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FM lecture no 37

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  Copyright: M. S. Humayun 1 Financial Management Lecture No. 37 Dividend Payout  Copyright: M. S. Humayun 2 Dividend Policy Issue ã Earnings and Positive Cash Flows can be allocated to the Following Cash Outflows:  – Buying assets (Capital Budgeting)  – Investing in Projects (Capital Budgeting)  – Paying Interest to Debtholders (ie. Banks) … Value holders who receive a slice of the Firm’s value in form of Interest Income.    –Paying Dividends to Shareholders (ie. Payout) … Value holders who receive a slide of the Firm’s value in form of Dividend income.   ã Major Questions:  – How much to Payout to Shareholders in form of Dividend? ã Payout Ratio = Dividend / Net Income ã Tradeoff between Dividend Income & Capital Gains. Recall Gordon’s Formula : Required Return on Equity or “Cost of Equity” = rCE = (DIV1/Po) + g = Dividend  Yield  + Capital Gains Yield  – How to Finance the Dividend Payout? ã Cash or Stock Dividend ã Use Internal  Retained Earnings OR External  Financing (ie. Debt or Equity)  – How often to make Dividend Payout? ã Stability   of Firm’s Track Record for Paying Regular and Growing Dividends   ãQuarterly, Annually, … Random    – Impact on Firm Value and Share Price? ã Whether or not Paying Out Dividend increases Firm Value or not depends on many things including ROE  of Firm versus the Required ROR (rE )  of its shareholders  Copyright: M. S. Humayun 3 Dividend Theories ã MM Irrelevance (Miller Modigliani) Dividend Payout is basically irrelevant because the way you SPLIT cashflows within and amongst the Shareholders and Debtholders has no affect on the Total Value of a Firm. Value is determined by HOW MUCH cashflows are generated by the working assets and the business risk of those assets. ã Bird in the Hand (Gordon & Lintner) Shareholder wealth (and Firm’s Value ) is maximized by a HIGH Dividend Payout because Investors think that Dividend Income is (more immediate, regular, &) less risky than Capital Gains Income. ã Tax Preference Shareholder wealth is maximized (and cost of equity rE is minimized) by LOW Dividend Payout because Marginal Tax Rate on Dividends is higher than on Capital Gains. Firms should accumulate high Retained Earnings that can then lead to Share Price Increase (Capital Gain) &/or Stock Repurchase  Copyright: M. S. Humayun 4 Other Factors Affecting Dividend Policy ã Signaling Theory  – In minds of Investors, change in Dividend Payout signals a change about management’s forecast about future expected earnings. Increase in Dividend Payout is seen as Positive Signal that firm will have good earnings in future so Stock Price rises. ã Clientele Effect  – Investors buy stocks whose Dividend Policy they like and sell the other ones. Change in Dividend Policy can cause change in type of shareholders. Income Investors will invest in High Dividend Stocks. Growth Investors will invest in those stocks offering larger Capital Gains Yield. ã  Agency Costs  – Shareholders (owners) incur agency costs to monitor managerial spending and decisions. High Dividend Payout forces firm to go to capital markets to raise external capital. So, management is subjected to outside scrutiny which is an external check on management spending. ã Legal Restrictions  – Debt Contracts: Loan Agreements and Bond Indentures restrict Dividend Payout to Shareholders if earnings or net working capital is too low to pay interest.  – Impairment of Capital Rule: Dividends can NOT exceed Retained Earnings which are shown on Balance Sheet.  – Cash Dividends can only be paid with cash. If cash balance (shown on Balance Sheet too) is not enough then Sell assets, Raise Equity, or Take Loan … etc.   ã Dividend Stability 
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