The Hindu Business Line : Tax factor in arriving at dividend decision

Generally, firms consider a number of factors while making dividend decision — tax is one of the important criteria. The issue is to decide whether the investor would prefer capital gain or cash payout of dividend.

As dividends are not taxable in the hands of the investor, all earning groups will prefer cash dividend and this has boosted the availability of dividend paying shares.

However, the firm has to pay dividend distribution tax before paying dividend and this results in increased cash outflow to the firm.

In the case of long-term capital gain, the investor is not required to pay tax and the company does not have to pay any tax. Tax, therefore, is a vital factor in deciding dividend.

Demat vs physical form

Explain briefly the advantages of holding securities in `demat' form rather than in physical form.

Advantages of demat: Securities can be purchased, sold and held in electronic form; no chance of risk of loss, theft or mutilation of securities; no bad deliveries, forgeries and duplicate certificates; easier pledging/hypothecation of securities; enables quick transfer of ownership; easy receipt of shares in IPO; no stamp duty (as against physical shares); and does not require filling up transfer deeds.

Hedge using futures

XYZ Ltd is an export-oriented business house based in Mumbai. The company invoices in customer's currency. Its receipt of $1,00,000 is due on September 1, 2005.

The contract size is Rs 4,72,000, and the market information as at June 1, 2005, is as follows:

Exchange rates ($/Rs): Spot, 0.02140; June, 0.02126

One-month forward, 0.02136; September, 0.02118

Three-month forward, 0.02127.

Initial margin: June, Rs 10,000; September, Rs 15,000

Interest rates in India: June, 7.5 per cent; September, 8 per cent.

On September 1, 2005, the spot rate ($/Re.) is 0.02133 and currency future rate is 0.2134. Comment which of the following methods would be most advantageous for XYZ Ltd: i) using forward contract; ii) using currency futures; iii) not hedging currency risks. It may be assumed that variation in margin would be settled on the maturity of the futures contract.

Step I: Exposure is in dollars, whereas currency future is available in rupees. Therefore the requirement is rupees for hedging. Selling dollar is equivalent to buying rupee.

Therefore, start with buying rupee futures for September 2005 and cancel the same on September 1, 2005, by selling same number of contracts.

No. of contracts to be bought = (1,00,000 / 0.02118) / 4,72,000 = 10

Step II: Cash flow in the spot market will be = 1,00,000 / 0.02133 = Rs 46,88,233

Step III: The rate of currency future on September 1, 2005, is given as 0.2134 which should be 0.02134. This appears to be a typing error. The currency future will give a profit calculated as under:

= No. of contract x contract size (0.02134 - 0.02118)

= 10 x 472000 x (0.02134 - 0.02118) = $755.20

Profit = Rs 35,406

Total cash flow under currency future hedge = Rs 46,88,233 + 35,406

Interest cost in initial margin = 15,000 x 10 x 8 per cent x 3/12 = *3000

Net cash flow = 4723639 - *3000 = 47,20,639

Hedge using forward contract: The relevant forward rate for the three-month period is 0.02127. The customer will sell forward and total cash flow after three months will be Rs 47,01,457.

Not hedging currency risk: Based on forward quote and future quote, the rupee is depreciating and dollar is appreciating and, therefore, the exporter may go for `No hedge'. However, this strategy is fraught with risk of exchange rate moving adversely on the date of settlement.

Between currency future and forward cover, the former appears to be beneficial as it gives more rupees.

Note: There appears to be one more technical errors in the data given for currency future. Typically, when the spot price moves down, the future price should also move down as the price of the future is derived from the spot price.

In the given quote, spot price has gone down from 0.02140$/Re to 0.02133 $/Re from June 1, 2005 to September 1, 2005, whereas currency future price has moved up from 0.02118 to 0.02134 for the same period.

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