Topic 6 Dividend Policy PDF

TOPIC 6 DIVIDEND POLICY Here starts the lesson!  Learning Objectives Here’s what you’ll learn in this topic: 1. Explain the relationship between firm’s dividend policy and common stock value. 2. Calculate the dividend policy using the appropriate...

TOPIC 6 DIVIDEND POLICY Here starts the lesson!  Learning Objectives Here’s what you’ll learn in this topic: 1. Explain the relationship between firm’s dividend policy and common stock value. 2. Calculate the dividend policy using the appropriate formula. 3. Distinguish between cash dividend, stock dividend, stock dividend and stock split 4. Understand the effects of dividend policy towards investors INTRODUCTI ON  Introducti on Dividend is the portion of corporate earnings paid out to stockholders. What is dividend? Dividends are usually declared periodically (quarterly, semiannually, or annually) by the directors of a corporation.  Introducti on Dividend policy refers to the pay-out policy that management follows in determining the size and pattern of distribution to What is dividend shareholder over time. policy? The key to dividend policy is centered upon the percentage of earnings that a firm should pay out.  The Relationship Between Firm’s Dividend Policy And Common  When deciding how much cash Stock to distributeValue to stockholders, financial managers must keep in mind that the firm’s objective is to maximize shareholder value.  If the firm increases the payout ratio, Dividend per Share (DPS) will increase, resulting in a higher stock price other things being equal.  However, if the firm increases DPS, there will be less money available for reinvestment causing “g” to decline. If “g” falls, this will lower the stock price. Recall BF1  The Relationship Between Firm’s Dividend Policy And Common Stock Value. Therefore, when setting the optimal dividend policy, the financial manager should strike a balance between current dividends and future growth to maximize the firm’s stock price. There are various theories that try to explain the relationship of a firm's dividend policy and common stock value.  The Relationship Between Firm’s Dividend Policy And Common Dividend Irrelevance Theory Stock Value. (or Dividend Incomplete Theory)  This theory significances that a firm's dividend policy has no effect on either its value or its cost of capital. Investors value dividends and capital gains equally.  If dividends are too high, investors may use some of the funds to buy more of the firm’s stock.  If dividends are too low, investors may sell off some of the stock to generate additional funds.  The Relationship Between Firm’s Dividend Policy And Common Dividend Relevance Theory Stock Value. (or Dividend Complete Theory)  The value of a firm is affected by its dividend policy. The optimal dividend policy is the one that maximizes the firm's value.  Retained earnings reinvested in the business theoretically belong to common stockholders, but there is uncertainty about their eventual translation into dividends  Stockholders might apply higher discount rate (Ke) and assign lower valuation  Dividends are viewed as “We are having a good year, and we wish to share the benefits with you!”  The Relationship Between Firm’s Dividend Policy And Common Optimal Dividend Policy Stock Value.  Proponents believe that there is a dividend policy that strikes a balance between current dividends and future growth that maximizes the firm's stock price.  The optimal dividend policy should maximize the price of the firm’s stock while holding the number of shares outstanding constant.  A decision to increase dividends will raise D1 putting upward pressure on P0. Increasing dividends, however, means reinvesting fewer dollars, lowering g, and putting downward pressure on P0.  The Residual Dividend Residual dividend policy Policy is a method of distribution where dividends are paid after all the requirements for capital expenditure are met. Thus, dividends are computed from the residual cash after spending on new capital assets. The aim of this dividend policy is to decide if there is enough money (for dividend) left after all optimum level of capital expenditures are met to declare as dividend. This theory suggests that no cash dividend is paid if the firm’s equity need is in excess of the amount of retained earnings. Dividend Income vs. Capital Gain  Capital = Initial sum  Dividends refer to assets invested or purchasing paid out of the profits of a price corporation to the  Capital gain = Difference stockholders between selling price  A dividend is a ‘reward’ or (higher) and initial sum ‘bonus’ that is given to invested (lower) shareholders who have  You will only realized invested in the company’s capital gains when the equity investment is sold  Dividends received are not  Short-term capital gain is ‘capital gain’, but treated taxed as ordinary income as income for that tax year for the year  Cash dividend is taxed as  Long-term capital gain is ordinary income for the taxed on net capital gains year  For ial tutor e Relevant exerc s is Formulas Earnings per share P/E Ratio = = Net Income Dividend ÷ No of Payout Share Price ÷ shares ratio Retention EPS = Dividend or Ratio = DPS ÷ Retain Net Income or Earning ÷ EPS Net Income Dividend Per Dividend Yield = share = Dividend Annual dividend ÷ No of shares per share ÷ Current share price  Lecture Exercise 1 Question: FineDining Co. has just declared a cash dividend of $1.50 per share. Some financial data extracted from the company’s financial statements: Gross Profit = $200,000, Finance Cost = $5,000, Tax Expense = $7,000, Common shares outstanding = 50,000 units Calculate the dividend payout ratio of the company.  Lecture Exercise 1 (contd.) Solution: Dividend payout ratio = DPS / EPS = 1.50 / 3.76 = 39.89% DPS = $1.50 (already provided in the question) EPS = Net Profit / No. of common shares outstanding = ($200,000 – 5,000 – 7,000) / 50,000 = $188,000 / 50,000 = $3.76  Lecture Exercise 2 Questions: Groot Plantation Co. published the following financial data for FY202x: Gross Income = $500,000, Operating Income = $400,000, Net Income = $300,000. Common shares outstanding = 100,000 units. The BOD declared 50% of earnings to be distributed as cash dividend to the common stockholders. Calculate the company’s: a) Dividend per share b) Earnings per share  Lecture Exercise 2 (contd.) Solutions: a) DPS = Total Dividend Amount / No. of common shares outstanding = (50% x $300,000) / 100,000 = $1.5 b) EPS = Income attributable to common shareholders / No. of common shares outstanding = $300,000 / 100,000 = $3 Types of Dividend Being Distributed Cash Dividend Stock Dividend Stock Splits Stock Repurchases  (1) Cash Dividend  It is a form of dividend that is paid in cash from the profits or retained earnings of the company Say the firm declares 50 cents dividend per share, if you own 100 shares, you will receive $50 cash dividend.  Effect on the balance sheet when cash dividend is declared/paid DCT Bhd’s Balance The retained earnings after dividend payment: Sheet before cash Retained earnings: dividend Shareholders’ Equity Retained earnings $200,000,000 before dividend payment Par (20m outstanding $20,000,000 shares @$1 per share) Add: Net income $150,000,000 Paid-in capital $100,000,000 Less: Dividend paid ($100,000,000) Retained earnings $200,000,000 Retained earnings after $250,000,000 dividend payment Total $320,000,000 Assume that DCT’s net income during DCT Bhd’s Balance the year is $150m. For that year the Sheet after cash BOD declared a cash dividend of $0.50 dividend Shareholders’ Equity per share. Hence, the total cash Par (20m outstanding $20,000,000 dividend paid out for that year is: shares @$1 per share) = Total no. of shares x Dividend per share Paid-in capital $100,000,000 = 20,000,000 x $0.50 = $100,000,000 Retained earnings $250,000,000 Total $370,000,000  (2) Stock Dividend Stock Dividend occurs when a firm issues new shares in lieu of paying a cash dividend. Say the firm declares a 10% stock dividend, if you own 100 shares, you will have an additional 10 shares  Effect on the balance sheet when stock dividend is declared XYZ Co’s Balance An accounting transfer will occur between Sheet before stock retained earnings and the two capital stock accounts based on the market value of the dividend Shareholders’ Equity stock dividend. Common stock (1,000,000 $10,000,000 shares at $10 par) If the stock is selling at $15 a share, $1m will be assigned to common stock (100,000 Capital in excess of par $5,000,000 shares x $10 par) and $500,000 to capital in Retained earnings $15,000,000 excess of par (100,000 x [$15 - $10]). The Total $30,000,000 value of stock dividend will be taken out from retained earnings just like cash dividend If a 10 percent stock dividend is XYZ Co’s Balance declared, shares outstanding will Sheet after stock increase by: Shareholders’ Equity dividend Common stock (1,100,000 $11,000,000 = Stock dividend declared x No. of shares at $10 par) common shares outstanding Capital in excess of par $5,500,000 = 10% x 1,000,000 = 100,000 Retained earnings $13,500,000 Total $30,000,000  Lecture Exercise 2 Question: United Equipment Corp. shows the following capital accounts before a 10 percent stock dividend: $ Common stock (200,000 shares at $5 par) 1,000,000 Capital in excess of par 600,000 Retained earnings 2,400,000 Net worth 4,000,000 The firm’s shares have a market price of $20. Show the revised capital accounts after the 10 percent stock dividend.  Lecture Exercise (contd.) Solution: Revised capital accounts after the 10 percent stock dividend: $ Common stock (220,000 shares at $5 par)* 1,100,000 Capital in excess of par 900,000** Retained earnings 2,000,000*** Net worth 4,000,000 * 200,000 x 10% = 20,000 new shares ** Capital in excess of par = $600,000 + $300,000 = $900,000; No. of new shares x (market price – par value) = 20,000 x ($20 - $5) = 20,000 x $15 = $300,000 *** Retained earnings = $2,400,000 - $100,000 - $300,000 = $2,000,000 Total par value of new shares = 20,000 x $5 = $100,000  (3) Stock Splits Stock Split on the other hand is when a firm increases the number of shares outstanding Say the firm announces a stock split of 2:1. If you own 100 shares, you will have an additional 200 shares  Effect on the balance sheet when stock splits is declared XYZ Co’s Balance Sheet before stock Effect: Stock splits cause the number of splits Shareholders’ Equity shares to double and the par value Common stock (1,000,000 $10,000,000 halves shares at $10 par) Capital in excess of par $5,000,000 Retained earnings $15,000,000 XYZ Co’s Balance Total $30,000,000 Sheet after stock splits Equity Shareholders’ The company declares a two-for-one Common stock (2,000,000 $10,000,000 stock split shares at $5 par) Additional new stock = 2 x current no. of Capital in excess of par $5,000,000 common shares outstanding Retained earnings $15,000,000 = 2 x 1,000,000 shares = 2,000,000 Total $30,000,000 New par value after stock splits = Current par value ÷ 2 = $10 / 2 = $5  Stock dividend & Stock Split – Value to the investors Is a stock dividend/stock Splits of real value to the investors? Answer: NO! Because …. The asset base remains the same & investors’ proportionate ownership in the business is unchanged. “The pie is divided into smaller pieces.” But stock dividends/split dividends may help firm reach an “optimal price range.”  Between cash dividend & (4) Stock Repurchases stock repurchase, which one benefits investors more? Discuss. (or Stock Buyback) Occurs when a firm repurchases its own stock Considered an alternative to cash dividend This results in a reduction in the number of shares outstanding  Effects when the firm repurchases its own shares on individual shareholders The effects of Stock Effects to shareholders (Stock buy Repurchases back): Financial data of Morgan Corporation (1) EPS will increase as the no. of shares outstanding is decreased. Earnings after taxes $3,000,000 Price for stock buy back Shares 1,000,000 = Current share price + Alternative cash EPS $3 dividend per share = $30 + $2 = $32 Market price per share $30 No. of shares buy back = Excess funds ÷ Repurchase price per Excess cash $2,000,000 share = $2,000,000 ÷ $32 = 62,500 shares Total shares outstanding after buy backs The company wishes to compare the value = Current shares outstanding – No. of to stockholders of a $2 cash dividend (on shares buy backs = 1,000,000 – 62,500 = the current shares outstanding). Discuss 937,500 the effects of both dividend policies to EPS with buy back = Earnings after tax ÷ shareholders. Total shares outstanding after buy backs = $3,000,000 ÷ 937,500 = $3.20 The effects of Stock Effects to shareholders (Stock buy Repurchases back): Financial data of Morgan Corporation (2) Increase in the price of the stock Earnings after taxes $3,000,000 P/E ratio = Current market price ÷ EPS = Shares 1,000,000 $30 ÷ $3 = 10 Assume that P/E ratio remains constants, EPS $3 the expected market price after buy Market price per share $30 backs = 10 x $3.2 = $32 Excess cash $2,000,000 Effects to shareholders (Cash The company wishes to compare the value dividend): to stockholders of a $2 cash dividend (on If the cash dividend is paid, the the current shares outstanding). Discuss shareholders will have $30 in stock and $2 the effects of both dividend policies to cash dividend. shareholders. Shareholder’s net wealth = $32  (4) Stock Repurchases (or Stock Buyback) (contd.) Benefits of stock repurchases are:  A means for providing an internal investment opportunity An approach for modifying the firm’s capital structure  A favourable impact on earnings per share The elimination of a minority ownership group of stockholders A minimization of the dilution in earnings per share associated with mergers A reduction in the firm’s costs associated with servicing small stockholders  Factors That Influence Dividend Policy In Practice  Legal Restrictions: Dividends cannot be paid out of the permanent capital accounts.  Liquidity: Retained earnings and cash are not identical.  Stability of earnings.  Leverage  Size of the company  Factors That Influence Dividend Policy In Practice (contd.) Ownership Control: Smaller firms may be averse to issuing new stock due to dilution of corporate control. Therefore, retain earnings and pay few dividends. Inflation: Since replacement costs of assets are higher in inflationary periods, more retention of earnings may be required. Dividend Reinvestment Plans: Investors can automatically reinvest dividends often at a discount with no transaction costs. Frequently a good investment tool. Companies may use these plans to raise additional equity capital.  Any Questions? End of Topic 6