DIVIDEND DECISIONS

The financial manager must take careful decisions on how the profit should be distributed among
shareholders. It is very important and crucial part of the business concern, because these
decisions are directly related with the value of the business concern and shareholders wealth.
Like financing decision and investment decision, dividend decision is also a major part of the
financial manager. When the business concerns decide dividend policy, they have to consider
certain factors such as retained earnings and the nature of shareholder of the business concern.
Meaning of Dividend
Dividend refers to the business concerns net profits distributed among the shareholders. It may
also be termed as the part of the profit of a business concern, which is distributed among its
shareholders.
According to the Institute of Chartered Accountant of India, dividend is defined as a
distribution to shareholders out of profits or reserves available for this purpose.
TYPES OF DIVIDEND/FORM OF DIVIDEND
Dividend may be distributed among the shareholders in the form of cash or stock. Hence,
Dividends are classified into:
A. Cash dividend
B. Stock dividend
C. Bond dividend
D. Property dividend
Cash Dividend
If the dividend is paid in the form of cash to the shareholders, it is called cash dividend. It is paid
periodically out the business concerns EAIT (Earnings after interest and tax). Cash dividends are
common and popular types followed by majority of the business concerns.
Stock Dividend
Stock dividend is paid in the form of the company stock due to raising of more finance.Under
this type, cash is retained by the business concern. Stock dividend may be bonus issue. This issue
is given only to the existing shareholders of the business concern.
Bond Dividend
Bond dividend is also known as script dividend. If the company does not have sufficient funds to
pay cash dividend, the company promises to pay the shareholder at a future specific date with the
help of issue of bond or notes.
Property Dividend
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Property dividends are paid in the form of some assets other than cash. It will distributed under
the exceptional circumstance. This type of dividend is not published in India.
DIVIDEND DECISION
Dividend decision of the business concern is one of the crucial parts of the financial manager,
because it determines the amount of profit to be distributed among shareholders and amount of
profit to be treated as retained earnings for financing its long term growth. Hence, dividend
decision plays very important part in the financial management. Dividend decision consists of
two important concepts which are based on the relationship between dividend decision and value
of the firm.

FACTORS DETERMINING DIVIDEND POLICY

Profitable Position of the Firm
Dividend decision depends on the profitable position of the business concern. When the firm
earns more profit, they can distribute more dividends to the shareholders.
Uncertainty of Future Income
Future income is a very important factor, which affects the dividend policy. When the
shareholder needs regular income, the firm should maintain regular dividend policy.
Legal Constrains
The Companies Act 1956 has put several restrictions regarding payments and declaration of
dividends. Similarly, Income Tax Act, 1961 also lays down certain restrictions on payment of
dividends.
Liquidity Position
Liquidity position of the firms leads to easy payments of dividend. If the firms have high
liquidity, the firms can provide cash dividend otherwise, they have to pay stock dividend.
Sources of Finance
If the firm has finance sources, it will be easy to mobilise large finance. The firm shall not go for
retained earnings.
Growth Rate of the Firm
High growth rate implies that the firm can distribute more dividend to its shareholders.
Tax Policy
Tax policy of the government also affects the dividend policy of the firm. When the government
gives tax incentives, the company pays more dividend.
Capital Market Conditions
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Due to the capital market conditions, dividend policy may be affected. If the capital market is
prefect, it leads to improve the higher dividend.

TYPES OF DIVIDEND POLICY

Dividend policy depends upon the nature of the firm, type of shareholder and profitable position.
On the basis of the dividend declaration by the firm, the dividend policy may be classified under
the following types:
Regular dividend policy
Stable dividend policy
Irregular dividend policy
No dividend policy.
Regular Dividend Policy
Dividend payable at the usual rate is called as regular dividend policy. This type of policy is
suitable to the small investors, retired persons and others.
Stable Dividend Policy
Stable dividend policy means payment of certain minimum amount of dividend regularly. This
dividend policy consists of the following three important forms:
Constant dividend per share
Constant payout ratio
Stable rupee dividend plus extra dividend.
Irregular Dividend Policy
When the companies are facing constraints of earnings and unsuccessful business operation, they
may follow irregular dividend policy. It is one of the temporary arrangements to meet the
financial problems. These types are having adequate profit. For others no dividend is distributed.
No Dividend Policy
Sometimes the company may follow no dividend policy because of its unfavourable working
capital position of the amount required for future growth of the concerns.

DIVIDEND THEORIES:
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Walter's model
Walter's model shows the relevance of dividend policy and its bearing on the value of the share.
Assumptions of the Walter model
1. Retained earnings are the only source of finance. This means that the company does not
rely upon external funds like debt or new equity capital.
2. The firm's business risk does not change with additional investments undertaken. It
implies that r(internal rate of return) and k(cost of capital) are constant.
3. There is no change in the key variables, namely, beginning earnings per share(E), and
dividends per share(D). The values of D and E may be changed in the model to determine
results, but any given value of E and D are assumed to remain constant in determining a
given value.
4. The firm has an indefinite life.
Basically, the firm's decision to give or not give out dividends depends on whether it has enough
opportunities to invest the retain earnings i.e. a strong relationship between investment and
dividend decisions is considered.
Model description
Dividends paid to the shareholders are reinvested by the shareholder further, to get higher
returns. This is referred to as the opportunity cost of the firm or the cost of capital, k e for the
firm. Another situation where the firms do not pay out dividends, is when they invest the profits
or retained earnings in profitable opportunities to earn returns on such investments. This rate of
return r, for the firm must at least be equal to ke. If this happens then the returns of the firm is
equal to the earnings of the shareholders if the dividends were paid. Thus, it's clear that if r, is
more than the cost of capital ke, then the returns from investments is more than returns
shareholders receive from further investments.
Walter's model says that if r<ke then the firm should distribute the profits in the form of
dividends to give the shareholders higher returns. However, if r>k e then the investment
opportunities reap better returns for the firm and thus, the firm should invest the retained
earnings. The relationship between r and k are extremely important to determine the dividend
policy. It decides whether the firm should have zero payout or 100% payout.
In a nutshell :

If r>ke, the firm should have zero payout and make investments.

If r<ke, the firm should have 100% payouts and no investment of retained earnings.

If r=ke, the firm is indifferent between dividends and investments.

Mathematical representation
Walter has given a mathematical model for the above made statements :

P = D+ (E-D). r/k
k
where,

P = Market price of the share

D = Dividend per share

r = Rate of return on the firm's investments

ke = Cost of equity

E = Earnings per share'

The market price of the share consists of the sum total of:

the present value of an infinite stream of dividends

the present value of an infinite stream of returns on investments made from retained
earnings.

Therefore, the market value of a share is the result of expected dividends and capital gains
according to Walter.
Criticism
Although the model provides a simple framework to explain the relationship between the market
value of the share and the dividend policy, it has some unrealistic assumptions.
1.

The assumption of no external financing apart from retained earnings, for the firm make
further investments is not really followed in the real world.

2.

The constant r and ke are seldom found in real life, because as and when a firm invests
more the business risks change.

Gordon's Model
Myron J. Gordon has also supported dividend relevance and believes in regular dividends
affecting the share price of the firm.
The Assumptions of the Gordon model
Gordon's assumptions are similar to the ones given by Walter. However, there are two additional
assumptions proposed by him :
1. The firm is an all equity firm. No external financing is used and investment programmes
are financed exclusively by retained earnings.
2. Return on investment( r ) and Cost of equity(Ke) are constant.
3. The firm has perpetual life.
4. The retention ratio, once decided upon, is constant. Thus, the growth rate, (g = br) is also
constant.
5. Ke > br
Model description
Investors are risk averse and believe that incomes from dividends are certain rather than incomes
from future capital gains, therefore they predict future capital gains to be risky propositions.
They discount the future capital gains at a higher rate than the firm's earnings thereby, evaluating
a higher value of the share. In short, when retention rate increases, they require a higher
discounting rate. Gordon has given a model similar to Walter's where he has given a
mathematical formula to determine price of the share.
Mathematical representation
The market prices of the share is calculated as follows:

Po = Y (1-b)
k-(b).(r)
where,

P0= Market price of the share

Y0 = Earnings per share

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b = Retention ratio (1 - payout ratio)

r = Rate of return on the firm's investments

k = Cost of equity

b.r = Growth rate of the firm (g)

Therefore the model shows a relationship between the payout ratio, rate of return, cost of capital
and the market price of the share.
Conclusions on the Walter and Gordon Model
Gordon's ideas were similar to Walter's and therefore, the criticisms are also similar. Both of
them clearly state the relationship between dividend policies and market value of the firm.

Miller and Modigliani Model (MM Model)

Miller and Modigliani Model assume that the dividends are irrelevant. Dividend
irrelevance implies that the value of a firm is unaffected by the distribution of dividends and is
determined solely by the earning power and risk of its assets. Under conditions of perfect capital
markets, rational investors, absence of tax discrimination between dividend income and capital
appreciation, given the firms investment policy, its dividend policy may have no influence on
the market price of the shares, according to this model.
Assumptions of MM model
1. Existence of perfect capital markets and all investors in it are rational. Information is
available to all free of cost, there are no transactions costs, securities are infinitely
divisible, no investor is large enough to influence the market price of securities and there
are no floatation costs.
2. There are no taxes. Alternatively, there are no differences in tax rates applicable to capital
gains and dividends.
3. A firm has a given investment policy which does not change. It implies that the financing
of new investments out of retained earnings will not change the business risk complexion
of the firm and thus there would be no change in the required rate of return.
4. Investors know for certain the future investments and profits of the firm (but this
assumption has been dropped by MM later).
Argument of this Model
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1. By the argument of arbitrage, MM Model asserts the irrelevance of dividends. Arbitrage

implies the distribution of earnings to shareholders and raising an equal amount
externally. The effect of dividend payment would be offset by the effect of raising
additional funds.
2. MM model argues that when dividends are paid to the shareholders, the market price of
the shares will decrease and thus whatever is gained by the investors as a result of
increased dividends will be neutralized completely by the reduction in the market value
of the shares.
3. The cost of capital is independent of leverage and the real cost of debt is the same as the
real cost of equity, according to this model.
4. That investors are indifferent between dividend and retained earnings implies that the
dividend decision is irrelevant. With dividends being irrelevant, a firms cost of capital
would be independent of its dividend-payout ratio.
5. Arbitrage process will ensure that under conditions of uncertainty also the dividend
policy would be irrelevant.

MM Model:
Market price of the share in the beginning of the period = Present value of dividends paid
at the end of the period + Market price of share at the end of the period.
P0 = 1/(1 + ke) x (D1 + P1)
Where: P0 = Prevailing market price of a share
ke = cost of equity capital
Dividend to be received at the end of
D1 =
period 1 and
Market price of a share at the end of
P1 =
period 1.