Dividend policy is concerned with financial policies regarding paying cash dividend in the present or paying an increased dividend at a later stage. Whether to issue dividends, and what amount, is determined mainly on the basis of the company's unappropriated profit (excess cash) and influenced by the company's long-term earning power. When cash surplus exists and is not needed by the firm, then management is expected to pay out some or all of those surplus earnings in the form of cash dividends or to repurchase the company's stock through a share buyback program.
Share repurchase is the re-acquisition by a company of its own stock. It represents a more flexible way of returning money to shareholders.
If there are no NPV positive opportunities, i.e. projects where returns exceed the hurdle rate, and excess cash surplus is not needed, then – finance theory suggests – management should return some or all of the excess cash to shareholders as dividends. This is the general case, however there are exceptions. For example, shareholders of a "growth stock", expect that the company will, almost by definition, retain most of the excess earnings so as to fund future growth internally. By with holding current dividend payments to shareholders, managers of growth companies are hoping that dividend payments will be increased proportionality higher in the future, to offset the retainment of current earnings and the internal financing of present investment projects.
In finance, the net present value (NPV) or net present worth (NPW) is the summation of the present (now) value of a series of present and future cash flows. Because NPV accounts for the time value of money NPV provides a method for evaluating and comparing products with cash flows spread over many years, as in loans, investments, payouts from insurance contracts plus many other applications.
Return on investment (ROI) is a ratio between the net profit and cost of investment resulting from an investment of some resources. A high ROI means the investment's gains favorably to its cost. As a performance measure, ROI is used to evaluate the efficiency of an investment or to compare the efficiencies of several different investments. In purely economic terms, it is one way of relating profits to capital invested. Return on investment is a performance measure used by businesses to identify the efficiency of an investment or number of different investments.
In business and for engineering economics in both industrial engineering and civil engineering practice, the minimum acceptable rate of return, often abbreviated MARR, or hurdle rate is the minimum rate of return on a project a manager or company is willing to accept before starting a project, given its risk and the opportunity cost of forgoing other projects. A synonym seen in many contexts is minimum attractive rate of return.
Management must also choose the form of the dividend distribution, generally as cash dividends or via a share buyback. Various factors may be taken into consideration: where shareholders must pay tax on dividends, firms may elect to retain earnings or to perform a stock buyback, in both cases increasing the value of shares outstanding. Alternatively, some companies will pay "dividends" from stock rather than in cash; see Corporate action. Financial theory suggests that the dividend policy should be set based upon the type of company and what management determines is the best use of those dividend resources for the firm to its shareholders. As a general rule, shareholders of growth companies would prefer managers to have a share buyback program, whereas shareholders of value or secondary stocks would prefer the management of these companies to payout surplus earnings in the form of cash dividends.
A dividend is a payment made by a corporation to its shareholders, usually as a distribution of profits. When a corporation earns a profit or surplus, the corporation is able to re-invest the profit in the business and pay a proportion of the profit as a dividend to shareholders. Distribution to shareholders may be in cash or, if the corporation has a dividend reinvestment plan, the amount can be paid by the issue of further shares or share repurchase. When dividends are paid, shareholders typically must pay income taxes, and the corporation does not receive a corporate income tax deduction for the dividend payments.
A treasury stock or reacquired stock is stock which is also bought back by the issuing company, reducing the amount of outstanding stock on the open market.
A dividend tax is the tax imposed by a tax authority on dividends received by shareholders (stockholders) of a company.
Coming up with the dividend policy is challenging for the directors and financial manager of a company, because different investors have different views on present cash dividends and future capital gains. Another confusion that pops up is regarding the extent of effect of dividends on the share price. Due to this controversial nature of a dividend policy it is often called the dividend puzzle.
An investor is a person that allocates capital with the expectation of a future financial return. Types of investments include: equity, debt securities, real estate, currency, commodity, token, derivatives such as put and call options, futures, forwards, etc. This definition makes no distinction between the investors in the primary and secondary markets. That is, someone who provides a business with capital and someone who buys a stock are both investors. An investor who owns a stock is a shareholder.
A capital gain refers to profit that results from a sale of a capital asset, such as stock, bond or real estate, where the sale price exceeds the purchase price. The gain is the difference between a higher selling price and a lower purchase price. Conversely, a capital loss arises if the proceeds from the sale of a capital asset are less than the purchase price.
A share price is the price of a single share of a number of saleable stocks of a company, derivative or other financial asset. In layman's terms, the stock price is the highest amount someone is willing to pay for the stock, or the lowest amount that it can be bought for.
Various models have been developed to help firms analyse and evaluate the perfect dividend policy. There is no agreement between these schools of thought over the relationship between dividends and the value of the share or the wealth of the shareholders in other words.
One school consists of people like James E. Walter and Myron J. Gordon (see Gordon model), who believe that current cash dividends are less risky than future capital gains. Thus, they say that investors prefer those firms which pay regular dividends and such dividends affect the market price of the share. Another school linked to Modigliani and Miller holds that investors don't really choose between future gains and cash dividends.
Myron Jules Gordon, was an American economist. He was Professor Emeritus of Finance at the Rotman School of Management, University of Toronto. In 1956, Gordon along with Eli Shapiro, published a method for valuing a stock or business, now known as the Gordon growth model.
The Modigliani–Miller theorem is an influential element of economic theory; it forms the basis for modern thinking on capital structure. The basic theorem states that in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. Since the value of the firm depends neither on its dividend policy nor its decision to raise capital by issuing stock or selling debt, the Modigliani–Miller theorem is often called the capital structure irrelevance principle.
Dividends paid by the firms are viewed positively both by the investors and the firms. The firms which do not pay dividends are rated in oppositely by investors thus affecting the share price. The people who support relevance of dividends clearly state that regular dividends reduce uncertainty of the shareholders i.e. the earnings of the firm is discounted at a lower rate, ke thereby increasing the market value. However, its exactly opposite in the case of increased uncertainty due to non-payment of dividends.
Two important models supporting dividend relevance are given by Walter and Gordon.
Walter's model shows the relevance of dividend policy and its bearing on the value of the share.
Basically, the firm's decision to give or not give out dividends depends on whether it has enough opportunities to invest the retained earnings i.e. a strong relationship between investment and dividend decisions is considered.
Dividends paid to the shareholders are reinvested by the shareholder further, to get higher returns. This is referred to as the opportunity cost of the firm or the cost of capital, ke for the firm. Another situation where the firms do not pay out dividends, is when they invest the profits or retained earnings in profitable opportunities to earn returns on such investments. This rate of return r, for the firm must at least be equal to ke. If this happens then the returns of the firm is equal to the earnings of the shareholders if the dividends were paid. Thus, it's clear that if r, is more than the cost of capital ke, then the returns from investments is more than returns shareholders receive from further investments.
Walter's model says that if r<ke then the firm should distribute the profits in the form of dividends to give the shareholders higher returns. However, if r>ke then the investment opportunities reap better returns for the firm and thus, the firm should invest the retained earnings. The relationship between r and k are extremely important to determine the dividend policy. It decides whether the firm should have zero payout or 100% payout.
In a nutshell :
Mandar Mathkar has given a mathematical model for the above made statements :
The market price of the share consists of the sum total of:
Therefore, the market value of a share is the result of expected dividends and capital gains according to Walter.
Although the model provides a simple framework to explain the relationship between the market value of the share and the dividend policy, it has some unrealistic assumptions.
Myron J. Gordon has also supported dividend relevance and believes in regular dividends affecting the share price of the firm.
Gordon's assumptions are similar to the ones given by Walter. However, there are two additional assumptions proposed by him :
Investors are risk averse and believe that incomes from dividends are certain rather than incomes from future capital gains, therefore they predict future capital gains to be risky propositions. They discount the future capital gains at a higher rate than the firm's earnings, thereby evaluating a higher value of the share. In short, when retention rate increases, they require a higher discounting rate. Gordon has given a model similar to Waltematical formula to determine price of the share.
The market prices of the share is calculated as follows:
Therefore, the model shows a relationship between the payout ratio, rate of return, cost of capital and the market price of the share.
Gordon's ideas were similar to Walter's and therefore, the criticisms are also similar. Both of them clearly state the relationship between dividend policies and market value of the firm.
The capital structure substitution theory (CSS)describes the relationship between earnings, stock price and capital structure of public companies. The theory is based on one simple hypothesis: company managements manipulate capital structure such that earnings-per-share (EPS) are maximized. The resulting dynamic debt-equity target explains why some companies use dividends and others do not. When redistributing cash to shareholders, company managements can typically choose between dividends and share repurchases. But as dividends are in most cases taxed higher than capital gains, investors are expected to prefer capital gains. However, the CSS theory shows that for some companies share repurchases lead to a reduction in EPS. These companies typically prefer dividends over share repurchases.
From the CSS theory it can be derived that debt-free companies should prefer repurchases whereas companies with a debt-equity ratio larger than
should prefer dividends as a means to distribute cash to shareholders, where
Low valued, high leverage companies with limited investment opportunities and a high profitability use dividends as the preferred means to distribute cash to shareholders, as is documented by empirical research.
The CSS theory provides more guidance on dividend policy to company managements than the Walter model and the Gordon model. It also reverses the traditional order of cause and effect by implying that company valuation ratios drive dividend policy, and not vice versa. The CSS theory does not have 'invisible' or 'hidden' parameters such as the equity risk premium, the discount rate, the expected growth rate or expected inflation. As a consequence the theory can be tested in an unambiguous way.
The Modigliani and Miller school of thought believes that investors do not state any preference between current dividends and capital gains. They say that dividend policy is irrelevant and is not deterministic of the market value. Therefore, the shareholders are indifferent between the two types of dividends. All they want are high returns either in the form of dividends or in the form of re-investment of retained earnings by the firm. There are two conditions discussed in relation to this approach :
Two important theories discussed relating to the irrelevance approach, the residuals theory and the Modigliani and Miller approach.
One of the assumptions of this theory is that external financing to re-invest is either not available, or that it is too costly to invest in any profitable opportunity. If the firm has good investment opportunity available then, they'll invest the retained earnings and reduce the dividends or give no dividends at all. If no such opportunity exists, the firm will pay out dividends.
If a firm has to issue securities to finance an investment, the existence of flotation costs needs a larger amount of securities to be issued. Therefore, the pay out of dividends depend on whether any profits are left after the financing of proposed investments as flotation costs increases the amount of profits used. Deciding how much dividends to be paid is not the concern here, in fact the firm has to decide how much profits to be retained and the rest can then be distributed as dividends. This is the theory of Residuals, where dividends are residuals from the profits after serving proposed investments.
This residual decision is distributed in three steps:
The dividend policy strongly depends on two things:
The dividend policy of such a kind is a passive one, and doesn't influence market price. the dividends also fluctuate every year because of different investment opportunities every year. However, it doesn't really affect the shareholders as they get compensated in the form of future capital gains.
The firm paying out dividends is obviously generating incomes for an investor, however even if the firm takes some investment opportunity then the incomes of the investors rise at a later stage due to this profitable investment.
The Modigliani–Miller theorem states that the division of retained earnings between new investment and dividends do not influence the value of the firm. It is the investment pattern and consequently the earnings of the firm which affect the share price or the value of the firm.
The MM approach has taken into consideration the following assumptions:
The dividend irrelevancy in this model exists because shareholders are indifferent between paying out dividends and investing retained earnings in new opportunities. The firm finances opportunities either through retained earnings or by issuing new shares to raise capital. The amount used up in paying out dividends is replaced by the new capital raised through issuing shares. This will affect the value of the firm in an opposite way. The increase in the value because of the dividends will be offset by the decrease in the value for new capital raising. step1: Find out P1 i.e.neaxt year price of the share
P0 = D1 + P1 / 1+Re
step2: No of shares to be issued
mP1 = I-(E-D1)
step3: Value of firm
nP0 = (n+m)P1-I+E / Re
Finance is a field that is concerned with the allocation (investment) of assets and liabilities over space and time, often under conditions of risk or uncertainty. Finance can also be defined as the art of money management. Participants in the market aim to price assets based on their risk level, fundamental value, and their expected rate of return. Finance can be split into three sub-categories: public finance, corporate finance and personal finance.
Fundamental analysis, in accounting and finance, is the analysis of a business's financial statements ; health; and competitors and markets. It also considers the overall state of the economy and factors including interest rates, production, earnings, employment, GDP, housing, manufacturing and management. There are two basic approaches that can be used: bottom up analysis and top down analysis. These terms are used to distinguish such analysis from other types of investment analysis, such as quantitative and technical.
In accounting, equity is the difference between the value of the assets and the value of the liabilities of something owned. It is governed by the following equation:
The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is commonly referred to as the firm's cost of capital. Importantly, it is dictated by the external market and not by management. The WACC represents the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere.
In finance, valuation is the process of determining the present value (PV) of an asset. Valuations can be done on assets or on liabilities. Valuations are needed for many reasons such as investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability, and in litigation.
In financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit from price movement – stocks that are judged undervalued are bought, while stocks that are judged overvalued are sold, in the expectation that undervalued stocks will overall rise in value, while overvalued stocks will generally decrease in value.
In economics and accounting, the cost of capital is the cost of a company's funds, or, from an investor's point of view "the required rate of return on a portfolio company's existing securities". It is used to evaluate new projects of a company. It is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.
In finance, particularly corporate finance capital structure is the way a corporation finances its assets through some combination of equity, debt, or hybrid securities.
In corporate finance, the return on equity (ROE) is a measure of the profitability of a business in relation to the equity, also known as net assets or assets minus liabilities. ROE is a measure of how well a company uses investments to generate earnings growth.
Business valuation is a process and a set of procedures used to estimate the economic value of an owner's interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to effect a sale of a business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners' ownership interest for buy-sell agreements, and many other business and legal purposes such as in shareholders deadlock, divorce litigation and estate contest. In some cases, the court would appoint a forensic accountant as the joint expert doing the business valuation.
In finance, the cost of equity is the return a firm theoretically pays to its equity investors, i.e., shareholders, to compensate for the risk they undertake by investing their capital. Firms need to acquire capital from others to operate and grow. Individuals and organizations who are willing to provide their funds to others naturally desire to be rewarded. Just as landlords seek rents on their property, capital providers seek returns on their funds, which must be commensurate with the risk undertaken.
The following outline is provided as an overview of and topical guide to finance:
Strategic financial management is the study of finance with a long term view considering the strategic goals of the enterprise. Financial management is nowadays increasingly referred to as "Strategic Financial Management" so as to give it an increased frame of reference.
A financial ratio or accounting ratio is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios.
In finance, the capital structure substitution theory (CSS) describes the relationship between earnings, stock price and capital structure of public companies. The CSS theory hypothesizes that managements of public companies manipulate capital structure such that earnings per share (EPS) are maximized. Managements have an incentive to do so because shareholders and analysts value EPS growth. The theory is used to explain trends in capital structure, stock market valuation, dividend policy, the monetary transmission mechanism, and stock volatility, and provides an alternative to the Modigliani–Miller theorem that has limited descriptive validity in real markets. The CSS theory is only applicable in markets where share repurchases are allowed. Investors can use the CSS theory to identify undervalued stocks.
The clean surplus accounting method provides elements of a forecasting model that yields price as a function of earnings, expected returns, and change in book value.
Corporate finance is an area of finance that deals with sources of funding, the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value. Although it is in principle different from managerial finance which studies the financial management of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.
The sum of perpetuities method (SPM) is a way of valuing a business assuming that investors discount the future earnings of a firm regardless of whether earnings are paid as dividends or retained. SPM is an alternative to the Gordon growth model (GGM) and can be applied to business or stock valuation if the business is assumed to have constant earnings and/or dividend growth. The variables are: