Chapter 10: Dividend Policy

Short Question Answer

1) What are the factors influencing dividend policy? 

Dividend policy of a firm is influenced by many factors. Some major factors are explained below:

• Legal requirements: Certain conditions imposed by law restrict the dividend payment. For example, dividends should not exceed the sum of current earnings and past accumulated earnings; accumulated loss must be set-off out of the current earnings before paying out any dividends; firm cannot pay dividend out of its paid up capital because it adversely affects the firm’s equity base; if a firm’s liabilities exceed its assets or if it is unable to pay the current obligations, it is strictly prohibited by law to pay dividends.
•  Liquidity position: Though the firm has good earnings, the firm cannot pay dividends if it runs short of cash.
• Repayment need: A firm uses debt financing for investment in assets. These debts must be repaid at maturity. The firm has to retain a certain proportion of the profits to meet the repayment needs of debt at maturity. This reduces the dividend payment capacity of the firm.
• Restrictions by creditors: Firm’s creditors also may impose restrictions on dividend payment. For example, the restriction to pay dividend out of past retained earnings or the restriction to pay any dividends on common stock before paying all accrued dividend on preferred stock and so on reduces the dividend payment capacity of the firm.
• Expected rate of return: If a firm expects a higher rate of return from new investment, the firm prefers to retain the earnings for reinvestment rather than distributing cash dividends.
• Earnings stability: Firms with relatively stable earnings tend to pay higher dividends. A firm with unstable earnings is relatively uncertain about its future earnings prospects. Such firms prefer to retain more out of current earnings.
• Desire for control: The management with high desire for control in the company does not prefer to issue additional common stock even if the need for additional capital arises. Issuing additional common stock may dilute their control authority. Instead of paying a dividend, the management prefers to retain the profits for reinvestment in such cases.
• Access to the capital market: A firm with easy access to capital markets does not require more retained earnings. On the other hand, smaller and newly established firms do not have easy access to the capital market and they would have to rely on internal sources of financing. Hence, they prefer to pay less in dividends and retain more for reinvestment.
• Personal tax bracket of shareholders: In a closely held firm, stockholders with higher marginal tax brackets prefer relatively lower cash dividends. Such stockholders prefer capital gain over dividend income.

2) Write notes on share repurchases. 

Share repurchases refers to the repurchase by the firm of outstanding shares of its common stock in the marketplace. There may be several motives for share repurchases. Some of the motives may be to obtain shares to be used in acquisitions, to have shares available for employee stock option plans, to achieve a gain in the book value of equity when shares are selling below their book value, to retire outstanding shares and so on. However, basically we are concerned with the motive of repurchasing for retirement of outstanding shares. This type of repurchase is considered to be similar to the payment of cash dividends. As an alternative to paying cash dividends, a firm may distribute its income by repurchasing its own shares.

Share repurchases can substitute the cash dividends as a way to distribute idle cash to stockholders. The basic advantage of share repurchases is that they enhance shareholder value. It is because as long as earnings remain constant, the repurchase of shares reduces the number of outstanding shares, raising the earnings per share and therefore the market price per share. In addition to maximizing shareholder wealth, share repurchases may result in tax benefits for certain shareholders because by the repurchase of shares capital gains substitute the dividends. The retirement of common stock by the repurchase can be regarded as a reverse dilution, because it results into increase in earnings per share and market price per share with a reduction in number shares outstanding.

3) What is the procedure of dividend payment? Explain. 

The dividend payment procedure is explained as follows:

• Declaration date: Company’s board meeting held on a certain date first announces the dividend. This date is called the declaration date. While declaring dividend the board specifies the amount of dividend to be paid to shareholders in the record of the company until a particular date. Dividend can be declared as absolute rupee per share or as percentage on par value of the share.
• Holder of the record date: While announcing dividend the company also specifies the date of record. For example, suppose a meeting of the company’s board held on December 1, 2015, declared a 15 percent cash dividend to the stockholders of record on January 31, 2016. In this example, December 1, 2015 is called the declaration date and January 31, 2016 is called record date. At the close of the record date, the company takes the record of shareholders from the shareholder registration book. All the stockholders of the record date are entitled to receive dividends declared by the board.
• Ex-dividend date: Usually it takes two to three days to appear the name of new shareholders in the company’s record after a transaction took place in stock market. For example, if January 31, 2016 is the record date, then the transaction has to take place three days before this date. If the transaction took place on January 28, the name of the new buyer will appear on the shareholder registration book of the company until January 31 and the new shareholder is entitled to receive dividend; otherwise the dividend goes to the old shareholder. The date after January 28 is called ex-dividend date. Any shareholder who purchases the shares on ex-dividend date will not receive the dividend.
• Payment date: While announcing dividend, the company’s board also specifies the date of starting actual dividend distribution. This date is called payment date. The dividend payment actually begins from the payment date.

4) What do you mean by stable dividend policy? Why do firms pursue it? 

A stable dividend policy is one in which firms attempt to maintain stability in dividend payment behavior. The common stockholders do generally prefer a stable dividend income on their investments. The term ‘stability here refers to the consistency in the stream of dividend payment. The firm can maintain stability in dividend payments by following several schemes as follows:

• Constant rupee per share dividend: Under this scheme, a fixed amount of dividend per share is paid on an annual basis irrespective of earnings for the year. The earnings may fluctuate from year to year but dividends per share remain constant. However, dividend per share does not remain fixed for all the periods to come. The amount of dividend per share is likely to increase when there is sustainable growth in earnings. Once the dividend is increased, the firm tries to maintain the dividend constant at the new level.
• Constant payout ratio: Under this scheme, the firm maintains a constant dividend payout ratio over the years. For example, if the dividend payout ratio is 30 percent, it implies that the firm pays 30 percent of its earnings in dividend every year. Dividend per share under this policy fluctuates with earnings in the exact proportion.
• Minimum regular plus extra: Under this policy, the firm always pays minimum regular dividend per share and also pays extra dividend over the minimum regular dividend if earnings increase as targeted. If earnings decline to normal level, the firm cuts extra dividend and pays only the minimum regular dividend.

The firms do pursue stable dividend policy. They normally avoid reducing dividends, because a dividend cut is a bad signal of companies’ future prospects.

Dividends are increased along with the increase in earnings. If future earnings are not expected to grow, the companies at least try to maintain the dividends at present level and they are increased only after an increase in earnings appears to be sustainable and relatively permanent. Once the dividends reach at an increased level, the firms try to maintain them at that level.

5) What are the differences between dividend payout schemes of constant dividend per share and constant payout ratio? 

Constant dividend per share and constant payout ratio both payout schemes prefer to maintain stability in dividend payment behavior. The fundamental differences between these two dividend payout schemes are as follows:

Constant Dividend Per Share	Constant Payout Ratio
Under this scheme, a constant rupee per share dividend is paid.	Under this policy a firm tries to maintain constant dividend payout ratio over the years.
The fixed amount of dividend per share is paid on an annual basis irrespective of earnings for the year. The earnings may fluctuate from year to year but dividends per share remain stable.	Because of fixed payout ratio, dividends per share under this policy fluctuate from year to year as the earnings fluctuate.
Dividend per share does not remain fixed for all the periods to come. The amount of dividend per share is likely to increase over the years along with the increase in earnings. Once the dividend is increased, the firm tries to maintain the dividend stable at that new level.	Under this policy, dividend increases or decreases in exact proportion of the change in earnings. If the firm suffers loss in any year, the dividend even becomes low or zero.

6) Distinguish between stock dividend and stock split. Discuss their significance. 

A stock dividend is the dividend paid in the form of additional shares of common stock. It is also called bonus share. Paying a stock dividend does not result in cash outflows from the firm. It simply involves a bookkeeping transfer from retained earnings to the capital stock account. Stock dividend conserves cash in the firm, so that it can be used in new projects. Stock dividend is a way of recapitalization of earnings. A stock split is similar to a stock dividend in an economic sense. When a company announces stock splits, it results in an increase in the number of outstanding shares with a proportionate decrease in par value and market price of the stocks. A firm with an exceptionally high market price of stock announces stock split to bring down the market price to a reasonable level so that small investors also can purchase the share.

Stock dividends and splits do not change the proportionate ownership of the company. Therefore, the stock dividends and splits have no economic value to the investors if the market is efficient. Stock dividends and split both result in an increase in the number of shares, so the market price per share should decline proportionately to remain the total value of common stock unchanged. However, stock dividends and stock splits might have psychological value. If stock dividends or stock splits are accompanied by an increased cash dividend, the dividend income of the investors increases after stock dividends or splits. It increases the shareholders wealth. Thus, investors perceive this favorably and will have a favorable impact on market price of shares.

Write short notes on

I) Types of dividend payout scheme

Dividend payout schemes can be in dividends. They are discussed below: two type: Residual dividend policy and stability

(a) Residual dividend policy: Under this policy, a firm pays dividend only after meeting its investment need at desired debt-asset ratio. This policy assumes that the firm wishes to minimize the need of external equity, and attempts to maintain current capital structure. Thus, under this policy, the firm uses internally generated equity more to finance the new projects that have positive NPV. Dividends are paid out of residual income left after meeting equity financing needs of new investment. Under this policy, net income is first set aside to meet the equity requirement of new investment. If net income is left after this dividend is paid otherwise not. If net income is short to meet the equity need of new investment, the approaches for external equity to satisfy the deficiency of equity need. Thus, under residual policy, the amount of dividends will change from year to year, depending on available investment opportunities. The amount of dividend under this policy is worked out as follows:

Dividend =  Net income – Equity requirement of new investment

In above relation, if net income is higher than the amount of equity requirement of new investment the firm pays dividend. Otherwise dividend is not paid rather deficiency in equity is met from external issue of shares.

(b) Stable dividend policy: Under stable dividend policy, firms attempt to maintain stability in dividend payment behavior. The stability in dividend is maintained according to the following dividend payment schemes:

• • • (i) Constant rupee per share dividend: Under this scheme, a constant rupee per share dividend is paid. The fixed amount of dividend per share is paid on an annual basis irrespective of earnings for the year. The earnings may fluctuate from year to year but dividends per share remain constant. However, dividend per share does not remain fixed for all the periods to come. The amount of dividend per share is likely to increase over the years along with the increase in earnings. Once the dividend is increased, the firm tries to maintain the dividend constant at the new level.
    • (ii) Constant payout ratio: Under this scheme, the firm maintains a constant dividend payout ratio over the years. For example, if the dividend payout ratio is 30 percent, it implies that the firm pays 30 percent of its earnings in dividend every year. Dividend per share under this policy fluctuates with earnings in the exact proportion.
    • (iii) Minimum regular plus extra: Under this policy, the firm always pays minimum regular dividend per share and also pays extra dividend over the minimum regular dividend if earnings increase as targeted. For example, with a ‘minimum Rs 2 per share regular dividend plus extra 30 percent on the EPS exceeding Rs 10’ policy, the firm regularly pays Rs 2 per share in dividend and pays extra 30 percent dividend on the earnings exceeding Rs 10 per share in any year. If earnings decline to normal level, the firm cuts extra dividends and pays only the minimum regular dividend.

Numerical Problems

1) Modern Cable TV Inc. has a target capital structure that consists of 60% debt and 40% equity. The company anticipates that its capital budget for the upcoming year will be Rs. 3,000,000. If Company reports net income of Rs. 2,000,000 and it follows a residual dividend payout policy, what will be its dividend payout ratio? And if retained earnings are reinvested at an internal rate of return of 20%, what is the anticipated growth rate in earnings?

2) In 2002 Quick company paid dividends totalling Rs. 3,600,000 on net income of Rs. 10,800,000. Year 2002 is considered a normal year, and for the past 10 years, earnings have grown at a constant rate of 8%. However, in 2003, earnings are expected to jump to Rs. 14,400,000, and the firm expects to have profitable investment opportunities of Rs. 8,400,000. It is predicted that Quick Company will not be able to maintain 2003 level of earnings growth and the company will return to its previous 8% growth rate. Company’s target capital structure is 30% debt and 70% equity. Calculate company’s total dividends for 2003 if it follows each of the following policies.

a. Its 2003 dividend payment is expected to grow at the long-run growth rate in earnings.

b. It continues the 2002 dividend payout ratio.

c. It uses a pure residual dividend policy.

d. Which policy company should pursue?

c. If residual dividend policy is adopted: We know, amount of new capital budget = Rs 8.400.000

Equity financing for new capital budget = Rs 8,400.000 x 0.70 = Rs 5,880,000

In 2003, the firm will have Rs 14,400.000 in net income out of which Rs 5,880,000 is retained to satisfy the equity requirement of the new capital budget. Thus rest can be paid in dividends:

Total dividend for 2003 = Rs 14,400,000 – Rs 5,880.000 Rs 8,520,000

d. The firm should pursue residual dividend policy in the year 2003 because with this policy the firm can satisfy the investment needs of new capital projects and maintain the target capital structure.

3) Pepsi Company expects Rs. 5 million after tax income next year, The firm’s current debt-equity ratio is 80%. If Pepsi has Rs. 5 million of profitable investment opportunities and wishes to maintain its current debt-equity ratio, how much should it pay out in dividend next year? What is the dividend payout ratio?

SOLUTION

We have,

Net income = Rs 5,000,000

Debt equity ratio (DE) = 80% or 0.8

Amount of capital budget= Rs 5,000,000

4) A firm’s expected net income for next year is Rs 2 million. The company’s target and current capital structure is 40 percent debt and 60 percent common equity. Company’s outstanding shares are 0.5 million of Rs 100 par. The optimal capital budget for the next year is Rs 0.40 million. If the company uses constant dividend per share of Rs 2 or constant payout at the rate of 80 percent after meeting next “year’s capital budget, determine the total dividend and retained earnings if any next year in each of the two schemes. [5]

5) Namaste Supermarkets, Inc. (50,000 common shares outstanding) currently has annual earnings before interest and taxes of Rs. 1,000,000. Its interest expenses are Rs. 300,000 a year, and it pays Rs. 200,000 annual dividends to its stockholders. The company’s tax rate is 25%, and its common stock’s current dividend yield is 2 percent.

a. Calculate the company’s earnings per share.

b. Calculate company’s dividend payout ratio.

c. Calculate the company’s current common stock price.

d. If Namaste declares and pays a 100 percent stock dividend and then pays an annual cash dividend of Rs. 2.10 per share, what is the effective rate by which the dividend has been increased?

6) After a three-for-one stock split, Express Company paid a dividend of Rs.5. This represents an 8 percent over last year’s pre-split dividend. The company’s stock sold for Rs.90 prior to the split. What was last year’s dividend per share?

SOLUTION

We have,

Stock split = 3 for 1

Dividend per share after split = Rs 5

Growth rate in pre split dividend (g) =  8%

Stock price before split = Rs 90

 Equivalent pre split DPS after growth = Rs 5 x 3 = Rs 15

We know,

Equivalent pre split DPS after growth = Pre split DPS before growth (1 + g)

Rs. 15 =  Pre split DPS before growth (1 + 0.08);

Pre split DPS before growth= Rs.15 / 1.08  = Rs. 13.89

Thus, last year’s dividend per share was Rs 13.89

Long Question Answer

1) What are the factors influencing dividend policy?

Dividend policy of a firm is influenced by many factors. Some major factors are explained below:

(i) Legal requirements: Certain conditions imposed by law restrict the dividend payment. For example, dividends should not exceed the sum of current earnings and past accumulated earnings; accumulated loss must be set-off out of the current earnings before paying out any dividends; firm cannot pay dividend out of its paid up capital because it adversely affects the firm’s equity base; if a firm’s liabilities exceed its assets or if it is unable to pay the current obligations, it is strictly prohibited by law to pay dividends.

(ii) Liquidity position: Though the firm has good earnings, the firm cannot pay dividends if it runs short of cash.

(iii) Repayment need: A firm uses debt financing for investment in assets. These debts must be repaid at maturity. The firm has to retain a certain proportion of the profits to meet the repayment needs of debt at maturity. This reduces the dividend payment capacity of the firm.

(iv) Restrictions by creditors: Firm’s creditors also may impose restrictions on dividend payment. For example, the restriction to pay dividend out of past retained earnings or the restriction to pay any dividends on common stock before paying all accrued dividend on preferred stock and so on reduces the dividend payment capacity of the firm.

(v) Expected rate of return: If a firm expects a higher rate of return from new investment, the firm prefers to retain the earnings for reinvestment rather than distributing cash dividends.

(vi) Earnings stability: Firms with relatively stable earnings tend to pay higher dividends. A firm with unstable earnings is relatively uncertain about its future earnings prospects. Such firms prefer to retain more out of current earnings.

(vii) Desire for control: The management with high desire for control in the company does not prefer to issue additional common stock even if the need for additional capital arises. Issuing additional common stock may dilute their control authority. Instead of paying a dividend, the management prefers to retain the profits for reinvestment in such cases.

viii) Access to the capital market: A firm with easy access to capital markets does not require more retained earnings. On the other hand, smaller and newly established firms do not have easy access to the capital market and they would have to rely on internal sources of financing. Hence, they prefer to pay less in dividends and retain more for reinvestment.

(ix) Personal tax bracket of shareholders: In a closely held firm, stockholders with higher marginal tax brackets prefer relatively lower cash dividends. Such stockholders prefer capital gain rather than dividend income.

2) Write notes on share repurchases. 

Share repurchases refers to the repurchase by the firm of outstanding shares of its common stock in the marketplace. There may be several motives for share repurchases. Some of the motives may be to obtain shares to be used in acquisitions, to have shares available for employee stock option plans, to achieve a gain in the book value of equity when shares are selling below their book value, to retire outstanding shares and so on. However, basically we are concerned with the motive of repurchasing for retirement of outstanding shares. This type of repurchase is considered to be similar to the payment of cash dividends. As an alternative to paying cash dividends, a firm may distribute its income by repurchasing its own shares.

Share repurchases can substitute the cash dividends as a way to distribute idle cash to stockholders. The basic advantage of share repurchases is that they enhance shareholder value. It is because as long as earnings remain constant, the repurchase of shares reduces the number of outstanding shares, raising the earnings per share and therefore the market price per share. In addition to maximizing shareholder wealth, share repurchases may result in tax benefits for certain shareholders because by the repurchase of shares capital gains substitute the dividends. The retirement of common stock by the repurchase can be regarded as a reverse dilution, because it results into increase in earnings per share and market price per share with a reduction in number shares outstanding.

3) What is the procedure of dividend payment? Explain. 

The dividend payment procedure is explained as follows:

(i) Declaration date: Company’s board meeting held on a certain date first announces the dividend. This date is called the declaration date. While declaring dividend the board specifies the amount of dividend to be paid to shareholders in the record of the company until a particular date. Dividend can be declared as absolute rupee per share or as percentage on par value of the share.

(ii) Holder of the record date: While announcing dividend the company also specifies the date of record. For example, suppose a meeting of the company’s board held on December 1, 2015, declared a 15 percent cash dividend to the stockholders of record on January 31, 2016. In this example, December 1, 2015 is called the declaration date and January 31, 2016 is called the record date. At the close of the record date, the company takes the record of shareholders from the shareholder registration book. All the stockholders of the record date are entitled to receive dividends declared by the board.

(iii) Ex-dividend date: Usually it takes two to three days to appear the name of new shareholders in the company’s record after a transaction took place in stock market. For example, if January 31, 2016 is the record date, then the transaction has to take place three days before this date. If the transaction took place on January 28, the name of the new buyer will appear on the shareholder registration book of the company until January 31 and the new shareholder is entitled to receive dividend; otherwise the dividend goes to the old shareholder. The date after January 28 is called ex-dividend date. Any shareholder who purchases the shares on ex-dividend date will not receive the dividend.

(iv) Payment date: While announcing dividend, the company’s board also specifies the date of starting actual dividend distribution. This date is called payment date. The dividend payment actually begins from the payment date.