Dividend irrelevance theory

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This theory was proposed by two Noble Laureates, Merton H. Miller and Franco Modigliani, and is also commonly called the M and M theorem. The theory was proposed in their article “Dividend Policy, Growth, and the Valuation of Shares,” which was published in the Journal of Business in October of 1961, pp. 411-433.

The theory suggests that, in a perfect world, dividends are irrelevant when the value of the stock and, therefore, of the firm is determined.

The theory implies that retained earnings belong to the shareholders of the company and shareholders are not concerned whether money is used to pay out dividends or for investment purposes because they benefit either way by receiving dividends or via share price appreciation.

If investors will require cash, they can always sell a few of the shares which increased in value due to investments.

Miller and Modigliani also suggest that the clientele effect exists. This refers to the tendency for investors to hold stocks which are in line with their dividend payment preferences.

Investors who prefer regular dividends hold stocks of the companies which provide such dividends and investors who prefer for funds to be reinvested and to be reflected in the share appreciation hold those stocks that are aligned with such preferences.

The clientele effect further supports the proposition that the dividend policy does not affect the value of the stock because investors obtain income from the shares in their preferred way.

Miller and Modigliani also suggest that if dividends affect stock price than it is because of the informational content in changes in dividends. Investors see changes in dividends as signals. Increases in dividends are seen as a positive signal pointing out that management expects earnings of the firm to increase in the future. Decrease in dividends is seen as negative signal which points out that management expects earnings to decrease in the future.

Overall, the dividend irrelevance theory suggests that firm do not require a dividend policy because it does not affect the value of the firm.

Residual theory of dividends

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Residual theory of dividends purports that dividends must only be distributed after firm undertakes all acceptable investments. To determine whether any retained earnings are left to be distributed to shareholders, the three steps described below are undertaken.

Step 1 – The optimal level of capital expenditures is determined by finding the intersection between the investment opportunities schedule and the weighted marginal cost of capital schedule.

Step 2 – Taking into account the optimal capital structure proportions, the amount of financing that must come from equity is determined.

Step 3 – Retained earnings are used to cover necessary expenditures in proportion to a company’s capital structure equity percentage. If retained earnings do not cover the portion that must come from equity then new stock is issued.

The dividends are only distributed if retained earnings were enough to cover the equity portion of the investment (the second portion of investment is covered by debt) and only if there are any funds left in the retained earnings after investment expenditure is covered.

The residual theory of dividends also implies that if companies do not have investments with internal rate of returns (IRR) higher than weighted marginal cost of capital (WMCC) or Net present value (NPV) higher than zero than all retained earnings should be distributed as dividends.

Test yourself:

ABC Company has a capital structure of 35% of debt and 65% of equity. ABC’s retained earnings in this financial period are $2,000,000. The new investment required, which were determined by the intersection of IOS and WMCC, is $2,400,000. Determine if ABC will be able to distribute any dividends.

Solution:

The funds required to cover new investment is $2,400,000. The amount that must come from equity is $2,400,000*.65=$1,560,000. The rest of the amount, which is $840,000 (2,400,000-1,560,000) will come from debt. The ABC Company has $2,000,000 of retained earnings. Since only $1,560,000 is required to cover portion of funds that must come from equity, $440,000 (=$2,000,000-$1,560,000) is left in the retained earnings and can be distributed to shareholders as dividends.

Test yourself:

BCD Company has a capital structure of 35% of debt and 65% of equity. BCD’s retained earnings in this financial period are $1,000,000. The new investment required, which were determined by the intersection of IOS and WMCC, is $2,400,000. Determine if BCD Company will be able to distribute any dividends in this financial period.

Solution:

The funds required to cover new investment is $2,400,000. The amount that must come from equity is $2,400,000*.65=$1,560,000. The rest of the amount, which is $840,000 (2,400,000-1,560,000), will come from debt. The firm has $1,000,000 in retained earnings. The additional common stock needs to be issued to the amount of $560,000 to obtain enough funds that must come from equity. Since retained earnings were completely used to cover the expenditures associated with investment, there can be no dividends that BCD Company can distribute to shareholders during this financial period.

From the above two examples it is evident how under the residual theory of dividends, dividends are only distributed if there is any money left in the retained earnings after all acceptable investments are undertaken.

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Declaring and payment of dividends

October 27June 28Firmsconsulting Leave a comment

The board of directors determines whether or not dividends will be declared for the current financial period. Such decisions are made during semi-annual or quarterly meetings of the board of directors.

If a decision to distribute dividends is made, it will be paid to all shareholders whose names are listed as shareholders on the record date.

Due to time that it takes for new shareholders to be listed, dividends are only paid out to those shareholders who acquired shares of the firm earlier than two business days before the record date.

Two business days prior to record date, along with usual fluctuations of the market, the stock price starts selling as ex dividend and drops by an amount close to the declared dividend. The payment date of the dividend usually occurs few weeks after the record date.

Test yourself:

ABC Company declared a quarterly dividend of $0.5 per share on 15^th of November. You purchased 800 shares of ABC on 1^st of November and 15% tax is applicable to any dividends received. Determine whether you are eligible to receive dividends and, if so, how much will you receive after tax is taken into account.

Solution:

The dividends were declared on 15^th of November. Since you purchased stock on 1^st of November, you are eligible to receive the dividends. Your before tax dividends amount to $400 (=800*$0.5). Your after-tax dividends amount to $340 (=$400*(1-.15)).

Dividend reinvestment plans (DRIPs) – many firms offer dividend reinvestment plans which allow current stockholders to use dividends to acquire more shares at about five percent below the market price of the firm’s shares.

This allows company to avoid under pricing and flotation costs involved in issuing new shares and shareholders also benefit due to lower prices per share. This arrangement makes obtainment of additional shares more attractive for current stockholders.

Dividend relevance and irrelevance

Whether dividend policy affects the share price and, therefore, a value of the firm is still an unresolved issue. Residual theory of dividends, the dividend irrelevance theory proposed by Merton H. Miller and Franco Modigliani, and dividend relevance theory proposed by Myron J. Gordon and John Lintner, provide different viewpoints on the issue and are briefly discussed in the next set of articles.

Importance of dividends and dividend policy

October 27October 18Firmsconsulting Leave a comment

Dividends are payments made by an organization to its shareholders from earnings generated in current or previous periods. Shareholders earn income from two sources, the capital gain due to appreciation of share and dividend yield. Dividend yield is calculated by dividing the current dividend by the price of a share.

Test yourself:

You purchased shares of ABC Company for $50 per share. Two months after the purchase of shares you received a dividend of $3 per share. What is the dividend yield on the ABC shares?

Solution:

The dividend yield = 3/50=6%.

The stock value is determined based on the present value of all expected dividends to be received from share over the infinite future period that firm is expected to be operational. Expected cash dividends give an indication of the firm’s current and future performance.

The constant growth valuation model can be used to evaluate the expected growth of a share price. The formula for the constant growth valuation model (Gordon model) is as follows: Po=D1/(r-g). As can be seen from this formula, if dividends do not grow then the share price will stay the same as long as required return stays the same. Assuming that required return is constant, for a share price to grow the dividends need to grow as well.

Test yourself:

ABC’s dividends over last few years were as follows:

2010: $3

2009: $2.9

2008: $2.4

2007: $2.3

2006: $2.1

2005: $2

The required return is 12%. What is the price of the share? What would be the price of the share if growth of the dividends were zero and the next period’s dividend would be $3.25?

Solution:

First we need to find the growth rate with the help of a financial calculator. The calculation is as follows:

PV: -2

FV: 3

N: 5

I: calculate = 8.45%

The ABC’s share price is found with the help of the Gordon model Po=D1/(r-g):

Po=3*(1+.0845)/(.12-.0845)

Po=3.25/.0355

Po=$91.65

To find the share price if the growth of dividends were zero we would use the formula Po=D1/r (for zero growth valuation model)

Po=3.25/.12

Po=$27.08

Without growth in dividends, ABC’s share price is valued to be significantly lower.

Dividend policy is less important than capital budgeting and capital structure decisions. However, generally, dividend policies are expected to influence the price of shares.

Cash dividends are paid out of the retained earnings. Retained earnings are an internal source of financing. Therefore, if a business requires financing then the bigger the cash dividends, the higher the amount of external financing will be required. External financing can be in the form of debt or equity.

Note: If you struggle with a calculation, read using a financial calculator article for some simple tips on using a financial calculator.

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Book value per share

October 27June 28Firmsconsulting Leave a comment

Book value per share is a value that common stock holders would have received if all assets of the firm were sold for its accounting value and if all liabilities were settled and residual value divided among common stock holders.

In other words, it is a book value of the firm (the net worth of the company, which is assets minus liabilities) divided by the number of shares of common stock outstanding.

The following formula is used to calculate book value per share:

Book value per share = TA-TL/Number of shares of common stock outstanding

Where TA is Total Assets and TL is total liabilities.

Book value per share method is criticized because it relies on historical data and does not take into account the future-expected earnings of the firm. Therefore, it does not reflect the real market value of the firm.

Overview of financial ratios

October 27June 28Firmsconsulting Leave a comment

Liquidity ratios

Current ratios measure liquidity, which refers to the ability of the firm to meet its short-term debt obligations. The formula for current ratio is as follows:

Current ratio=Current assets/Current liabilities

A positive current ratio is a must. A current ratio of at least two is generally advisable. If a company has current ratio of two, it means that it has current assets which would be able to cover current liabilities twice.

Activity ratios

Total asset turnover calculates how efficiently assets are used to generate sales. In other words, how efficiently the balance sheet is managed.

Total asset turnover=Sales/Total assets

The health of this ratio is an important factor which contributes to a healthy return on investment (ROI/ROA).

Inventory turnover ratio measures the liquidity of a firm’s inventory. It measures how many times the company turns over (sells, uses or replaces) its inventory during a period, such as the financial period.

It is calculated by dividing cost of goods sold by inventory.

Inventory turnover ratio = Cost of goods sold/Inventory

The result of this ratio is only meaningful in comparison. It can be compared to industry averages, to firms past inventory turnover ratios and to inventory turnover ratios of competitors.

Industry averages differ significantly between industries for inventory turnover ratio. Inventory turnover is positive (higher than zero) as long as firm has any inventory. Generally high inventory turnover is considered to be a good indicator.

However, the norm would differ significantly between industries. If industry turnover is too high compared to the norm within the industry, it may mean the company keeps too little inventory and, therefore, may lose some sales.

Debt ratios

Debt ratio measures how many of firm’s assets are financed by debt. The formula for debt ratio is as follows:

Debt ratio=Total liabilities/Total assets

For example, assume that ABC’s total liabilities are $1,700,000 and total assets are $4,000,000. The debt ratio of ABC is as follows: $1,700,000/$4,000,000=42.5%

This means that ABC’s capital structure is 42.5% of debt and 57.5% of equity.

Debt-equity ratio measures how much of equity and how much of debt a company uses to finance its assets.

Debt-equity ratio = Total debt / Equity

If the debt-equity ratio is less than one, then it means that equity is mainly used to finance operations. However, if the debt-equity ratio is more than one, then it means that debt is mostly used for financing. If the debt-equity ratio is equal to one, then it means that half of financing comes from debt and half from equity.

The more debt compared to equity the firm uses in financing its assets, the higher the financial risk and the higher potential return. Financial risk refers to risk of firm being forced into bankruptcy if the firm does not meet its debt obligations as they come due.

Times Interest Earned Ratio (Interest Coverage Ratio)

Times Interest Earned Ratio (Interest Coverage Ratio) measures the ability of the enterprise to meet its financial obligations (interest payments on debt that come due). The formula for the Times Interest Earned Ratiois as follows:

TIER=EBIT/interest charges

EBIT refers to earnings before interest and taxes, which is also called operating profit (refer to Income Statement format to see how it is calculated).

For example, assume that ABC has an operating profit of $550,000 and interest charges of $100,000. The TIER of ABC is as follows:

$550,000/$100,000=5.5

One should also compare ratios of individual firms to industry averages, to obtain a better understanding. It is generally advisable that TIER should be between 3 and 5.

ABC’s TIER could be too high. It may be possible that the firm is unnecessarily careful in using debt as a source of capital. This means the risk the firm takes is lower than average, but so is the return.

Profitability ratios

Operating profit margin measures how much of each sales dollar remains after all costs except for interest, tax and preferred dividends are deducted.In other words it measures how efficient the business manages its operations or how efficiently the firm manages its income statement (keeping a healthy balance between sales and costs).

Operating profit margin = Operating profit/Sales

For example, if ABC has a operating profit of $500,000 and sales of $3,000,000 then the operating profit margin is calculated as follows

Operating profit margin = $500,000/$3,000,000

Operating profit margin = 0.167 or 16.7%

The higher the operating profit margin, the better it is.

Return on total assets (ROA) is also called return on investment (ROI). It refers to how effective management is in generating returns on assets of the firm.

ROA/ROI=Earnings available for common stockholders/Total assets

For example, if ABC’s total assets are $3,500,000 and the earnings available for common stockholders is $400,000 than

ROA/ROI=400,000/3,500,000

ROA/ROI=0.11

This means that for every dollar of assets, ABC earned 11 cents. The more the firm earns on every dollar of assets the better.

Operating leverage

October 27October 18Firmsconsulting Leave a comment

Operating leverage is the relationship between sales and revenue (Price*Quantity of units sold) and operating profit (which is also called EBIT (earnings before interest and taxes)). It is a measure of how the potential use of fixed costs can enlarge the effect that change in sales volume has on operating profit (EBIT).

We can represent the calculation of operating leverage as follows:

Sales (P * Q)

Less: Fixed operating costs (FC)

Less: Variable operating costs (VC*Q)

= EBIT

EBIT = (P*Q)-FC-(VC*Q)

This simplifies into:

EBIT = Q * (P-VC) – FC

When do firms have operating leverage?

If a firm has fixed costs, it has operating leverage. Because fixed cost (FC) is unchanged, an increase in sales revenue (P*Q) results in a proportionally bigger increase in EBIT (earnings before interest and taxes, which is also called operating profit). However, decrease in sales revenue (P*Q) will result in a proportionally bigger decrease in EBIT.

Increase in operating leverage increases business risk, which is a chance that the business will not be able to cover its operating costs.

How to calculate the degree of operating leverage (DOL) of the firm?

To calculate degree of operating leverage, which is just a way to measure operating leverage of the firm, we can use the following formula:

DOL =% change in EBIT/% change in sales

Therefore, if the degree of operating leverage is greater than 1, than operating leverage exists (which is the case as long as the company has fixed operating costs).

Businesses can increase their operating leverage by substituting variable costs for fixed costs, where possible. For example, salaries to sales personnel could be fixed instead of variable of units sold. Of course, many other variables need to be taken into account to make such a decision, such as consideration of how such changes would affect motivation levels of sales personnel.

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Leverage

October 27June 28Firmsconsulting Leave a comment

In finance, leverage (which is also called gearing or levering) refers to the use of debt rather than equity as a source of capital to finance investments and reinvestments. The more debt the business uses the more leverage it has.

As leverage increases, the risks also increase and so does the return on investment. However, as leverage decreases, the risks also decrease as well as the return on investment. Management have almost total control over the risk introduced by increased leverage.

There are three types of leverage:

Operating leverage – refers to the relationship between sales revenue and operating profit (which is also called EBIT (earnings before interest and taxes))
Financial leverage – refers to the relationship between operating profit and EPS (earnings per share)
Combined or total leverage – refers to the relationship between sales revenue and EPS

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Month October 2010

Residual theory of dividends

Book value per share

Overview of financial ratios

Operating leverage