Dividend Policy (Good ) Essay Example

all earnings, the price of equity shares will stay the same. If the earnings are fully retained, the price will increase at the anticipated rate of return. Hence, it can be concluded that the cost of equity is dependent on the return on equity rather than dividends. Consequently, a corporation cannot aim to minimize dividends.

Equity shareholders are the owners of the corporation and retained earnings ultimately belong to them. If a company earns a return on equity of 10% and retains all of it, the net asset value (NAV) of the equity shares increases by 10%. Therefore, if there are no other factors affecting the equity price, the market price of the shares should rise by exactly 10% along with the increase in NAV. Essentially, shareholders enjoy a 10% gain in market price.

Regardless of whether a company distributes its earnings or not, shareholders can still earn a cash return of 10% without affecting the value of their shares. This indicates that shareholders can achieve a 10% return through capital appreciation or income, regardless of how profits are distributed. Therefore, the company's dividend policy does not necessarily affect the rate of return on equity for shareholders. This demonstrates the indifference or irrelevance of dividend policy from both the company and shareholder perspective (as discussed in the Modigliani and Miller approach later in this chapter).

The decision to keep or distribute profits is crucial as it affects the corporation's return on equity. Retained earnings benefit from leverage, which makes the return on equity relevant. Conversely, if all profits are given out, shareholders can decide whether to reinvest or consume the income at their own rate of return. Therefore,

determining whether the company retains or distributes its earnings depends on which reinvestment rate is higher – that of the company or the shareholders'. It is clear that the corporation's reinvestment rate surpasses that of shareholders due to two factors: (a) access to leverage, which may not be available to shareholders, and (b) intuitively, this is why shareholders initially invest in the company.

The general argument in favor of the company keeping its profits rather than distributing them is that it forms the basis of the Walter formula. However, there is a counter argument that shareholders not only need growth but also current income. Many investors rely on dividends for their livelihood. After all, what good is an increase in the market value of shares if I need cash for expenses? However, in today's age of demat securities and liquid stock markets, growth and income are practically the same. For instance, if I hold equity shares valued at $100 that appreciate to $110 because of retention, I can sell off 10/110% of my shares, earn $10 in cash, and still have shares worth $100. This is essentially the same as earning a cash dividend of $10 without any retention at all.

There is a debate about whether growth and income are interchangeable, but it is important to recognize that investors have different preferences for these elements. Some prioritize growth while others focus on income. However, many retail investors seek a balance between both because they do not see market value appreciation as the same as current cashflows. As a result, companies need to find a middle ground between meeting shareholders' desire for immediate income and capitalizing on

growth prospects by retaining earnings. This highlights the ongoing importance of dividend policy. Additionally, there are specific circumstances to consider, such as certain companies having lower reinvestment rates compared to their shareholders, indicating limited opportunities for significant reinvestment.

If a company's reinvestment rate is lower than shareholders', it is more advantageous to distribute earnings rather than retain them. This is consistent with traditional theories such as Walter's formula, which propose that dividends are only warranted when the company's reinvestment rate surpasses that of shareholders. Nevertheless, it is crucial to account for tax discrepancies and assume that taxes do not affect the parity between current dividends and share price appreciation.

Companies are obligated to pay taxes on dividends, either as income tax for shareholders or as a dividend distribution tax in certain countries such as India. Conversely, shareholders may face capital gains tax if they sell shares and make a profit. The tax implications for capital gains may differ from those of dividends. Therefore, the taxation can vary between the current dividends received and the rise in share price.

Shares with fixed returns: It is important to note that dividend policy is not relevant for shares that have fixed returns, such as preference shares. In these cases, dividends are payable according to the terms of the share issue. Entities requiring minimum distribution: There are situations where entities are obligated to distribute a minimum amount of dividends due to regulations. For example, real estate investment trusts must distribute a certain minimum amount in order to maintain tax transparent status. Other regulations or regulatory motivations may also require companies to distribute their profits. These regulations can affect the relationship between dividend

policy and the price of equity shares. Unlisted companies: It is worth mentioning that the discussion about the relationship between distributed and retained earnings, which can lead to market price appreciation, is only relevant for listed firms. However, even in the case of unlisted firms, retained earnings still belong to the shareholders since they are the owners of the company's residual wealth.

However, the idea of residual ownership may be considered a myth because companies typically only distribute assets in the event of winding up, which is rare. The following discussion on dividend policy in this chapter focuses on listed firms and their impact on the market price of equity shares. For unlisted firms, classical models such as Walter’s model or Gordon Growth model discussed below may be more relevant than market price-based models. Moving from dividends to the market value of equity, we can consider the dividend capitalisation approach. If we momentarily disregard the stock market capitalisation of a company, what is the true market value of an equity share? Let's consider the example of an unlisted company. Based on our understanding of present values, we know that the value of any asset depends on its cashflow.

The cashflow received by a shareholder from their equity is determined by dividends as long as the company remains operational and the shareholder does not sell their stock. In the absence of share sales or company liquidation, we can assume that dividends will continue indefinitely. Hence, the value of equity (VE) can be represented as the sum of discounted dividends (Di), using the formula VE = ?(1 + K * Di * E)^i, where K represents the cost of

equity and E denotes the year. This equation illustrates that shareholders will receive discounted dividends each year, with these discounts based on the cost of equity, which reflects shareholders' required return. Assuming a constant stream of dividends, Equation (1) simplifies to a geometric progression.

Equation (1) can be rearranged to calculate the price of equity if a constant stream of dividends is known or to determine the cost of equity if the dividend rate and market price of shares are given. By utilizing the geometric progression formula for perpetual progressions with constant dividends equal to D, Equation (1) can be expressed as: VE = D (1 + KE) / (1 - 1)^(1 + KE) (2) D KE Example: Let's assume a company has an equity nominal value of $100 and pays dividends at a 10% rate amounting to $10. If the cost of equity is 8%, then the market price per share will be calculated as 10/8%, resulting in $125. Considering dividend growth: In our simplified example, we assumed constant dividends. However, it is unusual for dividends to remain static, especially when companies retain some earnings. This implies that profits increase over time, leading to higher distributions. When dividends grow at a compounded rate denoted by g, Equation (2) transforms into: VE = D (1 + g) (1 + KE)/(1 - 1+ g )^(1 + KE)(3) D(1+g )KE-g It should be noted that even the first dividend is assumed to have grown at a rate of g. Essentially, though historically represented by D, we anticipate that this year's dividend has increased uniformly.

The numerator of Gordon's dividend growth formula can be simplified by excluding (1+g) if we

assume the current year's dividend will not grow and the growth will come from the following year. This formula is also referred to as Gordon's dividend growth formula.

Let's consider a company with a nominal equity value of $100, which historically pays dividends at a rate of 10%, totaling $10. Going forward, we expect the dividends to grow at an annual rate of 5%. With a cost of equity of 8%, what is the market value?

By plugging these numbers into the formula, we arrive at a market value of $350. It is worth noting that this valuation can also be tested on Excel.

When a continuously growing stream of dividends is discounted at 8% and a sufficient number (e.g. 1000) of these dividends, which are growing at a rate of 5%, are taken into account, the resulting value remains the same. For instance, let's consider a company with an equity nominal value of $100 and historical dividends of $10 at a rate of 10%. It is expected that these dividends will continue to grow annually at a rate of 12%. If the cost of equity is 8%, what would be the market value? In this scenario, the growth rate of dividends exceeds the discounting rate.

The increase in dividends acts as a multiplier and the discounting rate functions as a divisor. When the multiplier is greater than the divisor, each subsequent dividend's present value exceeds the previous one, leading to an infinite value for a perpetual series. It should be noted that the growth rate (g) signifies the increase in market value of a share. Therefore, shareholders receive current earnings and witness their investment's value appreciate.

The Walter Approach,

developed by James E Walter, is a model focused on dividends in the equity market. Its purpose is to determine whether a company should keep or distribute its earnings. This determination is based on comparing the reinvestment rate with the cost of equity. If the reinvestment rate surpasses the return rate for shareholders, it is advantageous for the company to retain its earnings. Conversely, if the reinvestment rate is lower, it is advisable for the company to distribute its earnings. When both rates are equal, there exists a choice between retaining and distributing earnings. The Walter formula calculates the market value of equity by combining current earnings and growth in price. This growth factor emerges from retained earnings generating a higher return compared to the cost of equity, resulting in continuous growth.

The formula for determining the market value of equity (VE) is VE = D KE + r (E - D)/K E, where g= r (E-D)/ K E. Here, r represents the rate of return on retained earnings, E represents the earnings rate, and D represents the dividend rate.

For instance, let's consider a company with an equity nominal value of $100. The dividends are paid at 10%, resulting in $10. If the company earns at a rate of 12% and has a cost of equity at 8%, we can calculate the market value of equity (VE) as follows: VE = $10 * 8% + (12% - 10%) / 8% * $100 = $162.50. This calculation is easily explained by noting that the company retains $2 each year, earning a return of 12% on it.

The capitalized value of $0.24 at a rate of 8% will result

in the expected growth. As a result, the sustainable earnings for shareholders will be $10 + $3. When this amount is capitalized at 8%, it reaches a value of $162.50.

The key takeaway from Walter's approach is not the market value of equity but rather how proper distribution policies can maximize this value. In the current case, it is not advisable for the company to distribute any dividends because it earns more than the shareholders' opportunity rate. By not distributing anything, the market value of the share may increase to $225. The Gordon growth model (Equation 3) is derived from a perpetual sum of a geometric progression, assuming that the growth rate is lower than the cost of equity. Modigliani and Miller's approach theorizes on the irrelevance of capital structure and, as a corollary, the irrelevance of the dividend payout ratio to firm value. Franco Modigliani received the Nobel Prize in 1985, while Merton Miller received it alongside Markowitz and Sharpe in 1990.

The M;M hypothesis, like other financial theories, is based on the concept of efficient capital markets. It proposes that a firm has two choices: (a) retaining earnings to finance new investment plans, or (b) distributing dividends and issuing new shares to fund new investment plans. The M;M approach is founded on simple propositions. A company would only retain earnings if it has investment opportunities. If the company doesn't retain earnings, it must find another source to finance these opportunities. While debt issuance is a possibility, M&M argues that the capital structure is irrelevant, and there is no difference between funding investments with equity or debt. Therefore, let's assume that the new growth plans are

funded with equity.

Shareholders determine the value of the company's equity shares by considering both the company's earnings and retentions. If the company pays dividends, shareholders factor that into the pricing of the shares. Likewise, if the company does not distribute dividends, it affects the share prices. In the event of dividend distribution, the company will raise funds for its financing requirements by issuing new shares. The price of these shares will account for the payment of dividends.

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