Q1 Write Short notes on Dividend Policy
Answer:
Firm’s dividend policy divides net earnings into retained earnings and dividends. Retained earnings provide necessary funds to finance long term growth while dividends are paid in cash generally. Dividend policy of the firm is governed by:
(i) Long Term Financing Decision:
a. When dividend decision is treated as a financing decision, net earnings are viewed as a source of long term financing.
b. When the firm does not have profitable investment opportunities, dividend will be paid. The firm grows at a faster rate when it accepts highly profitable opportunities.
c. External equity is raised to finance investments. But retained earnings are preferable because they do not involve floatation costs.
d. Payment of cash dividend reduces the amount of funds necessary to finance profitable investment opportunities thereby restricting it to find other avenues of finance.
e. Thus earnings may be retained as part of long term financing decision while dividends paid are distribution of earnings that cannot be profitably re-invested.
(ii) Wealth Maximization Decision:
a. Because of market imperfections and uncertainty, shareholders give higher value to near dividends than future dividends and capital gains.
b. Payment of dividends influences the market price of the share. Higher dividends increase value of shares and low dividends decrease it. A proper balance has to be struck between the two approaches.
c. When the firm increases retained earnings, shareholders' dividends decrease and consequently market price is affected. Use of retained earnings to finance profitable investments increases future earnings per share. On the other hand, increase in dividends may cause the firm to forego investment opportunities for lack of funds and there by decrease the future earnings per share.
d. Thus, management should develop a dividend policy which divides net earnings into dividends and retained earnings in an optimum way so as to achieve the objective of wealth maximization for shareholders.
e. Such policy will be influenced by investment opportunities available to the firm and value of dividends as against capital gains to shareholders.
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Q2 What are the factors determining dividend policy of the company? Or What are the determinants of dividend policy?
Answer:
The factors that affect the dividend policy of the company are:
1. Liquidity: Payment of dividend results in cash outflow. A company may have adequate earning but it may not have sufficient funds to pay dividends.
2. Repayment of debt: If debt is scheduled for payment then it may be difficult for the company to pay dividend.
3. Stability of profits: A company which has stable earnings can afford to have a higher dividend payout ratio.
4. Financial needs of the company: If the company has profitable projects and it is costly to raise funds, it may decide to retain the earnings.
5. Legal considerations: Legal stipulations do not require a dividend declaration but they specify the requirements under which dividends must be paid.
6. Shareholders preference: The dividend policy of a firm is likely to be affected by the owner’s considerations of (i) the tax status of the shareholders, (ii) their opportunities of investments and (iii) dilution of ownership.
7. State of Capital Market:
a. Favorable Market: Liberal dividend policy.
b. Unfavorable market: Conservative dividend policy.
8. Inflation: Inflation should also be considered in dividend policy.
Q3 Write short notes on Optimum Dividend Payout
Answer:
Investors put their money in the shares of a company in order to earn income on the investment by way of dividend and capital appreciation.
But what if you have the option to earn more than what the company will pay you via dividend and capital appreciation. It’s obvious that you will choose that option and are not going to put the money in shares.
Shareholders expect some returns from the company. It’s termed as cost of equity for the company (Ke) and the return that the company will earn on its investment is (r)
Considering this as the basis we come across three different situations:
A. When the company is earning more than what the investor would have earned
Means:
1. Investors expectation(Ke) are less than what the company earns(r)
2. Ke < r
3. Means the company is growth company.
4. Investors will be willing to let the company retain the profits and do not declare dividends in anticipation of the more returns in the future.
5. Hence the optimum payout ratio will be 0%
B. When the company is earning exactly same as the investor would have earned
Means:
1. Investors expectation(Ke) are equal to what the company earns(r)
2. Ke = r
3. Means the company is normal company.
4. Investors will be indifferent at this point as it does not matter whether company retain or distribute the profit as dividend
5. Hence the optimum payout ratio does not matter here.
C. When the company is earning less than what the investor would have earned
Means:
1. Investors expectation (Ke) are more than what the company earns(r)
2. Ke > r
3. Means the company is declining company.
4. Investors will be willing to let the company distribute all its profits by way of dividends
5. Hence the optimum payout ratio will be 100%
Q4 Explain the concept of Homemade Dividends
Answer:
A form of investment income that comes from the sale of a portion of shares held by a shareholder. This differs from dividends that shareholders receive from a company according to the number of shares the shareholder has.
The existence of homemade dividends is the reason some financial analysts believe that looking at a company’s dividend policy is not important. If investors desires an income stream they will either sell their shares when they want the income or they will invest in other income-generating assets.
Let’s take an example
ABC Ltd. is quoted at ₹50 and Sundar is holding 100 shares of this company. Now if the company declare a dividend of ₹2/share then you would expect the market prices ex-dividend to go down to Rs.48 after the record date.
1. The total wealth of the Sundar is 100 x 50 = 5000
2. Once the dividend has been paid it will become 100 x 48 +200= 5000
3. If Sundar was expecting more than Rs.2/dividend then he can add money to his pocket by selling 2 shares
Market value + Dividend + Sale Proceeds (100 − 2)x48 + 100x2 + 48x2 = 5000
Thus in all the above cases wealth of the shareholders was same and dividend policy of the company is irrelevant.
Q5 Explain various dividend policies
Answer:
1. Constant Dividend per Share
Some companies may follow the policy of paying constant dividend per share every year
irrespective of the earnings of that year.
This is because companies would like to retain some amount for the payment of dividend in the bad years as well.
When the company thinks it has reached a certain satisfied level of earnings then it can increase the annual dividend per share.
This type of policy is preferred by the investors who are dependent on dividend income for their expenses as the policy ensures regular amount of dividend.
e.g. Rs 20 per share will be paid every year.
2. Constant percentage of earnings
Some companies may like to follow the policy of paying constant % of earnings every year. This ratio which is based on the earnings of the company is known as the dividend payout ratio. By this the amount of dividend every year will be in direct proportion to the earnings of the company. This policy will ensure that the shareholders will get more returns in the year of high profits and they will get no returns in case company incurs losses.
e.g. 20% will be paid as dividend out of the profits of every year
3. Small Constant Dividend per Share plus Extra Dividend
Companies can adopt the policy to pay dividend which consist of two amount. First part will be certain fixed amount of dividend and other is variable dividend means extra.
Fixed amount of dividend will be paid every year irrespective of the performance of thecompany.Variableamountwilldependeachyearontheperformanceofthecompany.Ifthecompany earns high profits it can payout some extra dividend treating as variable amount and if the company earns normal profits only then company can either pay small amount as variable or else can even skip paying variable amount.
This way company can ensure that investors are satisfied with regular income and also with variables on the occasions. Even when the company fails to pay extra dividend it will not have any depressing effect on investors.
e.g₹20 per share plus 5% of the profits of every year.
Q6 Explain various forms of dividends
Answer:
(i) Cash dividend:
a. The company should have sufficient cash in bank account when cash dividends are declared. If it does not have enough bank balance, it should borrow funds.
b. For stable dividend policy a cash budget may be prepared for coming period to indicate necessary funds to meet regular dividend payments.
c. The cash account and reserve account of the company will be reduced when cash dividend is paid.
d. Both total assets and net worth of the company are reduced when cash dividend is distributed. According to Hastings, market price of share drops by the amount of cash dividend distributed.
(ii) Stock Dividend (Bonus shares):
a. It is distribution of shares in lieu of cash dividend to existing shareholders.
b. Such shares are distributed proportionately thereby retaining proportionate ownership of the company.
c. If a shareholder owns 100 shares at a time, when 10% dividend is declared he will have 10 additional shares there by increasing the equity share capital and reducing reserves and surplus (retained earnings).
d. The total net worth is not affected by bonus issue.
Q7 List down the assumptions under Gordon Growth Model
Answer:
This model explicitly relates the market value of the firm to dividend policy. In this model, the current ex-dividend at the amount which shareholders expected date of return exceeds the constant growth rate of dividends. It is based on the following assumptions:
The firm is an all equity firm, and it has no debt.
· No external financing is used and investment program are financed exclusively by retained earnings.
· The internal rate of return, r, of the firm is constant.
· The appropriate discount rate, ke, for the firm remains constant.
· The firm has perpetual life.
· The retention ratio, b, once decided upon, is constant. Thus, the growth rate, g = br, is also constant.
· The discount rate is greater than the growth rate, ke> br.
Q8 List down the assumptions under Modigliani Miller Hypothesis
Answer:
Modigliani and Miller Hypothesis is in support of the irrelevance of dividends. Modigliani and Miller argue that firm’s dividend policy has no effect on its value of assets and is, therefore of no consequence i.e. dividends are irrelevant to shareholders wealth. According to them, ‘Under conditions of perfect capital markets, rational investors, absence of tax discrimination between dividend income and capital appreciation, given the firm's investment policy, its dividend policy may have no influence on the market price of shares.
The hypothesis is based on the following assumptions:
• The firm operates in perfect capital markets in which all investors are rational and information is freely available to all.
• There are no taxes. Alternatively, there are no differences in the tax rates applicable to capital gains and dividends.
• The firm has a fixed investment policy.
• There are no floatation or transaction costs.
• Risk of uncertainty does not exist. Investors are able to forecast future prices and dividends with certainty, and one discount rate is appropriate for all securities and all time periods. Thus, r = k = kt for all t.
Q9 What is Radical Approach under Dividend Policy
Answer:
This approach takes into consideration the tax aspects on dividend i.e. the corporate tax and the personal tax. Also it considers the fact that tax on dividend and capital gains are taxed as different rate. The approach is based on one premise that if tax on dividend is higher than tax on capital gains, the share of the company will be attractive if the company is offering capital gain. Similarly, if tax on dividend is less than the tax on capital gains, i.e. company offering dividend rather than capital gains, will be priced better.
Q10 According to the position taken by Miller and Modigliani, dividend decision does not influence value. Please state briefly any two reasons, why companies should declare dividend and not ignore it.
Answer:
The position taken by M & M regarding dividend does not take into account certain practical realities is the market place. Companies are compelled to declare annual cash dividends for reasons cited below:-
(i) Shareholders expect annual reward for their investment as they require cash for meeting needs of personal consumption.
(ii) Tax considerations sometimes may be relevant. For example, dividend might be tax free receipt, whereas some part of capital gains may be taxable.
(iii) Other forms of investment such as bank deposits, bonds etc , fetch cash returns periodically, investors will shun companies which do not pay appropriate dividend.
(iv) In certain situations, there could be penalties for non-declaration of dividend, e.g. tax on undistributed profits of certain companies.
Q11 Write short note on effect of a Government imposed freeze on dividends on stock prices and the volume of capital investment in the background of Miller-Modigliani (MM) theory on dividend policy.
Answer:
✓ According to MM theory, under a perfect market situation, the dividend of a firm is irrelevant as it does not affect the value of firm.
✓ Thus under MM’s theory the government imposed freeze on dividend should make no
difference on stock prices.
✓ Firms if do not pay dividend swill have higher retained earning sand will either reduce the volume of new stock issues, repurchase more stock from market or simply invest extra cash in marketable securities.
✓ In all the above cases, the loss by investors of cash dividends will be made up in the form of capital gains. Whether the Government imposed freeze on dividends have effect on volume of capital investment in the background of MM theory on dividend policy have two arguments.
✓ One argument is that if the firms keep their investment decision separate from their
dividend and financing the freeze on dividend by the Government will have no effect on volume of capital investment.
✓ If the freeze restricts dividends the firm can repurchase shares or invest excess cash in
marketable securities e.g. in shares of other companies.
✓ Other argument is that the firms do not separate their investment decision from dividend and financing decisions. They prefer to make investment from internal funds. In this case,
the freeze of dividend by government could lead to increased real investment.
Q12 Write a short note on Traditional & Walter Approach to Dividend Policy
Answer :
According to the traditional position expounded by Graham and Dodd, the stock market places considerably more weight on dividends than on retained earnings. For them, the stock market is overwhelmingly in favor of liberal dividends as against niggardly dividends. Their view is expressed quantitatively in the following valuation model:
P = m (D+ E/3)
Where,
P = Market Price per share D = Dividend per share
E = Earnings per share m = a Multiplier.
As per this model, in the valuation of shares the weight attached to dividends is equal to four times the weight attached to retained earnings. In the model prescribed, E is replaced by (D+R) so that
P = m {D + (D+R)/3}
= m (4D/3) + m (R/3)
The weights provided by Graham and Dodd are based on their subjective judgments and not derived from objective empirical analysis. Notwithstanding the subjectivity of these weights, the major contention of the traditional position is that a liberal payout policy has a favorable impact on stock prices.
The formula given by Prof. James E. Walter shows how dividend can be used to maximize the wealth position of equity holders. He argues that in the long run, share prices reflect only the present value of expected dividends. Retentions influence stock prices only through their effect on further dividends. It can envisage different possible market prices in different situations and considers internal rate of return, market capitalization rate and dividend payout ratio in the determination of market value of shares.
Walter Model focuses on two factors which influences Market Price
(i) Dividend Per Share.
(ii) Relationship between Internal Rate of Return (IRR) on retained earnings and market expectations (cost of capital).
If IRR > Cost of Capital, Share price can be even higher in spite of low dividend. The relationship between dividend and share price on the basis of Walter’s formula is shown below:
Corporate actions.
https://www.youtube.com/watch?v=V8wKtp4aeQQ&t=2195s
Private Equity-03 https://youtu.be/Wip9pwV7fZU
Derivatives https://youtu.be/iV2p9a-TUFU
Cash Recon https://youtu.be/F6H-wgwuDa8
Cash Dividend https://youtu.be/F6H-wgwuDa8
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