Assignment On Dividend Policy Course Name: Principal of Finance Course Code: MGT-214
Submitted To M A Kaium Hossain Lecturer, Department of Management tu!ies "ni#ersit$ of %arisal
Submitted By M!& 'a$em Hossen (oll 'o) M-2*4 %%A 1st %atc+ Department of Management tu!ies "ni#ersit$ of %arisal
Date of Submission: November 17, 2013
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Di#i!en! Polic$ ntro!uction oncept of Di#i!en! Polic$ ignificance of Di#i!en! Polic$ T$pes of Di#i!en! Polic$ ta.ilit$ of Di#i!en! ignificance of ta.ilit$ of Di#i!en! Forms of Di#i!en! toc/ Di#i!en! 0 stoc/ split (easons for stoc/ split Factors !etermining Di#i!en! Polic$ of a firm Di#i!en! s capital gain T+eories of Di#i!en! Polic$ Di#i!en! Polic$ issues Pro.lem) page 3*, !emonstration pro.-1&1, +arles p 5ones
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Introduction Di#i!en! polic$ is t+e polic$ use! .$ a compan$ to !eci!e +o6 muc+ it 6ill pa$ out to
s+are+ol!ers in !i#i!en!s& n $our financial accounting course, $ou learn t+at after !e!ucting e7pense from t+e re#enue, a compan$ generates profit& Part of t+e profit is /ept in t+e compan$ as retaine! earnings an! t+e ot+er part is !istri.ute! as !i#i!en!s to s+are+ol!ers& From t+e s+are #aluation mo!el, t+e #alue of a s+are !epen!s #er$ muc+ on t+e amount of !i#i!en! !istri.ute! to s+are+ol!ers& Di#i!en!s are usuall$ !istri.ute! in t+e form of cas+ 8cas+ !i#i!en!s9 or s+are 8s+are !i#i!en!s 6+ic+ are .e$on! t+e remit of t+is article9& :+en a compan$ !istri.utes a cas+ !i#i!en!, it must +a#e sufficient cas+ to !o so& T+is creates a cas+ flo6 issue& Profit generate! ma$ not .e in t+e form of cas+& ;ou ma$ #erif$ t+is .$ loo/ing at t+e cas+ flo6 statement of a ompan$& A compan$ ma$ +a#e profit of <433 million .ut t+e cas+ onl$ increase .$ <1=3 million in a financial $ear& T+is is a concern to t+e management as insufficient cas+ ma$ mean t+e compan$ is una.le to !istri.ute a !i#i!en!& n#estors earn returns from t+eir s+ares in t+e form of capital gains an! !i#i!en! $iel!& Di#i!en! $iel! is an important ratio in e#aluating in#estment&
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T+e oncept of Di#i!en! polic$) T+e o.>ecti#es of t+e firm are to minimi?e t+e 6ealt+ of s+are+ol!ers stoc/+ol!er& oun! an! successful in#estment !ecision generate positi#e net cas+ flo6, 6+ic+ is use! eit+er for pa$ment of interest or !i#i!en! or retention 6it+in t+e firm to finance ne6 in#estment& T+e important aspect of a !i#i!en! !ecision is to !etermine t+e amount of earning to .e !istri.ute! to s+are +ol!ers, in one +an! an! t+e amount to .e retain in t+e firm, on t+e ot+er t+e !i#i!en! !ecision is regar!e! as t+e financing !ecision since t+e pa$ment of cas+ !i#i!en! re!uces amount of cas+ a#aila.le for in#estment an! t+e firm ma$ +a#e to ma/e a ne6 issue of s+are or !e.t& Di#i!en! !ecision is t+e core of t+e financial !ecision management& ince it affects capital structure !ecision an! in turn in#estment !ecision of t+at firm& T+e most significant aspect of !i#i!en! polic$ is to !etermine t+e amount of earnings to .e !istri.ute! to t+e s+are+ol!ers an! t+e amount to .e retain in t +e firm&
T$pes of Di#i!en! Polic$) T+e #arious t$pes of !i#i!en! polic$ are gi#en in .elo6) 1& Residual Dividend Policy: (etain an! rein#est earnings as long as returns on t+e in#estments e7cee! t+e returns stoc/+ol!ers coul! o.tain on ot+er in#estments of compara.le ris/& 2& Stable Dividend Policy: uc+ !i#i!en! polic$ refers to pa$ment of a specific amount of !i#i!en! eac+ $ear or perio!icall$ increasing t+e !i#i!en! at constant rate& n suc+ a polic$ t+e annual !ollar@ta/a !i#i!en! is reall$ pre!icta.le .$ in#estors& Most corporations attempt to maintain a sta.le gro6t+ in !i#i!en! polic$& & 4& Constant Payout Ratio Policy: uc+ a !i#i!en! polic$ refers to pa$ment of a constant percentage of earnings as !i#i!en!s financial $ear& %ut in practice, .ecause firmBs earnings surel$ 6ill fluctuate, t+is polic$ 6oul! mean t+at t+e amount of !i#i!en! 6oul! also #ar$& & Payment of Regular D dividend Plus Ratio: A polic$ of pa$ing a lo6 regular !i#i!en! plus a $ear- en! e7tra in goo! $ears is a compromise .et6een a sta.le !i#i!en! an! a constant pa$ment rate& uc+ a polic$ gi#es t+e firm fle7i.ilit$&
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ignificance of Di#i!en! Polic$) T+ere +as .een consi!era.le recent !e.ate a.out t+e importance of !i#i!en! polic$& n or!er to maintain t+e asset le#el, as 6ell as to finance in#estment opportunities, t+e firm must o.tain fun! from t+e issue of a!!itional eCuit$ or !e.t& n t+is case !i#i!en! polic$ is important& n ot+er 6or!, t+e !i#i!en! polic$ of t+e firm affects .ot+ s+are+ol!er 6ealt+ an! t+e long- term gro6t+ of a firm& o !i#i!en! polic$ is important to .e consi!ere!& T+e optimum !i#i!en! polic$ s+oul! stri/e t+e .alance .et6een current !i#i!en! an! future gro6t+ 6+ic+ ma7imi?es t+e price of a firms s+are&
ta.ilit$ of Di#i!en!s) ta.ilit$ of regularit$ of !i#i!en!s is consi!ere! as a !esira.le polic$ .$ t+e management of most companies in practice& +are+ol!ers also seem generall$ to fa#or t+is polic$ an! #alue sta.le !i#i!en!s +ig+er t+an t+e fluctuate ones& All ot+er t+ings .eing t+e same, sta.le !i#i!en! ma$ +a#e a positi#e impact on t+e mar/et price of t+e s+are& ta.ilit$ of !i#i!en!s sometimes means regularit$ in pa$ing some !i#i!en! annuall$, e#en t+oug+ t+e amount of !i#i!en! ma$ not .e relate! 6it+ earnings& T+ere are a num.er of companies 6+ic+ +a#e recor!s of pa$ing some !i#i!en! for a long un.ro/en perio!& More precisel$, sta.ilit$ of !i#i!en!s refers to t+e amounts pai! out regularl$& T+ree !istinct forms of suc+ sta.ilit$ ma$ .e !istinguis+e!) a) Constant dividend per share or dividend rate. b) Constant payout. c) Constant dividend per share plus etra dividend .
a) Constant dividend per share or dividend: A num.er of companies follo6 t+e polic$ of pa$ing a fi7e! amount per s+are or fi7e! rate on pai!-up capital as !i#i!en! e#er$ $ear irrespecti#e of t+e fluctuations in t+e earnings& T+is polic$ !ose not implies t+at t+e !i#i!en! per s+are or !i#i!en! rate 6ill ne#er .e increase!& :+en t+e compan$ reac+es ne6 le#els of earnings an! e7pects to maintain it, t+e annual !i#i!en! per s+are ma$ .e increase!& T is eas$ to follo6 t+is polic$ 6+en earnings are sta.le& Ho6e#er, if t+e earnings pattern of a compan$ s+o6e! 6i!e fluctuations, it is !ifficult to maintain suc+ a polic$& :it+ earnings fluctuating from $ear to $ear it is essential for a compan$ 6+ic+ 6ants to follo6 t+is polic$ to .uil! up surpluses in $ears of +ig+ t+an a#erage earnings to maintain !i#i!en!s in $ears to .elo6 a#erage earnings& n practice, 6+en a compan$ retains earnings in goo! $ears for t+is purpose, it earmar/s t+is surplus as reser#e for !i#i!en! eCuali?ation& T+ese fun!s are in#este! in current assets li/e tra!a.le securities, so t+at t+e$ ma$ easil$ .e con#erte! into cas+ at t+e time of pa$ing !i#i!en!s in .a! $ears& 5
b) Constant payout: T+e ratio of !i#i!en! to earnings is /no6n as pa$out ratio& ome companies ma$ follo6 a polic$ of constant pa$out ratio t+at pa$ing a fi7e! percentage of net earnings e#er$ $ear& :it+ t+is polic$ t+e amount of !i#i!en! 6ill fluctuate in !irect proportion to earnings& f a compan$ a!opts a 13 pa$out ratio t+en 43 of e#er$ ta/a of net earnings 6ill .e pai! out& For e7ample, if t+e compan$ earns t/&2 per s+are t+e !i#i!en! per s+are 6ill .e t/&*3 an! if it earns t/& 1&3 per s+are t+e !i#i!en! per s+are 6ill .e t/&3& T+is polic$ is relate! to a compan$Bs a.ilit$ to pa$ !i#i!en!s& f t+e compan$ incurs losses, no !i#i!en!s s+all .e pai! regar!less of t+e !esires of s+are+ol!ers internal financing 6it+ retaine! earnings is automatic 6+en t+is polic$ is follo6e!& At an$ gi#en pa$out ratio t+e amount of !i#i!en!s an! t+e a!!itions to retaine! earnings increase 6it+ !ecreasing earnings& T+is polic$ !oes not put an$ pressure on a compan$Bs liCui!it$ since !i#i!en!s are !istri.ute! onl$ 6+en t+e compan$ +as profit&
c) Constant dividend per share or etra dividend: "n!er t+e constant !i#i!en! per s+are polic$, t+e amount of !i#i!en! is a +ig+ le#el, an! t+is polic$ is usuall$ a!opte! .$ t+e companies 6it+ sta.le earnings& For companies 6it+ fluctuating earnings, t+e polic$ to pa$ a minimum !i#i!en! per s+are 6it+ a step- up feature is !esira.le& T+e small amount of !i#i!en! is fi7e! to re!uce t+e possi.ilit$ of e#er missing a !i#i!en! pa$ment& %$ pa$ing e7tra !i#i!en! 8a num.er of companies in %angla!es+ pa$ an interim !i#i!en! follo6e! .$ regular, final !i#i!en!9& n perio! of prosperit$ an attempts to .e ma!e to pre#ent in#estors from e7pecting t+at t+e !i#i!en! represents an increase in t+e esta.lis+e! !i#i!en! amount& T+is t$pe of polic$ ena.les a compan$ to pa$ constant amount of !i#i!en! regularl$ 6it+out a !efault an! allo6s a great !eal of fle7i.ilit$ for supplementing t+e income of s+are+ol!er onl$ 6+en t+e compan$Bs earnings are +ig+er t+an usual, 6it+out committing itself to ma/e larger pa$ments as a part of future fi7e! !i#i!en!&
ignificance of sta.ilit$ of !i#i!en!s) 6
T+e a!#antages of sta.ilit$ are !iscusse! .elo6) a) Resolution of !nvestor"s #ncertainty: $ :+en a compan$ follo6s a polic$ of sta.le !i#i!en!s it 6ill not c+anges t+e amount of !i#i!en! if t+ere are temporar$ c+anges in its earning& T+us 6+en t+e earnings of a compan$ fall an! it continues to pa$ same amount of !i#i!en! as in t+e past& imilarl$ t+e amount of !i#i!en!s increase! earning le#el onl$ 6+en it is possi.le to maintain it in future& b) !nvestors Desire %or Current !ncome: $ T+ere are man$ in#estors suc+ as ol!, retire!, an! 6omen 6+o !esire to recei#e perio!ic income& T+ese t$pes of in#estors 6ill prefer a compan$ 6it+ sta.le !i#i!en!s to t+e one 6it+ fluctuating !i#i!en!s& c) !nstitutional !nvestors Re&uirements: $ +are of t+e compan$ is not onl$ purc+ase! .$ in!i#i!uals .ut also .$ financial, e!ucational, an! social institutions an! trusts& E#er$ compan$ is intereste! to +a#e t+ese financial institutions in t+e last of t+eir in#estors& T+ese institutions generall$ in#est in t+e s+are of t+ose companies 6+ic+ +a#e a recor! of regular !i#i!en!s& T+us to cater t+e reCuirement of institutional in#estors a compan$ prefers to follo6 a sta.le !i#i!en! polic$&
d) Raising 'dditional %inance: $ A sta.le !i#i!en! polic$ is also a!#antageous in its effort tip raise e7ternal finance& ta.le an! regular !i#i!en! polic$ ten!s to ma/e t+e s+are of a compan$ as Cualit$ in#estment rat+er t+an t+e speculation in#estors purc+ase t+ese s+ear inten! to +ol! t+em for long perio!s of time& T+e lo$alt$ goo!6ill of s+are+ol!ers to6ar!s a compan$ increase 6it+ sta.le polic$&
Forms of !i#i!en! polic$ 7
T+e usual practice is to pa$ !i#i!en!s in cas+& t+er option is to pa$ment of t+e .onus s+ares or stoc/ !i#i!en!& a9 Cash Dividend: $ Most companies pa$ !i#i!en!s in cas+& ometimes cas+ !i#i!en! ma$ .e supplemente! .$ a .onus issue& A compan$ s+oul! +a#e enoug+ cas+ in its .an/ account 6+en cas+ !i#i!en!s are !eclare!& f it !oes not +a#e enoug+ .an/ .alance arrangement s+oul! .e ma!e to .orro6 fun!s& :+en t+e compan$ follo6s a sta.le !i#i!en! polic$, it s+oul! prepare a cas+ .u!get for t+e coming perio! to in!icate t+e necessar$ fun!s 6+ic+ 6oul! .e nee!e! to meet t+e regular !i#i!en! pa$ments of t+e compan$& (ample) <& for e#er$ s+are $ou +ol!& .9 Stoc Dividend: $ An issue of .onus s+are represents a !istri.ution of s+are in a!!ition to t+e cas+ !i#i!en! to e7isting s+are+ol!ers& T+is +as t+e effect of increasing t+e num.er of outstan!ing s+ears of t+e compan$& T+e s+ares are !istri.ute! proportionatel$& T+us, a s+are+ol!er retains +is proportionatel$ o6ners+ip of t+e compan$& T+e !eclaration of t+e .onus s+ares 6ill increase t+e pai!-up s+are capital an! re!uce t+e reser#es an! surplus of t+e compan$& T+e total net 6ort+ is not affecte! .$ t+e .onus issue in fact a .onus issue represents are capitali?ation of t+e o6ners eCuit$ portion, t+at t+e reser#es an! surplus merel$ an accounting transfer from reser#es an! surplus to pai!- up capital& (ample) 1 ne6 stoc/ for eac+ 13 $ou +ol!&
toc/ Di#i!en! 0 toc/ plit) 8
Stoc dividend is a !i#i!en! pa$ment in t+e form of s+ares of stoc/ to current o6ners t+at is t+e !i#i!en! 6+ic+ is pai! in t+e form of a!!itional s+ares of stoc/ rat+er t+an cas+&
Stoc split is an action ta/en .$ a firm to increase t+e num.er of s+ares outstan!ing& t is not+ing .ut splitting of e7isting s+ares into more s+ares& toc/ split can .e of an$ si?e for e7ample t+e stoc/ coul! .e split 2 for 1& for 1, 4 for 1or an$ ot+er 6a$& toc/ !i#i!en! 0 splits are treate! !ifferentl$ for accounting purpose .ut moti#es for using t+em can .e !ifferent& %ut t+ere is no real financial !ifference .et6een t+e t6o&
(ample: n Decem.er 1, 1=*, t+e .oar! of !irectors aut+ori?e! a t+ree for t6o stoc/ split of Ameritec+Bs common stoc/, affecte! in t+e form of a stoc/ !i#i!en!& T+e a!!itional s+ares 6ere !istri.ute! in 5anuar$ 1=* to s+are o6ners of recor! on Decem.er 1, 1=*& As a result of t+e split, 4**3=333 a!!itional s+ares 6ere issue! an! <4*&*8million9 6as transferre! from procee!s in e7cess of par to common stoc/&
(eason .e+in! plit) 1& To *ae Trading in Share 'ttractive : T+e main purpose of stoc/ split is to re!uce t+e mar/et price of t+e stoc/ in or!er to ma/e it attracti#e to t+e in#estors& :it+ re!uction in t+e mar/et price of t+e stoc/ t+e stoc/ of t+e compan$ are place! in a more popular tra!ing range& 2& To Signal the Possibility of +igher Profit !n The %uture : T+e stoc/ split is use! .$ t+e compan$ management to inform to t+e in#estors t+at t+e compan$ is e7pecte! to earn +ig+er profits in future& T+e mar/et price of t+e +ig+ gro6t+ firmBs stoc/s increases #er$ fast& & To ,ive +igher Dividend to the Shareholders : :+en t+e stoc/ is split sel!om !oes a compan$ re!uce or increase t+e cas+ !i#i!en! per s+are proportionatel$& Ho6e#er, t+e total !i#i!en!s of a stoc/+ol!er increase after a stoc/ split&
Factors Determining Di#i!en! Polic$ of a Firm)
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4& Stable Dividend Policy : ta.ilit$ or regularit$ of !i#i!en!s consi!ere! as a !esira.le polic$ .$ t+e management of most companies in practice& +are+ol!ers also seem general to fa#or t+is polic$ an! #alue sta.le !i#i!en!s +ig+er t+an t+e fluctuating ones& All ot+er t+ings .eing t+e same, sta.le !i#i!en! ma$ +a#e a positi#e impact on t+e mar/et price of t+e s+are& T+atBs 6+$ management al6a$s tries to sta.le t+e !i#i!en! polic$ of firm an! t+e$ ta/e suc+ !ecisions 6+ic+ sta.le t+e !i#i!en! polic$& T+us sta.le !i#i!en! polic$ 6or/s as a factor !etermining !i#i!en! polic$ & !nternal Constraint: Di#i!en! polic$ ma$ .e influence! .$ stoc/+ol!er or managerial control moti#es& f a controlling 8ma>orit$ o6ners+ip9 interest !oes not 6is+ ne6 s+ares to .e sol!, t+e firmBs onl$ source of ne6 eCuit$ 6ill .e retentions& T+is ma$ impale t+e firm to maintain a lo6 pa$out ratio to ensure an a!eCuate suppl$ of ne6 eCuit$ mone$& & -ners Consideration: T+e !i#i!en! polic$ of a firm is li/el$ to .e affecte! .$ t+e o6nerBs consi!erations of 8i9 in t+e ta7 status of t+e s+are+ol!ers 8ii9 t+en opportunities of in#estments an! 8iii9 !ilution of o6ners+ip& & Capital *aret Consideration : f a firm +as onl$ limite! access to capital mar/ets, it is li/el$ to follo6 lo6 !i#i!en! pa$out ratio& T+e$ are li/el$ to rel$ more +ea#il$ on returne! earnings as a source of financing t+eir in#estments& Firms 6+ic+ loan +ea#il$ or financial institution for raising fun!s !eclares a minimum !i#i!en! so t+at t+e$ can remain on t+e eligi.le
Dividend Vs capital gain: 10
:it+ t+e latest mar/et !eclines remin!ing us ane6 of t+e in+erent ris/s of stoc/s, its a goo! time to re-e7amine +o6 t+e stoc/ mar/et creates 6ealt+& T+ere are all sorts of 6rin/les .ut it all reall$ comes !o6n to t6o .ig t+ings) toc/s eit+er rise in price 8capital appreciation9 or companies pa$ out a portion of profits 8!i#i!en!s9& ollecting !i#i!en!s can .e a .oring 6a$ to accumulate 6ealt+, .ut its prett$ effecti#e& T+e fol/s at Morningstar@..otson +a#e stoc/ mar/et !ata going .ac/ to 1=2& #er t+at time 81=2 t+roug+ 233=9 stoc/s +a#e pro#i!e! an annual a#erage return of =&*1& f t+at return, t+e ..otson !ata s+o6, capital appreciation accounts for &4 percentage points, a .it more t+an +alf& Di#i!en!s, +o6e#er, are not far .e+in!, !eli#ering 4&1 percentage points& ome of $ou 6ill Cuic/l$ notice t+at t+e t6o components !o not precisel$ a!! up to =&*1, 6+ic+ o6es to statistical noise an! roun!ing o#er man$ !eca!es of !ata& %ut t+e .ig point remains) Di#i!en!s are t+e unsung +ero of t+e stoc/ mar/et an! in man$ 6a$s t+e more relia.le pro#i!er of 6ealt+& f course all t+at coul! c+ange if t+e ta7 treatment of !i#i!en!s c+anges !ramaticall$ in t+e $ears a+ea!, .ut t+ats a calculation e#er$one +as to !o for t+emsel#es& o is in#esting for !i#i!en!s a .etter 6a$ to increase $our nest eggI T+at !epen!s on t+e economic en#ironment& Gi#en t+e current glo.al uncertainties stoc/s coul! remain listless, gi#ing !i#i!en!s a leg up&
T+eories of Di#i!en! Polic$ 11
Di#i!en! refers to t+at portion of a firmBs net earnings 6+ic+ are pai! out to t+e s+are+ol!ers& o 6e can sa$ t+at !i#i!en! polic$ means t+e policies ta/en .$ t+e a!ministration of an organi?ation& T+ere are e7actl$ t6o main t+eories of !i#i!en! policies& T+ose are) /. rrele#ance T+eor$ 0. (ele#ance T+eor$
/. !rrelevance Theory : t implies t+at t+e #alue of a firm is unaffecte! .$ t+e !istri.ution of !i#i!en!s an! is !etermine! solel$ .$ t+e earning po6er an! ris/ of its assets& T+e most compre+ensi#e argument in support of t+e irrele#ance of !i#i!en! is pro#i!e! .$ t+e *odigliani$*iller 1**) +$pot+esis& Mo!igliani an! Miller maintain t+at !i#i!en! polic$ +as no effect on t+e s+are price of t+e firm an! is, t+erefore, of no conseCuence&
'ssumptions: T+e MM +$pot+esis of irrele#ance of !i#i!en!s is .ase! on t+e follo6ing critical assumptions) •
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Perfect capital mar/ets in 6+ic+ all in#estors are rational& nformation is a#aila.le to all free of cost, t+ere are no transactions costsJ securities are infinitel$ !i#isi.le, no in#estor is large enoug+ to influence t+e mar/et price of securities, t+ere are no flotation costs& T+ere are no ta7es& Alternati#el$, t+ere are no !ifferences in ta7 rates applica.le to capital gains an! !i#i!en!s& A firm +as a gi#en in#estment polic$ 6+ic+ !oes not c+ange& T+e operational implication of t+is assumption is t+at financing of ne6 in#estments out of retaine! earnings 6ill not c+ange t+e .usiness ris/ comple7ion of t+e firm an!, t+erefore, t+ere 6oul! .e no c+ange t+e reCuire! rate of return& T+ere is a perfect certaint$ .$ e#er$ in#estor as to future in#estments an! profits of t+e firm& n ot+er 6or!s, in#estors are a.le to forecast future prices an! !i#i!en!s 6it+ certaint$& T+is assumption is !roppe! .$ MM later&
*athematical (pression)
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Let us ta/e a one $ear time +ori?on to un!erstan! t+e in!ifference argument of M0M& :e use t+e follo6ing ne6 notations) Po: Price of t+e eCuit$ s+are at point 3 P/) Price of t+e eCuit$ s+are at point 1, t+at is, en! of perio! 1 D/) Di#i!en! per s+are .eing pai! in perio! 1 n) e7isting num.er of issue! s+ares m: ne6 s+ares to .e issue! !: n#estment nee!s of t+e compan$ in $ear 1 2) Profits of t+e firm $ear in 1
T+e relation .et6een t+e price at t+e .eginning of t+e $ear 8Po9, an! t+at at t+e en! of t+e $ear 8P19 is t+e simple Cuestion of !iscounte! #alue at t+e s+are+ol!ersB e7pecte! rate of return 8KE9& Hence, Po 8P1 D19 @ 81 8KE9 && 819 ECuation 89 is Cuite eas$ to un!erstan!& +are+ol!ers +a#e got a cas+ return eCual to D1 at t+e en! of ;ear 1, an! t+e s+are is still 6ort+ P1& Hence, !iscounte! at t+e cost of eCuit$, t+e !iscounte! #alue is t+e price at t+e .eginning of t+e perio!& Alternati#el$, it ma$ also .e state! t+at t+e P1 8P39N 81 8KE9 - D1 829 T+at is to sa$, if t+e compan$ !eclares !i#i!en!s, t+e price t+e en! of $ear 1 comes !o6n to t+e effect of t+e !istri.ution& ECuation 89 can .e manipulate!& %$ multipl$ing .ot+ si!es .$ n, an! a!!ing a selfcancelling num.er m, 6e ma$ 6rite 89 as follo6s) nPo O8nm9P1 -mP1 nD19@818KE9 89 'ote t+at 6e +a#e multiplie! .ot+ si!es .$ n, an! t+e a!!e! num.er m along 6it+ m is cancelle! .$ !e!ucting t+e same outsi!e t+e .rac/ets& mP1 represents t+e ne6 s+are capital raise! .$ t+e compan$ to finance its in#estment nee!s& Ho6 muc+ s+are capital 6oul! t+e compan$ nee! to raiseI Gi#en t+e in#estment nee!s an! t+e profits Q, t+e ne6 capital issue! 6ill .e gi#en .$ t+e follo6ing) mP1 R 8Q - nD19 & 849 Again, t+is is not !ifficult to un!erstan!, as t+e total amount of profit of t+e compan$ is Q, an!
13
t+e total amount !istri.ute! as !i#i!en!s is nD1& Hence, t+e compan$ is left 6it+ a fun!ing gap as s+o6n .$ eCuation 849& f t+e #alue of mP1 is su.stitute! in ECuation 89, 6e +a#e t+e follo6ing) nPo O8nm9P1 R S R 8Q - nD19nD19@818KE9 &&&&89 As nD1 6oul! cancel out, 6e 6ill .e left 6it+ t+e follo6ing) nPo O8nm9P1 R Q @818KE9 89 ince nPo is total #alue of t+e stoc/ at point 3, it is seen from ECuation 89 t+at !i#i!en! is not a factor in t+at #aluation at all&
0. Relevance Theory: t implies t+at s+are+ol!ers prefer current !i#i!en!s an! t+ere is no !irect relations+ip .et6een !i#i!en! polic$ an! mar/et #alue of a firm& :e foun! t6o t+eories representing t+e rele#ance t+eor$& T+ose are) a. 3alter"s *odel b. ,ordon"s *odel a)
3alter"s *odel:
T+e :alter formula .elongs to 5ames E :alter, an! is .ase! on a simple argument t+at 6+ere t+e rein#estment rate, t+at is, rate of return t+at t+e compan$ ma$ earn on retaine! earnings, is +ig+er t+an cost of eCuit$ 86+ic+, as 6e +a#e !iscusse! .efore, t+e e7pecte! returns of t+e s+are+ol!ers, or rate of return of t+e s+are+ol!ers9, t+en, it 6oul! .e in t+e interest of t+e firm to retain t+e earnings& f t+e compan$Bs rein#estment rate on retaine! earnings is t+e less t+an s+are+ol!ersB rate of return, t+e compan$ s+oul! not retain earnings& f t+e t6o rates are t+e same, t+en t+e compan$ s+oul! .e in!ifferent .et6een retaining an! !istri.uting&se& 'ssumptions:
T+e critical assumptions of :alterBs Mo!el are as follo6) •
•
• •
All financing is !one t+roug+ retaine! earnings) e7ternal sources of fun!s li/e !e.t or ne6 eCuit$ capital are not use!& :it+ a!!itional in#estments un!erta/en, t+e firmBs .usiness ris/ !oes not c+ange& t implies t+at t+e rate of return on firmBs in#estment an! cost of capital are constant& T+ere is no c+ange in /e$ #aria.le as EP an! DP& T+e firm +as perpetual 8or #er$ long9 life&
*athematical (pression:
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T+e :alter formula is .ase! on a simple anal$sis t+at t+e mar/et #alue of eCuit$ is t+e capitali?ation of t+e current earnings an! gro6t+ in price& Hence, t+e .asis of :alter formula is) E E K D g 819 Here, t+e gro6t+ factor occurs .ecause t+e rate of return on retention !one .$ t+e compan$ is +ig+er t+an t+e cost of eCuit$& T+at is to sa$, t+e compan$ continues to earn at r rate of return on t+e retaine! earnings, an! t+is is 6+at causes gro6t+ g& Hence, g r 8E-D9@ E K 829 nserting eCuations 829 into 819, 6e +a#e
r 8E - D9@ K E---
D
E
K E
K E
:+ere r rate of return on retaine! earnings of t+e
compan$ E earnings rate D !i#i!en! rate
.9 ,ordon"s *odel: Anot+er t+eor$ 6+ic+ conten!s t+at !i#i!en!s are rele#ant is Gor!onBs mo!el& T+is mo!el opines t+at !i#i!en! polic$ of a firm affects its #alue,
'ssumptions: t is .ase! on follo6ing assumptions) •
• • •
•
T+e firm is an all-eCuit$ firm& 'o e7ternal financing is use! an! in#estment programs are finance! e7clusi#el$ .$ retaine! earnings& (ate of return an! cost of eCuit$ is constant& T+e firm +as perpetual life& T+e retention ratio, once !eci!e! upon, is constant& T+us, t+e gro6t+ rate is also constant& ost of eCuit$ is greater t+an .orro6ing&
*athematically: 15
Gor!onBs gro6t+ mo!el is simpl$ & D ( 1 + g ) ¿ E K E − g
T+is is, as 6e +a#e seen a.o#e, !eri#e! from perpetual sum of a geometric progression, un!er t+e assumption t+at t+e gro6t+ rate is less t+an t+e cost of eCuit$&
Di#i!en! polic$ issues) Di#i!en! polic$ inclu!es signaling, percei#e! ris/, ta7-relate! issues, an! continuit$ 6it+ past !i#i!en!s& All four e7planations for pa$ing !i#i!en!s 8signaling, .ir!-in-t+e-+an!, ta7 preference, an! agenc$ costs9 recei#e some support, .ut t+e signaling e7planation recei#e! more support t+an t+e ot+er e7planations& T+e most important !eterminants of a compan$s !i#i!en! polic$ 6ere t+e le#el of current an! e7pecte! future earnings an! t+e pattern or continuit$ of past !i#i!en!s&
a) b) c) d)
Clientele (ffects !nformation (ffects 1Signaling) 'gency Costs (pectations Theory
a) Clientele (ffect: n#estors nee!ing current income 6ill .e !ra6n to firms 6it+ +ig+ pa$out ratios& n#estors preferring to a#oi! ta7es 6ill .e !ra6n to firms 6it+ lo6er pa$out ratios& 8i&e&, firms !ra6 a gi#en clientele, gi#en t+eir state! !i#i!en! polic$9& T+erefore, firms s+oul! a#oi! ma/ing !rastic c+anges in t+eir !i#i!en! polic$& •
•
•
•
f in#estors !o in fact +a#e a preference .et6een !i#i!en!s an! capital gains, 6e coul! e7pect t+em to see/ out firms t+at +a#e a !i#i!en! polic$ consistent 6it+ t+ese preferences& T+us t+ere 6oul! .e a Uclientele effect,V 6+ere firms !ra6 a gi#en clientele .ase! on !i#i!en! polic$& Ho6e#er, unless t+ere is a greater aggregate !eman! for a particular polic$ t+an is .eing satisfie! in t+e mar/et, !i#i!en! polic$ is still unimportant T+e clientele effect onl$ tells us to a#oi! ma/ing capricious c+anges in a compan$s !i#i!en! polic$&
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b) !nformation Content : +anges in !i#i!en! polic$ ma$ .e signals concerning t+e firmBs financial con!ition& A !i#i!en! increase ma$ signal goo! future earnings& A !i#i!en! !ecrease ma$ signal poor future earnings& •
•
•
•
•
E#i!ences in!icate t+at a large, une7pecte! c+ange in !i#i!en!s can +a#e significant impact on t+e stoc/ price& ome argue t+at management freCuentl$ +as insi!e information a.out t+e firm t+at it cannot ma/e a#aila.le to t+e in#estors& T+is information as$mmetr$ .et6een management an! in#estors ma$ result in a lo6er stoc/ price t+an it 6oul! .e if t+ere 6ere no as$mmetric information& n suc+ cases, !i#i!en! polic$ ma$ .e an important communication tool& t ma$ .e t+at in#estors use a c+ange in !i#i!en! polic$ as a signal a.out t+e firms WtrueW financial con!ition, especiall$ its earning po6er& T+erefore, un!er as$mmetric information, c+anges in !i#i!en! polic$ can affect t+e mar/et #alue of a firm&
c) 'gency Cost •
•
•
•
A firms !i#i!en! polic$ ma$ .e percei#e! .$ o6ners as a tool to minimi?e agenc$ costs& Hig+er !i#i!en! pa$ments !ecrease agenc$ costs .$ re!ucing t+e free cas+ flo6 a#aila.le to t+e managers of t+e firm& Hig+er !i#i!en!s re!uce retaine! earnings an! force management to go to t+e capital mar/ets to finance ne6 in#estments& ince t+e firm is reCuire! to pro#i!e information on its in#estment acti#ities in or!er to raise mone$ in t+e capital mar/et, t+e pa$ment of !i#i!en!s in!irectl$ results in a closer monitoring of managements in#estment acti#ities&
T+us !i#i!en! polic$ ma$ affect a firmBs mar/et #alue .$ affecting t+e agenc$ cost incurre! .$ t+e firm&
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d) (pectation theory: •
As t+e time approac+es for management to announce t+e amount of t+e ne7t !i#i!en!, in#estors form e7pectations as to +o6 muc+ t+e !i#i!en! 6ill .e& T+e in#estor t+en compares t+e actual !i#i!en! announce! 6it+ t+e e7pecte! !i#i!en!& f t+e amount of t+e !i#i!en! is as e7pecte!, e#en if it represents an increase from prior $ears, t+e mar/et price of t+e stoc/ 6ill remain unc+ange!& Ho6e#er, if t+e !i#i!en! is +ig+er or lo6er t+an e7pecte!, t+e in#estors 6ill reassess t+eir perceptions a.out t+e firm an! t+e #alue of t+e stoc/ .
Demonstration Pro.lem) Alp+a an! .eta t6o companies in t+e space tec+nolog$ in!ustr$ are close competitors, an! t+eir asset composition, capital structure, an! profita.ilit$ recor!s +a#e .een #er$ similar for se#eral $ears& T+e primar$ !ifference .et6een t+e companies from a financial management perspecti#e is t+eir !i#i!en! polic$& %eta tries to maintain a non !ecreasing !i#i!en!-pers+are series, 6+ile Alp+a maintains a constant !i#i!en! pa$out ratio eCual to 1@& T+eir recent EP, DP an! stoc/ price +istor$ are as follo6s) %eta
Alp+a
;ear
1= 1= 1= 1=4 1= 1=2 1=1
EP
DP
< &= &23 4&33 2& 2&31 1&4* 1&*
<3&3 3&3 3&3 3&4 3&43 3&43 3&43
toc/ Price (ange <1-4 3-43 2-42 21-2 14-22 11-1 1-1*
EP
DP
<4&33 &43 4&3 2&4 2&3 1&43 1&=3
<3& 3& 3&* 3&41 3&4 3&2 3&2
toc/ Price (ange <2-= 2*- 22-4 1-24 -1 -1 12-1
n all calculations .ello6 t+at reCuire a stoc/ price, use t+e a#erage of t+e t6o prices gi#en in t+e stoc/ price range& a& Determine t+e !i#i!en! pa$out ratio an! price-earnings ratio for .ot+ companies for all $ears& .& Determine t+e a#erage pa$out ratio an! price-earnings ratio for .ot+ companies o#er t+e perio! 1=1 t+roug+ 1=& c& T+e management of alp+a is pu??le! a.out 6+$ its stoc/ +as not performe! as 6ell +istoricall$ as %etaBs, e#en t+oug+ t+e Alp+a profita.ilit$ recor! is slig+tl$ .etter& T+e past t+ree $ears are particularl$ pu??ling& Ho6 6oul! $ou e7plain t+isI
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Solution: a.
Particular s Pa$out ratio %eta Alp+a toc/ Price %eta Alp+a P@E %eta Alp+a
b.
;ear Total 1
2
4
&21 &1
&23 &1
&1== &1
&1 &1
&12 &1
&1 &1
&12 &1
<1&3 <14&33
1&3 =&33
1*&33 11&3
24&33 23&33
4&3 &3
&33 2&33
&33 2&3
*&= &4
=&1 &4
=&3 &
=&4 *&2
*& *&
13&= =&4
=&* *&1
1&2 1&1=
& &4
A#erage Pa$out (atio an! Price Earnings (atio )
%eta) 'verage Payout Ratio
'verage Price (arnings
Total Payout Ratio No of Years
1.273
3&1*2
7
Total Price Earnings No of Years
65.7
=&4
7
Alp+a) 'verage Payout Ratio
'verage Price (arnings
Total Payout Ratio No of Years
1.169
Total Price Earnings No of Years
3&1
7
53.4 7
&4
c. 'otice first t+at o#er t+e entire se#en $ear perio!, %eta +as a greater !i#i!en! pa$out& Ho6e#er, if t+e !i#i!en! irrele#ance t+eor$ is true, t+is +ig+er pa$out s+oul! ma/e little !ifference& Also in t+e last t+ree $ears Alp+a +as pai! a .etter !i#i!en!& T+e pro.a.le reason is t+at t+e stoc/ mar/et is respon!ing a!#ersel$ to Alp+aBs fluctuating !i#i!en! per s+are +istor$ in comparison to %etaBs non !ecreasing !i#i!en! per s+are& Anot+er e7planation for t+e most recent t+ree $ears in t+at t+e mar/et #ie6s t+e future more fa#ora.l$ for %eta&
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20
