Dividend Decision 03


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Dividend Decision 03

  1. 1. The Dividend Decision
  2. 2. The 4 Major Finance Decisions <ul><li>Goal: Maximize the Value of the Firm </li></ul><ul><li>The Investment Decision </li></ul><ul><ul><li>Choose amongst potential investments (projects). </li></ul></ul><ul><li>The Financing Decision </li></ul><ul><ul><li>Where to raise funds for value-creating investments? </li></ul></ul><ul><ul><li>What should be the proportion of equity and debt? </li></ul></ul><ul><li>The Working Capital Decision </li></ul><ul><ul><li>To have just enough funds available for operations as required </li></ul></ul><ul><li>The Dividend Decision </li></ul><ul><ul><li>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? </li></ul></ul>
  3. 3. 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
  4. 4. Cash Flow Decisions <ul><li>Raise Cash by selling Securities to Investors </li></ul><ul><li>Invest Cash in Assets and firm’s operations </li></ul><ul><li>Generate Cash by firms operations </li></ul><ul><li>Return Part of Cash to the Investors </li></ul><ul><li>Reinvest Cash in the firm’s operations </li></ul>
  5. 5. Dividend Process <ul><li>The board of directors declares a payment </li></ul><ul><li>Declared dividends are distributable to shareholders on record on this date. </li></ul><ul><li>The dividend checks are mailed to shareholders of record. </li></ul><ul><li>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. </li></ul>
  6. 6. Dividend by corporate actions <ul><li>Bonus Shares </li></ul><ul><ul><li>fresh shares are given against existing shares for no extra charge </li></ul></ul><ul><li>Split Shares </li></ul><ul><ul><li>Shares are split in more number of shares </li></ul></ul><ul><li>Right shares at discount </li></ul><ul><ul><li>Additional shares are offered to existing share holders at a discount on the market price </li></ul></ul><ul><li>Buyback of Shares </li></ul><ul><ul><li>Reduces the total equity capital of the firm </li></ul></ul>
  7. 7. Dividend Impact on Shareholders <ul><li>Personal Tax </li></ul><ul><ul><li>Dividend: Income Tax </li></ul></ul><ul><ul><li>Sale at higher value: Capital Gains Tax </li></ul></ul><ul><li>Option to invest elsewhere </li></ul><ul><li>Immunity from future fall in price </li></ul>
  8. 8. Should Dividend Be Paid Out? <ul><li>Leftists: No </li></ul><ul><ul><li>Transaction cost and Tax </li></ul></ul><ul><ul><li>Investment Needs </li></ul></ul><ul><ul><li>Negative Signals on growth opportunities </li></ul></ul><ul><li>Rightists: Yes </li></ul><ul><ul><li>Informational signals for Psychology </li></ul></ul><ul><ul><ul><li>Dividend change is a signal about future earnings </li></ul></ul></ul><ul><ul><li>Clientele Effect </li></ul></ul><ul><ul><ul><li>Need for Income v/s Capgains (LIG) </li></ul></ul></ul>
  9. 9. Dividend Irrelevance <ul><li>Firm value will not be affected by dividend payments </li></ul><ul><li>Investors are concerned only with total returns—they are indifferent whether these returns come from capital gains or dividend income </li></ul><ul><li>M&M (Miller&Modigliani) </li></ul><ul><ul><li>“ The value of the corporation paying dividends equals that of the corporation paying no dividends.” </li></ul></ul>
  10. 10. Dividend Irrelevance <ul><li>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. </li></ul><ul><li>ABC management has two alternatives: </li></ul><ul><li>1. Pay no dividend and finance the project with the available cash. </li></ul><ul><li>The value of each share rises to Rs.26 following the announcement.. </li></ul><ul><li>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). </li></ul><ul><li>Hence the shareholder has one share worth Rs.26, or shares worth Rs.25 (0.9615) plus Rs.1 in cash. </li></ul><ul><li>2. Pay a dividend of Rs.1 per share and sell Rs.1 Cr. worth of new shares to finance the project. </li></ul><ul><li>After the company announces the project and pays the Rs.1 dividend, each share will be worth Rs.25. </li></ul><ul><li>To raise the Rs.1 Cr. needed for the project, the company must sell 4,00,000 (=1,00,00,000/25) shares. </li></ul><ul><li>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. </li></ul><ul><li>If a shareholder does not want the Rs.1 dividend, he can buy 0.04 shares (1/25). </li></ul><ul><li>Hence, the shareholder has one share worth Rs.25 and Rs.1 in dividends, or 1.04 shares worth Rs.26 in total. </li></ul><ul><li>Either way, value of firm and wealth of shareholders does not change. </li></ul>
  11. 11. Dividend Irrelevance Assumptions <ul><li>Investors can buy and sell stocks without incurring any transaction costs </li></ul><ul><li>Companies can issue stock without any cost </li></ul><ul><li>No corporate or personal taxes </li></ul><ul><li>Complete information is readily available </li></ul><ul><li>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). </li></ul>
  12. 12. Dividend Recommendations <ul><li>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. </li></ul><ul><li>If the actual rate of return is low relative to the required rate of return, then dividends should be increased. </li></ul>
  13. 13. Interactive Session