1. DIVIDEND POLICY CHAPTER 18

2. LEARNING OBJECTIVES  Explain the objectives of dividend policy in practice  Understand the factors that influence a firm’s dividend policy  Focus on the importance of the stability of dividend.  Discuss the significance and implications of bonus shares and stock splits and the share buyback  Explain Lintner's model of corporate behaviour of dividends 2

3. OBJECTIVES OF DIVIDEND POLICY  Firm’s Need for Funds  Shareholders’ Need for Income 3

4. PRACTICAL CONSIDERATIONS IN DIVIDEND POLICY  Firm’s Investment Opportunities and Financial Needs  Shareholders’ Expectations  Constraints on Paying Dividends  Legal restrictions  Liquidity  Financial condition and borrowing capacity  Access to the capital market  Restrictions in loan agreements  Inflation  Control 4

5. STABILITY OF DIVIDENDS  Constant Dividend per Share or Dividend Rate.  Constant Payout.  Constant Dividend per Share Plus Extra Dividend. 5

6. Constant dividend per share policy 6

7. Dividend policy of constant payout ratio 7

8. Significance of Stability of Dividends  Resolutions of investors uncertainty.  Investors’ desire for current income.  Institutional Investors’ Requirement.  Raising Additional Finances. 8

9. TARGET PAYOUT AND DIVIDEND SMOOTHING: LINTNER’S MODEL OF CORPORATE DIVIDEND BEHAVIOUR 9

10. FORMS OF DIVIDENDS  Cash Dividends  Bonus Shares (Stock Dividend) 10

11. Advantages of Bonus Shares  To shareholders:  Tax benefit  Indication of higher future profits  Future dividends may increase  Psychological value  To company:  Conservation of cash  Only means to pay dividend under financial difficulty and contractual restrictions  More attractive share price 11

12. Limitations of Bonus Shares  Shareholders’ wealth remains unaffected  Costly to administer  Problem of adjusting EPS and P/E ratio 12

13. Conditions for the Issue of Bonus Shares  Residual reserve criterion  Profitability criterion 13

14. Share split  A share split is a method to increase the number of outstanding shares through a proportional reduction in the par value of the share. A share split affects only the par value and the number of outstanding shares; the shareholders’ total funds remain unaltered. 14

15. Example  The following is the capital structure of Walchand Sons & Company:  Walchand Company split their shares two-for-one. The capitalization of the company after the split is as follows: 15

16. Bonus Share vs. Share Split  The bonus issue and the share split are similar except for the difference in their accounting treatment.  In the case of bonus shares, the balance of the reserves and surpluses account decreases due to a transfer to the paid-up capital and the share premium accounts. The par value per share remains unaffected.  With a share split, the balance of the equity accounts does not change, but the par value per share changes. 16

17. Reasons for Share Split  To make trading in shares attractive  To signal the possibility of higher profits in the future  To give higher dividends to shareholders 17

18. Reverse Split  Under the situation of falling price of a company’s share, the company may want to reduce the number of outstanding shares to prop up the market price per share.  The reduction of the number of outstanding shares by increasing per share par value is known as a reverse split.  The reverse split is generally an indication of financial difficulty, and is, therefore, intended to increase the market price per share. 18

19. BUYBACK OF SHARES  The buyback of shares is the repurchase of its own shares by a company.  As a result of the Companies Act (Amendment) 1999, a company in India can now buyback its own shares. 19

20. In India the following conditions apply in case of the buyback shares:  A company buying back its shares will not issue fresh capital, except bonus issue, for the next 12 months.  The company will state the amount to be used for the buyback of shares and seek prior approval of shareholders.  The buyback of shares can be affected only by utilizing the free reserves, viz., reserves not specifically earmarked for some purpose.  The company will not borrow funds to buy back shares.  The shares bought under the buyback schemes will be extinguished and they cannot be reissued. 20

21. Methods of Shares Buyback  First, a company can buy its shares through authorized brokers on the open market.  Second, the company can make a tender offer, which will specify the purchase price, the total amount and the period within which shares will be bought back. 21

22. Effects of the Shares Buyback  It is believed that the buyback will be financially beneficial for the company, the buying shareholders and the remaining shareholders.  Increase in the company’s debt-equity ratio due to reduced equity capital. 22

23. Advantages of the Buyback  Return of surplus cash to shareholders  Increase in the share value  Increase in the temporarily undervalued share price  Achieving the target capital structure  Consolidating control  Tax savings by companies  Protection against hostile takeovers 23

24. Drawbacks of the Buyback  Not an effective defence against takeover  Shareholders do not like the buyback  Loss to the remaining shareholders  Signal of low growth opportunities 24