Dividend The return given to the shareholders on their investment First Stage in Dividend Policy: Conservative Second Stage: Liberal Third Stage: No Dividend Policy India is in the second stage right now
Factors Determining Dividend Policy Company Policy Stability in Earnings Liquidity of the Co. Past Dividend Rates Projects under Consideration Market Expectation Taxation Legal restriction Independent Opportunities Restrictions of FIs Nature of Business Cost of Capital Phase of Trade Cycle Accumulated Reserves Co’s Growth Needs Bonus Issue
Types of Dividend Policies Conservative Dividend Policy Liberal Dividend Policy
Conservative Dividend Policy: Merits Good Treasury Mgt. Stability in Dividend Provision for Contingency Organic Growth Inorganic Growth Modest Expectation Taxation Higher Book Value Value Unlocking Research Oriented Companies
Demerits of Conservative Dividend Policy Lesser Image as a Creator of value for the Shareholders Book Value will be far more than Market Value of the Shares Accessing Capital Market becomes Difficult in the Future Lesser Liquidity for the Shares
Liberal Dividend Policy Handsome Dividend A Number of Interim Dividends within a Year Regular Issue of Bonus Shares Special dividends on Important Occasions Taking Care of Enhancing Shareholder Value as much as maximising Profits of the Company
Merits of Liberal Dividend Policy Good Image Shareholder Satisfaction Liquidity of the Scrip High Market Price Growth Driven Policy Accessing the Market Raising Finance Globally Constant Innovation
Demerits of Liberal Dividend Policy Difficult Treasury Management Lack of Stability in Dividend Payment Affecting Growth Prospects Insatiable Appetite of Shareholders High Dividend Tax
Bonus Shares Stock Dividend Capitalising the Reserves Given as a ratio 1:2 Conserves Cash For the Shareholder, tax liability is less as stock dividend is not treated as income
Benefits of Bonus Shares to the Company No cash Outflow Higher Liquidity Good Image Higher Market Capitalisation Reduction in Rate of Dividend No Dividend Tax Undercapitalisation
Benefits of Bonus Shares to the Shareholders Higher Holding Partial Liquidation Taxability Higher Liquidity Higher Future Dividend
Impact of Bonus Shares On Balance Sheet: Asset side not affected, Reserves come down and Share Capital goes up-Net worth does not change On Share Price: Immediate high, subsequent lower and higher in the long term On EPS: Gets reduced- Suggestible when the operating profit is expected to go up
Bonus Shares & SEBI Guidelines Provision in Articles of Association Increasing Authorised Capital Out of Free Reserves/Share Premium Not Out of revaluation Reserve Only on Fully Paid Shares Not in Lieu of Dividend Implementation within six months No Default on Financial Obligations Not in one year of Public Issue/Rights Issue Applicable to Listed Companies
Dividend Models Walter’s Model Gordon’s Model Modigliani-Miller Model
Walter’s Model James Walter & his Article, ”Dividend Policy: Its Influence on the value of the Firm” Growth Firm: ROI > k-optimal dividend is 0% Normal Firm: ROI =k, Any rate of dividend Declining Firm: ROI < k , 100% Pay-Out Ratio
Assumptions of Walter’s Model Only Two Sources of Finance: Equity Shares and Retained Earnings ROI is constant from one year to another K is constant from one year to another Firm has an infinite life
Computation of Market Value of Shares Where P=Market Price of Equity R=Rate of Return K=cost of capital E=Earnings per Share D=Dividend per Share
Problem No. 1 The National Sports Company with an EPS of Rs.11 and a cost of capital at 13%, achieved a Return on Investment at 18%. As per Walter’s Model, what would be the optimum pay-out ratio? What would be the share price at this ratio?
Problem No.2 The earning per share of a company are Rs.8.It has an internal rate of return of 14% and the capitalisation of its risk class is 12%. If Walter’s Model is used, What should be the optimum pay-out ratio of the firm? What would be the price of its share at this pay-out ratio? How shall the price of the share be affected, if 20% pay-out ratio was employed?
Percentage of Dividend & Dividend Pay-Out Ratio If Dividend is given as a percentage, it should be calculated on the face value. If it is given as a pay-out ratio, it should be calculated on the EPS
Problem No.3 Company A has achieved an EPS of Rs.8 for the year2007-08. What is the Dividend per Share if, (a) 25% dividend is declared on the share of Rs.10 face value (b) dividend pay-out ratio is 25%
Problem No.4 Fairever Cosmetics achieved an EPS of Rs.9 per share on its equity share of Rs.10 each., for the year 2006-07.It achieved a Return on Investment @ 14% with a cost of capital @ 16%. What is the ideal pay-out ratio? At that ratio, calculate the market value of share of the firm. If Board of Directors recommend a Dividend of Rs.4, what would be the market price of share of the firm?
Problem No.7 Consider the following data: Growth Normal Declining Firm FirmFirm ROI 17% 18% 19% K 15% 18% 20% EPS (Rs) 6 6 6 Calculate the market price of shares of the firms if the pay-out ratio is 20%, 45% or 70%. Also comment on it.
Criticisms of Walter’s Model Only zero debt companies have equity and retained earnings as the only two sources of finance ROI will not be constant K also will not remain constant
Dividend Capitalisation Model Myron J. Gordon concurred with Walter in Dividend being relevant to Market price of Share He differed in advocating growth as the driver of the market price Growth is the product of retention ratio (b) and Rate of Return (R)
Assumptions of Gordon’s Model Only Equity and Retained Earnings are the only sources of finance R is constant from one year to another Taxes do not exist K is also constant The Firm has a perpetual life
Miller-Modigliani Dividend Model Merton Miller & Franco Modigliani presented a paper in 1958 and argued that Dividend was irrelevant in determining the price of the share
It was the Investment policy and earnings of the firm that determined the share price
In 1961, an Article was published by them, which came to be known as Irrelevance Theory
Arbitrage Process Price may go up post declaration of dividend After the payment of dividend, the firm may have to access the capital market for the future requirement This will bring down the price of the shares to the previous levels The Theory impacted the capital market so much that nearly 70% of American Corporations became ‘No Dividend’ Corporations
Assumptions Perfect Capital Markets: - all the investors are rational -price sensitive information is available to all the investors simultaneously -securities are infinitely divisible - no single investor is big enough to influence the price 2. Non-Existence of Taxes 3. Constant Investment Policy 4. Forecasting Ability
Computation of Share Price Where Po = Price at the beginning P1 = Price at the end ke = Cost of Equity D = Dividend per Share
Exercise-page No.289 17. The share price of TVS Electronics Ltd. was ruling at Rs. 57.60. The Board of Directors declared a dividend of Re. 0.70 per share of Rs. 10. If cost of equity is 3%, calculate the share price after declaration of dividend using Miller Modigliani Dividend Model.
Exercise-Page No.289 16. Cost of Equity of VIP Industries Ltd. was 5% and the price of equity share was Rs. 122.60. The company declared a dividend at 20% on its equity shares having the face value at Rs. 10. What will be the share price after the declaration of dividend? 18. Triumph Engineering Ltd had 5,000 equity shares of Rs. 100 each. During a financial year, its cost of equity was 17%%. Using Miller - Modigliani model, decide what will be the price of the share, if no dividend is declared? If a dividend of Rs. 23 per share is declared, what will be the share price?
Exercise-Page No.289 19. United Pharma Ltd. had 3,00,000 outstanding equity shares of Rs.10 each on Jan 1,2007. The company now intends to pay Rs.6 per share for the current year. It belongs to a risk class whose appropriate capitalisation rate is 9%. Determine the price of the company’s share using Modigliani-Miller model, (i) when dividend is declared (ii) when no dividend is declared. 19. United Pharma Ltd. had 3,00,000 outstanding equity shares of Rs.10 each on Jan 1,2007. The company now intends to pay Rs.6 per share for the current year. It belongs to a risk class whose appropriate capitalisation rate is 9%. Determine the price of the company’s share using Modigliani-Miller model, (i) when dividend is declared (ii) when no dividend is declared. 19. United Pharma Ltd. had 3,00,000 outstanding equity shares of Rs.10 each on Jan 1,2007. The company now intends to pay Rs.6 per share for the current year. It belongs to a risk class whose appropriate capitalisation rate is 9%. Determine the price of the company’s share using Modigliani-Miller model, (i) when dividend is declared (ii) when no dividend is declared.
Exercise-Page No.292 17. Two chemical companies A Ltd. and B Ltd. had equity shares priced at Rs. 300 each. During the financial year 2006-07, each one made a net profit of Rs. 430 crores. Cost of equity is the same for both the companies at 16%. A Ltd. decided to declare a dividend at Rs. 7 per share and B Ltd. decided not to declare any dividend. Using Miller-Modigliani hypothesis, a) Calculate the share price of A Ltd. after dividend declaration b) Calculate the share price of BLtd. after the results c) Is there any difference in the total shareholder wealth between the two companies?
Exercise-Page No 292 16. The following seven engineering companies undertake turn-key projects in India. Their financials for 2004-05 are given below. All the companies have Rs. 10 as the Face value of share of a Company P0 D ke (%) ABG Heavy Industries Ltd 264 1.50 4.4 Engineers India Ltd 823 7.50 2.4 Hindustan Dorr-Oliver Ltd 813 1.20 2.2 MC. NallyBharath Ltd 130 0.30 2.3 Petronet Engineering Ltd 168 1.00 5.9 PSL Ltd 251 4.50 4.14 Sanghvi Motors Ltd. 840 5.00 2.1 Using Modigliani - Miller hypothesis, calculate the market price of shares after the declaration of dividend.
Exercise-page No.292 18. Apply Modigliani - Miller hypothesis and determine the share prices of the following companies after the declaration of dividend. Problem No. 19