Question

1. How do the availability and cost of outside capital affect payout (dividend) policy? Which market

imperfections lead a cost of outside capital?

2. Explain the logic of the residual payout (dividend) model and the steps a firm would take to

implement it.

Answer 1

Ans ) Dividend : Dividends are payments made to stockholders from a firm's earnings, whether those earnings were generated in the current period or in previous periods.

dividend policy : In Finance Management, once a company makes a profit, they must decide on what to do with those profits. They could continue to retain the profits within the company, or they could pay out the profits to the owners of the firm in the form of dividends. Once the company decides on whether to pay dividends, they may establish a somewhat permanent dividend policy, which may in turn impact on investors and perceptions of the company in the financial markets. What they decide depends on the situation of the company now and in the future. It also depends on the preferences of investors and potential investors.

dividend works

A dividend’s value is determined on a per-share basis and is to be paid equally to all shareholders of the same class (common, preferred, etc.). The payment must be approved by the Board of Directors.

When a dividend is declared, it will then be paid on a certain date, known as the payable date.

Steps of how it works:

1. The company generates profits and retained earnings
2. The management team decides some excess profits should be paid out to shareholders (instead of being reinvested)
3. The board approves the planned dividend
4. The company announces the dividend (the value per share, the date when it will be paid, the record date, etc.)
5. The dividend is paid to shareholders

Dividend Types include:

• Cash – this is the payment of actual cash from the company directly to the shareholders and is the most common type of payment. The payment is usually made electronically (wire transfer), but may also be paid by check or cash.
• Stock – stock dividends are paid out to shareholders by issuing new shares in the company. These are paid out pro-rata, based on the number of shares the investor already owns.
• Assets – a company is not limited to paying distributions to its shareholders in the form of cash or shares. A company may also pay out other assets such as investment securities, physical assets, and real estate, although this is not a common practice.
• Special – a special dividend is one that’s paid outside of a company’s regular policy (i.e., quarterly, annual, etc.). It is usually the result of having excess cash on hand for one reason or another.
• Common – this refers to the class of shareholders (i.e., common shareholders), not what’s actually being received as payment.
• Preferred – this also refers to the class of shareholders receiving the payment.
• Other – other, less common, types of financial assets can be paid out as dividends, such as options, warrants, shares in a new spin-ouspin-out

Factors effect dividend payout :

1) Legal requirements

There is no legal compulsion on the part of a company to distribute dividend. However, there certain conditions imposed by law regarding the way dividend is distributed. Basically there are three rules relating to dividend payments. They are the net profit rule, the capital impairment rule and insolvency rule.

2) . Firm's liquidity position

Dividend payout is also affected by firm's liquidity position. In spite of sufficient retained earnings, the firm may not be able to pay cash dividend if the earnings are not held in cash.

3) . Repayment need

A firm uses several forms of debt financing to meet its investment needs. These debt must be repaid at the maturity. If the firm has to retain its profits for the purpose of repaying debt, the dividend payment capacity reduces

. 4 ) expected rate of return

Expected rate of return also affects the dividend policy of the business firm If a firm has relatively higher expected rate of return on the new investment, the firm prefers to retain the earnings for reinvestment rather than distributing cash dividend.

5. Stability of earning

If a firm has relatively stable earnings, it is more likely to pay relatively larger dividend than a firm with relatively fluctuating earnings.

6. Desire of control

When the needs for additional financing arise, the management of the firm may not prefer to issue additional common stock because of the fear of dilution in control on management. Therefore, a firm prefers to retain more earnings to satisfy additional financing need which reduces dividend payment capacity.

7. Access to the capital market

If a firm has easy access to capital markets in raising additional financing, it does not require more retained earnings. So a firm's dividend payment capacity becomes high.

The external factors which affect the dividend policy are as follows:-

1) Economy in general state:

In uncertain economic conditions, management might retain large part of earnings to build reservoir to absorb future hurdles.

Period of recession or inflation or beginning stages of it company may also retain large part of earning to maintain the liquidity.

2) State of Capital Market:

Favourable Market: This is also called as liberal dividend policy.

Unfavourable market: This is also called as conservative dividend policy.

3) Legal Restrictions:

Methods to pay the dividends are either from the Current or past profits of the company and paying outside the capital is not allowed.

4) Contractual Restrictions:

Contractors may put some kind of restriction on the payment of dividends to save their interests during the hard times when the company or market is going through a low phase.

Ans) Residual dividend payout model :

A residual dividend is a dividend policy that companies use when calculating the dividends to be paid to shareholders. Companies that use a residual dividend policy fund capital expenditures with available earnings before paying dividends to shareholders. This means the dollar amount of dividends paid to investors each year will vary.

• Residual dividend policies are adopted by companies to prioritize capital expenditures over immediate shareholder dividend payments.
• Companies that maintain a residual dividend policy invest in growth opportunities from profits before paying shareholders their dividend.
• Management adopts a residual dividend policy to invest in the company’s development, such as upgrading manufacturing capacity or adopting new methods to reduce waste, theoretically resulting in greater long term growth.
• With an immediate reduction in dividend payouts and fluctuation on the amounts over time, management may need to justify its decisions to shareholders.

Residual Dividend Works

A residual dividend policy means companies use earnings to pay for capital expenditures first, with dividends paid with any remaining earnings generated. A company’s capital structure typically includes both long-term debt and equity, where capital expenditures can be financed with a loan (debt) or by issuing more stock (equity)

Requirements for Residual Dividend

When a business generates earnings, the firm can either retain the earnings for use in the company or pay the earnings as a dividend to stockholders. Retained earnings are used to fund current business operations or to buy assets. Every company needs assets to operate, and those assets may need to be upgraded over time and eventually replaced. Business managers must consider the assets required to operate the business and the need to reward shareholders by paying dividends.

For the residual dividend policy to work, it assumes the dividend irrelevance theory is true. The theory suggests that investors are indifferent to which form of return they receive from a company—whether it be dividends or capital gains. Under this theory, the residual dividend policy does not affect the company’s market value since investors value dividends and capital gains equally.

The calculation for residual dividends is done passively. Companies using retained earnings to finance capital expenditures tend to use the residual policy. The dividends for investors are generally inconsistent and unpredictable