Corporate Finance

PGDM – Div C - Trim III Part I

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Introduction
• The third major decision of a company is the distribution of cash to its
stockholders. This can take two forms: dividends and share
repurchase.
• Dividends and share repurchase, of course, reduce the amount of
earnings retained in a company and affect the total amount of
internal financing. Consequently, they must be considered in relation
to a company’s overall financing decision.
• We look at the %age of earnings a company pays out in cash
dividends to its shareholders. Known as the Dividend Payout Ratio, it
has both theoretical and managerial facets.

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Procedural Aspects of Paying Dividends
• When the BoD of a company declares a cash dividend, it specifies a Record
Date.
At the close of business that day, a list of stockholders is drawn up from the stock
transfer books of the company.
Stockholders on the list only are entitled to the dividend.
• The buyer and the seller of a stock have 2/3 business days to settle the
transaction. Therefore, new stockholders are entitled to dividends only if
they buy the stock 2/3 days before the record date.
• The ex-dividend date is usually set to be 2/3 business days before the
Record Date.
• Once the dividend is declared, stockholders become general creditors of
the company until the dividend is actually paid; the declared but unpaid
dividend is a current liability of the company coming out of retained
earnings.
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Dividend Payout Irrelevance
• We will see what happens to dividend payout ratio when perfect market assumptions hold. If the
dividend payout is a matter of indifference to investors, the corporation will treat retained
earnings simply as a means of financing.
• Dividends as a Residual
• We must decide in each period as whether to retain its earnings or to distribute part or all of them to
stockholders as cash dividends.
• As long as there are investment projects with returns exceeding those that are required, it will use retained
earnings and the amount of securities the increase in equity base will support, to finance these projects. Any
left over of retained earnings will then, be distributed to stockholders in the form of cash dividends. If not,
there will be no dividends.
When we treat dividend policy as strictly a financing decision, the payment of cash dividends is a passive
residual. The amount of dividend payout will fluctuate from period to period in keeping with fluctuations in the
amount of acceptable investment opportunities available to the firm. If these opportunities abound, the %age of
dividend is likely to be zero.
On the other hand, if the firm is unable to find profitable investment opportunities, dividend payout will be
100%. For solutions between these two extremes, the payout will be a fraction between zero and one.
• The treatment of dividend policy as a passive residual determined solely by the availability of
acceptable proposals implies that dividends are irrelevant; investor is indifferent between
dividends and retention by the firm.

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Irrelevance under Uncertainty
• In a world of perfect capital markets and the absence of taxation, dividend
payout would be a matter of irrelevance even with uncertainty.
• Investors are able to replicate any dividend stream the corporation might pay. If
dividends are less than desired, investors can sell portions of their stock to obtain the
desired cash distribution. Conversely, investors can use dividends to purchase
additional shares in the company. The investors able to manufacture “home-made”
dividends.
• One dividend policy is as good as the next. The firm is unable to create
value simply by altering the mix of dividends and retained earnings.
• There is conservation of value so that the sum of parts is always the same. The total
size of the pie is what's important and it is unchanged in the slicing.

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Factors affecting dividend policy
• Dividend pay-out ratio (D/P ratio)
• A constant D/P ratio may be maintained by a company.
• Stability
• Stable dividend may be preferred by some investors.
• Legal, contractual, internal constraints
• Certain restrictions are imposed through regulations such as, dividend cannot be paidout of
capital - only out of Net Profits and/or accumulated profits;
• Contractually restrained through loan agreements for obtaining approvals of financial institutions;
• Owners’ considerations
• Tax effect, dilution of ownership, etc.
• Clientele effect
• Some do not need dividends as an income stream – young investors would be in this category;
other investors would await dividends – retired and old investors would belong here.
• Capital market considerations
• Access to capital markets, to have eligibility for financial institutions to invest in equity of your
company;
• Inflation
• Replacement of assets will require financing for inflation – in such a case retained earnings may
play a significant role.
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Cash-Flow Ability To Service Debt
• While making capital structure decisions, we should analyse the cash-flow
ability of the firm to service fixed charges.
• The greater the dollar amount of senior securities a company issues and
shorter their maturity, the greater the fixed charges of that company. These
charges include principal and interest payments of debt, lease payments,
and preferred stock dividends.
• Before assuming additional fixed charges, the firm should analyse its
expected future cash flows, for fixed charges must be met with cash.
• The inability to meet these charges, with the exception of preferred stock dividends,
may result in financial insolvency.
• The greater and more stable the expected future cash flows of the firm, the
greater the debt capacity.

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Cash Flow Ability to Service Debt – contd.
!"#$
• Times Interest Earned = #%&'(')& *% +',&
• Suppose the most recent annual earnings before interest and taxes for a
company were $6 million, and the interest payments on all debt obligations
were $1.5 million. The times interest earned would be four (4).
!"#$
• Debt-Service Coverage = !"#$%#&'( &')*+$,-
#%&'(')&-
. /0'1 "',+
• If principal payments were $1million per annum and the tax rate were 40%,
the debt-service coverage ratio would be 1.89.
• Some focus on EBITDA instead of EBIT in the above computations. EBITDA
is the operating cash flow of a company. And if it can be fully dedicated to
debt service, EBITDA is the appropriate measure.
• However certain minimum capital expenditure may be necessary in order to keep
the business operating. To the extent these approximate to the amount of
depreciation and amortisation, EBIT would be a better measure for the coverage
ratios.

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A Pecking Order of Financing
1. Internal Financing of investment opportunities is preferred, in part
because it avoids the outside scrutiny of suppliers of capital.
• No floatation costs are associated with the use of retained earnings.
• A target dividend-payout ratio is set in keeping with long-run investment
opportunities.
• When cash flows are insufficient to fund all desirable investment
opportunities, and a “sticky” dividend policy precludes a dividend cut, resort
must be made to external financing.
2. A straight debt is preferred. Debt issues are regarded as “good
news” by the investors. The reason is the belief that management
will never issue an undervalued security. If debt is issued, this
means management believes the stock is undervalued and the debt
either overvalued or valued fairly by the market.
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A Pecking Order of Financing – contd.
3. Preferred Stock – which has some features of debt.
4. Various hybrid securities, like convertible bonds.
5. Finally, the least desirable security is to issue straight equity.
• The pecking order hypothesis suggests that corporations do not have
a well-thought-out capital structure. Capital structure results as a by-
product and changes wherever there is an imbalance between
internal cash flows and capital investments.
• Interesting as the pecking order hypothesis is, financing decisions
should be based on rigorous analysis embracing valuation.

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