FMT2 Session 3

Pradeepta Sethi
TAPMI

Residual distribution model

Dividends
paid
are
a
function
of the earnings in the year rather than a function of
dividends last year.
Residual = left over of earnings
Look at

firms investment opportunities

target capital structure
availability and cost of external capital

Pay dividend or repurchase stock only if more

earnings are available in excess after meeting
capital budget.

Residual distribution model

Retained earnings is cheaper than issuing new

stock.

Some firms produce a lot of cash but have limited

investment opportunities.

They pay high dividend- Attract investors

Other firms generate little or no excess cash

because they have many good investment
opportunities.

Attract investors who prefer capital gain.

Residual distribution model

Distributions = Net Income - Retained earnings

needed to finance investments

= Net Income [(Target equity ratio)*(Total capital

budget)]

Quiz Time
FMT2 corporation has a capital budget of Rs.
800,000.
The corporation wants to maintain target capital
structure: 40% in debt, and 60% in equity.
Forecasted net income: Rs. 600,000.
If all distributions are in the form of dividends,
how much of the Rs. 600,000 should we pay
out as dividends?

FMT Corporation

Of the Rs. 800,000 capital budget, 0.6(Rs.

800,000) = Rs. 480,000 must be equity to keep
at target capital structure.

With Rs.600,000 of net income, the residual is

Rs.600,000 - Rs.480,000 = Rs.120,000 =
dividends paid.

Payout

ratio

=
Rs.120,000/Rs.600,000
= 0.20 = 20%.

How would a drop in NI to

Rs.400,000 affect the dividend? A
rise to Rs.800,000?

NI = Rs.400,000: Need Rs.480,000 of equity, so

should retain the whole Rs.400,000. Dividends =
0.

NI = Rs.800,000: Dividends = Rs.800,000 Rs.480,000 = Rs.320,000.

Payout = Rs.320,000/Rs.800,000 = 40%.

How would a change in investment

opportunities affect dividend under
the residual policy?

Fewer good investments would lead to smaller

capital budget, hence to a higher dividend
payout.

More good investments would lead to a lower

dividend payout.

Decision rule

Advantages: Minimizes new stock issues and

flotation costs.

Disadvantages: Results in variable dividends,

sends conflicting signals, increases risk, and
doesnt appeal to any specific clientele.

Conclusion:
Consider residual policy when
setting target payout, but dont follow it rigidly.

Stock splits

If the price is within a specific range Optimal, the

firms value will be maximized.

Increases the number of shares outstanding.

Reduce the price per share in proportion to the
increase in shares.

e.g. 2-for-1, 3-for-1, 1.5-for-1

price is quite high

future is bright.
positive signals - boost stock prices.

Green Ply Industries 1:5

Stock splits
Before 2 for 1 stock split
Common stock
(5 par; 4,000 shares)

Rs. 20,000

Additional paid-in capital

Rs. 10,000

Retained earnings

Rs. 70,000

Total shareholders equity

Rs. 1,00,000

After 2 for 1 stock split

Common stock
(2.5 par; 8,000 shares)

Rs. 20,000

Additional paid-in capital

Rs. 10,000

Retained earnings

Rs. 70,000

Total shareholders equity

Rs. 1,00,000

Reverse stock split

A reverse stock split is the proportionate reduction in the

number of shares.
A reverse stock split has the opposite effect of the stock
split:

It reduces the number of shares, with the expectation of increasing

the stock price.

A 1:2 reverse stock split results in half the number of shares

outstanding after the split.
Reverse stock splits are most common for companies in
financial distress.
LG Balakrishnan and Bros went in for a reverse split to
consolidate the share's face value from Re1 to Rs10.

Reverse stock splits

Before 1 for 4 stock split
Common stock
(5 par; 4,000 shares)

Rs. 20,000

Additional paid-in capital

Rs. 10,000

Retained earnings

Rs. 70,000

Total shareholders equity

Rs. 1,00,000

After 1 for 4 stock split

Common stock
(20 par; 1,000 shares)

Rs. 20,000

Additional paid-in capital

Rs. 10,000

Retained earnings

Rs. 70,000

Total shareholders equity

Rs. 1,00,000

Stock dividends

Similar to stock splits divide the pie into smaller

slices. Known as bonus issue of shares.

e.g. 5% stock dividend, the holder of 100 shares would

receive an additional 5 shares (without cost)

Stock splits are generally used after a sharp

price run-up to produce a large price reduction.
Stock dividends used on a regular annual basis
will keep the stock price more or less
constrained.

Stock dividends
Before 100% Stock Dividend
Common stock
(5 par; 4,000 shares)

Rs. 20,000

Additional paid-in capital

Rs. 10,000

Retained earnings

Rs. 70,000

Total shareholders equity

Rs. 1,00,000

After 100% Stock Dividend

Common stock
(5 par; 8,000 shares)

Rs. 40,000

Additional paid-in capital

Rs. 10,000

Retained earnings

Rs. 50,000

Total shareholders equity

Rs. 1,00,000

Dividend Reinvestment Plan

(DRP)

Permits investors to reinvest cash dividends

automatically into the stock of the issuing company.

The shares may be acquired in the open market by

the issuer or may be newly issued shares.

Advantages to the issuer:

Encourage owners with smaller holdings to accumulate

shares.

Raise new equity capital without flotation costs.

Dividend Reinvestment Plan

(DRP)

Advantages to the investor:

Cost averaging of share purchases.

Opportunity (in some cases) to buy shares at a discount

from market value.

Disadvantages to the investor:

Dividends are taxed when received, whether reinvested

or not.

High participation rate in a DRP suggests that

stockholders might be better off if the firm
simply reduced cash dividends.