BRIEF ABOUT DERIVATIVES

1. DIVIDEND POLICY
THEORY AND PRACTICE

2. INTRODUCTION
 The financial manager must take careful
decisions on how the profits should be
distributed among shareholders.
 It is very crucial part of business concern, bze
these decisions are directly related with the
value of business concern and shareholders
wealth.

3. MEANING OF DIVIDEND
 Dividend refers to the business concerns net
profits distributed among the shareholders. It
may also be termed as the part of the profit of a
business concern, which is distributed among its
shareholders.
 According to‘insti.of charted Acct.of india’
dividend as a distribution to shareholders out of
profits or reserves available for this purpose.

4. DIVIDEND DECISIONS
 Dividends refer to that portion of a firm’s net
earnings which are paid out to the shareholders
 Since dividends are distributed out of the profits,
alternative to the payment of dividends is the
retention of the earnings/profits
 The retained earnings constitute an easily
accessible important source of financing the
investment requirement of the firm.

5. DIVIDEND DECISIONS
 There is, thus a type of inverse relationship
between retained earnings and cash dividends
i.e. larger retentions, lesser dividends and vice
versa
 Dividends decision is a major corporate
decision in the sense that the firm has to chose
between distributing the profits to the
shareholders and ploughing them back into the
business and the choice depends on the effect of
the decision on the firm’s value.

6. DIVIDEND DECISIONS
 Profitable companies regularly face 3 questions:
1. How much of its free cash flow should it pass
on to shareholders?
2. Should dividends be paid as cash dividend or by
repurchasing stock?
3. Should it maintain a stable, consistent payment
policy or should it let the payment vary as
conditions change

7. TYPES /FORMS OF DIVIDEND
DIVIDEND
CASH
DIVIDEND
BOND
DIVIDEND
STOCK
DIVIDEND
PROPERTY
DIVIDEND

8. CASH DIVIDEND
 A cash dividend is money paid to stock holder,
normally out of the corporation’s current earnings or
accumulated profits. Not all companies pay a
dividend usually, the board of determines if a
dividends is desirable their particular company
based upon various financial and economic factors.
Dividend are commonly paid in the form of cash
distributions to the shareholders on a monthly,
quarterly or yearly basis. It is taxable income to the
recipient

9. BOND DIVIDEND
 Bond dividend is know as scrip
dividend if the company does not have sufficient
funds to pay cash dividend ,the company
promises to pay the shareholder at a future
specific date with the help of issue of bond or
notes.

10. STOCK DIVIDEND(Bonus Shares)
 It is paid in the form of the company stock due
to raising of more finance. Under this type ,
cash is retained by the business concern. Stock
dividend may be bonus issue. This issue is
given only to the existing shareholders of the
business concerns.

11. BONUS SHARES
 Bonus shares represents a distribution of
shares in lieu of or in addition to the cash
dividend to the existing shareholders, if the
articles so permit. The shares are issued to the
existing ordinary shareholders in proportion to
their present holdings.

12. PROPERTY DIVIDEND
 Property dividend are paid in the form of
some assets other than cash. It will distribute
under the exceptional circumstance. This
type of dividend is not published in India

14. PAY-OUT RATIO
 It refers to the percentage of net income to be paid out as cash
dividend.
 It should be based in large part on investors preferences for
dividends vs capital gains i.e. do investors prefer
a. To have the firm distribute income as cash dividends
b. If the company increases the pay-out ratio this raises D1 which
would cause the stock price to rise

15. PAY-OUT RATIO
 To have it either repurchase stock or else plough the earnings back
into the business, both of which should result in capital gains
 Recall the constant growth stock valuation model
 Po= D1/Ks – g
 firm’s stock price

16. PAY-OUT RATIO
 If D1 is raised, then less funds will be available for growth
therefore g will decline, thus the stock price also declines
 Therefore dividends policy have two opposing effects.
 Optimal dividend policy is that policy which strikes a balance
between current dividends and future growth and maximizes the

17. DIVIDEND THEORIES

18. DIVIDEND IRRELEVANCE THEORY
 This is the theory that a firm’s policy has no
effect in either its value or its cost of capital
 MM argued that a firm’s value is determined
only by its basic earnings power and its business
risk
 They argued that the value of the firm depends
only on its income produced by its assets not on
how this income is split between dividends and
retained earnings

19. DIVIDEND IRRELEVANCE THEORY
 MM noted that any shareholder can in theory construct his/her
own dividend policy.
 If a firm does not pay dividends a shareholder who wants a 5%
dividend can create it by selling 5% of his/her stock or
 If a company pays a higher dividend than an investor desires ,
the investor can use the unwanted dividends to buy additional
shares of the company’s stock.

20. DIVIDEND IRRELEVANCE THEORY
 Therefore investors could buy and sell shares, they can create
their own dividend policy without incurring cost, the firm’s policy
would there fore be irrelevant
 Note: investors who want additional dividends must incur
brokerage costs to sell shares and investors who do not want
dividends must first pay taxes on unwanted dividends and incur
brokerage costs to purchase shares with after-tax dividends. Since
taxes and brokerage costs certainly exist, dividend policy may
well be relevant

21. BIRD-IN-HAND THEORY
 Gordon & Lintner argued that cost
of equity (Ks) decreases as the
dividend pay-out is increased
because investors are less certain of
receiving the capital gains that are
supposed to result from retaining
earnings than they are receiving
from dividend payments

22. BIRD-IN-HAND THEORY
 They argued that investors value a
dollar or shilling of expected
dividends more highly than
dollar/shilling of expected capital
gains because the dividend yield
component ,D1/P0 is less risky than
the g component in the total
expected return equation.
 Ks= D1/Po + g

23. BIRD-IN-HAND THEORY
 It is based on the logic that what is
available at present is preferable to what
may be available in the future.
 Basing his model on this argument,
Gordon and Linter argue that the future is
uncertain and the more distant the future
is, the more uncertain it is likely to be.
 Therefore, investors would be inclined to
pay a higher price for shares on which
current dividends are paid

24. TAX PREFERENCE THEORY
 There are two tax related reasons for thinking
that investors might prefer a low dividend pay-out
to high pay-out:
 Long-term capital gains are generally taxed at
lower rate, whereas dividend income is taxed at
effective rates (marginal rates), therefore wealthy
investors (who own most of the stock and receive
most of the dividends) might prefer to have
companies retain and plough back earnings into
the business
 Taxes are not paid on the gain until a stock is
sold. Due to time value effects the amount of
taxes paid in the future has a lower effective cost
than the amount paid today

25. TAX PREFERENCE THEORY
 Because of these tax advantages,
investors may prefer to have
companies retain most of their
earnings.
 Therefore investors would be willing
to pay more for low pay-out
companies than for otherwise
similar high pay-out companies

26. INFROMATION
CONTENT/SIGNALING THEORY
 The theory states that investors regard
dividend changes as signals of
management’s earnings forecasts
 It has been observed that an increase in
dividends is often accompanied by an
increase in the price of the stock, while a
reduction in dividends generally leads to a
stock price decline
 It means therefore that investors prefer
dividends to capital gains

27. INFROMATION
CONTENT/SIGNALING THEORY
 MM argued that companies are reluctant
to reduce dividends and hence do not
raise unless they anticipate higher
earnings in the future.
 Thus MM argued that a higher than
expected dividend increase is a signal to
investors that the firm’s management
forecasts good future earnings

28. INFROMATION
CONTENT/SIGNALING THEORY
 Conversely, a dividend reduction or a smaller
than expected increase is a signal that the firm’s
management is forecasting poor earnings in the
future.
 According to MM, therefore investors reactions to
changes in dividend policy do not necessary mean
that investors prefer dividend to retained
earnings.
 Rather, they argued the price changes following
dividends actions simply indicate that there is an
important information or signaling content in
dividend announcements

29. CLIENTELE EFFECT
 This the tendency of a firm to attract a
set of investors who like its dividend
policy
 Different groups or clienteles of stock
holders prefer dividend payout policies
e.g.
 Retires, the poor and the old etc generally
prefer cash income, so they may want the
firm to payout a high percentage of
earnings.

30. CLIENTELE EFFECT
 On the other hand, investors in their peak
earnings years might prefer re-
investment, because they have less need
for current investment income and would
simply reinvest dividends received after
paying income taxes on these dividends
 Investors who want current investment
income should own shares in high
dividend payout firms and vice versa

31. DIVIDEND POLICIES
 STABLE DIVIDEND POLICY
 This is where the dividend growth
rate is predictable
 The shareholders can also be
certain that the current dividend will
not be reduced.
 It may not grow at a stable rate but
management will probably be able
to avoid reducing the dividend

32. DIVIDEND POLICIES
 RESIDUAL DIVIDEND MODEL
 Dividend paid is equal to net income minus the
amount of retained earnings necessary to finance
the firm’s optimal capital budget
1. The determines the optimal budget
2. Determines the amount of equity needed to
finance that budget given its target capital
structure
3. It uses retained earnings to meet equity
requirements to the extent possible
4. It pays dividends only if more earnings are
available than are needed

33. STOCK SPLIT
 This is an action taken by a firm to
increase the number of shares
outstanding e.g. doubling the
number of shares outstanding by
giving each stock holder two new
shares for each one formally held

34. STOCK DIVIDENDS
 This dividend paid in the form of additional
shares of stock rather than cash
 Effects:
1. The price of a stock rises shortly after a company
announces a stock split or stock dividend
2. The price increases are as a result of investors
taking split/dividends as signals of higher future
earnings
3. However if during the next few months it does
not announce an increase in earnings and
dividends , then stock price will go back to the
earlier level

35. FACTORS AFFECTING DIVIDEND
POLICY
 They may be grouped into four
broad categories:
1. Constraints on dividends
2. Investment opportunities
3. Availability and cost of alternative
sources of capital
4. Effects of dividend policy on cost of
capital

36. 1. CONTRANTS
 BOND HOLDERS. Debt contracts often
limit dividend payments to earnings after
loan was granted
 PREFERRED STOCK RESTRICTIONS.
Common dividends cannot be paid if
company has not omitted its preferred
dividend
 IMPAIREMENT OF CAPITAL RULE.
Dividends payments cannot exceed the
balance sheet item retained earnings. It is
designed to protect creditors

37. 2. INVESTMENT OPPORTUNITIES
1. Number of profitable investment
opportunities available
2. Possibility of accelerating or
delaying projects will permit a
firms to adhere more closely to
stable dividend policy

38. 3. ALTERNATIVE SOURCES OF
CAPITAL
1. Cost of selling new stock. If the floatation are
high it is better to have a low payout ratio and
finance through retained earnings
2. Ability to substitute debt for equity. If a firm can
finance a given level of investment with either
debt or equity. Low flotation cost will permit a
more flexible dividend policy because equity can
either be raised by retained earnings or by selling
new stock
3. Control. If the management is concerned about
maintaining control, it may be reluctant to sell
new stock .

39. 4. EFFECTS OF DIVIDEND POLICY
ON COST OF CAPITAL
 It may be considered in terms of four factors
1. Shareholders desire for current versus future
income
2. Perceived riskiness of dividends versus capital
gains
3. The tax advantage of capital gains over
dividends
4. The information content of dividends
 The important of each factor in terms of its effect
on cost of capital varies from firm to firm
depending on the make-up of its current and
possible future stockholders

40.  THE END