Corporate Finance: Dividend Policy
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Questions and Answers

What is a key guideline firms should follow regarding dividends?

  • Avoid paying dividends if it means rejecting positive NPV projects. (correct)
  • Maintain a fixed dividend payout regardless of investment needs.
  • Always pay dividends even if profits are low.
  • Prioritize paying dividends over investing in new projects.

What is the main focus of managers regarding dividends according to Lintner's findings?

  • The absolute level of dividends paid.
  • Maximizing the total dividends distributed each year.
  • Changes in the dividend amount over time. (correct)
  • Maintaining a consistent dividend payout ratio.

Which of the following is not a consideration a company should have when making dividend decisions?

  • The expectations of common stock owners.
  • The company’s cash flow and cash position.
  • The company's future earnings potential.
  • The volatility of the stock market. (correct)

What type of dividend policy should a firm pursue according to the guidelines?

<p>A smoothed residual dividend policy. (C)</p> Signup and view all the answers

In the context of dividend policy, what does NPV stand for?

<p>Net Present Value. (B)</p> Signup and view all the answers

What is a major implication of accepting temporary departures from the target dividend payout ratio?

<p>It may help maintain investor confidence. (D)</p> Signup and view all the answers

Which statement about the relationship between dividends and earnings is true?

<p>Dividends follow a smoother path than earnings over time. (C)</p> Signup and view all the answers

What should a company define along with a target dividend payout ratio?

<p>A target debt-equity ratio. (A)</p> Signup and view all the answers

What is a plausible reason firms pay dividends?

<p>Investor preference for dividends (A)</p> Signup and view all the answers

Which factor is NOT typically considered when determining the dividend payout ratio?

<p>Market volatility (C)</p> Signup and view all the answers

What does a stable dividend payout ratio indicate?

<p>Consistent and predictable dividend payments (A)</p> Signup and view all the answers

Which of the following is a dubious reason for paying dividends?

<p>Bird-in-hand fallacy (C)</p> Signup and view all the answers

What is one key consideration in formulating a dividend policy?

<p>Debt financing limits and challenges (D)</p> Signup and view all the answers

Why might firms avoid issuing external equity?

<p>High issue costs and underpricing (A)</p> Signup and view all the answers

How does access to external sources of financing influence dividend decisions?

<p>It reduces the need for retained earnings (C)</p> Signup and view all the answers

Which of the following best describes the concept of dividend as a residual payment?

<p>Dividends come from leftover earnings after investment needs are met (A)</p> Signup and view all the answers

What does Lintner's model suggest about the behavior of dividends?

<p>Dividends are a function of current earnings and past dividends. (A)</p> Signup and view all the answers

According to Lintner’s model, what does the variable Dt represent?

<p>Dividend per share for year t (B)</p> Signup and view all the answers

If Kinematics Ltd. has an adjustment rate of 0.5 and a target payout ratio of 0.6, what is the weight of the current earnings in determining the dividend per share?

<p>0.5 (A)</p> Signup and view all the answers

Which of the following statements is true regarding the legal aspects of dividend payments?

<p>Dividends can only be paid out of profits after depreciation. (D)</p> Signup and view all the answers

What is one important procedural aspect before paying dividends?

<p>Approval from the board of directors (A)</p> Signup and view all the answers

In the event of a bonus share issue, which of the following remains unchanged?

<p>Shareholders' proportional ownership (B)</p> Signup and view all the answers

Which variable in Lintner's model refers to the earnings per share for the year?

<p>EPSt (A)</p> Signup and view all the answers

How often can dividends be declared according to company law provisions?

<p>At any time, based on available cash (A)</p> Signup and view all the answers

What happens to the book value per share during a stock split?

<p>It decreases. (D)</p> Signup and view all the answers

Which of the following statements is true regarding a bonus issue?

<p>It capitalizes a part of reserves. (B)</p> Signup and view all the answers

What is one primary rationale for implementing share buybacks?

<p>To achieve price stability. (A)</p> Signup and view all the answers

What is a common objection to share buybacks?

<p>They can be viewed as a manipulation tactic. (D)</p> Signup and view all the answers

Which of the following is a potential benefit of a stock split?

<p>Bringing market price per share within a more popular trading range. (A)</p> Signup and view all the answers

How do share buybacks primarily affect the company’s capital structure?

<p>They may rationalize the capital structure. (A)</p> Signup and view all the answers

Which of the following is NOT a reason for equity repurchases as suggested by the survey findings?

<p>To artificially inflate the stock price. (C)</p> Signup and view all the answers

In contrast to a bonus issue, what is a defining characteristic of a stock split?

<p>The par value of shares is reduced. (A)</p> Signup and view all the answers

What is the maximum percentage of shares a company can buy back annually with just a board resolution?

<p>10% (A)</p> Signup and view all the answers

What is the maximum post-buyback debt-equity ratio a company must maintain?

<p>2:1 (A)</p> Signup and view all the answers

Which of the following is NOT a common type of dividend policy?

<p>Dynamic dividend policy (B)</p> Signup and view all the answers

Under what condition can a company issue equity securities after completing a buyback programme?

<p>After a mandatory waiting period of 6 months (D)</p> Signup and view all the answers

What is the primary focus of firms when determining their target payout ratio for dividends?

<p>Proportion of earnings to reinvest (C)</p> Signup and view all the answers

Which step occurs last in the dividend payment procedure?

<p>Dividend payment (D)</p> Signup and view all the answers

What is the purpose of bonus shares?

<p>To reward shareholders without cash payments (D)</p> Signup and view all the answers

What happens during a stock split?

<p>The number of shares is increased proportionately while reducing the par value (A)</p> Signup and view all the answers

Flashcards

Dividend Decision

The process companies use to decide how much of their profits to distribute to shareholders as dividends.

Dividend Policy

The strategies a company uses to determine how much to pay out as dividends.

Payout Ratio

The proportion of earnings paid out as dividends.

Stable Dividends

A dividend policy that aims to maintain a steady payment level.

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Dividend as Residual

Dividends paid only after meeting all necessary investments and financial obligations.

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Investor Preference

The idea that investors prefer dividends, as it shows the company's performance.

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Information Signaling

Dividends can signal company health and future prospects.

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Bird-in-Hand Fallacy

The mistaken idea that having dividends is better than reinvesting profits.

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Dividend Policy Factors

Factors impacting dividend payouts include funds needed, liquidity, financing options, investor preferences, and costs.

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External Equity vs. Retained Earnings

External equity raising costs more due to factors like issue costs and underpricing. Retained earnings come with cheaper costs.

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Dividend Sticky Nature

Managers resist dividend changes, fearing future reversal needs.

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Lintner's Dividend Model

Describes how companies set dividends, considering current earnings and past dividends.

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Lintner's Model Equation

Dt = cr EPSt + (1-c) Dt-1, where Dt is dividend, c is adjustment rate, r is target payout rate, EPS is earnings, and Dt-1 is previous dividend.

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Target Payout Ratio

The desired percentage of earnings to pay out as dividends.

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Adjustment Rate

The rate at which a company adjusts its dividend to reach its target payout ratio.

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Cash Dividends

Dividends paid in cash to shareholders.

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Bonus Shares

Issuance of extra shares to shareholders, not a cash payment.

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Dividend Declaration Restrictions

Dividends can only be paid from current or prior year profits, after depreciation.

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Stock Split

A corporate action in which a company increases the number of its outstanding shares by a predetermined ratio while proportionally decreasing the par value of each share.

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Bonus Issue vs. Stock Split

A bonus issue involves capitalizing reserves by increasing the share capital without reducing the par value, whereas a stock split reduces the par value proportionately to increase the number of shares outstanding.

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Stock Buyback

A corporate action where a company purchases its own shares from the open market.

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Open Market Purchase

A method for share buybacks where the company buys shares from the secondary market over a specified period, with a maximum price set by the board.

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Rationale for Buybacks

Reasons for companies to repurchase shares, including efficient resource allocation, price stability, tax advantages, and greater control.

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Objections to Buybacks

Potential drawbacks of share buybacks, including concerns about unfair advantages and manipulation.

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US Equity Repurchases Reasons

Common reasons for US companies choosing to buy back shares include: boosting stock price, rationalizing capital structure, substituting cash dividends, avoiding dilution from stock grants.

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Dividend Decision

The management's communication of a firm's prospects through dividend payments.

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Positive NPV Projects

Projects with a projected return higher than their cost.

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Dividend Policy Guidelines

Rules for dividend payment that prioritize positive NPV projects and stable dividend payouts.

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Smoothed Residual Dividend Policy

A dividend policy that seeks to maintain stable and relatively consistent dividend payments over time.

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Pure Residual Dividend Policy

A dividend policy where dividends are paid only when earnings exceed investment needs.

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Fixed Dividend Payout Ratio

A dividend policy where a fixed percentage of earnings is paid out as dividends.

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Target Dividend Payout Ratio

A desired dividend payout percentage.

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Target Debt-Equity Ratio

Desired balance between debt and equity financing.

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Dividend Stream

The sequence of dividend payments over a period of time.

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Earnings

Profits made by a company.

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Investment Budget

Planned amount for capital investments.

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Equity Investment

Money spent to buy more shares in the company.

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Lintner's Survey

A study of how companies actually behave in their dividend payments.

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Long-run Target Payout Ratios

Companies have target dividend percentages they attempt to follow.

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Dividend Consistency

Following a regular pattern of payouts.

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Cash Flow

The movement of cash into and out of a company.

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Company Earnings Record

The historical trend in a company's profitability.

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Buyback Limit

A company can buyback up to 10% of its shares annually with a board resolution. Beyond that, shareholder approval is needed.

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Debt-Equity Ratio Limit

The post-buyback debt-equity ratio should not exceed 2:1.

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Capital & Reserves Limit

Buyback should not exceed 25 percent of the total paid-up capital and free reserves.

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Post-Buyback Equity Issue

A company cannot issue new equity securities within 6 months of completing a buyback program(with exceptions).

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Buyback Method

Buybacks must be handled by merchant bankers appointed by the company, not through direct negotiated deals.

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Dividend Policy Types

Dividend policies include generous, mostly fixed, and erratic policies.

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Dividend Policy Dimensions

Dividend policy considerations include the average payout ratio and the stability of dividends over time.

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Smoothed Residual Dividend

A stable, steadily growing dividend approach where dividends are paid only after meeting all necessary investments and financial obligations.

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Lintner's Study Dividend Behaviour

Firms prioritize the proportion of earnings to be reinvested and gradually achieve their target payout ratio.

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Dividend Payment Procedure

The dividend payment process includes board resolutions, shareholder approvals, record dates, and actual dividend payouts.

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Bonus Shares

Bonus shares are shares issued to existing shareholders based on capitalized reserves.

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Stock Split

In a stock split, the par value per share decreases, and the number of shares increases proportionally.

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Share Buyback

A share buyback is when a company purchases its own shares from the stock market.

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Study Notes

Dividend Decision

  • Firms pay dividends for various reasons, both plausible and dubious. Plausible reasons include investor preference for dividends and information signaling. Dubious reasons include the "bird-in-hand" fallacy and temporary excess cash.

Dividend Policy: Payout Ratio

  • Factors to consider when determining the dividend payout ratio include: funds requirement, liquidity, access to external financing, shareholder preferences, and the difference in cost of external equity and retained earnings, control and taxes.

Dividend Policy: Stability

  • Stable dividend payout ratio: Dividends consistently follow earnings, in rough proportion. Earnings fluctuations can lead to dividend fluctuations in a stable payout.

Dividend Policy: Steadily Changing Dividends

  • Dividends can smoothly change with earnings, though not necessarily in directly proportional amounts.

Key Considerations in Formulating Dividend Policy

  • Investment decisions largely impact value creation.
  • External equity is typically more expensive than internal equity because of issue costs and underpricing.
  • Promoters often avoid diluting their equity stake by issuing external equity.
  • Debt financing is limited; firms can't use it indefinitely.
  • Dividend decisions act as a form of communication about the company's prospects.

Guidelines for Dividend Policy

  • Dividends shouldn't be prioritized over positive Net Present Value (NPV) projects.
  • Minimize the need for external equity.
  • Target dividend payout ratio needs to be established, along with a target debt-to-equity ratio. This should consider investment needs, managerial preferences, capital market norms, and tax codes.
  • Accepting temporary deviations from the target dividend and debt-to-equity ratios is permissible.
  • Dividend cuts should be avoided.
  • Firms frequently employ a smoothed residual dividend policy rather than a pure residual or fixed dividend policy.

Dividend Stream Under Different Policies

  • Various tables present scenarios of how dividends are generated and allocated under different dividend policies (e.g., pure residual, fixed dividend, etc.) within specific examples for illustrative purposes.

Conference Board Survey

  • A survey of dividend policies reveals that companies primarily focus on their earnings record, future prospects, continuity of dividend payments, cash flow, current cash position, and anticipated funds needs, and the expectations of common shareholders.

Corporate Dividend Behaviour

  • Firms tend to set long-term target payout ratios.
  • Managers focus more on changes in dividends than their absolute levels.
  • Dividends closely follow earnings, but dividends tend to follow earnings with smoother fluctuations.
  • Dividends are often sticky because managers are reluctant to reverse dividend changes.

Lintner's Model

  • Lintner's model mathematically describes corporate dividend behavior, using an adjustment rate (c) and target payout rate (r), and relating them to earnings per share (EPS) and last year's dividend.

Example of Lintner's Model

  • Illustrative example of calculating a dividend per share for a fictitious firm based on Lintner's model, given specific target payout ratio and adjustment rate.
  • Dividend payment is governed by, and limited by, company law.
  • Cash dividends are most common (bonus shares are an exception).
  • Dividends are paid out of current or previous profits as determined by law and/or company accounting practice.
  • Reserves need to be maintained and profit transferred, which can affect dividend calculations.

Procedural Aspects

  • Important events and dates in dividend payments include board resolution, shareholder approval, record date, and dividend payment itself.

Bonus Shares

  • Bonus issues capitalize on retained earnings (i.e., free reserves, built up out of the genuine profits or share premiums).
  • Proportional ownership (of existing shareholders) remains unaltered.
  • Book value, earnings per share, and market price per share generally decrease.
  • Number of shares increases in proportion to the bonus issue.

Stock Splits

  • Stock splits lower the par value per share while proportionally increasing the number of shares outstanding.
  • A split does not alter shareholders' proportional ownership and doesn't impact the firm's overall capital structure in terms of free reserves.
  • Book value, earnings per share, and market price per share generally decrease.
  • Market price per share is frequently adjusted to a more manageable range for trading.

Share Buybacks

  • Share buybacks (also known as stock repurchases) are allowed in India since 1998.
  • Open-market buyback purchases shares from the secondary market, typically over a year.
  • A maximum price is set for the buyback, determined by the company’s board or by shareholder vote.

Rationale for Buybacks

  • Efficient allocation of resources
  • Price stabilization
  • Tax advantages
  • Control
  • Voluntary Character
  • No implied commitment

Objections to Buybacks

  • Unfair advantage
  • Manipulation

Survey Findings

  • Surveys of US corporate buybacks highlight that managers repurchase shares to boost share prices, rationalize capital structure, compensate for cash dividends, avoid dilution from stock grants, and to return excess cash to shareholders

Regulation of Buybacks

  • Companies can buy back up to 10% of their shares annually, with greater amounts requiring shareholder approval.
  • Post-buyback debt-equity ratio is limited to under 2:1.
  • Buybacks shouldn't exceed 25 percent of paid-up capital plus reserves.
  • After a buyback, companies may be barred from issuing new equity for a specified time.
  • Buybacks cannot use negotiated private deals; they need to go through open market transactions.
  • Buyback processes must be handled by a merchant banker.

Dividend Policies in Practice

  • Categories of observed dividend policies include generous dividend & bonus policies, more-or-less fixed dividend policies, and erratic dividend policies.

Summing Up

  • Several reasons for dividends, including plausible ones (investor preference) and dubious ones (temporary cash).
  • Key aspects: average payout ratio, and stability of dividends over time.
  • Smoothed residual dividends are common.
  • Lintner's studies show that companies often aim for a fixed target payout ratio.

Additional Information

  • The amount of dividend that can be distributed is legally constrained.
  • Important dividend-related events such as board resolution and shareholder approval occur before dividend distribution.
  • Bonus shares are issued from capitalizing existing reserves, whereas Stock splits change share parameters.
  • Share buybacks involve companies repurchasing their own shares from the market.

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