Where to raise funds for value-creating investments?
What should be the proportion of equity and debt?
The Working Capital Decision
To have just enough funds available for operations as required
The Dividend Decision
How much of a firm’s funds should be reinvested in the business, how much should be buffered as cash reserves and how much should be returned to the owners?
The 4 Major Finance Decisions LIABILITIES ASSETS FIXED LIABILITIES FIXED ASSETS Equity Land Debt Building Retained Earnings Plant/ Machinery CURRENT LIABILITIES CURRENT ASSETS Creditors Debtors Bills Payable Cash Financing Investment Working Capital Profits Profit Distribution
Cash Flow Decisions
Raise Cash by selling Securities to Investors
Invest Cash in Assets and firm’s operations
Generate Cash by firms operations
Return Part of Cash to the Investors
Reinvest Cash in the firm’s operations
The board of directors declares a payment
Declared dividends are distributable to shareholders on record on this date.
The dividend checks are mailed to shareholders of record.
Shares become ex-dividend on the date the seller is entitled to keep the dividend. At this point, the stock is said to be trading ex-dividend.
Dividend by corporate actions
fresh shares are given against existing shares for no extra charge
Shares are split in more number of shares
Right shares at discount
Additional shares are offered to existing share holders at a discount on the market price
Buyback of Shares
Reduces the total equity capital of the firm
Dividend Impact on Shareholders
Dividend: Income Tax
Sale at higher value: Capital Gains Tax
Option to invest elsewhere
Immunity from future fall in price
Should Dividend Be Paid Out?
Transaction cost and Tax
Negative Signals on growth opportunities
Informational signals for Psychology
Dividend change is a signal about future earnings
Need for Income v/s Capgains (LIG)
Firm value will not be affected by dividend payments
Investors are concerned only with total returns—they are indifferent whether these returns come from capital gains or dividend income
“ The value of the corporation paying dividends equals that of the corporation paying no dividends.”
ABC Ltd. has decided to invest Rs.1 Cr. in a new project with a NPV of Rs. 2 Cr., but it has not made an announcement. The company has Rs.1 Cr. in cash to finance the new project. ABC has 1 Cr. shares of stock outstanding, selling for Rs. 24 each, and no debt. Hence, its aggregate value is Rs.24 Cr.
ABC management has two alternatives:
1. Pay no dividend and finance the project with the available cash.
The value of each share rises to Rs.26 following the announcement..
Each shareholder can sell 0.0385 (= 1/26) shares to obtain a Rs.1 dividend, leaving him with .9615 shares value at Rs.25 (26 x 0.9615).
Hence the shareholder has one share worth Rs.26, or shares worth Rs.25 (0.9615) plus Rs.1 in cash.
2. Pay a dividend of Rs.1 per share and sell Rs.1 Cr. worth of new shares to finance the project.
After the company announces the project and pays the Rs.1 dividend, each share will be worth Rs.25.
To raise the Rs.1 Cr. needed for the project, the company must sell 4,00,000 (=1,00,00,000/25) shares.
Immediately following the share issue, ABC will have 10,400,000 shares trading for Rs.25 each, giving the company an aggregate value of 25 x 10,400,000 = Rs.26 Cr.
If a shareholder does not want the Rs.1 dividend, he can buy 0.04 shares (1/25).
Hence, the shareholder has one share worth Rs.25 and Rs.1 in dividends, or 1.04 shares worth Rs.26 in total.
Either way, value of firm and wealth of shareholders does not change.
Dividend Irrelevance Assumptions
Investors can buy and sell stocks without incurring any transaction costs
Companies can issue stock without any cost
No corporate or personal taxes
Complete information is readily available
Any cash remaining in the firm is invested in projects that have zero net present value. (such as financial investments) rather than used to take on poor projects (i.e. there are no agency costs of outside equity).
If the actual rate of return (accounting rate of return) on equity is greater than the required rate of return, then the excess funds should be invested in new projects. If necessary, the dividend payout ratio should also be decreased to release funds for new projects.
If the actual rate of return is low relative to the required rate of return, then dividends should be increased.