CPU

UNIVERISTY COLLEG

Course name: Project finical management

Group Assignments
on
Dividend policy

Group members
Habtamu Girma __ MPM/525/15
Birhan Degefu ____ MPM|545|15
Mekides Getaye__ __MPM/652/15
Fayza Mussa______ MPM/653/15
Henoke Asamenew _MPM/378/15
Nitshu Sisay ______MPM/302/15

Submitted to:- Simachew .M (PHD)

Julay 4 2023
Addis Ababa
Contents
Dividend Payment versus Profit Retention................................................3
Does Dividend Policy Affect Stock Price?...................................................5
The Dividend Decision in Practice...............................................................5
Dividend Payments Procedures..................................................................8
Factors Influencing Dividend Policy in Practice..........................................9
Stock Dividends and Stock Splits..............................................................12
Stock Repurchases.....................................................................................13
Dividend Payment versus Profit Retention
Distribution of dividend out of current earnings is crucial in financial management
decision making process. Since, there is no statutory obligation on a company to pay
dividend, therefore, it depends upon company's policy to pay it or not. The
distribution of dividend has two sides of financial importance. First, from the
investor’s perspective, and second is from company's viewpoint. From investors
point of view, every shareholder wants to increase its current returns on investments
thus, they prefer more dividend in order to increase their wealth. The more logical
stand point of shareholders may be of time value of money, i.e., receipt of dividend
today has more value than receiving the same later or at the time of liquidation of
company.
From the side of company’s management, the earnings may be retained for future
purposes instead of paying dividend. In case the higher amount of earnings is paid to
shareholders, as dividend, may reduce cash in hand as well as retained earnings of
the company. On the contrary, if lesser or no amount is paid to shareholders then a
substantial amount of earnings may be used in future for business growth, or
diversification purposes as ploughing back of profits. Since, retained earnings bear
less cost of capital therefore may be proven as economic source of finance without
incurring extra efforts and diluting shareholders right in a company.
The retained earnings are viewed as a source of financing, since paying out earnings
as cash dividends to shareholders (especially, equity shareholders), results in the
reduction of the cash asset. In order to increase assets back to the level that should
have prevailed and dividends not been paid the firm must obtain additional debt or
equity financing. By forgoing dividend payments and retaining earnings, the firm can
avoid having to raise a given amount of funds or can eliminate certain existing
sources
of financing. In either case, the retention of earnings is a source of funds. The
retention rate is also an indicator of future growth of a firm. The future growth of a
firm is a product of return on equity (ROE) and retained earnings (RE).
Growth of a firm = ROE x RE
Thus, a more retention of earnings results in higher growth, but certainly in long run
as it takes time to accumulate.
The second strong point of management to counter the investors perspective on
wealth-management is that an amount of retained earnings increase the wealth of
the shareholders at a higher rate than dividend payout itself The retained earnings
affect future earnings in cumulative manner, thus increase the shareholder capital,
hence maximize their wealth. So, it can be said that dividend declaration is a scale
to determine the level of retained earnings and dividend distribution, as shown in
Figure

From above discussion, it can be observed that dividend distribution policy is an

important topic because dividends represent major cash outlays for many firms.
Dividends at the heart of the difficult choice that management must make in
allocating their capital resources; reinvesting the money within the firm or
distribution of it to shareholders. Thus, financial manager must establish a dividend
policy that results in a distribution of earnings that will maximize share price, in
toto. Let's understand above discussion with the help of an illustration 1.

Illustration 1: A company has earnings after tax of 100000 and equity shares of
10000 which result into EPS = 10 per share in year, let's say, 1. The company
decides to pay 25% of total earnings to equity shareholders as dividend and
remaining 75% wants to retain, but the shareholders has desired to reverse the
order. Graphically show the impact of dividend pay-out on the growth of company
if return on equity is 20%.
Does Dividend Policy Affect Stock Price?
Before a dividend is distributed, the issuing company must first declare the dividend
amount and the date when it will be paid. It also announces the last date when shares
can be purchased to receive the dividend, called the ex-dividend date. This date is
generally one business day before the date of record, which is the date when the
company reviews its list of shareholders.

The declaration of a dividend naturally encourages investors to purchase stock.

Because investors know that they will receive a dividend if they purchase the stock
before the ex-dividend date, they are willing to pay a premium.

This causes the price of a stock to increase in the days leading up to the ex-dividend
date. In general, the increase is about equal to the amount of the dividend, but the
actual price change is based on market activity and not determined by any governing
entity.

On the ex-date, investors may drive down the stock price by the amount of the
dividend to account for the fact that new investors are not eligible to receive
dividends and are therefore unwilling to pay a premium.

However, if the market is particularly optimistic about the stock leading up to the ex-
dividend date, the price increase this creates may be larger than the actual dividend
amount, resulting in a net increase despite the automatic reduction. If the dividend is
small, the reduction may even go unnoticed due to the back and forth of normal
trading.

Many people invest in certain stocks at certain times solely to collect dividend
payments. Some investors purchase shares just before the ex-dividend date and then
sell them again right after the date of record—a tactic that can result in a tidy profit if
it is done correctly.

After the declaration of a stock dividend, the stock's price often increases; however,
because a stock dividend increases the number of shares outstanding while the value
of the company remains stable, it dilutes the book value per common share, and the
stock price is reduced accordingly.

The Dividend Decision in Practice

Dividend may be distributed among the shareholders in the form of cash or stock.
Hence, Dividends are classified into:
A. Cash dividend
B. Stock dividend
C. Bond dividend
D. Property dividend

Cash Dividend
If the dividend is paid in the form of cash to the shareholders, it is called cash
dividend. It is paid periodically out the business concerns EAIT (Earnings after
interest and tax). Cash dividends are common and popular types followed by majority
of the business concerns.
Stock Dividend
Stock dividend is paid in the form of the company stock due to raising of more
finance. Under this type, cash is retained by the business concern. Stock dividend
may be bonus issue. This issue is given only to the existing shareholders of the
business concern. Bond Dividend
Bond dividend is also known as script dividend. If the company does not have
sufficient funds to pay cash dividend, the company promises to pay the shareholder at
a future specific date with the help of issue of bond or notes.
Property Dividend
Property dividends are paid in the form of some assets other than cash. It will
distribute under the exceptional circumstance..
DIVIDEND DECISION
Dividend decision of the business concern is one of the crucial parts of the financial
manager, because it determines the amount of profit to be distributed among
shareholders and amount of profit to be treated as retained earnings for financing its
long term growth. Hence, dividend decision plays very important part in the financial
management. Dividend decision consists of two important concepts which are based
on the relationship between dividend decision and value of the firm.
WHO MAKES DIVIDEND DECISION?
The company's Board of Directors makes dividend decisions. They are faced with
the decision to pay out dividends or to reinvest the cash into new projects.
The tradeoff between paying dividends and retaining profits within the company:
The dividend policy decision is a trade-off between retaining earnings v/s paying out
cash dividends. Dividend policies must always consider two basic objectives:
1. Maximizing owners' wealth
2. Providing sufficient financing
While determining a firm's dividend policy, management must find a balance
between current income for stockholders (dividends) and future growth of the
company (retained earnings).
In applying a rational framework for dividend policy, a firm must consider the
following two issues:
1. How much cash is available for paying dividends to equity investors, after
meeting all needs-debt payments, capital expenditures and working capital (i.e. Free
Cash Flow to Equity - FCFE)
2. To what extent are good projects available to the firm (i.e. Return on equity - ROE
> Required Return)
Dividend Decision Matrix
Dividend Payments Procedures
Dividend policy is defined as the tradeoff between retaining earnings on the one hand
and paying out cash on the other hand. You can't pay out your "par" capital as a
dividend.
State law protects the firm's creditors (i.e., bondholders) from paying excessive
dividend.
[Extreme case : selling all the assets and payout all the proceeds as a dividend] ·
Paying a dividend reduces the amount of R/E. Many firms have automatic dividend
reinvestment plan (so call DRIP), under which the new shares are issued at a 5%
discount from the market price.
 It saves the underwriting costs of a regular share issue. Share repurchases as an
alternative to dividends
 Happens when cash resources have generally outrun good capital investment
opportunities. [i.e., a firm has accumulated large amounts of unwanted cash]
 Happens when the firm wants to change the capital structure by replacing
equity with debt. Major methods of repurchases
1. Acquisition in the open market
2. By a general tender offer to shareholders.
3. By direct negotiations with a major shareholder
[ i.e., Greenmail : Shares are repurchased by the target of the takeover at a price
which makes the hostile bidder happy to agree to leave the target alone]
Deprive the shareholders of the value.
Reasons for repurchases
A. Information or Signaling Hypothesis
- No Profitable use for internally generated funds.
- Firm believe that stock is undervalued.
- Mixed results (positive or negative)
B. Dividend or Personal Taxation Hypothesis
- In order to let the S/Holders benefit from the preferential tax treatment of
repurchases relative to dividend.
C. Leverage Hypothesis.
-Tax subsidy connected with the deductibility of interest payments. This subsidy is
passed on to the shareholders.
D. Bondholder Expropriation Hypothesis.
- Repurchase reduces the assets of the firm and therefore the value of the claims of
the bondholders.
- This plausibility of this hypothesis is weakened by the existence of the law and by
the bond covenants.

Factors Influencing Dividend Policy in Practice

There are several factors which affect dividend policy, the most important of which
are the following:
(a) legal rules,
A. liquidity position,
B. the need to pay off debt,
C. restrictions in debt contract,
D. rate of expansion of assets,
E. profit rate,
F. stability of earnings,
G. access to capital markets,
H. control
I. tax position of shareholders.
 Details about these factors will be presented in the following section. One of the
factors that determine the extent to which the company will pay out dividends instead
of retaining earnings are legal rules. This rules state that dividends must be paid out
from the earnings (profit) – whether from current earnings or from the earnings from
previous years, which is shown on the balance sheet in “retained earnings”.
State laws emphasize three rules; (a) the net profit rule, (b) capital impairment rule
and (c) insolvency rule. The net profit rule states that dividends can be paid out from
past and current earnings. Capital impairment rule protects the creditors by
forbidding dividend payout from the capital. Dividend payout from capital would
mean distributing the investment in the company, not the earnings, and such dividend
is called liquidating dividend. The insolvency rule states that corporations cannot pay
out dividends as long as they are insolvent, i.e. as long as their liabilities exceed the
value of their assets. Dividend payout under such circumstances would mean giving
the funds to the shareholders which rightfully belong to the creditors.
One of the factors affecting dividend policy of companies is its liquidity position.
Profits that are kept in retained earnings, which appears on the right side of the
balance sheet, are usually invested in the assets needed for work. Retained earnings
from past years are already invested in facilities and equipment, supplies and other
assets, meaning that they are not being retained as cash.
The need to pay off debt also determines the company's dividend policy. When the
company sells its debt as a way of financing expansion or using it as a replacement
for other forms of financing, it faces two alternatives. It can return the debt on the
maturity day by replacing it with another form of securities. However, the decision to
retire a debt will mostly require retaining the earnings. Dividend policy is also
affected by restriction in debt contract. Debt contracts, especially when a long-term
debt is involved, frequently restrict the ability of the company to pay cash dividends.
Such restrictions, designed to protect the position of a lender, usually state that (a)
future dividends can be paid out only if the earnings were made after signing the loan
contract (i.e. they cannot be paid out from past retained earnings) and that (b)
dividends cannot be paid out when the net working capital (working capital minus
short-term liabilities) or the indicator of current liquidity (working capital, cash being
one of its parts, divided by short-term liabilities) are below a certain level.
Company's dividend policy also depends on the rate of expansion of assets. The
bigger the need for assets, the bigger the possibility that the company will retain
earnings rather than paying them out. If the company wants to obtain assets from
external sources, a natural source for that lies in current shareholders who already
know the company. But, if the earnings are paid out as dividends and are subjected to
a high tax rate of personal income tax, only part of them will be available for
reinvestment.
Profit rate also affects dividend policy. The expected rate of return on assets
determines the relative attractiveness of paying out earnings to shareholders in the
form of dividends (who will use them elsewhere) or of using them in this (current)
company. Stability of earnings is also one of the factors which affects dividend
policy. The company that has relatively stable earnings is often able to make a rough
assessment of its future earnings. It is therefore more likely that such company will
pay out a larger percentage of its earnings than the company with variable earnings.
An unstable company is not sure whether the earnings they hope for will be achieved
in the years to come and it is more likely that they will retain a part of current
earnings. It will be easier to maintain a lower dividend if earnings decrease in the
future.
Access to capital markets also determines dividend policy. Understandably, an easier
access to capital markets and a wider range of alternative sources of financing make
the pursuit of dividend policy easier. Possible restrictions face the management with
a serious dilemma: whether to give up on profitable projects and jeopardize the future
cash flow and future gain or to reduce or completely give up on dividends and face
the effects of unfavorable information signaling. It should be mentioned that large,
affirmed companies with the record profitability and stability of earnings have an
easy access to capital markets and other forms of external financing. On the other
hand, potential investors see small or new companies as more risky. Their ability to
increase capital or debt funds from capital market is limited and they have to retain
more earnings for financing their business operations. Affirmed companies will
therefore probably have a higher rate of dividend payment than new or small
companies.
One of the important variables that affect dividend policy is the effect of alternative
sources of financing on the control situation in a company. If the company practices
the policy of larger dividend payouts, it is to be expected that it will reach for
external sources of financing, either because it needs additional capital for new
investment or to finance dividends themselves. The consequence of this activity can
be control dilution in the situations when shareholders from the control group do not
subscribe a sufficient number of new shares. Relying on internal financing with the
aim of maintaining control reduces the dividend payout.
 And finally, the tax position of shareholders greatly affects the desire for dividends.
In relation to that, it should be mentioned that there can sometimes be a conflict of
interests in large corporations between shareholders in high tax grades and those in
low tax grades. The former can prefer low dividend payout and high rate of retaining
earnings hoping for the appreciation of the company's equity. The latter can prefer a
relatively high dividend payout. Dividend policy in such companies can be a
compromise between a low and high payout – medium payout ratio. If one group
comes to dominate the company and sets, for example, the low payment policy, the
shareholders who want an income will probably send their shares with time and find
higher yielding shares. In that way, to a certain extent at least, the company's
dividend policy is determined by the type of shareholders that company has – and the
other way around. This is called the clientele effect on dividend policy.

Stock Dividends and Stock Splits

Stock splits are events that increase the number of shares outstanding and reduce the
par or stated value per share. For example, a two-for-one stock split would double the
number of shares outstanding and halve the par value per share. Existing shareholders
would see their shareholdings double in quantity, but there would be no change in the
proportional ownership represented by the shares (i.e., a shareholder owning 1,000
shares out of 100,000 would then own 2,000 shares out of 200,000).
Importantly, the total par value of shares outstanding is not affected by a stock split
(i.e., the number of shares times par value per share does not change). Therefore, no
journal entry is needed to account for a stock split. A memorandum notation in the
accounting records indicates the decreased par value and increased number of shares.
If the initial equity illustration for Embassy Corporation was modified to reflect a
four-for-one stock split of the common stock, the revised presentation would appear
as follows (the only changes are highlighted):
By reviewing the changes, you can see that the par has been reduced from $1.00 to
$0.25 per share, and the number of issued shares has quadrupled from 400,000 shares
to 1,600,000 (be sure to note that $1.00 X 400,000 = $0.25 X 1,600,000 = $400,000).
None of the account balances have changes.
Given the paucity of financial statement effect, why would a company bother with a
stock split? The answer is not in the financial statement impact, but in the financial
markets. Since the same company is now represented by more shares, one would
expect the market value per share to suffer a corresponding decline. For example, a
stock that is subject to a 3-1 split should see its shares initially cut in third. But,
holders of the stock will not be disappointed by this share price drop since they will
each be receiving proportionately more shares; it is very important to understand that
existing shareholders are getting the newly issued shares for no additional
investment. The benefit to the shareholders comes about, in theory, because the split
creates more attractive opportunities for other future investors to ultimately buy into
the larger pool of lower priced shares. Rapidly growing companies often have share
splits to keep the per share price from reaching stratospheric levels that could deter
some investors. In the final analysis, you should understand that a stock split is
mostly cosmetic as it does not change the underlying economics of the firm.
And, splits can come in odd proportions: 3 for 2, 5 for 4, 1,000 for 1, and so forth
depending on the scenario. A reverse split (1 for 5, etc.) is also possible, and will
initially be accompanied by a reduction in the number of issued shares along with a
proportionate increase in share price. Reverse splits are often seen when a stock’s
price has dropped below a minimum threshold level for continued listing on some
stock exchanges. Shareholders who suffer a reverse split are usually not too happy to
see their number of shares reduced; however, they still own the same proportionate
share of the company, as the reductive impact falls evenly on all shareholders. Again,
the reverse split does not change the underlying economics of the firm.

Stock Repurchases
A share repurchase is a transaction whereby a company buys back its own shares
from the marketplace. A company might buy back its shares because management
considers them undervalued. The company buys shares directly from the market or
offers its shareholders the option of tendering their shares directly to the company at
a fixed price.

Repurchases reduce the number of outstanding shares, which is something that

investors often feel will drive up share prices. This assumes demand for the shares
will not be diminished by the action.

Advantages and Disadvantages of Share Repurchases

Advantages

A share repurchase shows the corporation believes its shares are undervalued and is
an efficient method of putting money back in shareholders’ pockets.

The share repurchase reduces the number of existing shares, making each worth a
greater percentage of the corporation.

The stock’s EPS increases, which means the price-to-earnings ratio (P/E) will
decrease, assuming the stock price remains the same. Mathematically, the value of
the shares hasn’t changed, but the lower P/E ratio could make it appear that the share
price represents a better value, thus making the stock more attractive to potential
investors.

Disadvantages

A criticism of buybacks is that they are often ill-timed. A company will buy back
shares when it has plenty of cash or during a period of financial health for the
company and the stock market.

The stock price of a company is likely to be high at such times, and the price
might drop after a buyback. A drop in the stock price can imply that the
company is not so healthy after all.
A share repurchase can also give investors the impression that the corporation
does not have other profitable opportunities for growth, which is an issue for
growth investors looking for revenue and profit increases. A corporation is not
obligated to repurchase shares due to changes in the marketplace or economy.

Repurchasing shares puts a business in a precarious situation if the economy

takes a downturn or the corporation faces financial obligations that it cannot
meet.