SESSION 17
Corporate Finance
Term 3
Assistant Professor, Divya Aggarwal
FPM - XLRI
When MBA students come to faculty for marks increase
Student
Corporate Finance summarized
Maximize Business Value
Investment
Decision
Hurdle Rate?
Return Rate ?
Operating
Decision
Financing
Decision
Working Capital
Management?
Equity & Debt
mix?
Right kind of
debt?
Dividend Decision
How much to
Return?
How to return?
Share capital
Stock & NOSH
Authorized/Registered/Nominal capital: Maximum number of shares that a corporation is
legally permitted to issue, as specified in the MoA. Companies can increase authorized
capital with its shareholder’s approval
Issued capital: Number of shares issued by the company
Subscribed capital: Number of shares taken up by the public
Called up capital: Portion of subscribed capital that has been called up by the company for
payments
Paid up capital: Part of called up capital that has been paid up by the subscribers of the
share capital
NOSH: Stock currently held by investors
Accounting for share capital
• Par value : Companies Act require shares to have a par value i.e. amount that must be recorded as share
capital
• Securities Premium/Share premium : any amount received in excess of par value
• Accounting entry for it: Issue of share capital with par value at a premium
Assume ABC company issues 10,000 shares of INR 20 per equity share at INR 25 (including premium of INR 5)
requiring full payment. Journal entry for it will be:
Debit
Shares issues at premium of INR 5
Shares issues at par
Cash
Credit
250,000
To Equity share capital
200,000
To securities premium
50,000
Cash
200,000
To Equity share capital
200,000
• Sweat Equity : equity shares issued by a company to its directors or employees for providing intangible
assets such as know how. As per Company’s act a company cannot issue any shares at discount except
‘sweat equity’ shares.
• Right issue : offer of shares to the existing shareholders
Types of Equity Shareholders
Preference Shareholders
Equity Shareholders
Types of Equity Securities
• There are three features that characterize and vary among equity securities
Life
Voting Rights
Cash flow Rights
Types of Equity securities
Life
Voting Rights
Cash flow rights
Common Stock
Infinite
Yes
Yes
Preferred stock
Finite
Generally not
Priority over CS
• Some companies may issue different classes of common stock that provide different cash flow and voting
rights. In general, an arrangement in which a company offers two classes of common stock (e.g., Class A
and Class B) typically provides one class of shareholders with superior voting and/or cash flow rights.
• Preferred stock can be
• cumulative and non cumulative;
• participating and non participating;
• Redeemable and irredeemable
• Convertible and non convertible
Different Types of Payouts
• Regular cash dividend
• Stock Dividends
• Stock Split
• Stock Buybacks
Dividends
• Dividend : distribution of cash to shareholders
• Final dividend : approved in the company’s annual general meeting, paid at end of
accounting period
• Procedure for Cash Dividend
•
•
•
•
Declaration date: The board of directors declares a payment of dividends.
Record date: The declared dividends are distributable to shareholders of record on a specific date.
Ex-dividend date: Date on which seller is entitled to keep the dividend
Payment date: The dividend checks are mailed to shareholders of record.
Is Paying dividend irrelevant?
In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date
In a world without taxes, the stock price will fall by the amount of the dividend on the ex-date (Time
0). If the dividend is INR 1, price will be equal to P on the ex-date
Before ex date (-1) : Price = INR (P+1)
Ex-date (0)
: Price = INR P
Is Paying dividend irrelevant?
A compelling case can be made that dividend policy is irrelevant i.e. timing of dividends does
not matter when cash flows do not change.
In a world without taxes, dividend policy is irrelevant
Change in dividend policy did not affect the value of a share of stock as long as all
distributable cash flow is paid out
In other words, dividend policy will have no impact on the value of the firm because investors
can create whatever income stream they prefer by using homemade dividends.
Homemade Dividends
Bianchi, Inc., stock is worth $42 and the company is about to pay a $2 cash dividend.
Bob Investor owns 80 shares and prefers a $3 dividend.
Bob’s homemade dividend strategy:
Sell 2 shares ex dividend i.e. at a price of $ 40 (share price will reduce with the amount of
dividend paid)
Homemade Dividends
Cash from dividend
Cash from selling 2 shares
Total cash
Value of stock holdings
$3 Dividend
$160
$240
80
0
$240
$240
$40 × 78 = $3,120
$39 × 80 = $3,120
Is Paying dividend irrelevant? : Homemade Dividends
In the above example, Bob Investor began with a total wealth of $3,360:
$3,360 = 80 shares × $ 42 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
After a $3 dividend, his total wealth is still $3,360:
$3,360 = 80 shares × $ 39 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 + $240
After a $2 dividend and sale of 2 ex-dividend shares, his total wealth is still
$3,360:
$3,360 = 78 shares × $ 40 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 + $160 + $ 80
13
Dividends and Investment Policy
Firms should never forgo positive N P V projects to increase a dividend (or to pay a dividend
for the first time).
Recall that one of the assumptions underlying the dividend irrelevance argument is: “The
investment policy of the firm is set ahead of time and is not altered by changes in dividend
policy.”
To get the result that dividend policy is irrelevant, we needed three assumptions:
• No taxes.
• No transactions costs.
• No uncertainty.
14
Real-World Factors Favoring a High Dividend Policy
Desire for Current Income
Behavioral Finance
Clientele Effect
Characteristics of a Sensible Payout Policy:
• Over time, pay out all free cash flow
• Avoid cutting positive NPV projects to pay dividends or buy back shares
• Do not initiate dividends until the firm is generating substantial free cash flow
• Set the current regular dividend consistent with a long-run target payout ratio
• Set the level of dividends low enough to avoid expensive future external financing
• Use repurchases to distribute transitory cash flow increases
15
Owner changes : Reacquisition of shares
• Why do you think company will reacquire its own shares?
Wants to return
surplus cash to
shareholders
Prevent hostile takeover
by reducing number of
shares
Wants to signal that
stock is undervalued
Feels its overcapitalized
and dividend outgo is
large
• Can be done through buyback or treasury stock operation
• Buyback : Companies Act 2013, specifies rule and conditions for buyback with respect to extent of
usage of free reserves, quantum of paid up capital and free reserves to be bought back etc.
• Can be bought from existing shareholders on a proportionate basis or from the open market
• Treasury stock operation : company’s own share capital that was issued and reacquired by the
company as an investment. Currently treasury stock is not allowed in India.
What happens to the shares bought back? Where do they go?
Methods of BuyBack in India
Buyback Method
Price for buyback
Tender Offer
Fixed price
Open Offer
Market determined
Book-Building
Based on bidding
price
12 months from date 15-30 days
of resolution
Buy-back remains
open for
15-30 days
Prospectus required
No
No
Can promoters
participate in the
buy-back
Yes
No
Yes, filled with
regulator
Yes
Bonus Shares and Stock split
• Bonus shares : additional shares of a company’s share capital distributed to its
shareholders without payment. Permitted by the company law they can be issued out of
retained earnings or other reserves
• Will it have any cash impact?
• Does not affect the company’s assets or shareholder’s equity. Simply transfers retained
earnings or other items in reserves and surplus to share capital ---------------------------→
capitalization of reserves
Signal confidence to
shareholders
Avoid paying
dividends and cash
outflow
Stock split
• Stock split – essentially the same as a stock dividend except it is expressed as a ratio.
• For example, a 2-for-1 stock split is the same as a 100 percent stock dividend.
• Stock price is reduced when the stock splits.
• Common explanation for split is to return price to a “more desirable trading range.”