Dividend Decision And Stock RepurchaseDividend and Split by dffhrtcv3

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									 Dividend Decision
        And
       Stock
Repurchase/Dividend
      and Split
              Dividend Policy
• Determines the distribution of firm’s earnings
  between retention and dividend payment
  (Cash).

• Other Options:
  – Stock Dividend
  – Stock Split
  – Stock Repurchase
        Factors Affecting Dividend
                Decisions
•   Legal Rules
•   Liquidity Positions
•   Rate of Asset Expansion
•   Profit Rate
•   Stability of Earnings
•   Control
•   Need to Repay Debt
•   Restrictive Covenants
      Cash Dividends and Dividend Payment
•   Dividend: A payment made out of a firm’s earnings to its owners, in
    the form of either cash or stock.
•   If a payment is made from other sources than current or
    accumulated retained earnings, the term distribution is used.
•   Distribution from earnings is dividend while distribution from
    capital as a liquidating dividend.
•   Basic types of cash dividends:
    a) Regular Cash Dividends – paid regularly as a part of policy.
    b) Extra Dividends- extra part may or may not be repeated in
       future.
    c) Special Dividends- truly unusual or one-time event
    d) Liquidating Dividends- some or all of business has been
       luqidated
         Standard Method of Cash Dividend
                    Payment




1. Declaration Date: The BoD declares dividend
2. Ex-Dividend Date: The holder of the share certificate is entitled to
   dividend before this date. On or after this date, even if you buy the
   share, then the previous owner will get the dividend. Its two business
   days before the date of record.
3. Record Date: The declared dividends are distributable to those people
   who are shareholders of record as of this specific date.
4. Payment date: The dividends are paid to shareholders.
            More on Ex-Dividend Date
• Before, ex-dividend date, the stock is said to trade “with dividend” and
    afterwards the stock trades “ex dividend”
• The ex-dividend date convention removes any ambiguity about who is entitled
    to the dividend.
• The stock price will be affected when the stock goes “ex”.
Illustration:
• A share is selling for $ 10
• BoD declares $ 1 dividend per share, and record date is Tuesday, June 12
    (Sunday being off-day in market)
• Ex-Date – Friday (June 8)
• You buy stock on last hour of Thursday (June 7). You’ll get $ 1 dividend.
• You buy stock as the market opens on Friday (June 8). You wont get $ 1
    dividend.
• What happens to the value of stock overnight ?
      Price Behavior around Ex-Date

• Stock is worth about $ 1 less on Friday morning, so its price will
  drop by that amount.
• In general, we expect that the value of the share of stock will go
  down by about the dividend amount when the stock goes ex
  dividend. (Remember – ABOUT)
     Establishing Dividend Policy
• How do firms actually determine the level
  of dividends they will pay at a particular
  time ?

1. Residual Dividend Approach
2. Dividend Stability
3. A Compromise Dividend Policy
      Residual Dividend Approach
• A policy under which a firm pays dividends only after
  meeting its investment needs while maintaining a
  desired debt-equity ratio.
• Firm generally doesn’t wish to sell new equity to pay
  out dividend (expensive). (Firm wishes to minimize
  the need to sell new equity)
• Then it will have to rely on internally generated
  equity to finance new positive NPV projects.
• With a residual dividend policy, the firm’s objective
  is to meet its investment needs and maintain its
  desired debt-equity ratio before paying dividends.
                  Illustration:
Illustration:
• Imagine that a firm has $ 1,000 in earnings and
    debt equity ratio of 1:2.
Steps in implementing residual dividend policy:
1. Determine the amount of funds that can be
    generated without selling new equity.
  – If the firm reinvests the entire $ 1,000 and pays no
    dividend, then equity will increase by $ 1,000.
  – But debt equity ratio should be maintained.
  – So firm has to borrow additional amount of $ 500
  – Total amount of funds that can be generated without
    selling new equity is thus $ 1,000 + $ 500 = $ 1,500
                   Illustration (contd…)
2.   Decide whether or not a dividend will be paid.
     – To do that, compare the total amount that can be
       generated without selling new equity ( $ 1,500) to the
       planned capital spending.
     – If funds needed exceed funds available, then, no
       dividends will be paid.
     – In such case, dividends can only be paid by cutting out
       on some capital spending or by selling new equity.
     – If funds needed are less than funds generated, then a
       dividend will be paid, and the amount of dividend will be
       residual.
     – Suppose the firm has $ 900 in planned capital spending.
     – What will be residual fund available for dividend
       payment ?
•    Firm must generate this $ 900 ($ 1,000 is already there, but the firm has to
     maintain the current capital structure)
•    Firm will borrow 1/3 x $ 900 = $ 300
•    Rest $ 600 will be taken from available equity of $ 1,000
•    Residual fund available for dividend payment = $ 1,000 - $ 600 = $ 400
         Sum up of the illustration
•   Firm has after-tax earnings of $ 1,000.
•   Dividends paid are $ 400
•   Retained Earnings are $ 600
•   The firm’s debt equity ratio of 1:2 is unchanged.

      The relationship between investment and
         dividend payout for various levels of
                     investments :
                    The relationship
S.No   Aftertax    New     Additional Retained Additional Dividend
       Earnings Investment   Debt     Earnings   Stock

 1     $ 1,000    $ 3,000      ?         ?         ?         ?

 2      1,000     2,000        ?         ?         ?         ?

 3      1,000     1,500        ?         ?         ?         ?

 4      1,000     1,000        ?         ?         ?         ?

 5      1,000      500         ?         ?         ?         ?

 6      1,000       0          ?         ?         ?         ?
                    The relationship
S.No   Aftertax    New     Additional Retained Additional Dividend
       Earnings Investment   Debt     Earnings   Stock

 1     $ 1,000    $ 3,000    $ 1,000   $1,000   $ 1,000     $0

 2      1,000     2,000       667      1,000      333        0

 3      1,000     1,500       500      1,000       0         0

 4      1,000     1,000       333       667        0        333

 5      1,000      500        167       333        0        667

 6      1,000       0          0         0         0       1,000
                          The Relationship
                                                      A firm with many
                                                      investment
                                                      opportunities will pay
                                                      small amounts of
                                                      dividends and a firm
                                                      with few investment
                                                      opportunities will pay
                                                      relatively larger
                                                      amounts of dividends.




Younger, fast-growing firms commonly employ a low payout ratio, whereas
older, slower-growing firms in more mature industries use a higher payout
ratio.
  Formula under Residual Dividend
              Policy
Dividend = Net Income – [Capital Budget x Target equity ratio]



  Where, target equity ratio is the proportion of equity
  in the capital structure.

  If the answer comes in negative, it means that the
  firm has to raise that much amount from new
  equity sale (external equity financing)
                   Example
• Malkor Instruments Company treats dividends
  as a residual decision. It expects to generate
  Rs 2 million in net earnings after taxes in the
  coming year. The company has an all-equity
  capital structure and its cost of equity capital
  is 15%. The Company treats this cost as the
  opportunity cost of retained earnings.
  Because of floatation costs and under-pricing,
  the cost of common stock financing is higher.
  It is 16%.
  (a) How much in dividends should be paid if the
   company has Rs 1.5 million in projects whose
          expected return exceeds 15%?

• Dividend = Net Income – [Capital Budget x Target equity ratio]
  = Rs 2,000,00 – [1,500,000 x 1]
  = Rs 500,000

Company can pay Rs 500,000 in dividends
  (b) How much in dividends should be paid if the
    company has Rs 2 million in projects whose
          expected return exceeds 15%?

• Dividend = Net Income – [Capital Budget x Target equity ratio]
  = Rs 2,000,00 – [2,000,000 x 1]
  = Rs 0

Company can pay no dividend.
  (c) How much in dividends should be paid if the
    company has Rs 3 million in projects whose
  expected return exceeds 16%? What else should
                     be done
• Dividend = Net Income – [Capital Budget x Target equity ratio]
  = Rs 2,000,00 – [3,000,000 x 1]
  = - Rs 1,000,000

Company can pay no dividend.

  Company should raise Rs 1000,000 fund from
  external equity to finance the project
                 Dividend Stability
• Strict residual dividend policy might lead to a very unstable
  dividend policy.
• If investment opportunities in one period are quite high,
  dividends will be low or zero.
• Conversely, dividends might be high in the next period of
  investment opportunities are considered less promising.
• Consider a firm with seasonal sales pattern.
• Its annual earnings are forecasted to be equal year to year.
• But quarterly earnings vary greatly throughout the year.
• 1st quarter- low, raises in 2nd and 3rd, and then 4th highest
• The firm can choose between at least two types of dividend
  policies.
        Dividend Stability (contd…)
1. Each quarter’s dividend can be fixed fraction of that
   quarter’s earnings.
• Here, dividends will vary throughout the year.
• This is cyclical dividend policy, where dividends are
   constant proportion of earnings at each pay date.
2. Each quarter’s dividend can be a fixed fraction of yearly
   earnings.
• Here, all dividend payments will be equal.
• This is stable dividend policy, where dividends are a
   constant proportion of earnings over an earnings cycle.
Stable policy seems to be in the best interest of the firm and
       its stockholders, and stable policy would be more
                            common.
       A Compromise Dividend Policy
     This policy is based on five main goals: (in the order of
     importance)
1.   Avoid cutting back on positive NPV projects to pay a
     dividend
2.   Avoid dividend cuts
3.   Avoid the need to sell equity
4.   Maintain a target debt-equity ratio
5.   Maintain a target dividend payout ratio.
•    Debt-Equity ratio is viewed as long-range goal, it is
     allowed to vary in short run if necessary to avoid a
     dividend cut or the need to sell the new equity.
•    One can minimize the problems of dividend instability by
     creating two types of dividends : regular and extra.
           Share Repurchase
• When the firm has funds in excess of present
  and foreseeable future investment needs.

• It may distribute these funds either by cash
  dividends or by the repurchase of the sock.
             Stock Dividends
• Company distributes shares as dividends to
  the shareholders

• Either from past retained earnings or from net
  profit earned in the respective year.

• A company distributes stock dividend to raise
  capital, to save tax to the stockholders etc.
                      Stock Split
• Company brakes shares through splitting the par
  value of the share.

• A split takes place in two ways:
  1. Straight split
     •   Company increases he number of shares outstanding
         through reducing the par value
  2. Reverse split
     •   Company reduces the number of shares outstanding
         through merging the par value.
     •   This takes place to increase the value of stock.
                              Stock      Straight      Reverse        Stock
                             Dividend   Stock Split   Stock Split   Repurchase

Par Value per Share

Market Price per Share

Number of Shares

Common Stock

Additional Paid-in Capital

Retained Earnings

EPS

DPS (If not constant
dividend policy)
         Stock Repurchase (Share Buybacks)
• Another method used to pay out a firm’s earnings to its owners, which
    provides more preferable tax treatment than dividends.
Illustration:
• Imagine all-equity firm with excess cash of $ 300,000.
• The firm pays no dividends, and its net income for the year just ended is $
    49,000.
• The market value balance sheet at the end of the year is:

                        Market Value Balance Sheet
                       (before paying out excess cash)
 Excess cash        $ 300,000           Debt               $0

 Other assets       700,000             Equity             1,000,000

 Total              $ 1,000,000         Total              $ 1,000,000
                                Contd….
• There are 100,000 shares outstanding
• Price per share = $ 10
• EPS = $ 49,000/100,000 = $ 0.49
• P/E Ratio = $ 10 / 0.49 = 20.4
• The firm is considering two options:
Option 1: $ 300,000/100,000 = $3 per share extra dividend

                        Market Value Balance Sheet
                       (After paying out excess cash)
Excess Cash         $0                  Debt                $0

Other assets        700,000             Equity              700,000

Total               $ 700,000           Total               $ 700,000
                     Contd….
• There are still 100,000 shares outstanding. Hence
  each share is worth = $ 700,000/100,000 = $ 7
• Value per share has fallen, but what happened to
  shareholder’s wealth.
• A shareholder having 100 shares will have $700 + $
  300 = $ 1000 in his wealth and that is same as before
  (100x $10 = $ 1000)
• In this case, the stock price simply fell by $ 3 when
  the stock went ex dividend.
• EPS is still the same = $ 0.49
• P/E ratio falls to $ 7/ 0.49 = 14.3
                                 Contd…
Option 2: Company is thinking of using the money to repurchase $ 300,000 / 10
  = 30,000 shares.

                         Market Value Balance Sheet
                          (After Share Repurchase)
Excess Cash         $0                   Debt               $0
Other assets        700,000              Equity             700,000
Total               $ 700,000            Total              $ 700,000

• The worth of the company hasn’t changed ($700,000)
• Each share still worth $ 10
•EPS goes up to $ 49,000/70,000 = $ 0.70
•P/E ratio is same as that of option 1 = $ 10/0.70 = 14.3
   If there are no imperfections, a cash dividend and a share repurchase are
                          essentially the same thing.
       Equilibrium Repurchase Price
Equilibriu m Repurchase Price,

                   P *  Pc  S
                         S n
where,
S  number of shares outstanding prior torepurchase
Pc  current market price per share prior torepurchase
n  number of shares to be repurchase
Alternatively,
      T otalMarket Value prior torepurchase
P* 
         Number of shares after repurchase
Alternativ ely,
                  Pre Repurchase Share Price
P* 
      1  Percentage of Stock Repurchase Rate in fraction
Alternativ ely,
P *  Pc - Cash Dividend Per Share
                    Example
• Company A has enjoyed considerable recent
  success because they placed a huge order of
  their product. The business is not expected to
  be repeated, and Company has Rs 6 million in
  excess funds. The company wishes to distribute
  these funds via the repurchase of stock.
  Presently it has 2,400,000 shares outstanding,
  and the market price per share is Rs 25. It
  wishes to repurchase 10 percent of its stocks, or,
  240,000 shares.
   (a) Assuming no signaling effect, at what share
   price should the company offer to repurchase?

Equilibriu m Repurchase Price,

P *  Pc  S      25  2,400,000
                                      Rs 27.78
       S  n 2,400,000  240,000
Alternativ ely,
  *            Pre repurchase price            25
P                                                     Rs 27.78
      1 - Percentageof stock repurchase rate 1 - 0.10
(b) In total, how much will the company be
  distributing through share repurchase ?

Amount distributed through share repurchase
= P* x n
= Rs 27.78 x 240,000
= Rs 6,667,200
  (c) What is the total amount used from
retained earnings to repurchase the stocks
                      ?

               Rs 6,667,200
   (d) If the company were to pay out funds
through cash dividends instead, what would be
 the market price per share after distribution ?

• Cash dividend per share = P* - PC
 = Rs 27.78 – Rs 25 = Rs 2.78

• Price per share after cash dividend = PC - DPS
  = Rs 25 – Rs 2.78 = Rs 22.22
   Real world considerations in repurchase

• In the real world, there exists transaction costs and tax.
• Generally a repurchase has a significant tax advantage
  over a cash dividend.
• A dividend is fully taxed as ordinary income, and a
  shareholder has no choice about whether or not to
  receive the dividend.
• In a repurchase, a shareholder pays taxes only if:
   – The shareholder actually chooses to sell
   – The shareholder has a capital gain on the sale (only on profit)
• But there has to be some business-related reason for
  repurchasing.
• “ The stock is a good investment”, “investing in the stock is
  a good use of money” , “the stock is undervalued”
          Stock Dividends and Stock Splits

• Stock Dividend: Dividend paid out in shares of stock.
• The effect of a stock dividend is to increase the number of
  shares that each owner holds. (thus diluting the value of
  each shares outstanding)
• A stock dividend is commonly expressed as a percentage.
• Stock Split: Essentially the same thing as stock dividend,
  but in this case, there’s no change in the owner’s equity.
• It is expressed as a ratio instead of percentage.
• When a split is declared, each share is split-up to create
  additional shares.
• For eg. In a 3 for 1 stock split, each old share is split into
  three new shares.
                      Illustration Stock Dividend

  • Co. A has 10,000 shares outstanding, each selling for $ 66
  • Stock dividend announced = 10 %
  • Total no of shares outstanding after the dividend = 11,000
  Equity position of Co. A before stock dividend:
  Common Stock ( $1 par, 10,000 shares )                         $ 10,000
  Capital in excess of par value (Add. Paid in capital)          200,000
  Retained earnings                                              290,000
  Total owner’s equity                                           500,000

•After stock dividend, common stock a/c increases by $ 1,000
•But market price of each stock is more by $ 65.
•Excess of $ 65 x 1000 = $ 65,000 is added to Capital in excess of par
value.
                             Illustration
• Total owner’s equity is unaffected by the stock dividend because, no cash
  has come in or gone out.
• Equity position of Co A after stock dividend

 Common Stock ( $1 par, 11,000 shares )                          $ 11,000


 Capital in excess of par value (Additional paid in capital)     265,000


 Retained earnings                                               224,000


 Total owner’s equity                                            500,000
Market price per share after stock dividend
  *      Pre stock dividend price
P
     1  Percentagestock dividend rate

Alternatively,

P *  TotalMarket Value prior toStock Dividend
       Number of shares after Stock Dividend

Alternatively,
  *        S x Pc
P
     S  Stock Dividend
                      Example
• The Kleidon King Company has the following
  shareholder’s equity account:
  Common Stock ( Rs 8 par value)      Rs 2,000,000
  Additional paid-in capital          Rs 1,600,000
  Retained Earnings                   Rs 8,400,000
  Shareholder’s equity                Rs 12,000,000

The current market price of the stock is Rs 60 per share.
(a) What will happen to this account
and to the number of shares
outstanding with


(i) 20% stock dividend ?
(ii) a 2 for 1 stock split ?
(iii) a 1 for 2 reverse stock split ?
         (i) 20 % Stock Dividend
• Number of shares outstanding before stock
  dividend= Rs 2000,000/8 = 250,000
• Stock dividend = 20% of 250,000 = 50,000 shares
• Rs 8 x 50000 = Rs 400,000 added in common stock.
• Rs 52 premium x 50000 = Rs 2,600,000 added in
  additional paid in capital
• Rs (8+ 52) x 50,000 = Rs 3,000,000 deducted from
  retained earnings
• No of shares outstanding after stock dividend = Rs
  3,000,000
           After stock dividend
Common Stock ( Rs 8 par value)   Rs 2,400,000
Additional paid-in capital       Rs 4,200,000
Retained Earnings                Rs 5,400,000
Shareholder’s equity             Rs 12,000,000

Number of shares outstanding = 3,000,000
        (ii) a 2 for 1 stock split ?
• Par value after split = 8 x ½ = Rs 4
• Number of shares after split = 250,000 x 2/1 =
  500,000 shares

Common Stock ( Rs 4 par value)   Rs 2,000,000
Additional paid-in capital       Rs 1,600,000
Retained Earnings                Rs 8,400,000
Shareholder’s equity             Rs 12,000,000
  (iii) a 1 for 2 reverse stock split ?
• Par value after split = 8 x 2/1 = Rs 16
• Number of shares after split = 250,000 x 1/2 =
  125,000 shares

Common Stock ( Rs 16 par value) Rs 2,000,000
Additional paid-in capital      Rs 1,600,000
Retained Earnings               Rs 8,400,000
Shareholder’s equity            Rs 12,000,000
   (b) In the absence of an informational or signaling
effect, at what share price should be common stock sell
              after the 20% stock dividend ?

   Market price per share after stock dividend

    P *  Rs 60  Rs50
         1  0.20

   Alternatively,

   P *  Rs 60 x 250,000  Rs50
         250,000  50,000
 (b) What would have happened if
    there were signaling effect ?

• If there were a signaling or informational
  effect, the stock price per share might be
  somewhat higher than Rs 50
                        Exercise
          Common stock ($8 par value)    $2,000,000
          Additional paid-in capital      1,600,000
          Retained earnings               8,400,000
          Total shareholders’ equity     12,000,000

• The current market price of the stock is $ 60 per share.
• What will happen to this account and to the number of
  shares outstanding with
   – A 10 percent stock dividend
   – A 2-for-1 stock split
   – A 1-for-2 reverse stock split
• In the absence of an informational or signaling effect, at
  what share price should the common stock sell after the 10
  percent stock dividend? What might happen to stock price
  if there were signaling effect?
   • Present number of shares outstanding = 2,000,000 /
     8 = 250,000
                             Stock
                             dividend
Common stock                 275,000 @ 8 =
                             2,200,000
Additional paid in capital   2,900,000
Retained earnings            6,900,000
Total shareholders’          12 million
equity
   • Present number of shares outstanding = 2,000,000 /
     8 = 250,000
                             Stock         Stock split
                             dividend
Common stock                 275,000 @ 8 = 500,000 @ 4 =
                             2,200,000     2,000,000
Additional paid in capital   2,900,000     1,600,000
Retained earnings            6,900,000     8,400,000
Total shareholders’          12 million    12 million
equity
   • Present number of shares outstanding = 2,000,000 /
     8 = 250,000
                             Stock         Stock split     Reverse split
                             dividend
Common stock                 275,000 @ 8 = 500,000 @ 4 =   125,000 @ 16
                             2,200,000     2,000,000       = 2,000,000
Additional paid in capital   2,900,000     1,600,000       1,600,000
Retained earnings            6,900,000     8,400,000       8,400,000
Total shareholders’          12 million    12 million      12 million
equity
   • Present number of shares outstanding = 2,000,000 /
     8 = 250,000

                             Stock         Stock split     Reverse split
                             dividend
Common stock                 275,000 @ 8 = 500,000 @ 4 =   125,000 @ 16
                             2,200,000     2,000,000       = 2,000,000
Additional paid in capital   2,900,000     1,600,000       1,600,000
Retained earnings            6,900,000     8,400,000       8,400,000
Total shareholders’          12 million    12 million      12 million
equity

 The total market value of the firm before the stock dividend is
 $60x250,000 = $ 15 million. With no change in the total value of the
 firm the market price of share after stock dividend should be = $ 15
 million / 275,000 = 54.55 per share. However, if there is signaling
 effect, the total value of the firm might rise and share price be
 somewhat higher than 54.55 per share.

								
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