Dividend_Policy by nuhman10

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									   Main Ideas from this chapter
          This chapter describes the clear picture of different forms of
   dividend and dividend policies. The core ideas of this chapter are to make
   one clear about the different forms of dividend, dividend payment
   procedures, dividend payout policies, stock dividend, stock split, reverse
   stock split and repurchase of stock.

MEANING OF DIVIDEND POLICY
   Dividends refers to that portion of a firm's net earnings which are paid to
   shareholders. Dividend are paid either in cash or stock. Since dividends
   are distributed out of the profits, the alternative to the payment of
   dividends is the retention of earnings. The retained earnings constitute an
   important source of financing the investment requirements of the firm.
   There is inverse relationship between retained earnings and cash
   dividends. More dividends result in smaller retentions where as lesser
   dividend results in larger retentions. Thus, dividends and retained earnings
   are competitive and conflicting.
   Dividend decisions refers to the decisions regarding the division of net
   earnings to the dividend and retained earnings. A firm can distribute all of
   its earnings to the shareholders as dividends or can retain all of its
   earnings for re investment as retained earnings or can distribute a part of
   earnings as dividend and retain the balance for re-investment purpose.
   Dividend decision is a major financial decision in the sense that a firm has
   to choose between distributing profits to the shareholders and ploughing
   back them into the business. The selection would be influenced by the
   effect on the objective of financial management of maximizing
   shareholder's wealth.
   Given the objective of financial management of maximizing shareholder's
   wealth, the firm should be guided by the consideration as which
   alternative use of net earnings is consistent with the goal of wealth
   maximization. If paying dividends to shareholders will maximize the
   wealth of shareholder, the firm would be advised to use earnings for
   paying dividends to shareholders. The firm would be advised to retain the
   earnings if retaining earning will end to the maximization of wealth. Thus,
        optimal dividend policy is one which leads to maximization of wealth of
        owners.
        However, there are conflicting opinions regarding the impact of dividends
        on the valuation of a firm. According to one school of thought, called
        irrelevance theory of dividend, dividends are irrelevant so that amount of
        dividends paid has no effect on the valuation of a firm. This thought is led
        by Modigiliani and Miller. According to MM Hypothesis, dividend policy
        has no effect on the value of the firm.
        On the other hand, certain theories consider the dividend decision as
        relevant to the value of the firm. The dividend decision has effect on the
        value of the firm. This view is led by J.E. Walter, M.J. Gordon and others.
        The arguments given are support of irrelevance theory of dividend seems
        not to be hold true. Therefore, it should be concluded that dividend policy
        is relevant. A firm should try to follow an optimum dividend policy which
        maximizes the shareholder's wealth in long run. An optimum dividend
        policy will vary from firm to firm as it is determined by a number of
        factors.

DIVIDEND               PAYOUT           RATIO        AND       RETENTION
RATIO
        Dividend policy decision refers to the decision to pay out earnings or to
        retain them for reinvestment in the firm Dividend refers to the portion of
        net income paid out to the shareholders. The percentage of earnings paid
        out in form of cash dividend is known as dividend payout ratio. Dividend
        payout ratio can be calculated as under.

                                     Dividend Paid
                                      Net
                 Divide Payout ratio = income
                 Or
                                       Dividend Per Share
                                       Earning Per Share
        Where,
                                                 Dividend Paid
        Dividend Per Share         =
                                       No. of common shares outs tan ding

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                                                     Net income
      Earnings Per Share                = No. of common shares outs tan ding


      A firm may retain same portion of its earnings for reinvestment purpose.
      The percentage of earnings retained in the firm is called retention ratio.
      High dividend payout ratio means low retention ratio and vice versa.
      Retention ratio is calculated as under :
      Retention ratio = 1 - Dividend Paid out ratio
      Or
                              Re tained earnings
                                  =
                                  Net income
Example
      A company has net income of Rs 4,00,000 this year. It retained Rs
      1,60,000 of those earning for investment purpose. It has 40,000 shares
      outstanding.
      Required :      (i)        Earning per share
                      (ii)       Dividend per share
                      (iii)      Total dividend
                      (iv)       Dividend payout ratio
                      (v)        Retention ratio
Solution
      Given,
               Net income               =          Rs 4,00,000
               Retained earnings        =          Rs 1,60,000
               No. of shares            =       40,000
                                          Net income
      (i)      Earning per share        =
                                        No. of shares
                                        4,00 ,000
                                        =40 ,000
                                        =          Rs 10
        (ii)      Dividend Paid =        Net income - Retained earnings
                                         =       4,00,000 - 1,60,000
                                         =      Rs 2,40,000
                                             Dividend Paid
        (iii)     Dividend per share     =
                                              No. of shares

                                          240000
                                         =
                                           40000
                                        =    Rs 6
                                          Dividend Paid
        (iv)      Dividend payout ratio =
                                            Net income

                                            2,40 ,000
                                         =
                                             4,00 ,000
                                         = 0.60 or 60%
        (v)       Retention ratio =      1 - dividend payout ratio
                                   =     1 - 0.60
                                   =     0.40 or 40%
DIVIDEND PAYMENT PROCEDURES
        Cash dividend refers to the portion of net income paid out to shareholders
        in cash. The dividend payment procedures of a company can be described
        as under:
        1. Declaration date
               The date at which board of directors meet and issue a statement
               declaring dividend is called declaration date. The board of directors set
               the amount of dividend to be paid, the holder - of - record date and the
               payment date on this date. Generally, dividend is announced as a
               percentage of the per value of stock. However, it can be the absolute
               amount like Rs 5 per share in some cases.
        2. Holder - of - record date
               The date on which the company opens the ownership books to make a
               list of shareholders who are entitled to receive the dividend is called
               holder - of - record date. All the stockholders of the record date are
Corporate Finance – Risal et all                                                Page 4
           entitled to receive the dividend declared by the board of directors. The
           new stockholders would receive dividend if the name of shareholders
           is recorded in the ownership book on or before the date of record.
           However, if the notification about the transfer was received after the
           date of record, the old owner of the stock would receive the dividends.
      3. Ex - dividend date
           Ex-dividend date is two business days prior to the record date. Shares
           purchased after the ex-dividend date are not entitled to the dividend.
           The transaction must take place before the ex-dividend date to entitle
           the new holder to receive dividend. Thus, the date when the right to
           the dividend leaves the stock for new owner is called ex-dividend date.
      4. Payment date
           The date on which the company actually pays dividends or mails the
           cheques to the stockholders is called payment date. On this date, the
           company actually pays the dividend to all the stockholders of the date
           of record.
Example 2
      On July 31, 2009, Khushi Company Limited declared a dividend of Rs 5
      per share, payable on October 1 to the holders of record on September 1.
      Show the Khushi's dividend payment procedure.
Solution
      1. Declaration date : July 31, 2009 on which Khushi Company's board of
         directors declared a dividend of Rs 5 per share.
      2. Holder - of - record date : September 1, 2009 on which company
         makes a list of shareholders who are entitled to receive dividend.
      3. Ex-dividend date : August 30, 2009 after which dividends are entitled
         with the seller of the stock.
      4. Payment date : October 1, 2009 on which Khushi Company mails the
         cheque of dividends to the shareholder.
                                               2 days


        31-7-2009                  30-8-2009            1-19-2009         1-10-2009
        Declaration date           Ex-dividend date Holder-of-record date       Payment date

FACTORS AFFECTING DIVIDEND POLICY
        Dividend policy is concerned with determining the proportion of firm's net
        income to be distributed in the form of dividend and the proportion of
        earnings to be retained for investment purpose. A firm's dividend policy is
        influenced by a number of factors. Some of the major factors influencing
        the firm's dividend policy are as under :
        (1) Legal rules
             There are certain legal rules that may limit the amount of dividends a
             firm may pay. Following are the rules relating to dividend
             payment:
             (a) Net profit rule : According to this rule, dividends can be paid out
                 of present or past earnings. Amount of dividends can not exceed
                 the accumulated profits. If there is accumulated loss, it must be set
                 off out of the current earnings before paying out any dividends.
             (b) Insolvency rule :- According to this rule, a firm can not pay the
                 dividends when its liabilities exceed assets. When the firm's
                 liabilities exceed its assets, the firm is considered to be financially
                 insolvent. The firm, financially insolvent, is prohibited by law to
                 pay dividends.
             (c) Capital impairment rule :- According to this rule, a firm can not
                 pay dividend out of its paid up capital. The dividend payout that
                 impairs capital is considered illegal.
        2. Desire of shareholders
             Dividend policy is affected by the desire of shareholders Shareholders
             may be interested either in dividend income or capital gain. Wealthy
             shareholders may be interested in capital gain as against dividend
             income because of low tax rate on capital gain. Where as the

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   shareholders, whose sources of income is dividend only, are interested
   in dividend income and would not be interested in capital gain.
3. Liquidity position
   In order to pay dividend, a company requires cash, and, therefore, the
   availability of cash resources within the company will be a factor in
   determining dividend payments. Generally, the greater the cash
   position and overall liquidity of a company, the greater is the ability to
   pay dividends. A company must have adequate cash available as well
   as retained earnings to pay dividends. The liquidity position of the
   company will influence the dividend payout of a particular year.
4. Rate of expansion of business
   The rate of asset expansion needs to be taken into account. The more
   rapid the rate at which the firm is growing, the greater will be its needs
   for financing assets expansion. The greater the future need for funds,
   the more likely the firm is to retain earnings rather than pay them out.
5. Cost of external financing
   The cost of external financing will have impact on the dividend payout
   of a company. In situations, where the external funds are costlier, a
   firm may resort to low dividend payout and use the internal funds for
   financing its business.
6. Need to repay debt
   The need to repay debt also influence the availability of cash flow to
   pay dividend. If a firm has to repay debt in a particular year, firm may
   decide to low dividend payout and use the funds to repay the debt.
7. Contractual constraints
   When the company obtained loan funds from debenture holders or
   term lending institutions, the terms of issue or contract of loan may
   contain restrictions on dividend payments. Debt contracts often
   stipulate that no dividends can be paid unless the current ratio, times
   interest earned ratio and other safety ratios exceed stated minimums.
8. Access to the capital market
             The company, which has a good access to capital market, can follow a
             liberal dividend policy because this type of the company can raise the
             required funds from the capital market.
        9. Degree of control
             One of the important influencing factor on dividend policy is the
             objective of maintaining control over the company by the existing
             management or shareholders. The management who wish to maintain
             close control over the company will not much depend on the external
             sources of finance, and they maintain a low dividend payout policy
             and the funds generated from operations would be used for working
             capital and capital investment needs of the firm.
        10. Tax position of shareholders
             The tax position of shareholders also influences dividend policy. The
             company owned by wealthy shareholders having high income tax
             bracket tend toward lower dividend payout where as the company
             owned by small investors tend toward higher dividend payout.
        11. Stability of earnings
             The stability of earnings also effects the dividend policy decision. If
             the earnings of a firm are relatively stable, the firm is more likely to
             payout a higher percentage of earnings than the firm which has
             fluctuating earnings.
        12. General state of economy
             When state of economy is uncertain, both political and economic, the
             firm may maintain a low dividend payout policy, to withstand to the
             business risks.
Example 3
        For each of the companies described below, would you expect it to have a
        low, or high dividend payout ratio? Explain why?
        (a) A company with a large proportion of inside ownership, all of whom
            are high income individuals.



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       (b) A growth company with an abundance of good investment
           opportunities.
       (c) A company with volatile earnings and high business risk.
       (d) A company that has high liquidity and is experiencing ordinary
           growth.
Solution
       (a) Low payout ratio : Highly taxed owners generally prefer capital gains
           rather dividend income.
       (b) Low payout ratio : Earning are retained in business to support
           investment opportunities and there will be less residual funds to pay
           dividends.
       (c) Low payout ratio : The company will retain earnings to build its
           financial strength and to offset high business risk.
       (d) High payout ratio : The firm having high liquidity and no more assets
           expansion tend to pay higher dividend.
Example 4
       How would each of the following changes tend to affect dividend payout
       ratio, other things held constant?
       (a) An increase in personal income tax rate.
       (b) A decline in investment opportunities.
       (c) An increase in corporate profit.
       (d) A rise in interest rate.
Solution :
       (a) An increase in the personal income tax rate would lower the dividend
           payout ratio because shareholders with high income tax bracket prefer
           capital gain rather than dividend income.
       (b) A decline in investment opportunities would lead to high dividend
           payout ratio because less retention is required to support investment
           opportunities.
        (c) A permanent increase in corporate profit would lead to increase in
            dividend payout because the firm has more earnings to distribute
            dividend.
        (d) An increase in interest rate would lead to low dividend pay out
            because retained earnings may be a relatively attractive way of
            financing new investment.

DIVIDEND PAYOUT SCHEMES
        A firm can pay dividends using either residual dividend policy or stable
        dividend policy.
        1. Residual dividend policy
             Residual dividend policy is based on the assumption that investors
             prefer to have a firm retain and reinvest earnings rather than pay our
             them in dividends. Under residual dividend policy, a firm pays
             dividend only after meeting its investment need at desired debt - equity
             ratio. This policy is based on the following assumption:
             (a) The firm wishes to minimize the need of external equity.
             (b) The firm wishes to maintain its current capital structure.
             Under residual dividend policy, if the net income exceeds the portion
             of equity financing, then the excess of net income over equity need is
             paid as dividend. The company does not pay any dividend when net
             income is less than or equal to equity need for financing the
             investment proposals. In case, net income is not sufficient to meet
             equity need, the company should raise deficit amount by external
             equity. Following steps should be followed to determine amount of
             dividend under residual dividend policy :
             (a) Determine the optimal capital budget.
             (b) Find out target equity ratio in capital structure
                 Target equity ratio = 1 - Debt ratio.
             (c) Determine the amount of equity required to finance the optimal
             capital budget.


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              Equity financing required = Optimal Capital Budget  Target
              equity ratio
           (d) Pay dividends if earnings are more than equity financing required.
              Dividends = Net income - (Capital budget  Target equity ratio)
Example 5
      National Corporation has a target capital structure that consists of 60%
      debt and 40% equity. The company anticipates that its capital budget for
      the upcoming year will be Rs 3,00,000. If the company reports net income
      of Rs 2,00,000 and it follows a residual dividend policy, what will be its
      dividend payout ratio?
Solution
              Target debt ratio       = 60%
              Target equity ratio     = 40%
              Capital Budget          = Rs 300,000
              Net income              - Rs 2,00,000
      Under residual dividend policy,
      Dividend        = Net income - (Capital budget  Target equity ratio)
                      = 200000 - (300000  0.40)
                      = 200000 - 120000
                      = Rs 80,000
                                    Dividends
      Dividend payout ratio =
                                    Net income

                                  80000
                             =
                                 200000
                             = 0.4 or 40%
      2. Stable dividend policy :-
           Stability or regularity of dividend is considered as a desirable policy
           by the management of most companies because stable dividends have
             a positive impact on the market price of the share. Following are the
             most commonly used constant dividend policies :
             (a) Constant dividend per share :- Under this policy, a fixed amount of
                 dividend per share is paid on annual basis irrespective of earnings
                 of the company. The earnings may fluctuate from year to year but
                 dividend per share remains unchanged. However, it does not mean
                 that dividend per share never be increased. Dividend per share can
                 be increased when the firm can sustain the higher level. The
                 relationship between earning per share and dividend per share
                 under this policy can be shown by following figure :
             (b) Constant payout ratio :- Under this policy, a fixed percentage of
                 the net earnings is paid as dividends every year. If earnings vary,
                 the amount of dividend also varies from year to year. If earnings
                 increase, dividends also increase and if earnings decrease,
                 dividends also decrease. Dividends are paid when profits are
                 earned. No dividend is paid when the firm suffers loss in any year.
                 The relation between earning per share and dividend per share is
                 shown as under :
             (c) Regular dividend plus extra dividend policy :- Under this policy, a
                 minimum constant dividend per share is fixed and additional
                 dividend is paid over the regular low dividends in the years of
                 relatively high earnings. This policy is a compromise between
                 constant dividend per share and constant payout ratio policy. The
                 low regular dividend is maintained even when earnings decline and
                 extra dividends can be paid when earnings are more.
Example 6
        City corporation has the following earning per share over the last 5 years.
                          Year                        EPS (Rs)
                          1                           12
                          2                           12
                          3                           20
                          4                           20

Corporate Finance – Risal et all                                           Page 12
                            5                               24
                  Determine dividend per share under the following policies:
      (a) A constant dividend per share of Rs 8
      (b) A constant dividend pay out ratio of 40%
      (c) Rs 5 regular dividend per share and extra dividend to bring the pay out
          ratio to 40%.
Solution
      (a)         Constant dividend per share

   Year                1               2              3               4          5

   EPS                12               12             20             20          24

   DPS                 8               8              8               8          8

      (b)         Constant dividend payout ratio of 40%

   Year               1                2              3              4           5

   EPS               12            12                20              20         24

D/P Ratio            0.40         0.40               0.40            0.4        0.4

   DPS               4.80         4.80                8              8          9.60

      (c)         Regular dividend plus extra dividend

           Year                   1             2                3         4         5

            EPS                   12            12           20            20     24

  Minimum dividend                5             5                5         5         5

           Extra                   -            -                3         3     4.60

    Total dividend                5             5                8         8     9.60

FORMS OF DIVIDEND
      CASH DIVIDEND
         When dividend is distributed to shareholders in cash out of the earnings of
         the company, it is called cash dividend. When cash dividend is distributed,
         both total assets and net worth of the company decrease. Total assets
         decrease as cash decreases and net wath decreases as retained earnings
         decrease. The market price per share also decreases in most cases by the
         amount of cash dividend distributed.
         Marker price per share after cash dividend = Marker price per share before
         cash dividend - dividend per share.
Example 7
         The Neha Corporation's balance sheet as of 31st Dec. 2009 before the
         dividend is as follows :
                                       Balance Sheet

           Liabilities              Rs                 Assets               Rs

  Common stock (20000              200000     Cash & bank                  100000
  shares of Rs 10)

  Retained earnings                100000     Other current assets         100000

  Paid in Capital                    50000    Fixed assets                 300000

  Debt                             150000

                                   500000                                  500000

         Market price per share of common stock is Rs 17.5
         (a) Construct a profroma balance sheet if company pays Rs 2.5 per share
             cash dividend.
         (b) Determine the marker price per share after cash dividend.
Solution :-


         (a)                           Balance Sheet
                                    after cash dividend


Corporate Finance – Risal et all                                           Page 14
         Liabilities                   Rs             Assets              Rs

Common stock           (20000         200000    Cash & bank                 50000
shares of Rs 10)

Retained earnings                      50000    Other current assets       100000

Paid in Capital                        50000    Fixed assets               300000

Debt                                  150000

                                      450000                               450000

       W. Notes :
       Dividend Paid            = 20000  2.5 = Rs 50000
       Cash & bank balance = 100000 - 50000
                                = Rs 50000
       Retained earnings        = 100000 - 50000
                                = Rs 50000
       (b)    Marker price per share after cash dividend = Market price per
       share before cash dividend - dividend per share
                                = 17.5 - 2.50
                                = Rs 15

STOCK DIVIDEND/BONUS SHARES
       Stock dividend refers to the dividends paid to the existing stockholders in
       the form of additional shares of common stock. It represents a distribution
       of additional shares to existing shareholder. Stock dividend increases the
       number of outstanding shares of the firm's stock. It involves simply an
       accounting entry transfer from retained earnings account to the common
       stock and paid in capital accounts. Due to stock dividend, retained
       earnings decrease, common stock and paid in capital increase. The stock
       dividend does not affect the equity position of stockholders. Market price
       per share and earning per share after stock dividend will decrease.
        No. of bonus shares = No. of shares outstanding  % of stock dividend.
        Decrease in Retained earnings = No. of bonus shares  Market price per
        share.
        Increase in common stock = No. of bonus shares  par value per share.
        Increase in paid in capital = No. of bonus shares  paid in capital per
        share.
        Marker price per share after stock dividend =
                         Market price per share before stock dividend
                                  1  stock dividend in fracton
        Advantages
        The important benefits derived from stock dividend or issue of bonus
        shares are as follows :
        1. It preserves the company's liquidity as no cash leaves the company.
        2. The shareholders receive a dividend which can be converted into cash
           whenever he wishes through selling the additional shares.
        3. It broadens the capital base and improves image of the company.
        4. It reduces the marker price of the shares, rendering the shares more
           marketable.
        5. It is an indication to the prospective investors about the financial
           soundness of the company.
        6. The shareholders can take the advantage of tax saving from stock
           dividend.

        Disadvantages
        1. The future rate of dividend will decline.
        2. The future market price of share falls sharply after bonus issue.
        3. Issue of bonus shares involve lengthy legal procedures and approvals.
Example 8
        The Janaki Rice Mills has the following shareholder's equity account :


Corporate Finance – Risal et all                                           Page 16
      Common stock (Rs 10 par value)                                    2,00,000

      Additional Paid in Capital                                        2,00,000

      Retained earnings                                                 4,00,000

                  Shareholder' equity                                   8,00,000

      Market price of the stock is Rs 40 per share
      (a) Reformulate the shareholders equity account if the company declares
          20% stock dividend
      (b) What will be the share price after 20% stock dividend?
Solution
       (a)

      Common stock (24000 shares of Rs 10)                              2,40,000

      Additional Paid in Capital                                        3,20,000

      Retained earnings                                                 2,40,000

                  Shareholder' equity                                   8,00,000

      Working Notes :
             Addition bonus shares = 20,000  20% = 4,000
             Increase in common stock      = 4,000  10 = Rs 40,000
             Increase in paid in capital   = 4000  30 = Rs 1,20,000
             Decrease in retained earnings = 4000  40 = Rs 1,60,000
      (b)
                                                       Stock price before stock dividend
      Market price per share after stock dividend =
                                                        1  Stock dividend in fraction
                                                            40
                                                     =   1  0.20
                                                          40
                                                     =
                                                         1.20
                                                      = Rs 33.33

STOCK SPLIT
        A stock split is a method to reduce the marker price per share by giving
        certain number of share for one old share. Due to stock split, number of
        outstanding shares increase and par value and marker price of the stock
        decrease. A stock split affects only the par value, market value and the
        number of outstanding shares. However, net worth of the company
        remains unaltered.
        With a stock split, shareholder's equity account does not change, but the
        par value per share changes. The earnings per share will be diluted and
        marker price per share fall propotionately with a stock split. But, the total
        value of the holdings of a shareholder remains unaffected by a stock split.
        Following ate the reasons for splitting a firm's ordinary shares :
        1. Stock split results in reduction in market price of the share. It helps in
           increasing the marketability and liquidity of a company's shares.
        2. Stock splits are used by the company management to communicate to
           investors that the company is expected to earn higher profits in future.
        3. Stock split is used to give higher dividends to shareholders.
Example 9
        XZY Company has the following shareholder's equity account.

       Common stock (10000 shares of Rs 100 each)                          10,00,000

       Additional Paid in Capital                                          10,00,000

       Retained earnings                                                   20,00,000

                             Shareholder' equity                           40,00,000

        The current marker price per share is Rs 400 each.
        (a) Reformulate the shareholder's equity account if the company split their
            shares two - for - one
        (b) What will the marker price per share after stock split?


Corporate Finance – Risal et all                                            Page 18
Solution
       (a) Shareholder's equity after stock split

   Common stock (20000 shares of Rs 50)                                  10,00,000

   Additional Paid in Capital                                            10,00,000

   Retained earnings                                                     20,00,000

                     Shareholder' equity                                 40,00,000

       (b) Marker price per share after stock split = Rs 400  1/2 = Rs 200.

REVERSE STOCK SPLIT
       Reverse stock split is method used to raise marker price of a firm's stock
       by exchanging certain number of outstanding shares for one new share of
       stock. Due to reverse stock split, number of outstanding shares decreases,
       par value of the shares increases and marker price per share also increases.
       However, total net worth of the company remains unchanged. Reverse
       stock split is used to stop the marker price per share below a certain level.
       The reverse split is generally an indication of financial difficulty and is,
       therefore, intended to increase the marker price per share.
Example 10
       XYZ company has the following shareholder's equity account

    Common stock (20000 shares of Rs 50)                                 10,00,000

    Additional Paid in Capital                                             5,00,000

    Retained earnings                                                      5,00,000

                    Shareholder' equity                                  20,00,000

       What will happens to this account and no. of shares outstanding with a 1-
       for-2 reverse stock split?
Solution :
                             Shareholder's equity Account
      Common stock (10000 shares of Rs 100)                          Rs. 10,00,000

      Additional Paid in Capital                                       Rs. 5,00,000

      Retained earnings                                                Rs. 5,00,000

                             Shareholder' equity                     Rs. 20,00,000

                                   No. of Shares                         Rs. 10,000

REPURCHASE OF STOCK
        Stock repurchase is method in which a firm buys back shares of its own
        stock, there by decreasing shares outstanding, increasing earning per
        share, and, often increasing the stock price. It is an alternative to cash
        dividends. In a stock repurchase, the company pays cash to repurchase
        shares from its shareholders. These shares are usually kept in the
        company's treasury and then resold when the company needs money.
        If a firm has excess cash, it may purchase its own stock leaving fewer
        shares outstanding, increasing the earning per share and increasing the
        stock price. It may be an alternative to paying cash dividends. The benefits
        to the shareholders are the same under cash dividend and stock repurchase.
        In the absence of personal income taxes and transaction costs, both cash
        dividend and stock repurchase have no any difference to shareholders.
        Capital gain arising from repurchase should equal the dividend otherwise
        would have been paid.
        Repurchase price or equilibrium price is the price that brings capital gain
        equal to the cash dividend. Share price for repurchase or the equilibrium
        price is calculated from the following equation:
                                     SP    c
        Repurchase Price (P*) =
                                      S n
        Where,
                 S = Total number of shares outstanding
                 Pc = Current marker price per share
                 n = Number of shares to be repurchased.



Corporate Finance – Risal et all                                           Page 20
Share can be repurchased in different ways. A company can repurchase its
shares through authorized brokers on the open market. Shares can be also
repurchased by making a tender offer which will specify the purchases
price, the total amount and the period within which shares will be bought
back. Similarly, a company can purchase a block of shares from one large
holder on a negotiated basis.
Advantages of repurchase of stock
1. A firm an use idle cash to repurchase stock if it has less investment
   opportunities.
2. Dividend and earning per share will be increased through stock
   repurchase.
3. Stock repurchase will result in increase in the share value.
4. The buying shareholders will benefit since the company generally
   offer a price higher than the current market price of the share.
5. When shares are under valued in the market, a company can buy back
   shares at higher price to move up the current share price.
6. If a company has high proportion of equity in its capital structure, if
   can reduce equity capital by buying back its shares to achieve target
   capital structure.
7. The promoters of the company benefit by consolidating their
   ownership and control over companies through stock repurchase. They
   do not sell their shares to the company rather make the share
   repurchase attractive for others.
8. Repurchase of stock can remove a large block of stock that is
   overhanging the market and keeping the price per share down.
9. In a hostile takeover, a company may buy back its shares to reduce the
   availability of shares and make take over difficult.
10. Stockholder are given a choice of whether or not to sell their stock to
    the firm.
Disadvantages of stock repurchase
        1. Shareholders may not be indifferent between dividends and capital
           gains, and the price of stock might benefit more from cash dividends
           than from repurchase.
        2. The remaining shareholder may lose if the company pays excessive
           price for the shares under the stock repurchase scheme.
        3. Stock repurchase may signal to investors that the company does not
           have long - term growth opportunities to utilize the cash.
        4. The buyback of shares may be useful as a defense against hostile
           takeover only in case of cash rich companies.
Example 11 :-
        A company has Rs 16,00,000 in excess funds. The company wishes to
        distribute these funds to repurchase the stock.
        Presently, it has 4,00,000 shares outstanding and the market price per
        share is Rs. 36. It wishes to repurchase 10% of its stock or 40000 shares.
        a. Assuming no signaling effect, at what price should the company offer
           to repurchase?
        b. In total, how much will the company be distributing through share
           repurchase?
        c. If the company were to pay out the funds through cash dividend
           instead, what will be the market price per share after the distribution?
Solution
        (a)      Current marker price (Pc) = Rs 36
                 No. of shares outstanding (S) = 4,00,000
                 No. of shares repurchased (n) = 40,000
                 Required repurchase price (P*) = ?
                 Now,
                                       S  Pc
                          P*       =
                                       S n
                                         400000  36
                                   =
                                       400000  40000
Corporate Finance – Risal et all                                          Page 22
                            = Rs 40
      Assuming no signaling effect, the company should offer to repurchase its
      stock at Rs. 40.
      (b)    The company will be distributing Rs 16,00,000 (40,000  Rs 40)
      through share repurchase.
                                                Total dividend
      (c)    Cash dividend per share     = No. of Common Stock

                                                  16 ,00 ,000
                                            =
                                                   4,00 ,000
                                            = Rs 4
      Marker price per share after cash dividend   = Rs 36-4
                                                   = Rs 32.
Illustrative Problems
      1. MN Company expects to generate following net income during next
         years.
              Year                  Net income
              1                     4,00,000
              2                     6,00,000
              3                     8,00,000
              The company currently has 100000 shares outstanding.
      (a) Determine earning per share in each year.
      (b) Determine total dividend and dividend per share if a dividend pay out
          ratio of 50% is maintained.
      (c) Determine dividend per share if company declares Rs 2 regular
          dividend per share and extra dividend in order to bring the payout ratio
          to 50% if it otherwise would fall below.
Solution
      (a)     Earning Per Share

       Year                  1                     2                    3
      Net income               4,00,000                6,00,000         8,00,000

     No. of shares             1,00,000                1,00,000         1,00,000

     *Earning Per                  4                       6               8
        Share


                                                  Net income
                 * Earning Per Share =
                                                 No. of Shares

        (b)      Dividend per share & total dividend

              Year                      1                  2               3

         Net income                4,00,000            6,00,000         8,00,000

          D/P Ratio                    50%               50%             50%

      * Total dividend             2,00,000            3,00,000         4,00,000

       No. of Shares               1,00,000            1,00,000         1,00,000

    Dividend Per Share                  2                  3               4

        * Total dividend = Net income  dividend payout ratio


        ** Dividend Per Share =             Total dividend
                                            No. of Shares
        (c)      Dividend Per Share

              Year                           1                   2             3

         Net income                    4,00,000              6,00,000    8,00,000

        No. of shares                  1,00,000              1,00,000    1,00,000

     Earning Per Share                       4                   6             8

     Regular Dividend                        2                   2             2


Corporate Finance – Risal et all                                            Page 24
    Extra Dividend                     -                     1             2

Total dividend per share               2                     3             4

     2. Janakpur Rice Mill expects next year's net income to be Rs 12,00,000.
        Its debt to equity ratio is currently 60%. It has Rs 9,60,000 of
        profitable investment opportunities, and its wishes to maintain its
        existing debt ratio. According to residual dividend model, how large
        should the company's dividend payout ratio be next year?
     Solution,
             Debt    to equity ratio          =        60%
             Let,    Amount of equity         =        100
                     Amount of Debt           =        60
                     Total assets             =        100+60
                                              =        160
                                           Debt
             Debt ratio                =
                                           Assets
                                          60
                                       = 160
                                       = 0.375
             Equity ratio              = 1 - Debt ratio
                                       = 1 - 0.375
                                       = 0.625
                                       = 62.5%
             Dividend Paid = Net income - (Capital budget  equity ratio)
                                       = 12,00,000 - (96,00,000  0.625)
                                       = 12,00,000 - 6,00,000
                                       = Rs 6,00,000

                                                 Dividend
             Dividend payout ratio =         Total Net income
                                                      6,00 ,000
                                                 =   12 ,00 ,000
                                                 = 0.50 or 50%
        3. Nepal Industrial Bank has the following shareholder's equity account

          Common Stock (20,000 shares of Rs 10 per)                          2,00,000

          Paid in Capital                                                    1,00,000

          Retained earnings                                                  2,00,000

                          Shareholder's equity                               5,00,000

        Current Marker price of the stock is Rs 30 per share.
        (a) What happen to these accounts if the company declared 10% stock
            dividend?
        (b) What would happen to these accounts if the company declared a 2 - for
            - 1 stock split?
        (c) What would happen if there was a reverse stock of 1 - for - 4?
Solution
        (a)      Shareholder's equity after stock dividend

      Common Stock (22000 shares of Rs 10 per)                               2,20,000

      Paid in Capital                                                        1,60,000

      Retained earnings                                                      1,20,000

                        Shareholder's equity                                 5,00,000

        Working Notes :
                 Extra shares for stock dividend        = 20,000  10%
                                                        = 2,000 shares.
                 Increase in common stock               = 2,000  Rs 10 = Rs 20,000
                 Increase in paid up capital            = 2,000  Rs 30 = Rs 60,000

Corporate Finance – Risal et all                                             Page 26
       Decrease in retained earnings = 2,000  Rs 40
                                                = Rs 80,000
(b)    Shareholder's equity after stock split

 Common Stock (40,000 shares of Rs 5)                              2,00,000

 Paid in Capital                                                   1,00,000

 Retained earnings                                                 2,00,000

              Shareholder's equity                                 5,00,000

Working Notes :
       No. of shares after split      = 20,000  2/1
                                      = 40,000 shares.
       Par value after split          = 10  1/2
                                      = Rs 5
(c)    Shareholder's equity after Reverse stock split

 Common Stock (5,000 shares of Rs 40)                              2,00,000

 Paid in Capital                                                   1,00,000

 Retained earnings                                                 2,00,000

              Shareholder's equity                                 5,00,000

Working Notes :
       No. of shares after reverse stock split = 20,000  1/4
                                                = 5,000 shares
       Par share after reverse stock split      = 10  4/1
                                                = Rs 40
4. After a 4 - for - 1 stock split, Spice Nepal Limited paid a dividend of R
   3 per new share, which represents a 20% increase over last year's pre -
   split dividend. What was last year's dividend per share?
        Solution :
                 After stock split dividend per shares (D1)          = Rs 3
                 Before stock split dividend per share (D1)   = Rs 3  4/1
                                                                     = Rs 12
                 growth rate (g) = 20%
                 Last year's dividend (Do) = ?
                 We know,
                          D1       = Do (1+g)
                 or,      12    = Do (1 + 0.20)
                              12
                 or,      Do    =
                             1.20
                                = Rs 10.
                 Hence, last year's dividend per share was Rs 10.
        5. Khushi Compnay treats dividend as a residual decision. It expects to
           generate Rs 5 million in net earnings after tax in the coming year. The
           company has an all - equity capital structure and its cost of equity
           capital is 20%. The company treats this cost as the opportunities cost
           of retained earnings. Cost of external equity is 21%.
              (a) How much in dividends should be paid if the company has Rs 3
                  million in projects whose expected return exceeds 20% percent?
              (b) How much in dividends should be paid if it was Rs 5 million in
                  projects whose expected return exceeds 20%?
              (c) How much in dividends should be paid if it has Rs 6 million in
                  projects whose expected return exceeds 21%.
Solution
        (a) Dividends to be paid = Net income - (Capital budget  equity ratio)
                                   =5-31
                                   = Rs 2 million.
        (b)      Dividends to be paid

Corporate Finance – Risal et all                                              Page 28
                     = Net income - (Capital budget  equity ratio)
                     =5-51
                     = Nil
      (c)    Dividend to be paid (external financing) = Net income - (Capital
      budget  equity ratio)
                             =5-61
                             = (Rs 1 million)
      Hence, the company will not pay any dividend rather it should raise Rs 1
      million in additional new common stock externally to satisfy the financing
      need.
      6. ABC corporation has Rs 6 million in excess funds. The corporation
         wishes to distribute these funds via the repurchase of stock. Presently,
         it has 24,00,000 shares outstanding, and the marker price per share is
         Rs 25. It wishes to repurchase 10% of its stock, or 2,40,000 shares.
      (a) Assuming no signaling effect, at what price should the company offer
          to repurchase?
      (b) In total, how much will the company be distributing through share
          repurchase?
      (c) If the company were to pay out the funds through cash dividends in
          stead, what would be the marker price per share after the distribution?
Solution
      (a)    Current Marker Price (Pc) = Rs 25
             No. of shares outstanding (S) = 24,00,000
             No. of shares repurchased (n) = 2,40,000
             Repurchase Price (P*) = ?
             We know,
                                  S  Pc
                             P*      =
                                  S n
                                               24 ,00 ,000  25
                                           24 ,00 ,000  2,40 ,000
                                       =
                                       = Rs 27.78
        (b)      Total distribution through stock repurchase = 2,40,000  Rs 27.78
                                                                  = Rs 66,67,200
                                                         Dividend Paid
        (c)      Divident Per Share            =
                                                          No. of Shares
                                                         66 ,67 ,200
                                               =         24 ,00 ,000
                                               = Rs 2.78
                 Market price after cash dividend        = 25 - 2.78
                                                         = Rs 22.22
        7. Sharda Company repurchased 50,000 shares of its 5,00,000 shares
           outstanding at a price of Rs 55 per share. Immediately prior to the
           share repurchase announcement, share price was Rs 45. However,
           2,00,000 shares were tendered by stockholders wanting to sell. The
           company had to repurchase the 50,000 shares on a pro - rata basis
           according to the number of shares tendered.
        (a) Why did so many shareholders tender their shares? At what price
            should the company have made its repurchase offer?
        (b) Who gained from the offer? Who lost?
Solution
        (a) Current marker price (Pc) = Rs 45
              No. of shares outstanding (S) = 5,00,000
              No. of shares repurchased (n) = 5,00,00 shares
        Equilibrium price or repurchase price (P*) = ?
                           S  Pc
               P*     =
                           S n
                             5,00 ,000  45
                      = 5,00 ,000  50 ,000
                          = Rs 50

Corporate Finance – Risal et all                                              Page 30
         Since the offer price (Rs 55) is more than the equilibrium
  repurchase price, many shareholders tendered their shares to sell. The
  company should have made its offer at Rs 50 instead of Rs 55.
  (b) The holder of shares whose shares were repurchased gained from the
      tender offer and remaining shareholder suffered loss.

SUMMARY
  Dividend Policy is concerned with the decisions regarding division of net
  income to the dividend and retained earnings. The firm should determine
  optimum dividend policy which leads the firm to stockholders wealth
  maximization. A company can adopt either residual dividend policy or
  stable dividend policy. Three alternative stable dividend policies are
  constant dividend per share, constant dividend pay out and regular plus
  extra dividend policy.
  A firm's dividend payment procedures start with determining the
  declaration date on which board of directors declare dividends to be paid,
  the holders of record date and payment date.
  A firm's dividend policy is influenced by a large no. of factors like legal
  requirements, desire of shareholders, liquidity position; need to repay debt,
  desire of control, rate of business expansion, access to capital market, tax
  position of shareholders, restrictions in debt contracts etc.
  Cash dividend is the dividend, which is distributed to shareholders in cash.
  Due to cash dividend, total assets as well as net worth decrease as cash
  and retained earnings decrease. The market price of share also decreases
  by the amount of cash dividend distributed.
  A stock dividend refers to the dividend distributed to existing shareholders
  in the form of additional shares rather than in cash. Due to stock dividend,
  no. of outstanding shares increases, Common stock and paid in capital
  increases and retained earnings decrease. However, net worth remains
  unchanged.
  Stock split increases the number of outstanding shares with a
  proportionate decrease in par value. Reverse stock split decreases the
  number of shares outstanding with a proportionate increase in par value.
        With a stock split and reverse stock split, shareholder's equity remains
        unchanged.
        In a stock repurchase, a firm buys back some of its outstanding shares,
        thereby decreasing number of shares, increasing earning per share and
        marker price. It is an alternative to paying cash dividend.




Corporate Finance – Risal et all                                       Page 32

								
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