APPLICATION OF RESIDUAL DIVIDEND MODEL:Dividend Payout Procedure, Dividend Schemes for Optimizing Share Price

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Financial Management MGT201

Lesson 38

APPLICATION OF RESIDUAL DIVIDEND MODEL

Learning Objectives:

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

topics:

· Application of Residual Dividend Model

In this lecture we shall continue our discussion of dividend policy.

Capital Budgeting, Capital Structure & Dividend Policy:

· Once the Optimal Capital Budget and Target Capital Structure have been estimated for 5 or

more years, we can then calculate the Dividend Payout based on Residual (i.e. Left over

Earnings) Dividend Model. This is important because it combines Capital Budgeting, Capital

Structure, and Dividend Policy.

· Example: Firm with Earnings = NI =Rs.80, Target Debt Ratio = 20% (= D/V).

If Capital Expenditure Budget = Rs.100 then total value of firm's financing needs is

Rs.100. Debt = Rs.20. So, require Equity = Rs.80 (100 20).

· Can meet Capital Expenditure Budget exactly provided that all of Earnings of

Rs.80 are retained. Retained Earnings = Rs.80, Plough back = 100% (= (80/80)

x100). So, Zero Dividend Payout.

· Dividend Payout would be zero. Assuming that Firm would prefer to use

Retained Earnings (internal capital is cheaper) rather than external financing to

meet its Capital Budget Outlay.

If Cap Ex Budget = Rs.150 then shortfall of Rs.50 (= Total Financing Budget = 100

150). Means Firm has to raise external financing. What kind and at what cost?

· Can NOT raise external Debt because Target Capital Structure will change.

· Must raise external Equity. But Cost of Equity will increase. Recall that

Transaction and Flotation Costs of External New Stock Issuance is more than

Opportunity Cost of Using Retained Earnings.

· Again, assuming that Dividend Payout would be zero because Firm would want

to use entire Earnings as source of cheapest capital to meet Capital Expenditure

Budget.

If Capital Expenditure Budget = Rs.90 then surplus of Rs.10. What Capital Structure

and Dividend Payout?

· Capital Structure: Total Value of Capital Expenditure Budget = Rs.90. Can

NOT use all Rs.80 of Earning as Equity because that would mean a Debt Ratio

of 11% (= 10/90 x 100) which is not our target. Target Capital Structure is

20% Debt. So, optimal case is to use Rs.18 (=Rs.90 x 0.2) of Debt. So, Equity

should be Rs.72 (= 90 18)

· Dividend Payout: Residual Earnings can be used for Dividend Payout. So,

Dividend Payout = Total Earnings Equity = 80 72 = Rs.8. Dividend per

Share = Dividend / Number of Shares Outstanding.

Dividend Payout Procedure:

· Declaration Date

Board announces Dividend amount and dates i.e. Jan 30th 2003. Based on

Recommendation of CEO, CFO, and Treasurer

Declared dividend recorded as actual current liability on the Balance Sheet and

Retained Earnings reduced by same amount.

If announced Dividend is higher than before, generally Stock Price rises because

Investors take this to be a Positive Signal about future earnings

· Holder-of-record Date

Firm records names of shareholders in the Stock Transfer Register i.e. Feb 28th 2003.

About 1 month after Declaration Date

· Ex-Dividend Date (Important)

4 Days before Holder-of-record Date. Deadline for new buyers to notify Firm so that

Dividend is paid to them and not the previous registered owners i.e. Feb 24th 2003

Share Price expected to DROP by about the same amount as Dividend on this date.

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Payment Date

Firm mails cheques to registered shareholders i.e. March 15th, 2003. About 1 ½

months after Declaration Date.

Other Dividend Schemes:

· Dividend Reinvestment Plans (DRIP)

Firms give stockholders option to automatically reinvest cash dividends by buying more

of the same stock

Advantage for Firm: no transaction and flotation costs unlike new stock issuance.

Cheap way of raising equity.

Advantage for Investors: no brokerage fee paid to stock broker

· Stock Repurchase

Firms offer to repurchase stock at a price above the market price (this is a tricky

exercise) in order to compensate shareholders when dividends are cut.

Viewed as Positive Signal because shows confidence of management in buying back

shares of their own firm

Advantage for Investors who want to sell shares: lower marginal tax on capital gains

than on dividend income

Advantage for remaining Shareholders: number of shares outstanding falls so EPS rises

and Share Price rises.

· Fundamental Share Value Formula:

Share Price = Po = EPS x (P/E)

Advantages for Firm:

· Reduce the "Float" (equity or shares owned by outsiders). Removes excess

shareholders. Increases management control.

· Can be used in combination with Residual Dividend Policy to make extra

payouts on rare occasions when earnings and free cash flows are in surplus

· Can be used in combination with Debt Issuance (i.e. Using money from a loan

to buy back shares) to make very quick and large changes in Capital Structure.

Called REPLACEMENT

Dividend Schemes for Optimizing Share Price:

· Stock Dividends

Used to control the share price if it rises too fast. Brings share price down to within an

"Optimal Price Range" so that more investors can afford to trade in it and trading

volume rises. This is a commonly held belief.

Payment in the form of stock to existing shareholders. Can be declared frequently.

Example: Company offers 10% stock dividend to all shareholders. Means that if you

own 100 shares than company will give you 10 more shares free of cost. Number of

shares increases but Total Value of Firm is unchanged.

· Stock Splits

Also used to control share price if it rises too fast. Number of shares outstanding

increase.

Used to increase "Float"

Example: Company with 1000 shares outstanding to outside shareholders declares 2-

for-1 Stock Split. Means that the number of shares outstanding will increase to 2000

shares (i.e. 100% increase). Number of shares rises but Firm Value unchanged.

· Impact of Stock Dividends & Stock Splits on EPS and Price

In both cases (Stock Dividends and Stock Splits), EPS (Earnings PER SHARE =NI /

shares) and Dividend PER SHARE fall because number of shares outstanding increases.

Note: FIRM VALUE IS UNCHANGED only the number of SLICES OF THE

VALUE PIE (i.e. Number of Shares) have increases

Price rises immediately afterwards because investors take them to be Positive Signals

about the Company's future

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BUT if Company does NOT declare higher earnings and dividends in near future, Price

will come back down again.

Summary of Steps in Dividend Policy:

· Forecast Capital Expenditure Budget and Internal Sources of Funds (Next 5 Years).

Be conservative: Be on safe side -underestimate the Free Cash Flows

· Determine Optimal Capital Structure (or Range for Debt Ratio)

· Use Retained Earnings to finance most of the Capital Expenditure

· Calculate Residual Earnings and Determine Long-term Dividend Payout.

· Back-calculate the Short-term (Quarterly) Dividend Payout per Share. Set at SMALL

CONSTANT value which should grow slowly and never be lowered.

Stable Dividends signal financial stability and Less Risk

· Financial Manager and CEO submit recommendation to Board of Directors

· Board Announces Dividend and Dividend Cheques are mailed to Registered Shareholders

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