INDIAN INSTITUTE OF MANAGEMENT, INDORE
Gainesboro Machine Tool Corporation
Course Instructor: Prof A Kanagraj
Submitted By: Amol Vyawahare
Roll Number: 2008PGP021B
Gainesboro Machine Tool Corporation
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. Dividends are payments made to shareholders from a firm's earnings, whether those earnings were generated in the current period or in previous periods. It is a portion of the corporate profit. The dividend is most often quoted in terms of the dollar amount each share receives (dividends per share). It can also be quoted in terms of a percent of the current market price, referred to as dividend yield.
Dividends may affect capital structure.
• Retaining earnings increases common equity relative to debt. • Financing with retained earnings is cheaper than issuing new common equity.
There are various theories that try to explain the relationship of a firm's dividend policy and common stock value:- Dividend Irrelevance Theory
This theory purports that a firm's dividend policy has no effect on either its value or its cost of capital. Investors value dividends and capital gains equally.
Optimal Dividend Policy
Proponents believe that there is a dividend policy that strikes a balance between current dividends and future growth that maximizes the firm's stock price.
Dividend Relevance Theory
The value of a firm is affected by its dividend policy. The optimal dividend policy is the one that maximizes the firm's value.
Investors and Dividend Policy
Information Content or Signalling
Signalling hypothesis says that investors regard dividend changes as signals of management's earnings forecasts.
The clientele effect is the tendency of a firm to attract the type of investor who likes its dividend policy.
Free Cash Flow Hypothesis
All else equal, firms that pay dividends from cash flows that cannot be reinvested in positive net present value projects (free cash flows), have higher values than firms that retain free cash flows.
Residual Dividend Policy
Residual dividend policy is used by companies, which finance new projects through equity that is internally generated. In this policy, the dividend payments are made from the equity that remains after all the project capital needs are met. This equity is also known as residual equity.
Dividend / Retained Earnings Decision
There are various constraints that may impact on a firm's decision to pay out earnings in the form of dividends. • Cash flow constraints
• Contractual constraints
• Legal constraints
• Tax considerations
• Return considerations
Stock Dividends vs. Stock Splits
Here, the firm issues new shares in lieu of paying a cash dividend. If it is 10%, shareholders would get 10 shares for each 100 shares of stock owned. It will not affect the par value of the share.
When the board votes a stock split, the firm increases the number of shares outstanding, say 2:1. This will reduce the par value of the share.
Instead of paying dividends to the shareholders, companies can buyback their own stock in a share repurchase from its earnings. A share repurchase distributes cash to the existing shareholders in exchange for a fraction of the firm’s outstanding equity. That is, cash is exchanged for reduction in the number of shares...
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