect the present value of future+ dividends. According to him investment policy and dividend policy are interrelated and the choice of a appropriate dividend policy affects the value of an enterprise. His formula for determination of expected market price of a share is as follows:

Walter’s Model In a 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, it's 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. DIVIDEND MODELS Relevance Dividend Policy

Walter’s Model In a nutshell: If r>ke, the firm should have zero payout and make investments. If r<ke, the firm should have 100% payouts and no investment of retained earnings. If r=ke, the firm is indifferent between dividends and investments. DIVIDEND MODELS Relevance Dividend Policy

 Gordon's approach The value of a share, like any other financial asset, is the present value of the future cash flows associated with ownership. On this view, the value of the share is calculated as the present value of an infinite stream of dividends. Myron Gordon's Dividend Growth Model explains how dividend policy of a firm is a basis of establishing share value. Gordon's model uses the dividend capitalization approach for stock valuation. The formula used is as follows:

A Summary View of Dividend Policy Theories Dividend Irrelevance  Dividends do not make any difference (M & M theory)  If there are no taxes disadvantages associated with dividends. Dividend Relevance  Dividends are relevant and have positive impact on firm value  If stockholders like dividends, or dividends operate as a signal of future prospects. (Lintner & Gordon)  Dividends help to resolve agency problem and thus enhancing shareholder value. (Jenson)  Dividends are not good (Graham and Dodd)  If dividends have a tax disadvantage and increasing dividends reduce value.

TYPES OF DIVIDEND POLICIES

Types of Dividend Policies  Stable Dividend Policy - payment of certain sum of money is regularly paid to the shareholders. a) Constant dividend per share: here reserve fund is created to pay fixed amount of dividend in the year when the earning of the company is not enough. It is suitable for the firms having stable earning. b) Constant pay out ratio: it means the payment of fixed percentage of earning as dividend every year. c) Stable rupee dividend + extra dividend: it means the payment of low dividend per share constantly + extra dividend in the year when the company earns high profit.

Types of Dividend Policies  Regular dividend policy This type of dividend policy the investors get dividend at usual rate. Here the investors are generally retired persons or weaker section of the society who want to get regular income. This type of dividend payment can be maintained only if the company has regular earning.

Types of Dividend Policies  Regular Extra Dividend Policy As per this policy, a low, regular dividend is maintained and when times are good an extra dividend is paid. Extra dividend is the additional dividend optionally paid by the firm if earnings are higher than normal in a given period. Although the regular portion will be predictable, the total dividend will be unpredictable.

Types of Dividend Policies  Regular Stock Dividend Policy Firm pursuing this policy pays dividends in stock instead of cash. Stocks to pay dividends are designated as ‘bonus shares’ which are very frequently used to capitalize reinvested earnings of the firm. Issue of bonus shares does not at all affect liquidity position of the firm; it increases, indeed, the share holding of residual owners but not their equity in the firm.

Types of Dividend Policies  Other types of Dividend Policies  Multiple dividend increase policy  Uniform cash dividend plus bonus policy

Accounting for Cash and Stock Dividend  Cash Dividend When the board of directors declares a cash dividend, debit the Retained Earnings account and credit the Dividends Paya ble account, thereby reducing equity and increasing liabilities. When a dividend is eventually paid out, debit the Dividends Payable account and credit the Cash account, thereby reducing both cash and the offsetting liability.

Accounting for Cash and Stock Dividend  Cash Dividend The board of directors of Hostetler Corporation declares a Php1 dividend for each of the company's 10,000 shares outstanding. You would record the following entry: Declaration: Dr Retained Earnings10K CrDiv. Payable10K Payment: Dr Div. Payable10K CrCash10K

Accounting for Cash and Stock Dividend  Stock Dividends If the stock dividend declared is more than 20%-25%, it is a large stock dividend and is more like a stock split. In this case, declaration is recorded by debiting retained earnings by the product of par value per share, percentage of stock dividend and number of outstanding shares; and crediting stock dividends distributable.

Accounting for Cash and Stock Dividend  Stock Dividends A company has 200,000 outstanding shares of common stock of Php10 par value. It declares 10% stock dividend. The market price per share of common stock was Php15 on the date of declaration. Date of declaration: Dr Retained Earnings300K CrStock Dividends Distributable200K Cr Additional Paid-in Capital100K Date of distribution: Dr Stock Dividends Distributable 200K CrCommon stock200K

Steps in setting Dividends 1.Determine the investment opportunities with high NPV. 2.Project the firm’s investment financing needs 3.Set out a long-term target ratio for dividend payment 4.Set feasible current year’s target ratio 5.Set (annual/half yearly/quarterly (preferable) dividend rates

DIVIDEND AND A FIRM’S LIFE CYCLE

Measures of Dividend Policy  Dividend Payout This discloses what portion of the current earnings the company is paying to its stockholders in the form of dividend and what portion the company is ploughing back in the business for growth in future. It is computed by dividing the dividend per share by the earnings per share (EPS) for a specific period.

Measures of Dividend Policy Example The Best Buy Inc. has declared and paid a dividend of Php0.66 per share of common stock. The company does not have any preferred stock outstanding. The information about common stock and net income is given below: Common stock (10,000 shares, Php25 par value): Php250,000 Net income: Php22,000 An investor seeking for continuous dividend income wants to purchase the share of the Best Buy Inc. For this purpose, he requests you to compute the dividend payout ratio for him from the above information.

Measures of Dividend Policy Solution Dividend Payout=Php0.66/ Php2.2* = 0.3 or 30% *Earnings per share of common stock: Php22,000/10,000 shares

Measures of Dividend Policy  Dividend Yield It is a financial ratio that measures the annual value of dividends received relative to the market value per share of an investment security. In other words, the dividend yield formula calculates the percentage of a company’s market price of a share that is paid to shareholders in the form of dividends. It is computed by Dividend per share divided by Market value per share.

Measures of Dividend Policy Example The following information is related to ABC company and DEF company for the year 2018: Both the companies belong to same industry. ABC is an old and well-established company whereas DEF is a new company. The historical data shows that the ABC has a stable annual dividend distribution to stockholders. Required: Calculate dividend yield ratio of both the companies. Which company would you recommend for investment in shares? Explain with reasons. ABC Company DEF Company Cash Dividend declared and paid during the year 750, , Common Stock 25,000, ,000, Number of shares of common outstanding 50, , Par Value per share Market value per share

Measures of Dividend Policy Solution An investor should prefer the ABC company because its dividend yield ratio is significantly higher than that of DEF company ABC Company DEF Company Dividend per share = 750, , ,000 24,000 = Dividend Yield ratio = = 25% 10%

Measures of Dividend Policy  Dividend Payout = Dividend/Net Income  Measures the percentage of earnings that the company pay dividends.  If the net income is negative, the payout ratio cannot be computed.  Dividend Yield = Dividend per share/ Stock price  Measures the return that an investor can make from dividends alone  Becomes part of the expected return on the investment  Doesn’t necessarily indicate a good or bad perfomance

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