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Financial Management ­ MGT201
VU
Lesson 37
DIVIDEND PAYOUT
Learning Objectives:
After going through this lecture, you would be able to have an understanding of the following topic:
·  Dividend Payout
Dividend Policy is an important area connected to the capital structure in financial management as it
helps financial mangers to decide how much of the company's profits should be distributed to the
shareholders or equity holders in the form of dividends.
Dividend Policy Issue:
·  Earnings and Positive Cash Flows can be allocated to the Following Cash Outflows:
­  Buying assets like machines, building etc.
(Capital Budgeting)
­  Investing in Projects like acquiring new business (Capital Budgeting)
­  Paying Interest to Debt holders (i.e. Banks, Bondholders)
... Value holders who
receive a slice of the Firm's value in form of Interest Income.
­  Paying Dividends to Shareholders (i.e. Payout) ... Value holders who receive a slide of
the Firm's value in form of Dividend income.
Remember bondholders and shareholders both are investors but debt holders are creditors to the
company while shareholders are owners of the company.
·  Major Questions in Dividend Policy:
­  How much to Payout to Shareholders in form of Dividend?
·  Payout Ratio
= Annual Dividend Amount/ Net Income
AND
Dividend per Share
= Total Dividend Amount / Outstanding Number of Shares
·  There needs to be a tradeoff between Dividend Income & Capital Gains
Recall Gordon's Formula:
Required Return on Equity or "Cost of Equity"
= rCE = Dividend Yield + Capital Gains Yield
= (DIV1/Po) + g
Dividend Yield = Future Dividend/ Present Price
Capital Gains Yield = Dividend Growth Rate
­  How to Finance the Dividend Payout?
·  Cash or Stock Dividend
·  Use Internal Retained Earnings OR External Financing (i.e. Debt or Equity)
­  How often to make Dividend Payout?
·  Quarterly, Annually, Monthly... Random?
­  Impact of Dividend Policy on Firm Value and Share Price?
·  Whether or not Paying Out Dividend increases Firm Value or not depends on
many things including Return On Equity of Firm versus the Required Rate Of
Return (rE ) of its shareholders
To answer this question we need to consider some theories.
Dividend Theories:
·
MM Irrelevance (Miller Modigliani) Theory:
It is an extension of Miller Modigliani theory of capital structure we studied earlier. Dividend
Payout is basically irrelevant because the way you SPLIT cash flows within and amongst the
Shareholders and Debt holders has no affect on the Total Value of a Firm = Total debt + Total
Equity. Value is determined by HOW MUCH cash flows are generated by the working assets
and the business risk of those assets. Also investors are not influenced by whether the dividend
is paid in dividend yield form or capital gains yield form. These conclusions were drawn under
same ideal assumptions as made in capital structure theory.
·
Bird in the Hand (Gordon & Lintner) Theory:
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Financial Management ­ MGT201
VU
This theory is more practical. Shareholder wealth (and Firm's Value) is maximized by a HIGH
Dividend Payout because Investors think that Dividend Income is more immediate, regular, and
less risky than Capital Gains Income which is uncertain. So firm should pay as high dividend
payout as possible.
·  Tax Preference Theory:
Shareholder wealth is maximized (and cost of equity rE is minimized) by LOW Dividend Payout
because Marginal Tax Rate on Dividends is higher than on Capital Gains. Firms should
accumulate high Retained Earnings that can then lead to Share Price Increase (Capital Gain) or
Stock Repurchase.
In real world we have to consider both above factors while deciding for dividend payout i.e.
time value of dividend income and tax advantage of capital gains along with the following other factors:
Other Factors Affecting Dividend Policy:
·
Signaling Theory (Recall theory we studied earlier):
­  In minds of Investors, change in Dividend Payout signals a change about management's
forecast about future expected earnings. So increase in Dividend Payout is seen as
Positive Signal that firm will have good earnings in future so Stock Price rises. It has
real effects on the trading of shares of the company.
·
Clientele Effect:
­  Investors buy stocks whose Dividend Policy they like and sell the other ones. Change
in Dividend Policy can cause change in type of shareholders. Income Investors will
invest in High Dividend Stocks. Growth Investors will invest in those stocks offering
larger Capital Gains Yield. Income stocks are the shares of the companies who pay
regular fixed dividends like large Multinational corporations.
·
Agency Costs:
­  Shareholders (owners) incur agency costs to monitor and keep check on managerial
spending and decisions. High Dividend Payout forces firm to go to capital markets to
raise external capital. So, management is subjected to outside scrutiny which is an
external check on management spending.
·
Legal Restrictions:
­  Debt Contracts: Loan Agreements and Bond Indentures restrict Dividend Payout to
Shareholders if earnings or net working capital is too low to pay interest. So companies
have to fulfill certain conditions and meet targeted ratios.
­  Impairment of Capital Rule: Dividends can NOT exceed Retained Earnings which
are shown on Balance Sheet.
­  Cash Dividends can only be paid with cash: Cash means cash. If cash balance (shown
on Balance Sheet too) is not enough then Sell assets, Raise Equity, or Take Loan ... etc.
·
Dividend Stability:
­  Most firms aim for Steadily Increasing Dividend Policy but it is not easy and is a
challenge.
·  Earnings, Cash flows, Capital Structure, and Capital Budgets fluctuate up and
down with time but Dividend Payouts should NOT change much ­ known as
"Sticky Dividend Policy"
·  Financial Manager acts as Stabilizer Converting fluctuating unpredictable
Incoming cash flows and Transforming them into steady and regular cash
outflows to shareholders (in form of Dividends) and debt holders.
·  Standpoint of Investors: Provides low risk regular income for shareholders,
signals good future earnings, and growth compensates for Inflation. It keeps
running a source income regular to meet their day to day expenses.
Note: Growth = g
= Plough back x ROE
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Financial Management ­ MGT201
VU
= (1 ­ Dividend Payout) x ROE.
·
Standpoint of Firm: Payout small but regular and increasing dividends. It helps
to keep reserve earnings to meet future capital expenditure and investment
opportunities
·
Steadily Growing Dividend Payout Gives Positive Signals:
­  Financial Stability
­  Less Risk and Uncertainty
Residual Dividend Model
·  Residual Dividend Model:  Best Practical Model for numerical calculations of optimal
Dividend Policy. Sets Long-Term Target Dividend Payout Ratio from which to back-calculate
short-term Dividends.
·  Steps in Residual Dividend Model (RDM):
­  Forecast Capital Budget, Earnings, Cash Flows (for next 5 years)
·  Conservatism: To be on safe side, underestimate the Free Cash Flows
­  Determine Target optimal Capital Structure (or Practically Speaking, "Range" for Debt
Ratio) and forecast required Equity (for next 5 years)
­  Use Retained Earnings (internal capital) to finance most of the required Equity because
RE is less costly than external financing (higher transaction costs). Retained earnings
cost less than loans to acquire finance.
­  Leftover or "Residual" Earnings can be safely paid Out as Dividends in Long Term.
Then divide this into Small Yet Regular (may be quarterly) and Steadily Increasing
Dividend Payouts.
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Table of Contents:
  1. INTRODUCTION TO FINANCIAL MANAGEMENT:Corporate Financing & Capital Structure,
  2. OBJECTIVES OF FINANCIAL MANAGEMENT, FINANCIAL ASSETS AND FINANCIAL MARKETS:Real Assets, Bond
  3. ANALYSIS OF FINANCIAL STATEMENTS:Basic Financial Statements, Profit & Loss account or Income Statement
  4. TIME VALUE OF MONEY:Discounting & Net Present Value (NPV), Interest Theory
  5. FINANCIAL FORECASTING AND FINANCIAL PLANNING:Planning Documents, Drawback of Percent of Sales Method
  6. PRESENT VALUE AND DISCOUNTING:Interest Rates for Discounting Calculations
  7. DISCOUNTING CASH FLOW ANALYSIS, ANNUITIES AND PERPETUITIES:Multiple Compounding
  8. CAPITAL BUDGETING AND CAPITAL BUDGETING TECHNIQUES:Techniques of capital budgeting, Pay back period
  9. NET PRESENT VALUE (NPV) AND INTERNAL RATE OF RETURN (IRR):RANKING TWO DIFFERENT INVESTMENTS
  10. PROJECT CASH FLOWS, PROJECT TIMING, COMPARING PROJECTS, AND MODIFIED INTERNAL RATE OF RETURN (MIRR)
  11. SOME SPECIAL AREAS OF CAPITAL BUDGETING:SOME SPECIAL AREAS OF CAPITAL BUDGETING, SOME SPECIAL AREAS OF CAPITAL BUDGETING
  12. CAPITAL RATIONING AND INTERPRETATION OF IRR AND NPV WITH LIMITED CAPITAL.:Types of Problems in Capital Rationing
  13. BONDS AND CLASSIFICATION OF BONDS:Textile Weaving Factory Case Study, Characteristics of bonds, Convertible Bonds
  14. BONDS’ VALUATION:Long Bond - Risk Theory, Bond Portfolio Theory, Interest Rate Tradeoff
  15. BONDS VALUATION AND YIELD ON BONDS:Present Value formula for the bond
  16. INTRODUCTION TO STOCKS AND STOCK VALUATION:Share Concept, Finite Investment
  17. COMMON STOCK PRICING AND DIVIDEND GROWTH MODELS:Preferred Stock, Perpetual Investment
  18. COMMON STOCKS – RATE OF RETURN AND EPS PRICING MODEL:Earnings per Share (EPS) Pricing Model
  19. INTRODUCTION TO RISK, RISK AND RETURN FOR A SINGLE STOCK INVESTMENT:Diversifiable Risk, Diversification
  20. RISK FOR A SINGLE STOCK INVESTMENT, PROBABILITY GRAPHS AND COEFFICIENT OF VARIATION
  21. 2- STOCK PORTFOLIO THEORY, RISK AND EXPECTED RETURN:Diversification, Definition of Terms
  22. PORTFOLIO RISK ANALYSIS AND EFFICIENT PORTFOLIO MAPS
  23. EFFICIENT PORTFOLIOS, MARKET RISK AND CAPITAL MARKET LINE (CML):Market Risk & Portfolio Theory
  24. STOCK BETA, PORTFOLIO BETA AND INTRODUCTION TO SECURITY MARKET LINE:MARKET, Calculating Portfolio Beta
  25. STOCK BETAS &RISK, SML& RETURN AND STOCK PRICES IN EFFICIENT MARKS:Interpretation of Result
  26. SML GRAPH AND CAPITAL ASSET PRICING MODEL:NPV Calculations & Capital Budgeting
  27. RISK AND PORTFOLIO THEORY, CAPM, CRITICISM OF CAPM AND APPLICATION OF RISK THEORY:Think Out of the Box
  28. INTRODUCTION TO DEBT, EFFICIENT MARKETS AND COST OF CAPITAL:Real Assets Markets, Debt vs. Equity
  29. WEIGHTED AVERAGE COST OF CAPITAL (WACC):Summary of Formulas
  30. BUSINESS RISK FACED BY FIRM, OPERATING LEVERAGE, BREAK EVEN POINT& RETURN ON EQUITY
  31. OPERATING LEVERAGE, FINANCIAL LEVERAGE, ROE, BREAK EVEN POINT AND BUSINESS RISK
  32. FINANCIAL LEVERAGE AND CAPITAL STRUCTURE:Capital Structure Theory
  33. MODIFICATIONS IN MILLAR MODIGLIANI CAPITAL STRUCTURE THEORY:Modified MM - With Bankruptcy Cost
  34. APPLICATION OF MILLER MODIGLIANI AND OTHER CAPITAL STRUCTURE THEORIES:Problem of the theory
  35. NET INCOME AND TAX SHIELD APPROACHES TO WACC:Traditionalists -Real Markets Example
  36. MANAGEMENT OF CAPITAL STRUCTURE:Practical Capital Structure Management
  37. DIVIDEND PAYOUT:Other Factors Affecting Dividend Policy, Residual Dividend Model
  38. APPLICATION OF RESIDUAL DIVIDEND MODEL:Dividend Payout Procedure, Dividend Schemes for Optimizing Share Price
  39. WORKING CAPITAL MANAGEMENT:Impact of working capital on Firm Value, Monthly Cash Budget
  40. CASH MANAGEMENT AND WORKING CAPITAL FINANCING:Inventory Management, Accounts Receivables Management:
  41. SHORT TERM FINANCING, LONG TERM FINANCING AND LEASE FINANCING:
  42. LEASE FINANCING AND TYPES OF LEASE FINANCING:Sale & Lease-Back, Lease Analyses & Calculations
  43. MERGERS AND ACQUISITIONS:Leveraged Buy-Outs (LBO’s), Mergers - Good or Bad?
  44. INTERNATIONAL FINANCE (MULTINATIONAL FINANCE):Major Issues Faced by Multinationals
  45. FINAL REVIEW OF ENTIRE COURSE ON FINANCIAL MANAGEMENT:Financial Statements and Ratios