Agenda of presentation

Need for dividend policy balance between dividend payment and retention for growth Different kinds of dividend policies factors influencing dividend policy Indian companies declaring dividend need for cash retention for growth and effective tax rate influencing dividend policy Theories on dividend policy Determining growth rate based on return on equity Equity valuation based on dividend declared and growth rate Numerical exercises on equity valuation based on dividend amount and growth rate

Measures of Dividend Policy

Dividend Payout =Dividends/Earnings

Example Suppose the PAT of a limited company is Rs. 100 lacs. If it pays Rs. 50 lacs as dividend, the DPO ratio is 50%. The higher the DPO ratio, the less the retention ratio and vice-versa
Dividend yield = Dividends / Stock Price Example The market price of a stock is Rs. 4000/- and the dividend is Rs. 50/. Then the dividend yield is 1.25%, which is very poor in Indian conditions. Thus while dividend rate for the above stock assuming Rs. 100/- as the face value would be 50%, the dividend yield is just Rs. 1.25%

FACTORS INFLUENCING DIVIDEND POLICY

Profitability of operations If the company is in the growth phase, the % of dividend will be less The effective tax rate of the enterprise. Effective tax rate is different from income The expectations of the investors in the market Cost of borrowing The restrictions imposed by lenders, bond trustees, debenture trustees and others

FACTORS INFLUENCING DIVIDEND POLICY

Cost of public issues The compulsion to declare dividend to foreign joint venture partners and institutional investors Effects of dividend policy on the market value of the firm

Different kinds of dividend policies

Stable dividend policy irrespective of profitability Stable Dividend payout ratios Dividend being stepped up periodically

Indian companies declaring dividend

Mr. Ajay Shah of Indira Gandhi Institute for Development Research in the year 1996

The researcher had studied 1725 companies out of the listed companies in Mumbai Stock Exchange.
Three criteria: Had net profits in 1994-95 of more than 1% of sales; Are in manufacturing and not in finance or trading Are a part of the databases of CMIE The 1725 firms were broken up into two groups, high-tax firms where the average tax rate in 1994-95 was above 10%and the remaining low-tax firms

The findings in these two groups

1993-94 Low-tax Growth in GFA (%) Uses of funds (%) GFA Inventories Receivables Investments Cash Dividend payout (%) Number of companies 65.08 3.84 17.42 8.78 4.88 18.61 1043 39.03 13.68 21.54 13.08 12.66 25.65 682 66.49 8.62 14.54 7.20 3.16 18.77 1043 44.08 14.54 22.59 16.29 2.49 22.17 682 18.75 High-tax 16.66 1994-95 Low-tax 28.90 High-tax 20.77

Summary of observations
Low-tax companies have had faster growth of GFA

They allocated a much larger fraction of their incremental resources into asset formation; around 65% of the incremental resources were directed to GFA addition as compared with around 42% in the case of high-tax companies
Low-tax companies pay out a smaller fraction of earnings as dividends, as compared with high-tax companies Finally, low-tax companies invested a much smaller fraction of their incremental resources into financial markets. This evidence is consistent with the view that the low-tax phenomenon is primarily driven by the depreciation which is allowed to be written off in the income-tax at a rate that is higher than the rate in the books.

Theories on dividend policy

1. Dividend irrelevance theory Miller and Modigliani. 2. Walters Theory Long-term capital gains preferred to dividend, as tax on dividend is higher than long-term capital gains.

3. Gordons model a bird in the hand theory.

1. Dividend irrelevance theory

Preposition - Dividends do not affect the value of a limited company. Underlying assumptions
There are not tax differences between dividends and capital gains for shares If a company pays too much in cash, they can issue new stock with no floatation costs or signalling consequences to replace this cash If companies pay too little in dividends, they do not use the excess cash for bad projects or acquisitions but use them only for their existing business Investors are rational and dissemination of information is effective

Examination with reference to India

Prior to 01-04-2002, there was no tax on dividend in the hands of the shareholders. With effect from 01-04-2002, tax on dividend in the hands of the investors has resumed. Further the capital gains tax on indexed stocks is 10% as against personal tax that would vary from one slab of income to another. Even then it would be prudent to assume that on an average the tax rate would not be less than 20% and hence capital gains tax is less than income-tax No transaction costs impossible to raise resources without any transaction costs in India especially if the firm were coming out with Initial Public Offer. This is true of developed markets in the West too. Although investors are getting to be rational in India and that dissemination of information is improving, there is still much scope for improvement.

2. Walters Theory
Preposition Long-term capital gains are less than tax on dividends. This is true of India at present. Underlying assumptions:
Dividend rate does not influence the market value. Profit retention rate influences the market. The short-term tax on dividends is higher than the long-term capital gains on the shares.

Example
A listed companys return on equity is 18% and its dividend payout is 50%. The growth rate = (1 - 0.5) x 0.18 = 0.09 x 100 = 9%. This is the growth rate that is expected in dividend amount paid out to the shareholders. In India, at present the long-term capital gains tax is 10% and hence the investors would prefer market appreciation to dividends. To sum up Walters theory on dividend, as dividends have a tax disadvantage, they are bad and increasing dividends will reduce the value of the firm. As a corollary, it is only the retained earnings that give growth to an organisation and contribute to the increase in value of the firm.