DIVIDEND POLICY

Learning objectives
After careful review of this chapter, one should able to understand the:
 Overview of dividend
 Forms of dividend
 Meaning of dividend policy
 Dividend payout ratio
 Factors affecting dividend policy
 Cash dividend payment procedure.
 Residual theory of dividend policy.
 Different types of dividend policies.
 Stock dividend
 Stock split
 Reverse stock split
 Stock repurchase.
 Main Ideas from this chapter

This chapter describes the clear picture of different forms of dividend and dividend
policies. The core ideas of this chapter are to make one clear about the different
forms of dividend, dividend payment procedures, dividend payout policies, stock
dividend, stock split, reverse stock split and repurchase of stock.

MEANING OF DIVIDEND POLICY

Dividends refer to that portion of a firm's net earnings which are paid to
shareholders. Dividends are paid either in cash or stock. Since dividends are
distributed out of the profits, the alternative to the payment of dividends is the
retention of earnings. The retained earnings constitute an important source of
financing the investment requirements of the firm. There is inverse relationship
between retained earnings and cash dividends. More dividends result in smaller
retentions where as lesser dividend results in larger retentions. Thus, dividends and
retained earnings are competitive and conflicting.
Dividend decisions refer to the decisions regarding the division of net earnings to the
dividend and retained earnings. A firm can distribute all of its earnings to the
shareholders as dividends or can retain all of its earnings for reinvestment as retained
earnings or can distribute a part of earnings as dividend and retain the balance for re-
investment purpose.
Dividend decision is a major financial decision in the sense that a firm has to choose
between distributing profits to the shareholders and ploughing back them into the
business. The selection would be influenced by the effect on the objective of
financial management of maximizing shareholder's wealth.
Given the objective of financial management of maximizing shareholder's wealth, the
firm should be guided by the consideration as which alternative use of net earnings is
consistent with the goal of wealth maximization. If paying dividends to shareholders
will maximize the wealth of shareholder, the firm would be advised to use earnings
for paying dividends to shareholders. The firm would be advised to retain the
earnings if retaining earning will end to the maximization of wealth. Thus, optimal
dividend policy is one which leads to maximization of wealth of owners.
However, there are conflicting opinions regarding the impact of dividends on the
valuation of a firm. According to one school of thought, called irrelevance theory of
dividend, dividends are irrelevant so that amount of dividends paid has no effect on
the valuation of a firm. This thought is led by Modigiliani and Miller. According to
MM Hypothesis, dividend policy has no effect on the value of the firm.

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On the other hand, certain theories consider the dividend decision as relevant to the
value of the firm. The dividend decision has effect on the value of the firm. This
view is led by J.E. Walter, M.J. Gordon and others.
The arguments given are support of irrelevance theory of dividend seems not to be
hold true. Therefore, it should be concluded that dividend policy is relevant. A firm
should try to follow an optimum dividend policy which maximizes the shareholder's
wealth in long run. An optimum dividend policy will vary from firm to firm as it is
determined by a number of factors.

DIVIDEND PAYOUT RATIO AND RETENTION RATIO

Dividend policy decision refers to the decision to pay out earnings or to retain them
for reinvestment in the firm. Dividend refers to the portion of net income paid out to
the shareholders. The percentage of earnings paid out in form of cash dividend is
known as dividend payout ratio. Dividend payout ratio can be calculated as under.

Dividend Paid
Divide Payout ratio =
Net income
Or
Dividend Per Share
Earning Per Share
Where,
Dividend Per Share = Dividend Paid
No. of common shares outs tan ding
Net income
Earnings Per Share =
No. of common shares outs tan ding

A firm may retain same portion of its earnings for reinvestment purpose. The
percentage of earnings retained in the firm is called retention ratio. High dividend
payout ratio means low retention ratio and vice versa.
Retention ratio is calculated as under:
Retention ratio = 1 - Dividend Paid out ratio
Or
=
Re tained earnings
Net income
 Example
A company has net income of Rs 4, 00,000 this year. It retained Rs 1, 60,000 of those
earning for investment purpose. It has 40,000 shares outstanding.
Required: (i) Earnings per share
(ii) Dividend per share
(iii) Total dividend
(iv) Dividend payout ratio
(v) Retention ratio
Solution
Given,
Net income = Rs 4, 00,000
Retained earnings = Rs 1, 60,000
No. of shares = 40,000
Net income
(i) Earning per share =
No. of shares
4,00,000
=
40,000
= Rs 10
(ii) Dividend Paid = Net income - Retained earnings
= 4, 00,000 - 1, 60,000
= Rs 2, 40,000
(iii) Dividend per share = Dividend Paid
No. of shares
240000
=
40000
= Rs 6
(iv) Dividend payout ratio = Dividend Paid
Net income
2,40,000
=
4,00,000
= 0.60 or 60%

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(v) Retention ratio = 1 - dividend payout ratio

= 1 - 0.60
= 0.40 or 40%

DIVIDEND PAYMENT PROCEDURES

Cash dividend refers to the portion of net income paid out to shareholders in cash.
The dividend payment procedures of a company can be described as under:
1. Declaration date
The date at which board of directors meet and issue a statement declaring dividend is
called declaration date. The board of directors set the amount of dividend to be paid,
the holder - of - record date and the payment date on this date. Generally, dividend is
announced as a percentage of the par value of stock. However, it can be the absolute
amount like Rs 5 per share in some cases.
2. Holder - of - record date
The date on which the company opens the ownership books to make a list of
shareholders who are entitled to receive the dividend is called holder - of - record
date. All the stockholders of the record date are entitled to receive the dividend
declared by the board of directors. The new stockholders would receive dividend if
the name of shareholders is recorded in the ownership book on or before the date of
record. However, if the notification about the transfer was received after the date of
record, the old owner of the stock would receive the dividends.
3. Ex - dividend date
Ex-dividend date is two business days prior to the record date. Shares purchased after
the ex-dividend date are not entitled to the dividend. The transaction must take place
before the ex-dividend date to entitle the new holder to receive dividend. Thus, the
date when the right to the dividend leaves the stock for new owner is called ex-
dividend date.
4. Payment date
The date on which the company actually pays dividends or mails the cheques to the
stockholders is called payment date. On this date, the company actually pays the
dividend to all the stockholders of the date of record.
 Example
On July 31, 2009, Khushi Company Limited declared a dividend of Rs 5 per share,
payable on October 1 to the holders of record on September 1. Show the Khushi's
dividend payment procedure.
Solution
1. Declaration date: July 31, 2009 on which Khushi Company's board of directors
declared a dividend of Rs 5 per share.
2. Holder - of - record date: September 1, 2009 on which company makes a list of
shareholders who are entitled to receive dividend.
3. Ex-dividend date: August 30, 2009 after which dividends are entitled with the
seller of the stock.
4. Payment date: October 1, 2009 on which Khushi Company mails the cheque of
dividends to the shareholder.
2 days

31-7-2009 30-8-2009 1-19-2009 1-10-2009

Declaration date Ex-dividend date Holder-of-record date Payment date

FACTORS AFFECTING DIVIDEND POLICY

Dividend policy is concerned with determining the proportion of firm's net income to
be distributed in the form of dividend and the proportion of earnings to be retained
for investment purpose. A firm's dividend policy is influenced by a number of
factors. Some of the major factors influencing the firm's dividend policy are as under:
1. Legal rules
There are certain legal rules that may limit the amount of dividends a firm may pay.
Following are the rules relating to dividend payment:
(a) Net profit rule: According to this rule, dividends can be paid out of present
or past earnings. Amount of dividends can not exceed the accumulated
profits. If there is accumulated loss, it must be set off out of the current
earnings before paying out any dividends.
(b) Insolvency rule: According to this rule, a firm can not pay the dividends
when its liabilities exceed assets. When the firm's liabilities exceed its
assets, the firm is considered to be financially insolvent. The firm,
financially insolvent, is prohibited by law to pay dividends.

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(c) Capital impairment rule: According to this rule, a firm can not pay
dividend out of its paid up capital. The dividend payout that impairs capital
is considered illegal.
2. Desire of shareholders
Dividend policy is affected by the desire of shareholders. Shareholders may be
interested either in dividend income or capital gain. Wealthy shareholders may be
interested in capital gain as against dividend income because of low tax rate on
capital gain. Where as the shareholders, whose sources of income is dividend only,
are interested in dividend income and would not be interested in capital gain.
3. Liquidity position
In order to pay dividend, a company requires cash, and, therefore, the availability of
cash resources within the company will be a factor in determining dividend
payments. Generally, the greater the cash position and overall liquidity of a
company, the greater is the ability to pay dividends. A company must have adequate
cash available as well as retained earnings to pay dividends. The liquidity position of
the company will influence the dividend payout of a particular year.
4. Rate of expansion of business
The rate of asset expansion needs to be taken into account. The more rapid the rate at
which the firm is growing, the greater will be its needs for financing assets
expansion. The greater the future need for funds, the more likely the firm is to retain
earnings rather than pay them out.
5. Cost of external financing
The cost of external financing will have impact on the dividend payout of a
company. In situations, where the external funds are costlier, a firm may resort to
low dividend payout and use the internal funds for financing its business.
6. Need to repay debt
The need to repay debt also influences the availability of cash flow to pay dividend.
If a firm has to repay debt in a particular year, firm may decide to low dividend
payout and use the funds to repay the debt.
7. Contractual constraints
When the company obtained loan funds from debenture holders or term lending
institutions, the terms of issue or contract of loan may contain restrictions on
dividend payments. Debt contracts often stipulate that no dividends can be paid
unless the current ratio, times interest earned ratio and other safety ratios exceed
stated minimums.
 8. Access to the capital market
The company, which has a good access to capital market, can follow a liberal
dividend policy because this type of the company can raise the required funds from
the capital market.
9. Degree of control
One of the important influencing factors on dividend policy is the objective of
maintaining control over the company by the existing management or shareholders.
The management who wish to maintain close control over the company will not
much depend on the external sources of finance, and they maintain a low dividend
payout policy and the funds generated from operations would be used for working
capital and capital investment needs of the firm.
10. Tax position of shareholders
The tax position of shareholders also influences dividend policy. The company
owned by wealthy shareholders having high income tax bracket tend toward lower
dividend payout where as the company owned by small investors tend toward higher
dividend payout.
11. Stability of earnings
The stability of earnings also effects the dividend policy decision. If the earnings of a
firm are relatively stable, the firm is more likely to payout a higher percentage of
earnings than the firm which has fluctuating earnings.
12. General state of economy
When state of economy is uncertain, both political and economic, the firm may
maintain a low dividend payout policy, to withstand to the business risks.
Example
For each of the companies described below, would you expect it to have a low, or
high dividend payout ratio? Explain why?
(a) A company with a large proportion of inside ownership, all of whom are high
income individuals.
(b) A growth company with an abundance of good investment opportunities.
(c) A company with volatile earnings and high business risk.
(d) A company that has high liquidity and is experiencing ordinary growth.
Solution
(a) Low payout ratio: Highly taxed owners generally prefer capital gains rather
dividend income.

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(b) Low payout ratio: Earning are retained in business to support investment
opportunities and there will be less residual funds to pay dividends.
(c) Low payout ratio: The Company will retain earnings to build its financial
strength and to offset high business risk.
(d) High payout ratio: The firm having high liquidity and no more assets expansion
tend to pay higher dividend.
Example
How would each of the following changes tend to affect dividend payout ratio, other
things held constant?
(a) An increase in personal income tax rate.
(b) A decline in investment opportunities.
(c) An increase in corporate profit.
(d) A rise in interest rate.
Solution:
(a) An increase in the personal income tax rate would lower the dividend payout
ratio because shareholders with high income tax bracket prefer capital gain rather
than dividend income.
(b) A decline in investment opportunities would lead to high dividend payout ratio
because less retention is required to support investment opportunities.
(c) A permanent increase in corporate profit would lead to increase in dividend
payout because the firm has more earnings to distribute dividend.
(d) An increase in interest rate would lead to low dividend pay out because retained
earnings may be a relatively attractive way of financing new investment.

DIVIDEND PAYOUT SCHEMES

A firm can pay dividends using either residual dividend policy or stable dividend
policy.
1. Residual dividend policy
Residual dividend policy is based on the assumption that investors prefer to have a
firm retain and reinvest earnings rather than pay out them in dividends. Under
residual dividend policy, a firm pays dividend only after meeting its investment need
at desired debt - equity ratio. This policy is based on the following assumption:
(a) The firm wishes to minimize the need of external equity.
 (b) The firm wishes to maintain its current capital structure.
Under residual dividend policy, if the net income exceeds the portion of equity
financing, then the excess of net income over equity need is paid as dividend.
The company does not pay any dividend when net income is less than or equal to
equity need for financing the investment proposals. In case, net income is not
sufficient to meet equity need, the company should raise deficit amount by
external equity. Following steps should be followed to determine amount of
dividend under residual dividend policy:
(a) Determine the optimal capital budget.
(b) Find out target equity ratio in capital structure
Target equity ratio = 1 - Debt ratio.
(c) Determine the amount of equity required to finance the optimal capital
budget.
Equity financing required = Optimal Capital Budget  Target equity ratio
(d) Pay dividends if earnings are more than equity financing required.
Dividends = Net income - (Capital budget  Target equity ratio)
Example
National Corporation has a target capital structure that consists of 60% debt and 40%
equity. The company anticipates that its capital budget for the upcoming year will be
Rs 3, 00,000. If the company reports net income of Rs 2, 00,000 and it follows a
residual dividend policy, what will be its dividend payout ratio?
Solution
Target debt ratio = 60%
Target equity ratio = 40%
Capital Budget = Rs 300,000
Net income = Rs 2, 00,000
Under residual dividend policy,
Dividend = Net income - (Capital budget  Target equity ratio)
= 200000 - (300000  0.40)
= 200000 - 120000
= Rs 80,000
Dividend payout ratio = Dividends
Net income
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80000
=
200000
= 0.4 or 40%
2. Stable dividend policy
Stability or regularity of dividend is considered as a desirable policy by the
management of most companies because stable dividends have a positive impact on
the market price of the share. Following are the most commonly used constant
dividend policies:
(a) Constant dividend per share: Under this policy, a fixed amount of
dividend per share is paid on annual basis irrespective of earnings of the
company. The earnings may fluctuate from year to year but dividend per
share remains unchanged. However, it does not mean that dividend per share
never be increased. Dividend per share can be increased when the firm can
sustain the higher level. The relationship between earning per share and
dividend per share under this policy can be shown by following figure:
EPS and DPS in Rs.

EPS

DPS

1 2 3 4 5 6 7 Years

(b) Constant payout ratio: Under this policy, a fixed percentage of the net
earnings are paid as dividends every year. If earnings vary, the amount of
dividend also varies from year to year. If earnings increase, dividends also
increase and if earnings decrease, dividends also decrease. Dividends are
paid when profits are earned. No dividend is paid when the firm suffers loss
in any year. The relation between earning per share and dividend per share is
shown as under:
 EPS and DPS in Rs.

25 EPS

20
DPS
15

10

1 2 3 4 5 6 7 Years

(c) Regular dividend plus extra dividend policy: Under this policy, a
minimum constant dividend per share is fixed and additional dividend is
paid over the regular low dividends in the years of relatively high earnings.
This policy is a compromise between constant dividend per share and
constant payout ratio policy. The low regular dividend is maintained even
when earnings decline and extra dividends can be paid when earnings are
more.
Example
City Corporation has the following earning per share over the last 5 years.
Year EPS (Rs)
1 12
2 12
3 20
4 20
5 24
Determine dividend per share under the following policies:
(a) A constant dividend per share of Rs 8
(b) A constant dividend pay out ratio of 40%
(c) Rs 5 regular dividend per share and extra dividend to bring the payout ratio to
40%.

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Solution
(a) Constant dividend per share

Year 1 2 3 4 5

EPS 12 12 20 20 24

DPS 8 8 8 8 8

(b) Constant dividend payout ratio of 40%

Year 1 2 3 4 5

EPS 12 12 20 20 24

D/P Ratio 0.40 0.40 0.40 0.4 0.4

DPS 4.80 4.80 8 8 9.60

(c) Regular dividend plus extra dividend

Year 1 2 3 4 5

EPS 12 12 20 20 24

Minimum dividend 5 5 5 5 5

Extra - - 3 3 4.60

Total dividend 5 5 8 8 9.60

FORMS OF DIVIDEND
CASH DIVIDEND
When dividend is distributed to shareholders in cash out of the earnings of the
company, it is called cash dividend. When cash dividend is distributed, both total
assets and net worth of the company decrease. Total assets decrease as cash
decreases and net wealth decreases as retained earnings decrease. The market price
per share also decreases in most cases by the amount of cash dividend distributed.
Marker price per share after cash dividend = Marker price per share before cash
dividend - dividend per share.
 Example
The Neha Corporation's balance sheet as of 31st Dec. 2009 before the dividend is as
follows:
Balance Sheet

Liabilities Rs Assets Rs

Common stock 200,000 Cash & bank 100,000

(200,00 shares @ Rs 10)

Retained earnings 100,000 Other current assets 100,000

Paid in Capital 50,000 Fixed assets 300,000

Debt 150,000

500,000 500,000

Market price per share of common stock is Rs 17.5

(a) Construct a profroma balance sheet if company pays Rs 2.5 per share cash
dividend.
(b) Determine the marker price per share after cash dividend.
Solution
(a) Balance Sheet
After cash dividend

Liabilities Rs Assets Rs

Common stock 200,000 Cash & bank 50,000

(20,000 shares of Rs 10)

Retained earnings 50,000 Other current assets 100,000

Paid in Capital 50,000 Fixed assets 300,000

Debt 150,000

450,000 450,000

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Working Notes:
Dividend Paid = 20,000  2.5 = Rs 50,000
Cash & bank balance = 100,000 - 50,000
= Rs 50,000
Retained earnings = 100,000 - 50,000
= Rs 50,000
(b) Marker price per share after cash dividend = Market price per share before
cash dividend - dividend per share
= 17.5 - 2.50
= Rs 15

STOCK DIVIDEND/BONUS SHARES

Stock dividend refers to the dividends paid to the existing stockholders in the form of
additional shares of common stock. It represents a distribution of additional shares to
existing shareholder. Stock dividend increases the number of outstanding shares of
the firm's stock. It involves simply an accounting entry transfer from retained
earnings account to the common stock and paid in capital accounts. Due to stock
dividend, retained earnings decrease, common stock and paid in capital increase. The
stock dividend does not affect the equity position of stockholders. Market price per
share and earning per share after stock dividend will decrease.
No. of bonus shares = No. of shares outstanding  % of stock dividend.
Decrease in Retained earnings = No. of bonus shares  Market price per share.
Increase in common stock = No. of bonus shares  par value per share.
Increase in paid in capital = No. of bonus shares  paid in capital per share.
Market price per share before stock dividend
Marker price per share after stock dividend =
1  stock dividend in fracton
Advantages
The important benefits derived from stock dividend or issue of bonus shares are as
follows:
1. It preserves the company's liquidity as no cash leaves the company.
2. The shareholders receive a dividend which can be converted into cash whenever
he wishes through selling the additional shares.
3. It broadens the capital base and improves image of the company.
 4. It reduces the marker price of the shares, rendering the shares more marketable.
5. It is an indication to the prospective investors about the financial soundness of
the company.
6. The shareholders can take the advantage of tax saving from stock dividend.
Disadvantages
1. The future rate of dividend will decline.
2. The future market price of share falls sharply after bonus issue.
3. Issue of bonus shares involves lengthy legal procedures and approvals.
Example
The Janaki Rice Mills has the following shareholder's equity account:

Common stock (Rs 10 par value) 2,00,000

Additional Paid in Capital 2,00,000

Retained earnings 4,00,000

Shareholder' equity 8,00,000

Market price of the stock is Rs 40 per share

(a) Reformulate the shareholders equity account if the company declares 20% stock
dividend
(b) What will be the share price after 20% stock dividend?
Solution
(a)

Common stock (24000 shares of Rs 10) 2,40,000

Additional Paid in Capital 3,20,000

Retained earnings 2,40,000

Shareholder' equity 8,00,000

Working Notes:
Addition of bonus shares = 20,000  20% = 4,000
Increase in common stock = 4,000  10 = Rs 40,000
Increase in paid in capital = 4000  30 = Rs 1, 20,000

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Decrease in retained earnings = 4000  40 = Rs 1, 60,000

(b)
Stock price before stock dividend
Market price per share after stock dividend=
1  Stock dividend in fraction

40
= 1  0.20
40
=
1.20
= Rs 33.33

STOCK SPLIT
A stock split is a method to reduce the marker price per share by giving certain
number of share for one old share. Due to stock split, number of outstanding shares
increase and par value and marker price of the stock decrease. A stock split affects
only the par value, market value and the number of outstanding shares. However, net
worth of the company remains unaltered.
With a stock split, shareholder's equity account does not change, but the par value per
share changes. The earnings per share will be diluted and marker price per share fall
proportionately with a stock split. But, the total value of the holdings of a shareholder
remains unaffected by a stock split. Following ate the reasons for splitting a firm's
ordinary shares:
1. Stock split results in reduction in market price of the share. It helps in increasing
the marketability and liquidity of a company's shares.
2. Stock splits are used by the company management to communicate to investors
that the company is expected to earn higher profits in future.
3. Stock split is used to give higher dividends to shareholders.
Example
XZY Company has the following shareholder's equity account.

Common stock (10000 shares of Rs 100 each) 10,00,000

Additional Paid in Capital 10,00,000

Retained earnings 20,00,000

Shareholder' equity 40,00,000

 The current market price per share is Rs 400 each.
(a) Reformulate the shareholder's equity account if the company split their shares
two - for - one
(b) What will the marker price per share after stock split?
Solution
(a) Shareholder's equity after stock split

Common stock (20000 shares of Rs 50) 10,00,000

Additional Paid in Capital 10,00,000

Retained earnings 20,00,000

Shareholder' equity 40,00,000

(b) Marker price per share after stock split = Rs 400  1/2 = Rs 200.

REVERSE STOCK SPLIT

Reverse stock split is method used to raise marker price of a firm's stock by
exchanging certain number of outstanding shares for one new share of stock. Due to
reverse stock split, number of outstanding shares decreases, par value of the shares
increases and marker price per share also increases. However, total net worth of the
company remains unchanged. Reverse stock split is used to stop the marker price per
share below a certain level. The reverse split is generally an indication of financial
difficulty and is, therefore, intended to increase the marker price per share.
Example
XYZ Company has the following shareholder's equity account

Common stock (20000 shares of Rs 50) 10,00,000

Additional Paid in Capital 5,00,000

Retained earnings 5,00,000

Shareholder' equity 20,00,000

What will happens to this account and no. of shares outstanding with a 1-for-2
reverse stock split?

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Solution
Shareholder's equity Account

Common stock (10000 shares of Rs 100) Rs. 10,00,000

Additional Paid in Capital Rs. 5,00,000

Retained earnings Rs. 5,00,000

Shareholder' equity Rs. 20,00,000

No. of Shares Rs. 10,000

REPURCHASE OF STOCK
Stock repurchase is method in which a firm buys back shares of its own stock, there
by decreasing shares outstanding, increasing earning per share, and, often increasing
the stock price. It is an alternative to cash dividends. In a stock repurchase, the
company pays cash to repurchase shares from its shareholders. These shares are
usually kept in the company's treasury and then resold when the company needs
money.
If a firm has excess cash, it may purchase its own stock leaving fewer shares
outstanding, increasing the earning per share and increasing the stock price. It may
be an alternative to paying cash dividends. The benefits to the shareholders are the
same under cash dividend and stock repurchase. In the absence of personal income
taxes and transaction costs, both cash dividend and stock repurchase have no any
difference to shareholders. Capital gain arising from repurchase should equal the
dividend otherwise would have been paid.
Repurchase price or equilibrium price is the price that brings capital gain equal to the
cash dividend. Share price for repurchase or the equilibrium price is calculated from
the following equation:
S  Pc
Repurchase Price (P*) =
S n
Where,
S = Total number of shares outstanding
Pc = Current market price per share
n = Number of shares to be repurchased.
 Share can be repurchased in different ways. A company can repurchase its shares
through authorized brokers on the open market. Shares can be also repurchased by
making a tender offer which will specify the purchases price, the total amount and
the period within which shares will be bought back. Similarly, a company can
purchase a block of shares from one large holder on a negotiated basis.
Advantages of repurchase of stock
1. A firm use idle cash to repurchase stock if it has less investment opportunities.
2. Dividend and earning per share will be increased through stock repurchase.
3. Stock repurchase will result in increase in the share value.
4. The buying shareholders will benefit since the company generally offer a price
higher than the current market price of the share.
5. When shares are under valued in the market, a company can buy back shares at
higher price to move up the current share price.
6. If a company has high proportion of equity in its capital structure, if can reduce
equity capital by buying back its shares to achieve target capital structure.
7. The promoters of the company benefit by consolidating their ownership and
control over companies through stock repurchase. They do not sell their shares to
the company rather make the share repurchase attractive for others.
8. Repurchase of stock can remove a large block of stock that is overhanging the
market and keeping the price per share down.
9. In a hostile takeover, a company may buy back its shares to reduce the
availability of shares and make take over difficult.
10. Stockholder is given a choice of whether or not to sell their stock to the firm.
Disadvantages of stock repurchase
1. Shareholders may not be indifferent between dividends and capital gains, and the
price of stock might benefit more from cash dividends than from repurchase.
2. The remaining shareholder may lose if the company pays excessive price for the
shares under the stock repurchase scheme.
3. Stock repurchase may signal to investors that the company does not have long -
term growth opportunities to utilize the cash.
4. The buyback of shares may be useful as a defense against hostile takeover only
in case of cash rich companies.

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Example
A company has Rs 16, 00,000 in excess funds. The company wishes to distribute
these funds to repurchase the stock.
Presently, it has 4, 00,000 shares outstanding and the market price per share is Rs.
36. It wishes to repurchase 10% of its stock or 40000 shares.
a. Assuming no signaling effect, at what price should the company offer to
repurchase?
b. In total, how much will the company be distributing through share repurchase?
c. If the company were to pay out the funds through cash dividend instead, what
will be the market price per share after the distribution?
Solution
(a) Current market price (Pc) = Rs 36
No. of shares outstanding (S) = 4, 00,000
No. of shares repurchased (n) = 40,000
Required repurchase price (P*) =?
Now,
S  Pc
P* =
S n
400000  36
=
400000  40000
= Rs 40
Assuming no signaling effect, the company should offer to repurchase its stock at Rs.
40.
(b) The company will be distributing Rs 16, 00,000 (40,000  Rs 40) through share
repurchase.
Total dividend
(c) Cash dividend per share =
No. of Common Stock

16,00,000
= 4,00,000
= Rs 4
Marker price per share after cash dividend = Rs 36 - 4
= Rs 32.
ILLUSTRATIVE PROBLEMS
Illustration No. 1
MN Company expects to generate following net income during next years.
Year Net income
1 4, 00,000
2 6, 00,000
3 8, 00,000
The company currently has 100000 shares outstanding.
(a) Determine earning per share in each year.
(b) Determine total dividend and dividend per share if a dividend pay out ratio of
50% is maintained.
(c) Determine dividend per share if company declares Rs 2 regular dividend per
share and extra dividend in order to bring the payout ratio to 50% if it otherwise
would fall below.
Solution
(a) Earning Per Share
Year 1 2 3
Net income 4,00,000 6,00,000 8,00,000
No. of shares 1,00,000 1,00,000 1,00,000
*Earning Per Share 4 6 8
Net income
* Earning Per Share =
No. of Shares
(b) Dividend per share & total dividend

Year 1 2 3

Net income 4,00,000 6,00,000 8,00,000

D/P Ratio 50% 50% 50%

* Total dividend 2,00,000 3,00,000 4,00,000

No. of Shares 1,00,000 1,00,000 1,00,000

Dividend Per Share 2 3 4

* Total dividend = Net income  dividend payout ratio

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Total dividend
** Dividend Per Share = No. of Shares
(c) Dividend Per Share
Year 1 2 3
Net income 4,00,000 6,00,000 8,00,000
No. of shares 1,00,000 1,00,000 1,00,000
Earning Per Share 4 6 8
Regular Dividend 2 2 2
Extra Dividend - 1 2
Total dividend per share 2 3 4

Illustration No. 2
Janakpur Rice Mill expects next year's net income to be Rs 12, 00,000. Its debt to
equity ratio is currently 60%. It has Rs 9, 60,000 of profitable investment
opportunities, and its wishes to maintain its existing debt ratio. According to residual
dividend model, how large should the company's dividend payout ratio be next year?
Solution
Debt to equity ratio = 60%
Let, Amount of equity = 100
Amount of Debt = 60
Total assets = 100+60
= 160
Debt
Debt ratio =
Assets

60
= 160
= 0.375
Equity ratio = 1 - Debt ratio
= 1 - 0.375
= 0.625
= 62.5%
 Dividend Paid = Net income - (Capital budget  equity ratio)
= 12, 00,000 - (96, 00,000  0.625)
= 12, 00,000 - 6, 00,000
= Rs 6, 00,000

Dividend
Dividend payout ratio =
Total Net income

6,00,000
= 12,00,000
= 0.50 or 50%
Illustration 3
Nepal Industrial Bank has the following shareholder's equity account

Common Stock (20,000 shares of Rs 10 per) 2,00,000

Paid in Capital 1,00,000

Retained earnings 2,00,000

Shareholder's equity 5,00,000

Current Marker price of the stock is Rs 30 per share.

(a) What happen to these accounts if the company declared 10% stock dividend?
(b) What would happen to these accounts if the company declared a 2 - for - 1 stock
split?
(c) What would happen if there was a reverse stock of 1 - for - 4?
Solution
(a) Shareholder's equity after stock dividend

Common Stock (22000 shares of Rs 10 per) 2,20,000

Paid in Capital 1,60,000

Retained earnings 1,20,000

Shareholder's equity 5,00,000

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Working Notes:
Extra shares for stock dividend = 20,000  10%
= 2,000 shares.
Increase in common stock = 2,000  Rs 10 = Rs 20,000
Increase in paid up capital = 2,000  Rs 30 = Rs 60,000
Decrease in retained earnings = 2,000  Rs 40
= Rs 80,000
(b) Shareholder's equity after stock split

Common Stock (40,000 shares of Rs 5) 2,00,000

Paid in Capital 1,00,000

Retained earnings 2,00,000

Shareholder's equity 5,00,000

Working Notes:
No. of shares after split = 20,000  2/1
= 40,000 shares.
Par value after split = 10  1/2
= Rs 5
(c) Shareholder's equity after Reverse stock split

Common Stock (5,000 shares of Rs 40) 2,00,000

Paid in Capital 1,00,000

Retained earnings 2,00,000

Shareholder's equity 5,00,000

Working Notes:
No. of shares after reverse stock split = 20,000  1/4
= 5,000 shares
Par share after reverse stock split = 10  4/1
= Rs 40
 Illustration 4
After a 4 - for - 1 stock split, Spice Nepal Limited paid a dividend of R 3 per new
share, which represents a 20% increase over last year's pre - split dividend. What was
last year's dividend per share?
Solution:
After stock split dividend per shares (D1) = Rs 3
Before stock split dividend per share (D1) = Rs 3  4/1
= Rs 12
Growth rate (g) = 20%
Last year's dividend (Do) =?
We know,
D1 = Do (1+g)
Or, 12 = Do (1 + 0.20)
12
Or, Do = 1.20
= Rs 10.
Hence, last year's dividend per share was Rs 10.
Illustration 5
Khushi Company treats dividend as a residual decision. It expects to generate Rs 5
million in net earnings after tax in the coming year. The company has an all - equity
capital structure and its cost of equity capital is 20%. The company treats this cost as
the opportunities cost of retained earnings. Cost of external equity is 21%.
(a) How much in dividends should be paid if the company has Rs 3 million in
projects whose expected return exceeds 20% percent?
(b) How much in dividends should be paid if it was Rs 5 million in projects
whose expected return exceeds 20%?
(c) How much in dividends should be paid if it has Rs 6 million in projects
whose expected return exceeds 21%.
Solution
(a) Dividends to be paid = Net income - (Capital budget  equity ratio)
=5-31
= Rs 2 million.

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(b) Dividends to be paid

= Net income - (Capital budget  equity ratio)
=5-51
= Nil
(c) Dividend to be paid (external financing) = Net income - (Capital budget 
Equity ratio)
=5-61
= (Rs 1 million)
Hence, the company will not pay any dividend rather it should raise Rs 1 million in
additional new common stock externally to satisfy the financing need.
Illustration 6
ABC Corporation has Rs 6 million in excess funds. The corporation wishes to
distribute these funds via the repurchase of stock. Presently, it has 24, 00,000 shares
outstanding, and the marker price per share is Rs 25. It wishes to repurchase 10% of
its stock, or 2, 40,000 shares.
(a) Assuming no signaling effect, at what price should the company offer to
repurchase?
(b) In total, how much will the company be distributing through share repurchase?
(c) If the company were to pay out the funds through cash dividends in stead, what
would be the marker price per share after the distribution?
Solution
(a) Current Market Price (Pc) = Rs 25
No. of shares outstanding (S) = 24, 00,000
No. of shares repurchased (n) = 2, 40,000
Repurchase Price (P*) =?
We know,
S  Pc
P* =
S n

24,00,000  25
=
24,00,000  2,40,000
= Rs 27.78
 (b) Total distribution through stock repurchase = 2, 40,000  Rs 27.78
= Rs 66, 67,200
Dividend Paid
(c) Divident Per Share =
No. of Shares

66,67,200
=
24,00,000
= Rs 2.78
Market price after cash dividend = 25 - 2.78
= Rs 22.22
Illustration 7
Sharda Company repurchased 50,000 shares of its 5, 00,000 shares outstanding at a
price of Rs 55 per share. Immediately prior to the share repurchase announcement,
share price was Rs 45. However, 2, 00,000 shares were tendered by stockholders
wanting to sell. The company had to repurchase the 50,000 shares on a pro - rata
basis according to the number of shares tendered.
(a) Why did so many shareholders tender their shares? At what price should the
company have made its repurchase offer?
(b) Who gained from the offer? Who lost?
Solution
(a) Current market price (Pc) = Rs 45
No. of shares outstanding (S) = 5, 00,000
No. of shares repurchased (n) = 50, 000 shares
Equilibrium price or repurchase price (P*) =?
S  Pc
P* =
S n

5,00,000  45
=
5,00,000  50,000
= Rs 50
Since the offer price (Rs 55) is more than the equilibrium repurchase price, many
shareholders tendered their shares to sell. The company should have made its offer at
Rs 50 instead of Rs 55.
(b) The holder of shares whose shares were repurchased gained from the tender offer
and remaining shareholder suffered loss.

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SUMMARY
Dividend Policy is concerned with the decisions regarding division of net income to
the dividend and retained earnings. The firm should determine optimum dividend
policy which leads the firm to stockholders wealth maximization. A company can
adopt either residual dividend policy or stable dividend policy. Three alternative
stable dividend policies are constant dividend per share, constant dividend pay out
and regular plus extra dividend policy.
A firm's dividend payment procedures start with determining the declaration date on
which board of directors declare dividends to be paid, the holders of record date and
payment date.
A firm's dividend policy is influenced by a large no. of factors like legal
requirements, desire of shareholders, liquidity position; need to repay debt, desire of
control, rate of business expansion, access to capital market, tax position of
shareholders, restrictions in debt contracts etc.
Cash dividend is the dividend, which is distributed to shareholders in cash. Due to
cash dividend, total assets as well as net worth decrease as cash and retained earnings
decrease. The market price of share also decreases by the amount of cash dividend
distributed.
A stock dividend refers to the dividend distributed to existing shareholders in the
form of additional shares rather than in cash. Due to stock dividend, no. of
outstanding shares increases, Common stock and paid in capital increases and
retained earnings decrease. However, net worth remains unchanged.
Stock split increases the number of outstanding shares with a proportionate decrease
in par value. Reverse stock split decreases the number of shares outstanding with a
proportionate increase in par value. With a stock split and reverse stock split,
shareholder's equity remains unchanged.
In a stock repurchase, a firm buys back some of its outstanding shares, thereby
decreasing number of shares, increasing earning per share and marker price. It is an
alternative to paying cash dividend.
NUMERICAL PROBLEMS
Problem No. 1
Due to increase in demand, Koshi Company plans to expand production capacity by
40% with a Rs 10, 00,000 investment in plant & machinery. The firm wants to
maintain a 40% debt to total assets ratio in its capital structure, it also wants to
maintain its past dividend policy of distributing 55% of net income. If the company's
net income was Rs 5, 00,000, how much external equity must the company seek to
expand capacity as desired?
Problem No. 2
The moon company expects to generate following net income during next 3 years.
Year Net income (Rs)
1 4, 00,000
2 3, 00,000
3 5, 00,000
The company has currently 40,000 shares outstanding.
(a) Determine the earning per share in each year.
(b) Determine total dividend and dividend per share if a dividend payout
ratio of 40% is maintained.
Problem No. 3
The Star Company expects to generate following net income during next 3 years.
Year Net income Capital expenditure
1 5, 00,000 3, 00,000
2 8, 00,000 5, 00,000
3 10, 00,000 12, 00,000
The firm has currently 50,000 shares outstanding
Required:
(a) Earnings per share in each year.
(b) Dividend per share if dividend payout ratio of 60% is maintained.
(c) Dividend per share if company follows a residual dividend policy.

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Problem No. 4
Sun Music Company's earnings per share over the last 5 years were the following:
Year Earning per share (Rs)
1 20
2 25
3 30
4 35
5 40
Determine dividend per share under the following policies:
(a) Constant dividend payout ratio of 40%
(b) A regular dividend of Rs 14 and extra dividend to bring the payout ratio of
60% if it otherwise would fall below.
Problem No. 5
A corporation had following earning per share over the last 5 years.
Year EPS (Rs)
1 6
2 6
3 10
4 10
5 20
Required:
(a) If the firm's dividend policy is based on constant payout ratio of 40% for
all years with positive earning, determine dividend per share in each year.
(b) If the firm has a regular dividend policy of paying Rs 4 per share, regardless
of the per share earnings, determine dividend per share in each year.
(c) If the firm's policy is pay out Rs 3 per share each period, except in those
periods when earnings are above Rs 6; when they pay out an extra dividend
equal to 20% of earnings above Rs 6, determine dividend per share in each
year.
 Problem No. 6
Mithila Sporting Incorporation is prepared to report the following income statement
for the year 2009.
Sales 1,52,00,000
Less, operating cost 1,19,00,000
EBIT 33,0,000
Less, interest 3,00,000
Earning before tax 30,00,000
Les, Tax @ 40% 12,00,000
Net income 18,00,000
Prior to reporting these income statements, the company wants to determine its
annual dividend. The company has 5, 00,000 shares of stock outstanding and its
stock trades at Rs 48 per share.
(a) The company had a 40% dividend payout ratio in 2008. If the company
wants to maintain this payout ratio in 2009, what will be it’s per share
dividend in 2009?
(b) If the company maintains this 40% payout ratio, what will be the current
yield of the company's stock?
(c) The company reported net income of Rs 1500,000 in 2008. Assume that the
number of shares outstanding has remained constant. What was the
company's per share dividend in 2008?
(d) As an alternative to maintain the same dividend payout ratio, the company is
considering maintaining the same dividend per share in 2009 that it paid in
2008. If it chooses this policy, what will be the company's dividend payout
ratio in 2009?
Problem No. 7
The sunlight company expects with some degree of certainty to generate the
following net income and to have the following capital expenditures during the next
5 years (in thousands of rupees):
Year Net income (Rs) Capital expenditure (Rs)
1 2000 1000
2 1500 1500
3 2500 2000
4 2300 1500
5 1800 2000

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The company currently has 1 million of common stock outstanding and pays
dividend of Rs 1 per share.
(a) Determine dividend per share and external financing required if dividend
policy is treated as a residual decision.
(b) Determine the amounts of external financing in each year that will be
necessary if the present dividend per share is maintained.
(c) Determine dividend per share and the amounts of external financing that will
be necessary if a dividend payout ratio of 50% is maintained.
(d) Under which of the three dividend policies are aggregate dividend
maximized? External financing minimized?
Problem No. 8
Bishal Supermarkets Inc. (50,000 common shares outstanding) currently has annual
earnings before interest and taxes of Rs 10, 00,000. Its interest expenses are Rs 2,
00,000 a year, and it pays Rs 1, 00,000 in annual dividends to its stockholder. The
company's tax rute is 40% and its common stock's current dividend yield is 2%.
(a) Calculate the company's earning per share
(b) Calculate the company's divided payout ratio.
(c) Calculate the company's current common stock price.
(d) If Bishal declares and pays a 100% stock dividend and then pays an annual
cash dividend of Rs 1.10 per share, what is the effective rate by which the
dividend has been increased?
Problem No. 9
In 2009, the Simran Company paid dividend totaling Rs 11, 25,000. For the past 10
years, earnings have grown at a constant rate of 10%. After tax income was Rs 37,
50,000 for 2009. However, in 2010, earnings were Rs 67, 50,000 with investment of
Rs 50, 00,000. It is predicted that the company will not be able to maintain this
higher level of earnings and will return to its previous 10% growth rate. Calculate
dividends for 2010 if the company follows each of the following policies.
(a) Its dividend payment is stable.
(b) Its dividend payment is growing's.
(c) It continues the 2009 dividend payout ratio.
(d) It uses a residual dividend policy (30% of Rs 50, 00,000 investment was
finance with debt)
 (e) The investment in 2010 is financed 90% with retained earnings and 10%
with debt. Any earnings not invested are paid out as dividends.
(f) The investment in 2010 is financed 30% with external equity, 30% with debt
and 40% with retained earnings. Any earnings not invested are paid out as
dividends.
Problem No. 10
In 2009, the Everest Company paid dividends totaling Rs 36, 00,000 on net income,
of Rs 10.8 Million. 2009 was a normal year, and for the past 10 years, earnings have
grown at a constant rate of 10%. However, in 2010, earnings are expected to jump to
Rs 14.4 Million, and firm expects to have profitable investment opportunities of Rs
8.40 Million. It is predicted that Everest Company will not be able to maintain the
2010 level of earning growth - the high 2010 earnings level is attributable to an
exceptionally profitable new product line introduced that year - and the company will
return to its previous 10% growth rate. Everest's target debt ratio is 40% Calculate
Everest's total dividends for 2010 if it allows each of the following policies:
(a) Its 2010 dividend payment is set to force dividends to grow at the long run
growth rate in earnings.
(b) It continues the 2009 dividend payout ratio.
(c) It uses a pure residual dividend policy (40% of the Rs 8.4 Million
investment is finance with debt)
(d) It employs a regular - dividend plus extra policy, with the regular dividend
being based on the long run growth rate and the extra dividend being set
according to the residual policy.
Problem No. 11
A firm has 500000 shares of Rs 10 per common stock, a contributed capital in excess
of par account of Rs 2 million and retained earnings of Rs. 3 million, all before the
declaration of dividend. The board of directors declared Rs 2 per share cash
dividend. What are the balances in equity accounts if the market value of the stock is
Rs 20 per share? What will be the market price after cash dividend?

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