Financial Management

Dividend Policy
Bean Counters
Tarun Yadav
Rohit Iyer
Avanish Kumar
Roshan Jaiswal
Manish Omhare 1
Source of Infromation
http://www.umsl.edu

http://moneycontrol.com

http://rediffmoney.com

http://livemint.com

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 Reliance Industries Ltd.
Reliance Industries Limited is India's largest private sector
conglomerate (by market value) , with an annual turnover of US$ 35.9
billion and profit of US$ 4.85 billion for the fiscal year ending in
March 2008 making it one of India's private sector Fortune Global
500 companies, being ranked at 206th position in 2008.

Reliance Industries Ltd.

Type Public (NSE: RELIANCE)
Industry Oil Conglomerates

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Dividend Policy
 It is the decision about how much of earnings to pay out as
dividends versus retaining and reinvesting earnings in the
firm.

 With more and more firms using stock repurchase semi-

regularly, a better term might be “ distribution policy.”

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Steps in Setting Dividend Policy
 Identify target capital structure

 Forecast capital needs over planning horizon

 Estimate annual debt and equity needs

 Set long run target payout ratio based on the residual

mode

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Elements of dividend policy
 Rupees/dollars of dividend to be paid out in the near
future.

 Target payout ration: Long run policy regarding the

average percentage of earnings to be paid out to
stockholders.

 Declaration of dividend policy and then stick with it.

Should or shouldn’t?

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Investors preference theories
 Irrelevant: Investors do not care what payout is set.

 Bird-in-the hand: Investors prefer a high payout.

 Tax preference: Investors prefer a low payout in order to

get growth and capital gains.

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Dividend Irrelevance Theory
 Investors are indifferent between dividends and
retention-generated capital gains. If they want cash, they
can sell stock. If they don’t want cash they can use
dividends to buy stock.

 Modigliani-Miller supports irrelevance but their theory is

based on unrealistic assumptions, i.e. no taxes or
brokerage costs, and hence may not be true.

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Bird-in-the-Hand Theory
 Investors think dividends are less risky than potential
future capital gains, hence they like dividends.

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Tax Preference Theory
 Retained earning lead to capital gains, which are taxed at
lower than dividends. Capital gain taxes are also deferred.

 This could cause investors to prefer firms with low

payouts.

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 Implications of Theories
 Irrelevance

 Bird-in-hand
 Any payout okay
 Tax preference
 Set high payout

 Set low payout

Theory

Implication

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Empirical Test Vs. Judgment
 Empirical testing has not been able to determine which
theory is correct.

 Thus managers must use judgment when setting policy.

 Analysis is used, but it must be applied with judgment.

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Signaling/Information Content
 Managers hate to cut dividends, so they won’t raise
dividends unless they thing the increase is sustainable.

 Thus, investors view dividend increase as signals of

management’s positive view of the future.

 Therefore, if a company’s stock price increase at the time

it announces a dividends increase, this could reflect
expectations for higher future EPS, not a preference for
dividend over retentions and capital gains.

 Conversely, a dividend cut would be a signal that managers

are worried about future earnings.

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Signaling/Information Content2
 This signaling impact constrains dividend decisions by
imposing a large cost on a dividend cut and by discouraging
managers from raising dividends until they are sure about
future earnings.

 Managers tend to raise dividends only when they believe

future earnings can comfortably support a higher dividend
level and they cut dividends only as a last resort.

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Clientele Effect
 Different groups of investors, or clienteles, prefer
different policies, e.g. retirees need dividends for income.

 A firms’ past dividend policy determines its current

clientele of investors.

 Clientele effects impede changing policy. Taxes and

brokerage costs hurt investors who switch companies.

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Impact of Dividend Policy
 Firms with high payouts will have to go to the capital
markets more frequently.

 Bankers will supply capital more willingly to better-

managed firms.

 Lower retentions mean less opportunity for managers to

invest unwisely.

 Therefore, stockholder worry less if the payout is high.

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Residual Dividend Model
 Find the retained earnings needed to support the capital
budget.

 Pay out any leftover earnings ( the residual ) as dividend.

 This policy minimizes new equity issues, and hence a

floating and signaling costs.

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Investment Opportunities
Effect of investment opportunities under the residual
dividend policy.

 Fewer good investment would lead to a smaller capital

budget, hence a higher dividend payout.

 More good investments would lead to a lower dividend

payout.

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 Residual Dividend Model
 Minimizes new stock issues, hence
floating costs and negative signals
associated with new stock.
 Variable dividends send
conflicting signals, increase risk,
and do not appeal to any specific
Advantage

clientele. It results in higher

required return.

Disadvantage

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Dividend reinvestment plan
(DRIP)
 Shareholders can automatically reinvest their dividends in
shares of the company’s common stock. Get more shares
rather than cash.

 There are two types of plans:

• Open market purchase plans
• New stock plan

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Open Market Purchase Plan
 Dividends to be reinvested are turned over to a trustee,
who buys shares on the open market and holds them for
participating stockholders.

 Brokerage costs are low because of volume purchase.

 Convenient and easy way to invest systematically

 Company pays administrative costs.

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New Stock Plan
 Firm issues new stock to DRIP participants, then keeps
money otherwise used for dividends and uses it for other
purposes.

 No fee charged. Stock is sometimes sold at discount from

market price set about equal to flotation costs of
underwritten stock offering.

 Only firms that need new equity capital use new stock
plans.

 Firms with no need for new equity capital use open market
purchase plans.

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Stock Repurchases
 Repurchases: When a firm buys its own stock back.

 Reasons for repurchases:

• An alternative to distributing cash as dividends.
• To dispose of one-time cash from an asset sale.
• To make a large capital structure change.

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Advantages of Repurchases
 Stockholders can tender or not.

 Distribute cash without setting high dividend that can’t be

maintained

 Treasury stock can be used in takeovers or resold to raise

cash

 Stockholders get capital gains rather than higher-taxed

dividends

 May signal that managers think stock is under-valued.

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Disadvantages of Repurchases
 May be seen as a negative signal of poor investment
opportunities.

 Selling stockholders may not be well informed, hence

unfair to them

 Firm may have to bid up the price to complete repurchase

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 Stock Dividends Vs. Stock Splits
 Stock dividend: Firm issues new
share in place of paying cash
dividend. If 10% stock dividend,
 Stock Split: Firm increase the
get 10 shares for each 100
number of shares outstanding.
owned.
If 2:1, gives stockholder twice
 Small stock dividends (5-10 %) as many share and vice versa.
are a bad idea.
 It can be used to keep the price
 Big stock dividends (25+%) are in the optimal range.
treated as splits.
 It occur when management is
confident, so splits are
interpreted as positive signals.

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Conclusion
 Consider residual model when setting long-run target
payout ratio, but don’t follow it rigidly in the short run.

 Pay a stable, dependable dividend.

 Supplement dividends with stock repurchase when

warranted.

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