Financial Management MGT201
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.
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
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.
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:
Financial Management MGT201
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
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.
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.
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.
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.
Most firms aim for Steadily Increasing Dividend Policy but it is not easy and is a
· 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
Financial Management MGT201
= (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
Steadily Growing Dividend Payout Gives Positive Signals:
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
· 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
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