DIVIDEND PAYOUT:Other Factors Affecting Dividend Policy, Residual Dividend Model

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Financial Management MGT201

Lesson 37

DIVIDEND PAYOUT

Learning Objectives:

After going through this lecture, you would be able to have an understanding of the following topic:

· Dividend Payout

Dividend Policy is an important area connected to the capital structure in financial management as it

helps financial mangers to decide how much of the company's profits should be distributed to the

shareholders or equity holders in the form of dividends.

Dividend Policy Issue:

· Earnings and Positive Cash Flows can be allocated to the Following Cash Outflows:

Buying assets like machines, building etc.

(Capital Budgeting)

Investing in Projects like acquiring new business (Capital Budgeting)

Paying Interest to Debt holders (i.e. Banks, Bondholders)

... Value holders who

receive a slice of the Firm's value in form of Interest Income.

Paying Dividends to Shareholders (i.e. Payout) ... Value holders who receive a slide of

the Firm's value in form of Dividend income.

Remember bondholders and shareholders both are investors but debt holders are creditors to the

company while shareholders are owners of the company.

· Major Questions in Dividend Policy:

How much to Payout to Shareholders in form of Dividend?

· Payout Ratio

= Annual Dividend Amount/ Net Income

AND

Dividend per Share

= Total Dividend Amount / Outstanding Number of Shares

· There needs to be a tradeoff between Dividend Income & Capital Gains

Recall Gordon's Formula:

Required Return on Equity or "Cost of Equity"

= rCE = Dividend Yield + Capital Gains Yield

= (DIV1/Po) + g

Dividend Yield = Future Dividend/ Present Price

Capital Gains Yield = Dividend Growth Rate

How to Finance the Dividend Payout?

· Cash or Stock Dividend

· Use Internal Retained Earnings OR External Financing (i.e. Debt or Equity)

How often to make Dividend Payout?

· Quarterly, Annually, Monthly... Random?

Impact of Dividend Policy on Firm Value and Share Price?

· Whether or not Paying Out Dividend increases Firm Value or not depends on

many things including Return On Equity of Firm versus the Required Rate Of

Return (rE ) of its shareholders

To answer this question we need to consider some theories.

Dividend Theories:

MM Irrelevance (Miller Modigliani) Theory:

It is an extension of Miller Modigliani theory of capital structure we studied earlier. Dividend

Payout is basically irrelevant because the way you SPLIT cash flows within and amongst the

Shareholders and Debt holders has no affect on the Total Value of a Firm = Total debt + Total

Equity. Value is determined by HOW MUCH cash flows are generated by the working assets

and the business risk of those assets. Also investors are not influenced by whether the dividend

is paid in dividend yield form or capital gains yield form. These conclusions were drawn under

same ideal assumptions as made in capital structure theory.

Bird in the Hand (Gordon & Lintner) Theory:

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Financial Management MGT201

This theory is more practical. Shareholder wealth (and Firm's Value) is maximized by a HIGH

Dividend Payout because Investors think that Dividend Income is more immediate, regular, and

less risky than Capital Gains Income which is uncertain. So firm should pay as high dividend

payout as possible.

· Tax Preference Theory:

Shareholder wealth is maximized (and cost of equity rE is minimized) by LOW Dividend Payout

because Marginal Tax Rate on Dividends is higher than on Capital Gains. Firms should

accumulate high Retained Earnings that can then lead to Share Price Increase (Capital Gain) or

Stock Repurchase.

In real world we have to consider both above factors while deciding for dividend payout i.e.

time value of dividend income and tax advantage of capital gains along with the following other factors:

Other Factors Affecting Dividend Policy:

Signaling Theory (Recall theory we studied earlier):

In minds of Investors, change in Dividend Payout signals a change about management's

forecast about future expected earnings. So increase in Dividend Payout is seen as

Positive Signal that firm will have good earnings in future so Stock Price rises. It has

real effects on the trading of shares of the company.

Clientele Effect:

Investors buy stocks whose Dividend Policy they like and sell the other ones. Change

in Dividend Policy can cause change in type of shareholders. Income Investors will

invest in High Dividend Stocks. Growth Investors will invest in those stocks offering

larger Capital Gains Yield. Income stocks are the shares of the companies who pay

regular fixed dividends like large Multinational corporations.

Agency Costs:

Shareholders (owners) incur agency costs to monitor and keep check on managerial

spending and decisions. High Dividend Payout forces firm to go to capital markets to

raise external capital. So, management is subjected to outside scrutiny which is an

external check on management spending.

Legal Restrictions:

Debt Contracts: Loan Agreements and Bond Indentures restrict Dividend Payout to

Shareholders if earnings or net working capital is too low to pay interest. So companies

have to fulfill certain conditions and meet targeted ratios.

Impairment of Capital Rule: Dividends can NOT exceed Retained Earnings which

are shown on Balance Sheet.

Cash Dividends can only be paid with cash: Cash means cash. If cash balance (shown

on Balance Sheet too) is not enough then Sell assets, Raise Equity, or Take Loan ... etc.

Dividend Stability:

Most firms aim for Steadily Increasing Dividend Policy but it is not easy and is a

challenge.

· Earnings, Cash flows, Capital Structure, and Capital Budgets fluctuate up and

down with time but Dividend Payouts should NOT change much known as

"Sticky Dividend Policy"

· Financial Manager acts as Stabilizer Converting fluctuating unpredictable

Incoming cash flows and Transforming them into steady and regular cash

outflows to shareholders (in form of Dividends) and debt holders.

· Standpoint of Investors: Provides low risk regular income for shareholders,

signals good future earnings, and growth compensates for Inflation. It keeps

running a source income regular to meet their day to day expenses.

Note: Growth = g

= Plough back x ROE

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Financial Management MGT201

= (1 Dividend Payout) x ROE.

Standpoint of Firm: Payout small but regular and increasing dividends. It helps

to keep reserve earnings to meet future capital expenditure and investment

opportunities

Steadily Growing Dividend Payout Gives Positive Signals:

Financial Stability

Less Risk and Uncertainty

Residual Dividend Model

· Residual Dividend Model: Best Practical Model for numerical calculations of optimal

Dividend Policy. Sets Long-Term Target Dividend Payout Ratio from which to back-calculate

short-term Dividends.

· Steps in Residual Dividend Model (RDM):

Forecast Capital Budget, Earnings, Cash Flows (for next 5 years)

· Conservatism: To be on safe side, underestimate the Free Cash Flows

Determine Target optimal Capital Structure (or Practically Speaking, "Range" for Debt

Ratio) and forecast required Equity (for next 5 years)

Use Retained Earnings (internal capital) to finance most of the required Equity because

RE is less costly than external financing (higher transaction costs). Retained earnings

cost less than loans to acquire finance.

Leftover or "Residual" Earnings can be safely paid Out as Dividends in Long Term.

Then divide this into Small Yet Regular (may be quarterly) and Steadily Increasing

Dividend Payouts.

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