Main Ideas from this chapter
This chapter describes the clear picture of different forms of
dividend and dividend policies. The core ideas of this chapter are to make
one clear about the different forms of dividend, dividend payment
procedures, dividend payout policies, stock dividend, stock split, reverse
stock split and repurchase of stock.
MEANING OF DIVIDEND POLICY
Dividends refers to that portion of a firm's net earnings which are paid to
shareholders. Dividend are paid either in cash or stock. Since dividends
are distributed out of the profits, the alternative to the payment of
dividends is the retention of earnings. The retained earnings constitute an
important source of financing the investment requirements of the firm.
There is inverse relationship between retained earnings and cash
dividends. More dividends result in smaller retentions where as lesser
dividend results in larger retentions. Thus, dividends and retained earnings
are competitive and conflicting.
Dividend decisions refers to the decisions regarding the division of net
earnings to the dividend and retained earnings. A firm can distribute all of
its earnings to the shareholders as dividends or can retain all of its
earnings for re investment as retained earnings or can distribute a part of
earnings as dividend and retain the balance for re-investment purpose.
Dividend decision is a major financial decision in the sense that a firm has
to choose between distributing profits to the shareholders and ploughing
back them into the business. The selection would be influenced by the
effect on the objective of financial management of maximizing
shareholder's wealth.
Given the objective of financial management of maximizing shareholder's
wealth, the firm should be guided by the consideration as which
alternative use of net earnings is consistent with the goal of wealth
maximization. If paying dividends to shareholders will maximize the
wealth of shareholder, the firm would be advised to use earnings for
paying dividends to shareholders. The firm would be advised to retain the
earnings if retaining earning will end to the maximization of wealth. Thus,
optimal dividend policy is one which leads to maximization of wealth of
owners.
However, there are conflicting opinions regarding the impact of dividends
on the valuation of a firm. According to one school of thought, called
irrelevance theory of dividend, dividends are irrelevant so that amount of
dividends paid has no effect on the valuation of a firm. This thought is led
by Modigiliani and Miller. According to MM Hypothesis, dividend policy
has no effect on the value of the firm.
On the other hand, certain theories consider the dividend decision as
relevant to the value of the firm. The dividend decision has effect on the
value of the firm. This view is led by J.E. Walter, M.J. Gordon and others.
The arguments given are support of irrelevance theory of dividend seems
not to be hold true. Therefore, it should be concluded that dividend policy
is relevant. A firm should try to follow an optimum dividend policy which
maximizes the shareholder's wealth in long run. An optimum dividend
policy will vary from firm to firm as it is determined by a number of
factors.
DIVIDEND
RATIO
PAYOUT
RATIO
AND
RETENTION
Dividend policy decision refers to the decision to pay out earnings or to
retain them for reinvestment in the firm Dividend refers to the portion of
net income paid out to the shareholders. The percentage of earnings paid
out in form of cash dividend is known as dividend payout ratio. Dividend
payout ratio can be calculated as under.
Dividend Paid
Divide Payout ratio =Net income
Or
Dividend Per Share
Earning Per Share
Where,
Dividend Per Share
Corporate Finance – Risal et all
=
Dividend Paid
No. of common shares outs tan ding
Page 2
Net income
= No. of common shares outs tan ding
Earnings Per Share
A firm may retain same portion of its earnings for reinvestment purpose.
The percentage of earnings retained in the firm is called retention ratio.
High dividend payout ratio means low retention ratio and vice versa.
Retention ratio is calculated as under :
Retention ratio = 1 - Dividend Paid out ratio
Or
Re tained earnings
=
Net income
Example
A company has net income of Rs 4,00,000 this year. It retained Rs
1,60,000 of those earning for investment purpose. It has 40,000 shares
outstanding.
Required :
(i)
Earning per share
(ii)
Dividend per share
(iii)
Total dividend
(iv)
Dividend payout ratio
(v)
Retention ratio
Solution
Given,
(i)
Net income
=
Rs 4,00,000
Retained earnings
=
Rs 1,60,000
No. of shares
=
Earning per share
40,000
Net income
=
No. of shares
4,00,000
=40,000
=
Rs 10
(ii)
Dividend Paid =
Net income - Retained earnings
=
=
(iii)
Dividend per share
=
4,00,000 - 1,60,000
Rs 2,40,000
Dividend Paid
No. of shares
240000
40000
=
Rs 6
Dividend Paid
Dividend payout ratio =
Net income
=
(iv)
2,40,000
4,00,000
= 0.60 or 60%
=
(v)
Retention ratio =
1 - dividend payout ratio
=
1 - 0.60
=
0.40 or 40%
DIVIDEND PAYMENT PROCEDURES
Cash dividend refers to the portion of net income paid out to shareholders
in cash. The dividend payment procedures of a company can be described
as under:
1. Declaration date
The date at which board of directors meet and issue a statement
declaring dividend is called declaration date. The board of directors set
the amount of dividend to be paid, the holder - of - record date and the
payment date on this date. Generally, dividend is announced as a
percentage of the per value of stock. However, it can be the absolute
amount like Rs 5 per share in some cases.
2. Holder - of - record date
The date on which the company opens the ownership books to make a
list of shareholders who are entitled to receive the dividend is called
holder - of - record date. All the stockholders of the record date are
Corporate Finance – Risal et all
Page 4
entitled to receive the dividend declared by the board of directors. The
new stockholders would receive dividend if the name of shareholders
is recorded in the ownership book on or before the date of record.
However, if the notification about the transfer was received after the
date of record, the old owner of the stock would receive the dividends.
3. Ex - dividend date
Ex-dividend date is two business days prior to the record date. Shares
purchased after the ex-dividend date are not entitled to the dividend.
The transaction must take place before the ex-dividend date to entitle
the new holder to receive dividend. Thus, the date when the right to
the dividend leaves the stock for new owner is called ex-dividend date.
4. Payment date
The date on which the company actually pays dividends or mails the
cheques to the stockholders is called payment date. On this date, the
company actually pays the dividend to all the stockholders of the date
of record.
Example 2
On July 31, 2009, Khushi Company Limited declared a dividend of Rs 5
per share, payable on October 1 to the holders of record on September 1.
Show the Khushi's dividend payment procedure.
Solution
1. Declaration date : July 31, 2009 on which Khushi Company's board of
directors declared a dividend of Rs 5 per share.
2. Holder - of - record date : September 1, 2009 on which company
makes a list of shareholders who are entitled to receive dividend.
3. Ex-dividend date : August 30, 2009 after which dividends are entitled
with the seller of the stock.
4. Payment date : October 1, 2009 on which Khushi Company mails the
cheque of dividends to the shareholder.
2 days
31-7-2009
30-8-2009
1-19-2009
1-10-2009
Declaration date
Ex-dividend date Holder-of-record date
Payment date
FACTORS AFFECTING DIVIDEND POLICY
Dividend policy is concerned with determining the proportion of firm's net
income to be distributed in the form of dividend and the proportion of
earnings to be retained for investment purpose. A firm's dividend policy is
influenced by a number of factors. Some of the major factors influencing
the firm's dividend policy are as under :
(1) Legal rules
There are certain legal rules that may limit the amount of dividends a
firm may pay. Following are the rules relating to dividend
payment:
(a) Net profit rule : According to this rule, dividends can be paid out
of present or past earnings. Amount of dividends can not exceed
the accumulated profits. If there is accumulated loss, it must be set
off out of the current earnings before paying out any dividends.
(b) Insolvency rule :- According to this rule, a firm can not pay the
dividends when its liabilities exceed assets. When the firm's
liabilities exceed its assets, the firm is considered to be financially
insolvent. The firm, financially insolvent, is prohibited by law to
pay dividends.
(c) Capital impairment rule :- According to this rule, a firm can not
pay dividend out of its paid up capital. The dividend payout that
impairs capital is considered illegal.
2. Desire of shareholders
Dividend policy is affected by the desire of shareholders Shareholders
may be interested either in dividend income or capital gain. Wealthy
shareholders may be interested in capital gain as against dividend
income because of low tax rate on capital gain. Where as the
Corporate Finance – Risal et all
Page 6
shareholders, whose sources of income is dividend only, are interested
in dividend income and would not be interested in capital gain.
3. Liquidity position
In order to pay dividend, a company requires cash, and, therefore, the
availability of cash resources within the company will be a factor in
determining dividend payments. Generally, the greater the cash
position and overall liquidity of a company, the greater is the ability to
pay dividends. A company must have adequate cash available as well
as retained earnings to pay dividends. The liquidity position of the
company will influence the dividend payout of a particular year.
4. Rate of expansion of business
The rate of asset expansion needs to be taken into account. The more
rapid the rate at which the firm is growing, the greater will be its needs
for financing assets expansion. The greater the future need for funds,
the more likely the firm is to retain earnings rather than pay them out.
5. Cost of external financing
The cost of external financing will have impact on the dividend payout
of a company. In situations, where the external funds are costlier, a
firm may resort to low dividend payout and use the internal funds for
financing its business.
6. Need to repay debt
The need to repay debt also influence the availability of cash flow to
pay dividend. If a firm has to repay debt in a particular year, firm may
decide to low dividend payout and use the funds to repay the debt.
7. Contractual constraints
When the company obtained loan funds from debenture holders or
term lending institutions, the terms of issue or contract of loan may
contain restrictions on dividend payments. Debt contracts often
stipulate that no dividends can be paid unless the current ratio, times
interest earned ratio and other safety ratios exceed stated minimums.
8. Access to the capital market
The company, which has a good access to capital market, can follow a
liberal dividend policy because this type of the company can raise the
required funds from the capital market.
9. Degree of control
One of the important influencing factor on dividend policy is the
objective of maintaining control over the company by the existing
management or shareholders. The management who wish to maintain
close control over the company will not much depend on the external
sources of finance, and they maintain a low dividend payout policy
and the funds generated from operations would be used for working
capital and capital investment needs of the firm.
10. Tax position of shareholders
The tax position of shareholders also influences dividend policy. The
company owned by wealthy shareholders having high income tax
bracket tend toward lower dividend payout where as the company
owned by small investors tend toward higher dividend payout.
11. Stability of earnings
The stability of earnings also effects the dividend policy decision. If
the earnings of a firm are relatively stable, the firm is more likely to
payout a higher percentage of earnings than the firm which has
fluctuating earnings.
12. General state of economy
When state of economy is uncertain, both political and economic, the
firm may maintain a low dividend payout policy, to withstand to the
business risks.
Example 3
For each of the companies described below, would you expect it to have a
low, or high dividend payout ratio? Explain why?
(a) A company with a large proportion of inside ownership, all of whom
are high income individuals.
Corporate Finance – Risal et all
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(b) A growth company with an abundance of good investment
opportunities.
(c) A company with volatile earnings and high business risk.
(d) A company that has high liquidity and is experiencing ordinary
growth.
Solution
(a) Low payout ratio : Highly taxed owners generally prefer capital gains
rather dividend income.
(b) Low payout ratio : Earning are retained in business to support
investment opportunities and there will be less residual funds to pay
dividends.
(c) Low payout ratio : The company will retain earnings to build its
financial strength and to offset high business risk.
(d) High payout ratio : The firm having high liquidity and no more assets
expansion tend to pay higher dividend.
Example 4
How would each of the following changes tend to affect dividend payout
ratio, other things held constant?
(a) An increase in personal income tax rate.
(b) A decline in investment opportunities.
(c) An increase in corporate profit.
(d) A rise in interest rate.
Solution :
(a) An increase in the personal income tax rate would lower the dividend
payout ratio because shareholders with high income tax bracket prefer
capital gain rather than dividend income.
(b) A decline in investment opportunities would lead to high dividend
payout ratio because less retention is required to support investment
opportunities.
(c) A permanent increase in corporate profit would lead to increase in
dividend payout because the firm has more earnings to distribute
dividend.
(d) An increase in interest rate would lead to low dividend pay out
because retained earnings may be a relatively attractive way of
financing new investment.
DIVIDEND PAYOUT SCHEMES
A firm can pay dividends using either residual dividend policy or stable
dividend policy.
1. Residual dividend policy
Residual dividend policy is based on the assumption that investors
prefer to have a firm retain and reinvest earnings rather than pay our
them in dividends. Under residual dividend policy, a firm pays
dividend only after meeting its investment need at desired debt - equity
ratio. This policy is based on the following assumption:
(a) The firm wishes to minimize the need of external equity.
(b) The firm wishes to maintain its current capital structure.
Under residual dividend policy, if the net income exceeds the portion
of equity financing, then the excess of net income over equity need is
paid as dividend. The company does not pay any dividend when net
income is less than or equal to equity need for financing the
investment proposals. In case, net income is not sufficient to meet
equity need, the company should raise deficit amount by external
equity. Following steps should be followed to determine amount of
dividend under residual dividend policy :
(a) Determine the optimal capital budget.
(b) Find out target equity ratio in capital structure
Target equity ratio = 1 - Debt ratio.
(c) Determine the amount of equity required to finance the optimal
capital budget.
Corporate Finance – Risal et all
Page 10
Equity financing required = Optimal Capital Budget  Target
equity ratio
(d) Pay dividends if earnings are more than equity financing required.
Dividends = Net income - (Capital budget  Target equity ratio)
Example 5
National Corporation 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 3,00,000. If the company reports net income
of Rs 2,00,000 and it follows a residual dividend policy, what will be its
dividend payout ratio?
Solution
Target debt ratio
= 60%
Target equity ratio
= 40%
Capital Budget
= Rs 300,000
Net income
- Rs 2,00,000
Under residual dividend policy,
Dividend
= Net income - (Capital budget  Target equity ratio)
= 200000 - (300000  0.40)
= 200000 - 120000
= Rs 80,000
Dividend payout ratio =
Dividends
Net income
80000
200000
= 0.4 or 40%
=
2. Stable dividend policy :Stability or regularity of dividend is considered as a desirable policy
by the management of most companies because stable dividends have
a positive impact on the market price of the share. Following are the
most commonly used constant dividend policies :
(a) Constant dividend per share :- Under this policy, a fixed amount of
dividend per share is paid on annual basis irrespective of earnings
of the company. The earnings may fluctuate from year to year but
dividend per share remains unchanged. However, it does not mean
that dividend per share never be increased. Dividend per share can
be increased when the firm can sustain the higher level. The
relationship between earning per share and dividend per share
under this policy can be shown by following figure :
(b) Constant payout ratio :- Under this policy, a fixed percentage of
the net earnings is paid as dividends every year. If earnings vary,
the amount of dividend also varies from year to year. If earnings
increase, dividends also increase and if earnings decrease,
dividends also decrease. Dividends are paid when profits are
earned. No dividend is paid when the firm suffers loss in any year.
The relation between earning per share and dividend per share is
shown as under :
(c) Regular dividend plus extra dividend policy :- Under this policy, a
minimum constant dividend per share is fixed and additional
dividend is paid over the regular low dividends in the years of
relatively high earnings. This policy is a compromise between
constant dividend per share and constant payout ratio policy. The
low regular dividend is maintained even when earnings decline and
extra dividends can be paid when earnings are more.
Example 6
City corporation has the following earning per share over the last 5 years.
Year
EPS (Rs)
1
12
2
12
3
20
4
20
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Page 12
5
24
Determine dividend per share under the following policies:
(a) A constant dividend per share of Rs 8
(b) A constant dividend pay out ratio of 40%
(c) Rs 5 regular dividend per share and extra dividend to bring the pay out
ratio to 40%.
Solution
(a)
Constant dividend per share
Year
1
2
3
4
5
EPS
12
12
20
20
24
DPS
8
8
8
8
8
(b)
Constant dividend payout ratio of 40%
Year
1
2
3
4
5
EPS
12
12
20
20
24
D/P Ratio
0.40
0.40
0.40
0.4
0.4
DPS
4.80
4.80
8
8
9.60
(c)
Regular dividend plus extra dividend
Year
1
2
3
4
5
EPS
12
12
20
20
24
Minimum dividend
5
5
5
5
5
Extra
-
-
3
3
4.60
Total dividend
5
5
8
8
9.60
FORMS OF DIVIDEND
CASH DIVIDEND
When dividend is distributed to shareholders in cash out of the earnings of
the company, it is called cash dividend. When cash dividend is distributed,
both total assets and net worth of the company decrease. Total assets
decrease as cash decreases and net wath decreases as retained earnings
decrease. The market price per share also decreases in most cases by the
amount of cash dividend distributed.
Marker price per share after cash dividend = Marker price per share before
cash dividend - dividend per share.
Example 7
The Neha Corporation's balance sheet as of 31st Dec. 2009 before the
dividend is as follows :
Balance Sheet
Liabilities
Rs
Assets
Rs
Common stock (20000
shares of Rs 10)
200000
Cash & bank
100000
Retained earnings
100000
Other current assets
100000
Fixed assets
300000
Paid in Capital
Debt
50000
150000
500000
500000
Market price per share of common stock is Rs 17.5
(a) Construct a profroma balance sheet if company pays Rs 2.5 per share
cash dividend.
(b) Determine the marker price per share after cash dividend.
Solution :-
(a)
Balance Sheet
after cash dividend
Corporate Finance – Risal et all
Page 14
Liabilities
Common stock
shares of Rs 10)
Rs
(20000
200000
Assets
Cash & bank
Rs
50000
Retained earnings
50000
Other current assets
100000
Paid in Capital
50000
Fixed assets
300000
Debt
150000
450000
450000
W. Notes :
Dividend Paid
= 20000  2.5 = Rs 50000
Cash & bank balance = 100000 - 50000
= Rs 50000
Retained earnings
= 100000 - 50000
= Rs 50000
(b)
Marker price per share after cash dividend = Market price per
share before cash dividend - dividend per share
= 17.5 - 2.50
= Rs 15
STOCK DIVIDEND/BONUS SHARES
Stock dividend refers to the dividends paid to the existing stockholders in
the form of additional shares of common stock. It represents a distribution
of additional shares to existing shareholder. Stock dividend increases the
number of outstanding shares of the firm's stock. It involves simply an
accounting entry transfer from retained earnings account to the common
stock and paid in capital accounts. Due to stock dividend, retained
earnings decrease, common stock and paid in capital increase. The stock
dividend does not affect the equity position of stockholders. Market price
per share and earning per share after stock dividend will decrease.
No. of bonus shares = No. of shares outstanding  % of stock dividend.
Decrease in Retained earnings = No. of bonus shares  Market price per
share.
Increase in common stock = No. of bonus shares  par value per share.
Increase in paid in capital = No. of bonus shares  paid in capital per
share.
Marker price per share after stock dividend =
Market price per share before stock dividend
1  stock dividend in fracton
Advantages
The important benefits derived from stock dividend or issue of bonus
shares are as follows :
1. It preserves the company's liquidity as no cash leaves the company.
2. The shareholders receive a dividend which can be converted into cash
whenever he wishes through selling the additional shares.
3. It broadens the capital base and improves image of the company.
4. It reduces the marker price of the shares, rendering the shares more
marketable.
5. It is an indication to the prospective investors about the financial
soundness of the company.
6. The shareholders can take the advantage of tax saving from stock
dividend.
Disadvantages
1. The future rate of dividend will decline.
2. The future market price of share falls sharply after bonus issue.
3. Issue of bonus shares involve lengthy legal procedures and approvals.
Example 8
The Janaki Rice Mills has the following shareholder's equity account :
Corporate Finance – Risal et all
Page 16
Common stock (Rs 10 par value)
2,00,000
Additional Paid in Capital
2,00,000
Retained earnings
4,00,000
Shareholder' equity
8,00,000
Market price of the stock is Rs 40 per share
(a) Reformulate the shareholders equity account if the company declares
20% stock dividend
(b) What will be the share price after 20% stock dividend?
Solution
(a)
Common stock (24000 shares of Rs 10)
2,40,000
Additional Paid in Capital
3,20,000
Retained earnings
2,40,000
Shareholder' equity
8,00,000
Working Notes :
Addition bonus shares = 20,000  20% = 4,000
Increase in common stock
= 4,000  10 = Rs 40,000
Increase in paid in capital
= 4000  30 = Rs 1,20,000
Decrease in retained earnings = 4000  40 = Rs 1,60,000
(b)
Stock price before stock dividend
1  Stock dividend in fraction
40
1  0.20
=
40
=
1.20
Market price per share after stock dividend =
= Rs 33.33
STOCK SPLIT
A stock split is a method to reduce the marker price per share by giving
certain number of share for one old share. Due to stock split, number of
outstanding shares increase and par value and marker price of the stock
decrease. A stock split affects only the par value, market value and the
number of outstanding shares. However, net worth of the company
remains unaltered.
With a stock split, shareholder's equity account does not change, but the
par value per share changes. The earnings per share will be diluted and
marker price per share fall propotionately with a stock split. But, the total
value of the holdings of a shareholder remains unaffected by a stock split.
Following ate the reasons for splitting a firm's ordinary shares :
1. Stock split results in reduction in market price of the share. It helps in
increasing the marketability and liquidity of a company's shares.
2. Stock splits are used by the company management to communicate to
investors that the company is expected to earn higher profits in future.
3. Stock split is used to give higher dividends to shareholders.
Example 9
XZY Company has the following shareholder's equity account.
Common stock (10000 shares of Rs 100 each)
10,00,000
Additional Paid in Capital
10,00,000
Retained earnings
20,00,000
Shareholder' equity
40,00,000
The current marker price per share is Rs 400 each.
(a) Reformulate the shareholder's equity account if the company split their
shares two - for - one
(b) What will the marker price per share after stock split?
Corporate Finance – Risal et all
Page 18
Solution
(a) Shareholder's equity after stock split
Common stock (20000 shares of Rs 50)
10,00,000
Additional Paid in Capital
10,00,000
Retained earnings
20,00,000
Shareholder' equity
40,00,000
(b) Marker price per share after stock split = Rs 400  1/2 = Rs 200.
REVERSE STOCK SPLIT
Reverse stock split is method used to raise marker price of a firm's stock
by exchanging certain number of outstanding shares for one new share of
stock. Due to reverse stock split, number of outstanding shares decreases,
par value of the shares increases and marker price per share also increases.
However, total net worth of the company remains unchanged. Reverse
stock split is used to stop the marker price per share below a certain level.
The reverse split is generally an indication of financial difficulty and is,
therefore, intended to increase the marker price per share.
Example 10
XYZ company has the following shareholder's equity account
Common stock (20000 shares of Rs 50)
10,00,000
Additional Paid in Capital
5,00,000
Retained earnings
5,00,000
Shareholder' equity
20,00,000
What will happens to this account and no. of shares outstanding with a 1for-2 reverse stock split?
Solution :
Shareholder's equity Account
Common stock (10000 shares of Rs 100)
Rs. 10,00,000
Additional Paid in Capital
Rs. 5,00,000
Retained earnings
Rs. 5,00,000
Shareholder' equity
No. of Shares
Rs. 20,00,000
Rs. 10,000
REPURCHASE OF STOCK
Stock repurchase is method in which a firm buys back shares of its own
stock, there by decreasing shares outstanding, increasing earning per
share, and, often increasing the stock price. It is an alternative to cash
dividends. In a stock repurchase, the company pays cash to repurchase
shares from its shareholders. These shares are usually kept in the
company's treasury and then resold when the company needs money.
If a firm has excess cash, it may purchase its own stock leaving fewer
shares outstanding, increasing the earning per share and increasing the
stock price. It may be an alternative to paying cash dividends. The benefits
to the shareholders are the same under cash dividend and stock repurchase.
In the absence of personal income taxes and transaction costs, both cash
dividend and stock repurchase have no any difference to shareholders.
Capital gain arising from repurchase should equal the dividend otherwise
would have been paid.
Repurchase price or equilibrium price is the price that brings capital gain
equal to the cash dividend. Share price for repurchase or the equilibrium
price is calculated from the following equation:
S  Pc
Repurchase Price (P*) =
S n
Where,
S = Total number of shares outstanding
Pc = Current marker price per share
n = Number of shares to be repurchased.
Corporate Finance – Risal et all
Page 20
Share can be repurchased in different ways. A company can repurchase its
shares through authorized brokers on the open market. Shares can be also
repurchased by making a tender offer which will specify the purchases
price, the total amount and the period within which shares will be bought
back. Similarly, a company can purchase a block of shares from one large
holder on a negotiated basis.
Advantages of repurchase of stock
1. A firm an use idle cash to repurchase stock if it has less investment
opportunities.
2. Dividend and earning per share will be increased through stock
repurchase.
3. Stock repurchase will result in increase in the share value.
4. The buying shareholders will benefit since the company generally
offer a price higher than the current market price of the share.
5. When shares are under valued in the market, a company can buy back
shares at higher price to move up the current share price.
6. If a company has high proportion of equity in its capital structure, if
can reduce equity capital by buying back its shares to achieve target
capital structure.
7. The promoters of the company benefit by consolidating their
ownership and control over companies through stock repurchase. They
do not sell their shares to the company rather make the share
repurchase attractive for others.
8. Repurchase of stock can remove a large block of stock that is
overhanging the market and keeping the price per share down.
9. In a hostile takeover, a company may buy back its shares to reduce the
availability of shares and make take over difficult.
10. Stockholder are given a choice of whether or not to sell their stock to
the firm.
Disadvantages of stock repurchase
1. Shareholders may not be indifferent between dividends and capital
gains, and the price of stock might benefit more from cash dividends
than from repurchase.
2. The remaining shareholder may lose if the company pays excessive
price for the shares under the stock repurchase scheme.
3. Stock repurchase may signal to investors that the company does not
have long - term growth opportunities to utilize the cash.
4. The buyback of shares may be useful as a defense against hostile
takeover only in case of cash rich companies.
Example 11 :A company has Rs 16,00,000 in excess funds. The company wishes to
distribute these funds to repurchase the stock.
Presently, it has 4,00,000 shares outstanding and the market price per
share is Rs. 36. It wishes to repurchase 10% of its stock or 40000 shares.
a. Assuming no signaling effect, at what price should the company offer
to repurchase?
b. In total, how much will the company be distributing through share
repurchase?
c. If the company were to pay out the funds through cash dividend
instead, what will be the market price per share after the distribution?
Solution
(a)
Current marker price (Pc) = Rs 36
No. of shares outstanding (S) = 4,00,000
No. of shares repurchased (n) = 40,000
Required repurchase price (P*) = ?
Now,
P*
=
=
Corporate Finance – Risal et all
S  Pc
S n
400000  36
400000  40000
Page 22
= Rs 40
Assuming no signaling effect, the company should offer to repurchase its
stock at Rs. 40.
(b)
The company will be distributing Rs 16,00,000 (40,000  Rs 40)
through share repurchase.
Total dividend
(c)
Cash dividend per share
= No. of Common Stock
16,00,000
4,00,000
= Rs 4
=
Marker price per share after cash dividend
= Rs 36-4
= Rs 32.
Illustrative Problems
1. MN Company expects to generate following net income during next
years.
Year
Net income
1
4,00,000
2
6,00,000
3
8,00,000
The company currently has 100000 shares outstanding.
(a) Determine earning per share in each year.
(b) Determine total dividend and dividend per share if a dividend pay out
ratio of 50% is maintained.
(c) Determine dividend per share if company declares Rs 2 regular
dividend per share and extra dividend in order to bring the payout ratio
to 50% if it otherwise would fall below.
Solution
(a)
Year
Earning Per Share
1
2
3
Net income
4,00,000
6,00,000
8,00,000
No. of shares
1,00,000
1,00,000
1,00,000
*Earning Per
Share
4
6
8
Net income
No. of Shares
* Earning Per Share =
(b)
Dividend per share & total dividend
Year
1
2
3
Net income
4,00,000
6,00,000
8,00,000
D/P Ratio
50%
50%
50%
* Total dividend
2,00,000
3,00,000
4,00,000
No. of Shares
1,00,000
1,00,000
1,00,000
Dividend Per Share
2
3
4
* Total dividend = Net income  dividend payout ratio
** Dividend Per Share =
(c)
Dividend Per Share
Total dividend
No. of Shares
Year
1
2
3
Net income
4,00,000
6,00,000
8,00,000
No. of shares
1,00,000
1,00,000
1,00,000
Earning Per Share
4
6
8
Regular Dividend
2
2
2
Corporate Finance – Risal et all
Page 24
Extra Dividend
-
1
2
Total dividend per share
2
3
4
2. Janakpur Rice Mill expects next year's net income to be Rs 12,00,000.
Its debt to equity ratio is currently 60%. It has Rs 9,60,000 of
profitable investment opportunities, and its wishes to maintain its
existing debt ratio. According to residual dividend model, how large
should the company's dividend payout ratio be next year?
Solution,
Debt
to equity ratio
=
60%
Let,
Amount of equity
=
100
Amount of Debt
=
60
Total assets
=
100+60
Debt ratio
=
=
Debt
Assets
160
60
= 160
= 0.375
Equity ratio
= 1 - Debt ratio
= 1 - 0.375
= 0.625
= 62.5%
Dividend Paid = Net income - (Capital budget  equity ratio)
= 12,00,000 - (96,00,000  0.625)
= 12,00,000 - 6,00,000
= Rs 6,00,000
Dividend payout ratio =
Dividend
Total Net income
6,00,000
12,00,000
= 0.50 or 50%
=
3. Nepal Industrial Bank has the following shareholder's equity account
Common Stock (20,000 shares of Rs 10 per)
2,00,000
Paid in Capital
1,00,000
Retained earnings
2,00,000
Shareholder's equity
5,00,000
Current Marker price of the stock is Rs 30 per share.
(a) What happen to these accounts if the company declared 10% stock
dividend?
(b) What would happen to these accounts if the company declared a 2 - for
- 1 stock split?
(c) What would happen if there was a reverse stock of 1 - for - 4?
Solution
(a)
Shareholder's equity after stock dividend
Common Stock (22000 shares of Rs 10 per)
2,20,000
Paid in Capital
1,60,000
Retained earnings
1,20,000
Shareholder's equity
5,00,000
Working Notes :
Extra shares for stock dividend
= 20,000  10%
= 2,000 shares.
Increase in common stock
= 2,000  Rs 10 = Rs 20,000
Increase in paid up capital
= 2,000  Rs 30 = Rs 60,000
Corporate Finance – Risal et all
Page 26
Decrease in retained earnings = 2,000  Rs 40
= Rs 80,000
(b)
Shareholder's equity after stock split
Common Stock (40,000 shares of Rs 5)
2,00,000
Paid in Capital
1,00,000
Retained earnings
2,00,000
Shareholder's equity
5,00,000
Working Notes :
No. of shares after split
= 20,000  2/1
= 40,000 shares.
Par value after split
= 10  1/2
= Rs 5
(c)
Shareholder's equity after Reverse stock split
Common Stock (5,000 shares of Rs 40)
2,00,000
Paid in Capital
1,00,000
Retained earnings
2,00,000
Shareholder's equity
5,00,000
Working Notes :
No. of shares after reverse stock split = 20,000  1/4
= 5,000 shares
Par share after reverse stock split
= 10  4/1
= Rs 40
4. After a 4 - for - 1 stock split, Spice Nepal Limited paid a dividend of R
3 per new share, which represents a 20% increase over last year's pre split dividend. What was last year's dividend per share?
Solution :
After stock split dividend per shares (D1)
Before stock split dividend per share (D1)
= Rs 3
= Rs 3  4/1
= Rs 12
growth rate (g) = 20%
Last year's dividend (Do) = ?
We know,
D1
or,
or,
= Do (1+g)
12
= Do (1 + 0.20)
12
Do
=
1.20
= Rs 10.
Hence, last year's dividend per share was Rs 10.
5. Khushi Compnay treats dividend as a residual decision. It expects to
generate Rs 5 million in net earnings after tax in the coming year. The
company has an all - equity capital structure and its cost of equity
capital is 20%. The company treats this cost as the opportunities cost
of retained earnings. Cost of external equity is 21%.
(a) How much in dividends should be paid if the company has Rs 3
million in projects whose expected return exceeds 20% percent?
(b) How much in dividends should be paid if it was Rs 5 million in
projects whose expected return exceeds 20%?
(c) How much in dividends should be paid if it has Rs 6 million in
projects whose expected return exceeds 21%.
Solution
(a) Dividends to be paid = Net income - (Capital budget  equity ratio)
=5-31
= Rs 2 million.
(b)
Dividends to be paid
Corporate Finance – Risal et all
Page 28
= Net income - (Capital budget  equity ratio)
=5-51
= Nil
(c)
Dividend to be paid (external financing) = Net income - (Capital
budget  equity ratio)
=5-61
= (Rs 1 million)
Hence, the company will not pay any dividend rather it should raise Rs 1
million in additional new common stock externally to satisfy the financing
need.
6. ABC corporation has Rs 6 million in excess funds. The corporation
wishes to distribute these funds via the repurchase of stock. Presently,
it has 24,00,000 shares outstanding, and the marker price per share is
Rs 25. It wishes to repurchase 10% of its stock, or 2,40,000 shares.
(a) Assuming no signaling effect, at what price should the company offer
to repurchase?
(b) In total, how much will the company be distributing through share
repurchase?
(c) If the company were to pay out the funds through cash dividends in
stead, what would be the marker price per share after the distribution?
Solution
(a)
Current Marker Price (Pc) = Rs 25
No. of shares outstanding (S) = 24,00,000
No. of shares repurchased (n) = 2,40,000
Repurchase Price (P*) = ?
We know,
P*
S  Pc
=
S n
24,00,000  25
24,00,000  2,40,000
=
= Rs 27.78
(b)
(c)
Total distribution through stock repurchase = 2,40,000  Rs 27.78
Divident Per Share
=
=
= Rs 66,67,200
Dividend Paid
No. of Shares
66,67,200
24,00,000
= Rs 2.78
Market price after cash dividend
= 25 - 2.78
= Rs 22.22
7. Sharda Company repurchased 50,000 shares of its 5,00,000 shares
outstanding at a price of Rs 55 per share. Immediately prior to the
share repurchase announcement, share price was Rs 45. However,
2,00,000 shares were tendered by stockholders wanting to sell. The
company had to repurchase the 50,000 shares on a pro - rata basis
according to the number of shares tendered.
(a) Why did so many shareholders tender their shares? At what price
should the company have made its repurchase offer?
(b) Who gained from the offer? Who lost?
Solution
(a) Current marker price (Pc) = Rs 45
No. of shares outstanding (S) = 5,00,000
No. of shares repurchased (n) = 5,00,00 shares
Equilibrium price or repurchase price (P*) = ?
S  Pc
P*
=
S n
5,00,000  45
= 5,00,000  50,000
= Rs 50
Corporate Finance – Risal et all
Page 30
Since the offer price (Rs 55) is more than the equilibrium
repurchase price, many shareholders tendered their shares to sell. The
company should have made its offer at Rs 50 instead of Rs 55.
(b) The holder of shares whose shares were repurchased gained from the
tender offer and remaining shareholder suffered loss.
SUMMARY
Dividend Policy is concerned with the decisions regarding division of net
income to the dividend and retained earnings. The firm should determine
optimum dividend policy which leads the firm to stockholders wealth
maximization. A company can adopt either residual dividend policy or
stable dividend policy. Three alternative stable dividend policies are
constant dividend per share, constant dividend pay out and regular plus
extra dividend policy.
A firm's dividend payment procedures start with determining the
declaration date on which board of directors declare dividends to be paid,
the holders of record date and payment date.
A firm's dividend policy is influenced by a large no. of factors like legal
requirements, desire of shareholders, liquidity position; need to repay debt,
desire of control, rate of business expansion, access to capital market, tax
position of shareholders, restrictions in debt contracts etc.
Cash dividend is the dividend, which is distributed to shareholders in cash.
Due to cash dividend, total assets as well as net worth decrease as cash
and retained earnings decrease. The market price of share also decreases
by the amount of cash dividend distributed.
A stock dividend refers to the dividend distributed to existing shareholders
in the form of additional shares rather than in cash. Due to stock dividend,
no. of outstanding shares increases, Common stock and paid in capital
increases and retained earnings decrease. However, net worth remains
unchanged.
Stock split increases the number of outstanding shares with a
proportionate decrease in par value. Reverse stock split decreases the
number of shares outstanding with a proportionate increase in par value.
With a stock split and reverse stock split, shareholder's equity remains
unchanged.
In a stock repurchase, a firm buys back some of its outstanding shares,
thereby decreasing number of shares, increasing earning per share and
marker price. It is an alternative to paying cash dividend.
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