Financial Management

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Financial Management ­ MGT201
VU
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 ˝
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)
·  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
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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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