# UNIT 2 n DIVIDEND n n PAYOUT RATIO

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UNIT 2 n DIVIDEND n n PAYOUT RATIO (OR) DIVIDEND RATIO n n The percentage of earnings given as dividend to shareholders RETENTION RATIO n n The return given to shareholders on purchase of share is called as dividend The percentage of earnings retained by the company is called as retention ratio CAPITAL GAIN n The gain the shareholders receive while selling the shares is called as capital gain

n DIVIDEND DECISIONS: n n It is the decision taken by the company to determine the amount of earnings to be given as dividend and the amount of earnings to be retained by the company. Optimum payout ratio: n It is the best payout ratio that the company can give to the shareholders which should try to maximise the value of the shareholders

THEORIES OF DIVIDEND n 1. RELEVANT THEORY n n WALTER MODEL GORDON MODEL According to walter and gordon, the dividend decision affects the market price of the share. So the both theories are called as relevant theory 2. IRRELEVANT THEORY n n MM HYPOTHESIS According to MM, the dividend decision does not affect the market price, so it is called as irrelevant theory

RELEVANT THEORY n WALTER MODEL n ASSUMPTIONS n n n Only internal financing ‘r’ and ‘k’ are constant 100 percent payout or retention Constant EPS and dividend The firm has infinite life

WALTER MODEL contd… n Formula n n n n P 0 = Div + (EPS – Di. V) (r/k) k Where, P 0 = Market price of share Div = Dividend per share EPS = Earnings per share r = rate of return (or) internal rate of return (or) productivity of retained earnings K = cost of capital (or) discount rate (or) capitalization rate (or) requires rate of return

WALTER MODEL contd… n n n If r > k , then it is a Growth firm, the optimum payout ratio is 0% If r = k, then it is a normal firm, the optimum payout ratio is not applicable If r < k, then it is a declining firm, the optimum payout ratio is 100%

WALTER MODEL contd… n Criticism or disadvantages of walter model: n n n No external financing Constant return Constant cost of capital

RELEVANT THEORY n GORDON MODEL: (or) Dividend growth model n ASSUMPTIONS n n n n Only internal financing ‘r’ and ‘k’ are constant All equity firm Perpetual earnings No taxes Constant retention K is greater than ‘g’ , growth rate

growth model n Formula n n n n P 0 = EPS ( 1 – b) k - br Where, P 0 = Market price of share EPS = Earnings per share r = rate of return (or) internal rate of return (or) productivity of retained earnings K = cost of capital (or) discount rate (or) capitalization rate (or) requires rate of return b = retention ratio

GORDON MODEL: (or) Dividend growth model n n n If r > k , then it is a Growth firm, the optimum payout ratio is 0% If r = k, then it is a normal firm, the optimum payout ratio is not applicable If r < k, then it is a declining firm, the optimum payout ratio is 100%

IRRELEVANT THEORY n MM hypothesis: (Modigliani Miller) n Assumptions: n n n Perfect capital market No taxes Fixed investment policy No risk r = k

MM hypothesis n Formula to calculate market price of share n P 1 = P 0 ( 1 + Ke) – Div 1 n Where n n P 1 = market price of the share P 0 = current market price of the share Ke= cost of equity capital Div 1 = dividend per share

MM hypothesis n According to MM hypothesis, a firm can pay dividend and if they require any additional capital for investments that can be get by retained earnings or by issue of new shares to the shareholders.

MM hypothesis n n n The number of new shares to be issued can be found out m. P 1 = I – (X – n. Div 1) Where n n n m= no. of new shares to be issued P 1 = price of the share when dividend is declared I = investment amount required X= netprofit n= no. of outstanding shares Div 1= dividend per share

Dividend policy n n n n Dividend policy of the firm affects the firm’s investment opportunities as well as wealth of the shareholders of that firm If firm earns profit, that has to be divided into two parts: dividend and retained earnings. Retained earnings are used to finance long term investment opportunities of the firm Dividends are given to shareholders as cash Both dividend and retained earnings result in cash outflow. If more dividends are given , then retained earnings will be low. For future investments the firm again has to issue new shares or has to go for debt. So, Dividend policy of the firm affects the firm’s investment opportunities as well as wealth of the shareholders of that firm

Dividend policy n The following questions are related to the dividend policy of the firm n n n n n Firm’s future investment opportunities and financial needs Shareholders expectation on dividend Firm’s risk in business Firm’s constraints in paying dividend Control of firm Stable dividend policy of the firm Form of dividend Share split Share buyback

Different types of Dividend policy (or) Dividend policies in practice n n n Constant dividend per share Constant payout Constant dividend per share plus extra dividend High payout Low payout

Constraints in paying dividend (or) Factors affecting/influencing dividend decisions (or) determinants of dividend n n n n Legal restrictions Liquidity Financial conditions and borrowing capacity Access to the capital market Restrictions in loan agreements Inflation control

Stability of dividend (or) Stable dividend policy n Types: n n Merits: n n n Constant dividend per share Constant payout Constant dividend per share plus extra dividend Resolution of investors uncertainty Investors desire for current income Institutional investors requirement Raising additional finances Dangers of stability of dividend: n n n Once established, cannot be changed Even if one year without dividend will affect the shareholders a lot Dividend to be paid even if there is no profit

Forms or types of dividend n n n Cash dividend Stock dividend or bonus shares Bond dividend Scrip dividend Property dividend

Stock dividend or bonus shares n n Bonus share or stock dividend is nothing but giving a part as cash dividend and balance dividend in the form of additional shares Advantages: n n n n n To shareholders: Tax benefits Indication of higher future profits Future dividends may increase Psychological value To company Conservation of cash Only means to pay dividend during financial difficulty More attractive share price Disadvantages: n n n Shareholders wealth remain unaffected Costly to administer Problem of adjusting EPS and P/E ratio

Share split or stock split n n Share split is a method to increase the number of outstanding shares through a proportional reduction in the par value of the share. Reasons for share split: n n n To make shares attractive It is the indication higher future profits To give higher dividend to shareholders

Reverse split n n The reduction in the number of outstanding shares by increasing the par value of the share is called as reverse split This is done if the company’s share price falls.

Share buyback or Equity repurchase (or) Stock repurchase n Buyback of shares n n The buyback of shares is the repurchase of its own shares by a company Methods of share buyback: n n Through authorized brokers Through tender offer

Share buyback or Equity repurchase cond. . n Advantages of share buyback n n n n Return of surplus cash to shareholders Increase in the share value Increase in the temporarily undervalued shares Achieving the target capital structure Consolidating control Tax savings by companies Protection against hostile takeover Disadvantages of share buyback n n Not an effective defence against takeover Shareholders do not like the buyback Loss to the remaining shareholders Signal of low growth opportunities

Dividend as a residual payment n Internal equity (in the form of retained earnings) is cheaper than external equity. An important dividend prescription advocates a residual policy to dividends. According to this policy the equity earnings of the firm are first applied to provide equity finance required for supporting investments. The surplus, if any, left meeting the equity investment needs is distributed as dividends. Put differently, dividends are merely treated as a residual payment after equity investment needs are fulfilled. Firms subscribing to the residual dividend policy may adopt one of the following approaches: n n n Pure Residual Dividend Approach: According to this approach, dividends are equal to earnings minus investment needs. Obviously when investment exceed earnings no dividends are paid. Fixed Dividend Payout Approach: As per this approach, dividends are a fixed proportion of earnings. The proportion is set in such a manner that in the long run dividends are equal to equity earnings minus equity finance required to support investments. Smoothed Residual Dividend Approach: Under this approach, dividends are varied gradually over time. The level of dividends is so set that in the long run the total dividends paid are equal to total earnings less equity finance required to support investments.

Capital budgeting or Capital expenditure decisions or Investment decisions n Definition: n The firm’s decision to invest their current funds in long term assets in anticipation of future benefits over a series of years.

Importance of investment decisions n n n It influences the firm’s growth in the long run It affects the risk of the firm It involves commitment of large amount of funds They are irreversible They are the most difficult decision to make

Types of investment decisons n Expansion and diversification n Replacement and modernization n n Related diversification Unrelated diversification Otherwise called as cost reduction investments Mutually exclusive investment Independent investments Contingent investments

Mutually exclusive projects n n Mutually exclusive projects are two projects wherein the taking up of one project prevents the taking up of the other project. Say for ex if there are two projects A and B respectively then A and B are said to be mutually exclusive if the investor decides to invest in project A he cannot invest in project B and vice versa. It can also be termed as It is important for a fund manager to rank these mutually exclusive project based on the return. These rankings are important while making investment decisions. Usually fund managers uses NPV and IRR method to rank the projects. In most of the cases these two methods fail miserably. Therefore it becomes difficult for the investor to make decisions. The main problem in the above two method is the lack of consideration of the time period in these methods. Time period plays a vital role in the investment decisions. Since the time period is not considered in the above two method ranking based on the above two methods often end up in a failure. Mathematically it can stated that the varying cash in flow of the various investments are the primary reason for the not including the time factor in the calculation.

Phases (or) steps in capital budgeting (or) Procedures adopted in the process of investment decisions n Ist step Identification involved in capital budgeting proposals 2 nd step Screening the proposal 3 rd step Evaluation of various proposals 4 th step Fixing the priorities 5 th step Final approval and planning the capital expenditure 6 th step Implementing the proposal 7 th step Performance review

Methods of capital budgeting (or) Techniques of capital budgeting (or) Investment evaluation criteria n General methods n Traditional methods n n n Discounted cash flow (DCF) methods n n Payback period (PB) Average rate of return (ARR) Net present value(NPV) Profitability index (PI) Internal rate of return (IRR) Risk analysis methods n n n n Risk adjusted discount rate Probability assignment Sensitivity analysis Standard deviation Coefficient of variation Certainty equivalent approach Decision tree approach

General methods in capital budgeting n General methods n Traditional methods n n n Payback period (PB) Average rate of return (ARR) Discounted cash flow (DCF) methods n n n Net present value(NPV) Profitability index (PI) Internal rate of return (IRR)

General methods in capital budgeting n Payback period: n n It is the number of years required to recover the amount invested in a project Even cash inflow: n n n Annual cash inflow Uneven cash inflow: n n Payback = Initial investment Payback can be calculated by cumulative method Acceptance rule: n The project with shortest payback can be selected

General methods in capital budgeting contd… n Payback contd… n Advantages n n n Simplicity cost effective Short term effects Risk shield liquidity Disadvantages n n n Cash flows after payback not considered Not an appropriate method to measure the profitability of project Fails to consider the cash flow pattern Administrative difficulties Inconsistent with the shareholder value

General methods in capital budgeting contd… n Average rate of return (or) Accounting rate of return (ARR) n n n Also known as Return on Investment (ROI) It is the ratio of average annual cash inflows and average investment ARR = Average annual cash inflow X 100 Initial investment / 2 Acceptance rule: In two projects, project with highest ARR is selected

General methods in capital budgeting contd… n Advantages of ARR: n n Simplicity Accounting data Accounting profitability Disadvantages of ARR: n n n Cash flows ignored Time value ignored Arbitrary cut-off

General methods in capital budgeting contd… n Net Present value (NPV) n n n It is the difference between present value of cash inflow and present value of cash outflow NPV = PV of cash inflow – PV of cash outflow Acceptance rule: n n n If NPV > 0 = accept the project If NPV = 0 = may or may not accept the project If NPV < 0 = reject the project

General methods in capital budgeting contd… n Advantages of NPV: n n n It recognizes the time value of money Measure of true profitability It gives value additivity It helps in shareholder value maximization Disadvantages of NPV: n n Difficult to estimate cash flow Difficult to measure discount rate Should be useful if used in mutually exclusive projects Ranking of projects using NPV is not independent of discount rate.

General methods in capital budgeting contd… n Profitability Index (PI) n n n Also called as Benefit Cost Ratio (BCR) It is the ratio of present value of cash inflow and present value of cash outflow Profitability index = PV of cash inflows PV of cash outflows Acceptance rule: n n n If PI > 1 = accept the project If PI = 1 = may or maynot accept the project If PI < 1 = reject the project

General methods in capital budgeting contd… n Advantages n n Recognizes the time value of money Value maximization Relative profitability Disadvantages n n Difficult to estimate cash flow Difficult to measure discount rate

General methods in capital budgeting contd… Internal rate of return( IRR) It is the rate at which the present value of cash inflows and present value of cash out flows IRR = PV of cash inflows = PV of cash outflows Acceptance rule: If IRR > k = accept If IRR = k = may or may not accept If IRR < k = reject the project

General methods in capital budgeting contd… n Advantages: n n n It recognizes the time value of money Measure of true profitability It helps in shareholder value maximization Acceptance rule same as NPV Disadvantages: n n n Multiple rates Mutually exclusive projects Value additivity

Different types of risks n n n n Corporate risk International risk Stand-alone risk Competitive risk Market risk Project specific risk Industry specific risk

Risk analysis techniques in capital budgeting (or) mathematical models of risk analysis in capital budgeting n Risk analysis methods n n n n Risk adjusted discount rate Probability assignment Sensitivity analysis Standard deviation Coefficient of variation Certainty equivalent approach Decision tree approach

Risk analysis techniques in capital budgeting (or) mathematical models of risk analysis in capital budgeting n Risk adjusted discount rate: n n n Risk adjusted discount rate accounts for risk by varying the discount rate depending on the degree of risk. Risk adjusted discount rate = Risk free rate + Risk premium Risk free rate is the compensation for time Risk premium is the compensation for risk

(or) mathematical models of risk analysis in capital budgeting (or) Different methods of appraising investment proposals under risks and uncertainties n Advantages n n Simple and easy to understand It helps risk averse businessmen to choose projects It incorporates risk and uncertainty Disadvantages n n Not an easy way to derive risk adjusted discount rate Not much used in practice Does not make risk adjustment in the numerator of the cash flow forecast It is based on the assumption that investors are risk averse

(or) mathematical models of risk analysis in capital budgeting (or) Different methods of appraising investment proposals under risks and uncertainties n Sensitivity analysis n n n It is the way of analyzing change in the projects NPV for a given change in one of the variables Cash flows may be forecasted under different economic conditions like good, normal and bad conditions. Good condition is called as optimistic and bad condition is called as pessimistic NPV under each condition is calculated. Then the difference between optimistic and pessimistic NPV is calculated. If the difference is more, then that project is more risky.

(or) mathematical models of risk analysis in capital budgeting (or) Different methods of appraising investment proposals under risks and uncertainties n Advantages n n n It helps the decision maker to identify the variables that affect the cash flow forecast It helps to understand the project in total It helps to identify weak spots and actions required to rectify it. It exposes inappropriate forecasts and helps to concentrate relevant variables Disadvantages n n It does not provide clear cut results It fails to focus on the interrelationship between variables

(or) mathematical models of risk analysis in capital budgeting (or) Different methods of appraising investment proposals under risks and uncertainties n Standard deviation: n n n It helps to measure the deviation about the expected cash flows of each of the possible cash flows. Std. deviation is the square root of the variance The formula is σ =√ Σ PDCf 2 Where n P = Probability D = Deviation of cash flow from the mean Cf = cash flow n If the std. deviation is more then that project is more risky n n

(or) mathematical models of risk analysis in capital budgeting (or) Different methods of appraising investment proposals under risks and uncertainties n Coefficient of variation: (Co. V) n n It is the ratio of standard deviation and mean Cov = Standard deviation Mean The project with high Cov is more risky

(or) mathematical models of risk analysis in capital budgeting (or) Different methods of appraising investment proposals under risks and uncertainties n Certainty equivalent approach: n n Advantages n n It is the coefficient which helps to bring down the cash inflows to a conservative to reduce risk It explicitly recognizes risk Disadvantages n n n The procedure of reducing the cash flows is implicit It may be inconsistent from one investment to other May not be suitable for large organization Difficult to calculate Since there are many stages, there are chances that the good investment opportunity may go away from the company

(or) mathematical models of risk analysis in capital budgeting (or) Different methods of appraising investment proposals under risks and uncertainties n Decision tree approach n n It is the pictorial or graphical representation of present cash inflows, its future consequences, future commitments and its consequences Decision tree is drawn with decision points

Risk analysis techniques in capital budgeting (or) mathematical models of risk analysis in capital budgeting (or) Different methods of appraising investment proposals under risks and uncertainties n Steps in decision tree: n n n Advantages n n n Define investment Identify decision alternatives Draw a decision tree Analyze data It brings clarity Graphic visualizations Disadvantages n n Some time more complicated Takes more time and data

Difference between bond and debenture n Bonds and debentures are fixed income instruments which are taken by investors looking for regular, fixed income through payment of interest on the principal purchase. Bonds and debentures are debt instruments with different types of exposure. In general terms bondholders are secured by access to the underlying asset in case of default by the issuer. Debentures, on the other hand, are unsecured, and debenture holders do not have recourse to assets in the case of default by the debenture issuer.

Difference between book value and market value n Book value is the price paid for a particular asset. This price never changes so long as you own the asset. On the other hand, market value is the current price at which you can sell an asset.

Capital rationing n n n Capital Rationing in simple words refers to a situation where an organization cannot undertake all the projects which are having positive net present value because of shortage of capital. When company do capital rationing than it will select only that project which gives the company maximum profit. Capital rationing can be better understood with the help of an example suppose you are having $100 and you go to a restaurant where pizza and burger both cost $100 and you are hungry and can eat both if you are given an option but since you have only $100 you will have to choose either pizza or burger. In the same way if a company has limited capital than it cannot take all the projects but only select those projects which it can afford with the limited amount of capital. Companies go for capital rationing when they are not able to raise fresh capital from the markets because of external factors like slowdown in an economy, higher interest rate environment etc…, or due to internal factors like excessive debt in the balance sheet of the company, no further issue of equity capital so as to prevent dilution of control of existing shareholders of the company etc……

Statutory framework for payment of dividend under company’s act n n n Section 205 (2 A) of the Act prescribes that before any dividend is declared or paid, certain percentage of profits as may be prescribed by the Central Government, but not exceeding 10% will have to be transferred to the reserves of the Company. The company may, however, voluntarily create more than the prescribed percentage and transfer to the reserves of the Company. If in a particular year, on account of inadequacy of profit, the company has to pay dividends out of the previous year’s reserves, it should follow such rules as may be made by the Central Government. In case of any deviation from such rules, then the company can do so only with the previous approval of the Central Government. The term “Reserve” meant in the said Rules means “Free Reserves” i. e. reserve which are not created or set apart or intended for any special purpose. For e. g. Development Rebate Reserve, Capital Reserve or Special Reserve will not come under the category of free reserves for the purposes of this rule. According to the Companies ( Transfer of Profits to Reserves) Rules 1975, before declaration or payment of dividend, profits shall be compulsorily transferred to reserves at the following rates: -

Statutory framework for payment of dividend under company’s act … n n n n n Rate of proposed dividend Amount to be transferred to Reserves Not exceeding 10% Nil Exceeding 10% but not exceeding 12. 5% 2. 5% of current profits Exceeding 12. 5% but not exceeding 15% 5% of current profits Exceeding 15% but not exceeding 20% 7. 5% of current profits Exceeding 20% 10% of current profits. Under the Companies Bill 2009, it is left to the discretion of the company to determine the percentage of profits to be transferred to reserves.

Statutory framework for payment of dividend under company’s act … n Procedure for declaration of Dividend n n n n n 1) Recommendation by Board of Directors: - 2) Approval by the Shareholders: - 3) Dividend now includes interim dividend: - 4) Dividend to be deposited in a separate bank account: - 5) Dividend to be paid by cheque or warrant 6) Time frame for payment of dividend 7) Transfer of unpaid dividend 8) Transfer of unpaid or unclaimed dividend to the Investor Education and Protection Fund: - 9) Directors Report

Problems in unit 2 n Dividend n n Walter model Gordon model MM hypothesis Capital budgeting n n General methods like payback, ARR, NPV, PI, IRR Risk analysis methods like Sensitivity analysis, standard deviation, certainty equivalent approach, coefficient of variation, risk adjusted discount rate

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