2.

7 Dividend
Policy
This Section
Includes :
• Dividend Decision and Valuation of Firm
• Walters Model
• Gordon Model
• MM model
• Residual Model
• Divident Discount Model
• Lintner Model
• Types of Dividends and Dividend Policies
• Factors Affecting Dividend Policies
• Stability of Divident
• Share Buyback
INTRODUCTION
:
The term dividend refers to that part of profits of a company which is
distributed by the company among its shareholders. It is the reward of the
shareholders for investments made by them in the shares of the company. The
investors are interested in earning the maximum return on their investments
and to maximize their wealth. A company, on the other hand, needs to provide
funds to finance its long-term growth. If a company pays out as dividend most
of what it earns, then for business requirements and further expansion it will
have to depend upon outside resources such as issue of debt or new shares.
Dividend policy of a firm, thus affects both the long-term financing and the
wealth of shareholders. As a result, the firm’s decision to pay dividends must
be reached in such a manner so as to equitably apportion the distributed
profits and retained earnings. Since dividend is a right of shareholders to
participate in the profits and surplus of the company for their investment in the
share capital of the company, they should receive fair amount of the profits. The
company should, therefore, distribute a reasonable amount as dividends (which
should include a normal rate of interest plus a return for the risks assumed) to
its members and retain the rest for its growth and survival.
DIVIDEND DECISION AND VALUATION OF
FIRM :
The value of the firm can be maximized if the shareholders wealth is maximized.
There are conflicting views regarding the impact of dividend decision on the
valuation of the firm. According to one school of thought dividend decision does
not affect the share-holders’ wealth and hence the valuation of the firm. On
the other hand, according to the other school of thought, dividend decision
33
Financial Management
Decisions
materially affects the shareholders’ wealth and also the valuation of the firm.
We have discussed below the views of the two schools of thought under two
groups:
a . The Relevance Concept of Dividend or the Theory of Relevance.
b.The Irrelevance Concept of Dividend or the Theory of Irrelevance

34
The Relevance Concept of Dividends : According to this school of thought,
dividends are relevant and the amount of dividend affects the value of the firm.
Walter, Gordon and others propounded that dividend decisions are relevant in
influencing the value of the firm. Walter argues that the choices of dividend
policies almost and always affect the value of the enterprise.
The Irrelevance Concept of Dividend : The other school of thought
propounded by Modigliani and Miller in 1961. According to MM approach, the
dividend policy of a firm is irrelevant and it does not affect the wealth of the
shareholders. They argue that the value of the firm depends on the market
price of the share; the dividend decision is of no use in determining the value
of the firm.
WALTER’S MODEL
:
Walter’s model, one of the earlier theoretical models, clearly indicates that
the choice of appropriate dividend policy always affects the value of the
enterprise. Professor James E. Walter has very scholarly studied the
significance of the relationship between the firm’s internal rate of return, r, (or
actual capitalization rate) and its Cost of Capital, Ke (normal capitalization rate)
in determining such dividend policy as will maximize the wealth of the
stockholders.
Water’s model is based on the following
premises:
(1) The firm finance its entire investments by means of retained earnings.
New equity stock or debenture is not issued to raise funds.
(2) Internal rate of return (r) and cost of capital (Ke) of the firm remain
constant. (3) The firm’s earnings are either distributed as dividends or
reinvested internally. (4) Earnings and dividends of the firm never
change.
(5) The firm has long or infinite life.
The formula used by Walter to determine the market price per
share is :
r
D+ (E − D)
P= K
K
Where
,
P = Market price per share
D = Dividend per share
E = Earnings per share
r = Internal rate of return (Actual
capitalization rate) K = Cost capital (External
capitalization rate)
It may be noted that Walter’s formula has the same effect as the continuing
dividend growth
formula. It seeks to measure the effect of dividends on common stock value by
35
Financial Management
Decisions
comparing
actual and normal capitalization
rates.
Another feature of Water’s formula is that it provides an added or reduced
Weight to the retained earnings portion of the capitalization earnings formula.
The factors ‘r’ and ‘k’ are placed in front of retained earnings to change its
weighted value under different situations as discussed below:

36
1. Growth Firms
In growth firms internal rate of return is greater than the normal rate(r > k).
Therefore,
r/k factor will greater
than 1.
Such firms must reinvest retained earnings since existing alternative
investments offer a lower return than the firm is able to secure. Each
rupee of retained earnings will have a higher weighting in Water’s
formula than a comparable rupee of dividends. Thus, large the firm
retains, higher the value of the firm. Optimum dividend payout radio for
such a firm will be zero.
2. Normal Firm
Normal firms comprise those firms whose internal rate of return is equal
to normal
capitalization (r=k). These firms earn on their investments rate of return
equal to market
rate of return. For such firms dividend policy will have no effect on the
market value
per share in the Walter’s model. Accordingly, retained earnings will have
the same
weighted value as dividends. In this case the market value per share is
affected by the
payout
ratio.
3. Declining Firms
Firms which earn on their investments less than the minimum rare
required by
investments are designated as declining firms. The management of such
firms would
like to distribute its earnings to the stockholders so that they may either
spend it or
invest elsewhere to earn higher return than earned by the declining firms.
Under such
a situation each rupee of retained earnings will receive lower weight than
dividends
and market value of the firm will tend to be maximum when it does not
retain earnings
at
all.
4. Evaluation of the Walter’s Model
Professor Walter has endeavoured to show in an erudite manner the effects
of dividend
policy on value of equity shares under different situations of a firm.
However, the basic
premises on which edifice of the theory is laid down are unrealistic and

37
 Financial Management
Decisions
therefore,
conclusions drawn from the Walter’s model are hardly true for real life
situations.
Thus, for instance assume that a firm finances its investment opportunities only
by means of
internal sources and no external financing is resorted to for this purpose.
Under such a
situation, either the value of the firm’s investment or dividend or both will be
sub-optimum.
In its attempt to maximize the value of the firm, the management should go
on making
investments so long as return of investment is equal to the cost of capital. This is
the optimum
level of investment, the remaining amount should be raised from external
sources. On the
contrary, Walter argues that value of the firm is maximized by retaining all the
profits because
magnitude of investments financed by retained earnings may be less than the
optimum level
of
investment.

Further, Professor Walter has assumed that ‘r’ remains constant under all the
situations. As a matter of fact, ‘r’ tends to decrease in correspondence with
increase in level of investments. This is why it is suggested that the management
should make investments upto optimal level where r = k.

38
Finally, assumption of constant cost of capital k is incorrect. On the contrary,
it varies in tune with change in risk of the firm.

Illustration 1 : The earnings per share of a company is Rs. 8 and the rate of
capitalisation applicable is 10%. The company has before it an option of
adopting (i) 50%, (ii)
75%and(iii)100% dividend payout ratio. Compute the market price of the
company’s quoted shares as per Walter’s model if it can earn a return of (i)
15%, (ii) 10% and (iii) 5% on its retained earnings.
Computation of market price of Company’s share by applying
Walter’s formula

Ra
D+ E − D)
Rc (
P =
R c

Where P = Market price per share

D = Dividend per share
R a = Internal rate of return on investment
Rc = Cost of capital 10%or 0.10
E = Earnings per Rs. 8
share
Now, we can calculate the market price per share based on different IRRS and
dividend payout rations.
(i) Market price per share when Ra
= 15% When dividend
payout ratio is 50% Dividend
paid = 8 × 50/100 = Rs. 4
0.15
4+ (8 − 4)
P= 0.10 = Rs. 100
0.10
(b) When dividend payout ratio is 75%
Dividend paid = Rs. 8×75/100 = Rs. 6
0.15
6+ (8 − 6)
P= 0.10 = Rs. 90
0.10
(c) When dividend payout ratio is
100%
dividend paid = Rs. 8
0.15
8+ (8 − 8)
P= 0.10 = Rs. 80
0.10
39
 (II) Market price per share when Ra = 10%
(a) When dividend payout ratio is 50% i.e., Rs. 4
0.10
4+ (8 − 4)
P= 0.10 = Rs. 80
0.10
(b) When dividend payout ratio is 75% i.e., Rs. 6
0.10
6+ (8 − 6)
P= 0.10 = Rs. 80
0.10
(c) When dividend payout ratio is 100% i.e., Rs. 8
0.10
8+ (8 − 8)
P= 0.10 = Rs. 80
0.10

(III) Market price per share when Ra = 5%

(a) When dividend payout ratio is 50% i.e., Rs. 4
0.05
4+ (8 − 4)
P= 0.10 = Rs. 60
0.10
(b) When dividend payout ratio is 75% i.e., Rs. 6
0.05
6+ (8 − 6)
P= 0.10 = Rs. 70
0.10
(c) When dividend payout ratio is 100% i.e., Rs. 8
0.05
8+ (8 − 8)
P= 0.10 = Rs. 80
0.10

GORDON’S MODEL
:
Myron Gordon has also developed a model on the lines of Prof. Walter
suggesting that dividends are relevant and the dividend decision of the firm
affects its value. His basic valuation model is based on the following
assumptions:
1 . The firm is an all equity firm.
2 . No external financing is available or used. Retained earnings represent the
only source
of financing investment programmes.
3 . The rate of return on the firm’s investment r, is constant.
 4. The retention ratio, b, once decided upon is constant. Thus, the growth
rate of the firm g = br, is also constant.
5 . The cost of capital for the firm remains constant and it is greater than the
growth rate, i.e. k > br.
6 . The firm has prepetual life.
7 . Corporate taxes do not exist.

According to Gordon, the market value of a share is equal to the present value
of future stream of dividends. Thus,

D1 D2 Dt
P = + +
(1 + K ) (1 + K ) 2 (1 + K ) t

n
Dt
=∑
t =1 (1 + K ) t

Gordon’s basis valuation formula can be simplified as under:

E (1 − b )
P =
Ke − br

D
or, P =
Ke − g

Where,
P = Price of shares
E = Earnings per share
b = Retention Ratio
ke = Cost of equity capital
br = g = growth rate in r, i.e., rate of return on investment of an all-
equity firm
D = Dividend per share

The implications of Gordon’s basic valuation model may be summarized as below:

1 . When the rate of return of firm’s investment is greater than the required
rate of return,
i.e. when r > k, the price per share increases as the dividend payout ratio
decreases.
Thus, growth firm should distribute smaller dividends and should retain
maximum
earnings.
2 . When the rate of return is equal to the required rate of return, i.e, when r =
k, the price
38 Fianancia l Managemen t & internationa l finance
per share remains unchanged and is not affected by dividend policy.
Thus, for a
normal firm there is no optimum dividend payout.

39
 3 . When the rate of return is less than the required rate of return, i.e.,
when r<k, the price per share increases as the dividend payout ratio
increases. Thus, the shareholders of declining firm stand to gain if the firm
distributes its earnings. For such firms, the optimum pay out would be
100%.

MODIGLIANI-MILLER’S MODEL (M-M’S

MODEL) :
Modigliani-Miller’s (M-M’s) thoughts for irrelevance of dividends are most
comprehensive
and logical. According to them, dividend policy does not affect the value of a
firm and is
therefore, of no consequence. It is the earning potentiality and investment
policy of the firm
rather than its pattern of distribution of earnings that affects value
of the firm.

Basic Assumptions of M-M

Approach
(1) There exists perfect capital market where all investors are rational.
Information is
available to all at no cost; there are no transaction costs and floatation
costs. There is
no such investor as could alone influence market value of shares.
(2) There does not exist taxes. Alternatively, there is no tax differential
between income
on dividend and capital gains.
(3) Firm has uncertainty as to future investments and profits of the firm.
Thus, investors
are able to predict future prices and dividend with certainty. This
assumption is
dropped by M-M later.

M-M’s irrelevance approach is based on arbitrage argument. Arbitrage is the

process of entering into such transactions simultaneously as exactly balance or
completely offset each other. The two transactions in the present case are
payment of dividends and garnering funds to exploit investment opportunities.
Suppose, for example, a firm decides to invest in a project it has alternatives:

(1) Pay out dividends and raise an equal amount of funds from
the market;
(2) Retain its entire earnings to finance the investment programme. The
arbitrage
process is involved where a firm decides to pay dividends and raise
funds
from outside.
When a firm pays its earnings as dividends, it will have to approach market for
procuring funds to meet a given investment programme. Acquisition of
additional capital will dilute the firms share capital which will result in drop in
share values. Thus, what the stockholders gain in cash dividends they lose in
decreased share values. The market price before and after payment of dividend
would be identical and hence the stockholders would be indifferent between
dividend and retention of earnings. This suggests that dividend decision is
irrelevant.

M-M’s argument of irrelevance of dividend remains unchanged whether external

funds are obtained by means of share capital or borrowings. This is for the
fact that investors are indifferent between debt and equity with respect to
leverage and cost of debt is the same as the real cost of equity.
Finally, even under conditions of uncertainty, divided decision will be of no
relevance because of operation of arbitrage. Market value of share of the two
firms would be the same if they
identical with respect to business risk, prospective future earnings and
investment policies. This is because of rational behavior of investor who would
prefer more wealth to less wealth. Difference in respect of current and future
dividend policies cannot influence share values of the two firms.

M-M approach contains the following mathematical formulations to prove

irrelevance of dividend decision.

The market value of a share in the beginning of the year is equal to the
present value of dividends paid at the year end plus the market price of the
share at the end of the year, this can be expressed as below:

Po D1 + P1
− − − − − −− → Equation (1)
= (1 + K )
Where,
P0 = Existing price of a
share k = Cost of capital
D1 = Dividend to be received at the year end
P1 = Market value of a share at the year end

If there is no additional financing from external sources, value of the firm (V) will
be number of share (n) multiplied by the price of each share (Po). Symbolically:

n ( D1 + P1)
V = nPo = − − − − − −− → Equation ( 2 )
(1 + K )

If the firm issues m number of share to raise funds at the end of year 1 so as
to finance investment and at price P1, value of the firm at time o will be:

nD1 + (n − m ) P1 − mP1
nPo = − − − − − −− → Equation (3)
1+K
Thus, the total of the firm as per equation (3) is equation to the capitalized
value of the dividends to be received during the period, plus the value of the
number of share outstanding at the end of the period, less the value of the newly
issued shares.
A firm can finance its investment programme either by ploughing back of
its earnings or by issue of new share or by both. Thus, total amount of new
share that the firm will issue to finance its investment will be:

mP 1 = l – (X - nD )
1 1 1

= 11 − X 1 + nD1 − − − − − −− → Equation(4)
Where,

mP 1 = Total amount of funds raised by issue of new share to finance

investment projects.
11 = Total amount of investment during first period
X1 = Total amount of net profit during first period

If equation (4) substituted into equation (3), we find the following

equation:

( n + m ) P1 − L1 + X
nPo = − − − − − −− → Equation 5
1

1+ K

On comparison of equation (5) with equation (3) we find that there is no

difference between the two valuation equations although equation (5) has
expressed the value of firm without dividends. This led M-M to conclude that
dividend policy has no role to play in influencing share value of a firm.

Criticism of MM
Approach
MM hypothesis has been criticised on account of various unrealistic
assumptions as given
below
.
1 . Perfect capital market does not exist in reality.
2 . Information about the company is not available to all the persons.
3 . The firms have to incur flotation costs while issuing securities.
4 . Taxes do exit and there is normally different tax treatment for dividends
and capital
gain.
5 . The firms do not follow a rigid investment policy.
6 . The investors have to pay brokerage, fees etc., while doing any
transaction.
7 . Shareholders may prefer current income as compared to further gains.

Illustration. Agile Ltd. belongs to a risk class of which the appropriate

capitalisation rate is
10%. It currently has 1,00,000 shares selling at Rs. 100 each. The firm is
contemplating
declaration of a dividend of Rs.6 per share at the end of the current fiscal year
which has just
begun. Answer the following questions based on Modigliani and Miller Model and
assumption
of no
taxes:
Fianancia l Managemen t & internationa l finance 41
 (i) What will be the price of the shares at the end of the year if a diviend is
not declared? (ii) What will be the price if dividend is declared?
(iii) Assuming that the firm pays dividend, has net income of Rs. 10 lakh
and new investments of Rs. 20 lakhs during the period, how many new
shares must be issued?
Modigliani and Miller - Dividend
Irrelevancy Model

P1 + D1
Po =
1+Ke

42
 Where,
D1 = Contemplated dividend per Rs. 6
share
P1 = Market price of share at the year end (to be determined)
Po = Existing market price of Rs. 100
share
Ke = Cost of equity capital or rate of 10% or 0.10
capitalisation

(i) If dividend is not declared

⎡ P1 + D1 ⎤
P 0 = ⎣ 1 + K ⎢e ⎦ ⎥

⎡ P1 + 0 ⎤
100 = ⎢ 1+ 0.10⎥
⎣ ⎦

⎡ P1 ⎤
100 ⎢
= ⎣1.10

100 × 1.10 = P1
P = Rs. 110
1

(ii) If dividend is
declared :

P1 + D1 ⎤
P0 = ⎡
⎢ ⎥
⎣ 1+ K e ⎦

⎡ P1 + 6 ⎤
100 ⎢ ⎥
=
⎣1+ 0.10 ⎦

⎡P +6⎤
100 = ⎢ 1 ⎥
⎣ 1.10 ⎦
100 × 1.10 = P 1 + 6
110 = P1 + 6
P1 = 110 - 6
P1 = Rs. 104
(ii) Calculation of No. of Shares to be issued
Particular Dividen Dividend
s d not
Net Income declare
10,00,00 declared
10,00,000
Less : Dividends 0
paid Retained 6,00,00
4,00,00 10,00,000
earnings New 0 20,00,000
investments 20,00,00
Amount to be raised by issue of new shres (A) 16,00,000 10,00,000
Market pice per share (B) Rs. 104 Rs. 110
New shares to be issued (A)/(B) (C) 15,385 9,091

Alternatively, the number of new shares to be issued is calculated as follows :

I − (E −
∆N = nD1 )
P1
Where,
n = Number of Shares outstanding at the beginning of the period
i.e., 1,00,000 shares
∆N = Change in the number of Shares outstanding during the
period (to be ascertained)
I = Total investment required for capital budget i.e., Rs. 20,00,000
E = Earning of the firm during the period after payment of dividend.
If dividend declared =10,00,000 - 6,00,000 = Rs.4,00,000
If no dividend declared = 10,00,000
Now we can calculate the number of new shares to be issued:
(I)If dividend declared:
20,00,000 −
∆N = = 15385 Shares
4,00,000
Rs.104
(II) If no dividend
declared:
20,00,000 −
∆N = = 9091 Shares
10,00,000
110
Verification of M.M. Dividend Irrelevancy Theory

Existing 1,00,00 1,00,000

shares 0 9,091
New shares 15,38
issued 1,15,38 1,09,091
5
Total No. of shares at the end (i) Rs. 104 Rs. 110
Market price per share (ii) Rs. 120 Rs. 120 lacs
Total market value of shares at the year end lacs
Therefore, whether dividends are paid or not, value of the firm remains the
same as per
M.M.
approach.
RESIDUAL MODEL
:
If a firm wishes to avoid issue of shares, then it will have to rely on internally
generated funds to finance new positive NPV projects. Dividends can only be
paid out of what is left over. This leftover is called a residual and such a
dividend policy is cllaed residual dividend approach.
When we treat dividend policy as strictly a financing decision, the payment of
cash dividends is a passive residual. The amount of dividend payount will
fluctuate from period to period in keeping with fluctuations in the number of
acceptable investment opportunities available to the firm. If these oportunities
abound, the percentage of dividend payout is likely to be zero. On the other hand
if the firm is unable to find pofitable investment opportunities, dividend payout
will be 100%.
With a residual dividend policy, the firm’s objective is to meet its
investment needs and mostly to maintain its desired debt equity ratio
before paying dividends. To illustrate imagine that a firm has Rs. 1000 in
earnings and a debt equity ratio of 0.5. Thus the firm has
0.5 of debt for every 1.5 of the total value. The firms capital structure is 1/3 of
debt and 2/3 of equity.
The first stpe in implementing a residual dividend policy is to deermine the
amount of funds that can be generated without selling new equity. If the firm
reinvests the entire Rs. 1000 and pays no dividend, then equity will increase by
Rs. 1000. To keep the debt equity ratio constant, the firm must borrow Rs. 500.
The second stpe is to decide whether or not the dividend will be paid. If funds
needed are less than the funds generated then a dividend will be paid. The
amount of dividend will be the residual after meeting investment needs.
Suppose we require Rs. 900 for a project. Then 1/3 will be contributed by debt
(i.e. Rs. 300) and the balance by equity/retained earnings. Thus the firm would
borrow Rs. 300 and fund Rs. 600 from the retained earnings. The residual i.e. Rs.
1000 – Rs. 600 = Rs. 400 would be distributed as dividend.
More clarity can be had from the data givne
below :
 PAT New Debt portion Retained Additiona Dividends
Invst. Earnings l
Equit
1000 3000 1000 1000 100 0
1000 2000 66 1000 303 0
1000 1500 570 1000 3
0 0
1000 1000 303 667 0 33
1000 50 136 333 0 636
1000 00 7
0 0 0 7
1000
DIVIDEND DISCOUNT MODEL :
The dividend disocunt model is a more conservative variation of discounted cash
flows, that
says a share of stock is worth the present value of rather than its
its future earnings.
This model was popularized by John Burr Williams .
in
... a stock is worth the present value of all the dividends ever to be paid upon it,
no more, no less... Present earnings, outlook, financial condition, and
capitalization should bear upon the price of a stock only as they assist buyers
and sellers in estimating future dividends.
The dividend discount model can be applied effectively only when a company
is already distributing a significant amount of earnings as dividends. But in
theory it applies to all cases, since even retained earnings should eventually
turn into dividends. That’s because once a company reaches its “mature”
stage it won’t need to reinvest in its growth, so management can begin
distributing cash to the shareholders. As Williams puts it.
If earnings not paid out in dividends are all successfully reinvested... then
these earnings should produce dividends later; if not, then they are money
lost... In short, a stock is worth
only .
The Dividend Discount Model (DDM) is a widely accepted stock valuation tool
found in most introdutory finance and invesment taxtbooks. The model
calculates the present value of the future dividends that a company is expected
to apply to its shareholders. It is particularly useful because it allows investors to
determine an absolute or “intrinsic” value of a particular comapny that is not
influenced by current stock market conditions. The DDM is also useful because
the measurement of future dividends (as opposied to earnings for example)
facilitates an “apples-to-apples” comparison of companies across different
industries by focusing on the actual cash investors can expect to receive.

There are three alternative dividend discount models used to

45
Financial Management
Decisions
determine the intrinsic value of a share of stock
a . the constant (or no-growth) dividend model;
b. the constant growth dividend model; and
c. the two-stage (or two-phase) dividend growth model.

46
Constant dividends :
where : • = intrinsic value
• = expected dividend
• = appropriate discont factor for the investment

This method is useful for analyzing preferred shares where the dividend is fixed.
However, the constant dividend model is limited in that it does not allow for
future growth in the dividend payments for growth industries. As a result the
constant growth dividend model may be more useful in examining a firm.

Constant dividend
growth : = intrinsic value
where : • = expected dividend
• = appropriate discont factor for the investment
• = constant dividend growth rate
•
The constand dividend growth model is useful for mature industries, where the
dividend growth is likely to be steady. Most mature blue chip stocks may be
analyzed quickly with the constant dividend growth model. This model has its
limitations when considering a firm which is in its growth phase and will move
into a mature phase at some time the future. A two stage growth dividend
model may be utilized in such situations. This model allows for adjustment to
the assumptions of timing and magnitude of the growth of the firm.
For initial dividend growth & then steady
growth :
n t
⎡ (1 + g ) D (1 + g
D 0⎤
∑ 1 0 2
P= ⎢ t) ⎥ +
t =1 (1 + K e
−
k e g2
⎦
⎣
where = instrinsic value = PV of dividends + PV of price
:
= expected dividend
= appropriate discount factor for the investment
= initial dividend growth rate
= steady dividend growth rate

LINTNER MODEL :
John Lintner surveyed dividend behavior of several corporate and
showed that a . Firms set long run target payout ratios.
b. Managers are concerned more about change in the dividend than the
absolute level c. Dividends tend to follow earnings, but dividends follow a
smoother path than earnings
d. Dividends are sticky in nature because managers have a reluctance to
effect dividend changes that may have to be reversed.
Lintner expressed corporate dividend behavior in the form of a
following model :
D t= cr EPSt +
(1-c)Dt–1
D t = DPS for
year t
c = Adjustment rate or Speed or Adjustment
r = Target Payout Rate
EPS1 = EPS for year t
D t–1 = DPS for year t–1
The Lintner model shows that the current dividend depends partly on curent
earnings and partly on previous years dividend. Likewise the dividend for the
previous year depends on the earnings of that year and the dividend for the
year preceding that year, so on and so forth. Thus as per the Lintner Model,
dividends can be described in terms of a weighted average of past earnings.
Dividend
Dates
What is a Declaration, Record, Ex-Dividend &
Payment dates?
Decleration date : The date on which board of directors declare dividend
is called a declaration date.
Record date : Record date, is that date when the company closes its
stock transfer books and makes up a list of the shareholders
for payment of dividends.
Ex-dividend date : It is that date notified by the stock exchange, as a
date which will entail a buyer of shares, the dividend, if
bought before the ex-dividend date. This date sets up the
convention of declaring that the right to the dividend
remains with the stock until ‘x’ days prior to the Record
date. Thus whoever buys share on or beyond the ex-
dividend date are not entitled to dividend.
Payment date : The date on which the company mails the cheques to the
recorded holders.
Exampl
e:
Let us say, settlement of stocks follows “T+3”, which means that, when you
buy a stock, it takes three days from the transaction date (T) for the change to
be entered into the comany’s record books. As mentioned, if you are not in the
company’s record books on the date of record, you won’t receive the dividend
payment. To ensure that you are in the record books, you need to buy stock at
least three days before the date of record, which also happens to be the day
before the ex-dividend date.
Ex-Dividend Date Date of Record

Fianancia l Managemen t & internationa l finance 47

 Monday Tuesday Wednedsda Thursday Friday
y
5th 6th 7th 8th 9th

48
As you can see by the diagram above, if you buy on the ex-dividend date, which
is only two days before the date of record, you will not recive the dividend
because your name will not appear in the company’s record books until Friday. If
you want to buy the stock and receive the dividend, you need to buy it on the
Monday the 5th. (When the stock is trading with the dividend the term “cum
dividend” is used). If you want to sell the stock and still receive the dividend, you
need to sell on or after Tuesday the 6th.

TYPES OF DIVIDEND
POLICY :
The various types of dividend policies are discussed as
follows:

1 . Regular Dividend
Policy
Payment of dividend at the usual rate is termed as regular dividend. The
investors such as
retired persons, widows and other economically weaker persons prefer to get
regular dividends.
A regular dividend policy offers the following
advantages.
a . It establishes a profitable record of the company.
b. It creates confidence amongst the shareholders.
c. It aids in long-term financing and renders financing
easier. d. It stabilizes the market value of shares.
e. The ordinary shareholders view dividends as a source of funds to meet
their day-to- day living expenses.
f. If profits are not distributed regularly and are retained, the shareholders
may have to pay a higher rate of tax in the year when accumulated
profits are distributed.

However, it must be remembered that regular dividends can be maintained only

by companies of long standing and stable earnings. A company should establish
the regular dividend at a lower rate as compared to the average earnings of the
company.

2 . Stable Dividend
Policy
The term ‘stability of dividends’ means consistency or lack of variability in the
stream of
dividend payments. In more precise terms, it means payment of certain
minimum amount
of dividend regularly. A stable dividend policy may be established in any of the
following
three
forms.
Fianancia l Managemen t & internationa l finance 49
 (a) Constant dividend per share: Some companies follow a policy of paying
fixed dividend per share irrespective of the level of earnings year after
year. Such firms, usually, create a ‘Reserve for Dividend Equalisation’ to
enable them to pay the fixed dividend even in the year when the
earnings are not sufficient or when there are losses. A policy of constant
dividend per share is most suitable to concerns whose earnings are
expected to remain stable over a number of years. Figure given below
shows the behavior of dividend in such policy.

50
 EPS

Earnings and
Dividend DPS

Time Years

(b) Constant pay out ratio: Constant pay-out ratio means payment of a fixed
percentage of net earnings as dividends every year. The amount of
dividend in such a policy fluctuates in direct proportion to the earnings of
the company. The policy of constant pay-out is preferred by the firms
because it is related to their ability to pay dividends. Figure given below
shows the behavior of dividends when such a policy is followed.

E PS

Earnings and
Dividend DPS

Time Years

(c) Stable rupee dividend plus extra dividend: Some companies follow a policy
of paying constant low dividend per share plus an extra dividend in the
years of high profits. Such a policy is most suitable to the firm having
fluctuating earnings from year to year.

Fianancia l Managemen t & internationa l finance 51

Advantages of Stable Dividend Policy
A stable dividend policy is advantageous to both the investors and the company
on account of the following;
a) It is sign of continued normal operations of the
company. b) It stabilizes the market value of shares.
c) It creates confidence among the investors.
d) It provides a source of livelihood to those investors who view dividends as a
source of
funds to meet day-to-day expenses.
e) It meets the requirements of institutional investors who prefer companies
with stable
dividends.
f) It improves the credit standing and makes financing easier.
g) It results in a continuous flow to the national income stream and thus
helps in the
stabilization of national economy.

Dangers of Stable Dividend Policy

Inspite of many advantages, the stable dividend policy suffers from certain
limitations. Once
a stable dividend policy is followed by a company, it is not easier to change it. If
the stable
dividends are not paid to the shareholders on any account including insufficient
profits, the
financial standing of the company in the minds of the investors is damaged and
they may
like to dispose off their holdings. It adversely affects the market price of shares of
the company.
And if the company pays stable dividends in spite of its incapacity, it will be
suicidal in the
long-run.
3 . Irregular Dividend Policy
Some companies follow irregular dividend payments on account of the following:
a . Uncertainty of earnings.
b. Unsuccessful business operations.
c. Lack of liquid resources.
d.Fear of adverse effects of regular dividends on the financial standing of the
company.

4 . No Dividend Policy
A company may follow a policy of paying no dividends presently because of its
unfavourable
working capital position or on account of requirements of funds for future
expansion and
growth.

5. Residual Dividend Policy

When new equity is raised floatation costs are involved. This makes new equity
costlier than
retained earnings. Under the Residual approach, dividends are paid out of
profits after
making provision for money required to meet upcoming capital expenditure
commitments.

TYPES OF DIVIDENDS:
Dividends may be declared in the form of cash, stock, scrips, bonds and
property. We shall discuss each of these forms.
1. Cash
Dividends
Cash dividend is, by far, the most important form of dividend. In cash
dividends stock
holders receive cheques for the amounts due to them. Cash generated by
business earnings
is used to pay cash dividends. Sometimes the firm may issue additional stock to
use proceeds
so derived to pay cash dividends or approach bank for the purpose. Generally,
stockholders
have strong preference for cash
dividends.

2. Stock
Dividends
Stock dividends rank next to cash dividends in respect of their popularity. In
this form of
dividends, the firm issues additional shares of its own stock to the stockholders in
proportion
to the number of shares held in lieu of cash dividends. The payment of stock
dividends
neither affects cash and earnings position of the firm nor is ownership of
stockholders changed.
Indeed there will be transfer of the amount of dividend from surplus account to
the capital
stock account which tantamount to capitalization of retained earnings. The net
effect of this
would be an increase in number of shares of the current stockholders. But
there will be no
change in their equity. With payment of stock dividends the stockholders have
simply more
shares of stock to represent the same interest as it was before issuing stock
dividends. Thus,
there will be merely an adjustment in the firm’s capital structure in terms of both
book value
and market price of the common
stock.

3 . Stock
Splits
Closely related to a stock dividend is a stock split. From a purely economic
point of view a stock split is nothing but a gaint stock dividend. A stock split is
a change in the number of outstanding shares of stock achieved through a
proportional reduction of increase in the par value of the stock. The
management employs this device to make a major adjustment in the market
price of the firm’s stock and consequently in its earnings and dividends per
share. In stock split only the par value and number of outstanding shares are
51
affected. The amounts in the common stock, premium and retained earnings
remain unchanged. This is exhibited in the table. It may be noted from the
table that although number of shares was doubled, capital account of the firm
did not change because of proportional reduction in par value of the stock.

EFFECT OF A 2-FOR-1 STOCK SPLIT ON A FIRM’S

EQUITY

Before the Stock After the Stock Split

Split
Common Stock (Re. 1 par, 40,000 4,00,00
shares) 0 4,00,00
0.50 par, 8,00,000 0
Premium 3,00,00 3,00,00
Retained earnings 0 0
40,00,00 40,00,00
Except in accounting treatment, the stock dividend and stock split are very
similar. Stock split is recorded as a doubling of the number of the shares
outstanding and having of the par value per share. For a stock dividend,
however, the account increases by the par value of

52
shares issued, increases the capital-surplus account by the difference between
the market value of the shares issued and the par value, and reduces the
retained earnings account by an amount needed to leave networth unchanged.
For both stock splits and stock dividends, therefore, networth is unaffected. The
difference in accounting procedure may be illustrated.

A company has the following

networth: Capital Stock:
Common Shares, Rs. 10 par, 2,00,000

20,00,000
Retained earnings

45,00,000
65,00,000

After a 2-for-1 split, this would appear as

follows: Capital Stock:
Common Shares, Rs. 5 par, 4,00,000

20,00,000
Retained earnings

45,00,000
65,00,000

After a 100 per cent stock dividend the networth would show as follows (using
par value as a basis for the transfer):
Capital Stock:
Common Shares, Rs. 10 par, 4,00,000

40,00,000
Retained earnings

25,00,000
65,00,000
Owing to differences in accounting procedure the balance sheet will differ in
each case, the
net effect is the
same.
A . Reasons for stock
splits
A number of reasons may be offered for splitting of the firm’s common stock.
53
These are:
i) Broader Marketability of the
stock
The basic reason of stock split is to provide broader and more stable market for
the stock. It
is agreed that when stock prices of a company tend to rise sharply due to
economic prosperity
of the company and its improved profitability and it is believed that the price of
the sock has
moved out of the price range of any investors narrowing the market of stock, the
management
may, in a bid to promote wider distribution of shares, resort to stock split.
Stock split will
result in lowering price of stock and the stocks will be within easy reach of
common investors.

ii) Need for Garnering External

Resources
A company contemplating to garner funds from the market may use stock split
to prepare
ground for new issues. In times of rising stock prices, market price of shares of
profitable and
prosperous companies rises beyond the reach of a large number of investors.
In view of
limited saleability of shares, companies may experience a great problem in
acquiring desired

54
amount of capital. Thus, to increase the marketability of new issues, stock split
is very often used.
iii) Merger or Acquisition of
Companies
A firm contemplating merger or acquisition through exchange of stock will
often split its
stock to make the transactions more attractive to stockholders of the firm it is
taking over.
Suppose, for example, Globe Company offers to acquire assets of Alfred
Company through
an exchange of stock. The management of Globe Company decides that an
exchange ratio
of 1 to 10 (1 share of Globe Company for 10 shares of Alfred Company) would
be fair to
stockholders of both companies. However, 1:10 exchange ratio may not appeal to
stockholders
of Alfred company and the offer may be rejected. In such a situation stock
split may be
employed to make the offer attractive. Thus, the management of Globe Company
by splitting
1 share in 5 shares, may put the exchange ratio at 1:2 which may be readily
accepted by
stockholders of Alfred
Company.

B. Reverse
Split
Sometimes, a company may think of reducing the number of shares so as to
enhance its
share price. This can be accomplished by means of reverse split which means
reduction in
number of outstanding shares. To illustrate, assume a company has 4,00,000
outstanding
shares of Re. 1 share. If the management declares 1-for-2 reverse split, the
company will
have 2,00,000 shares of Rs. 2 per share. Under this arrangement stockholders
receive fewer
shares with higher par
value.

The basic purpose of reverse split is to increase the market value of each share.
Companies experiencing financial trouble usually find their share prices
declining in the market. Such companies follows the policy of reverse split so as
to check further price decline and raise it. The announcement of a reverse split is
an indication that the company is in financial jeopardy. Reverse stock splits are
not as common as stock split ups.

55
Stock splits must be approved by a majority in number, representing three-
fourths in value of members of the firm and approved by a Court of Law. The
firm is required to give notice of this alternation to the Registrar of Joint Stock
Companies within 30 days of doing so (Section 391, Indian Companies Act,
1956).

4 . Scrip
Dividend
Scrip dividend means payment of dividend in scrip of promissory notes.
Sometimes company
needs cash generated by business earnings to meet business requirements
because of temporary
shortage of cash. In such cases the company may issue scrip or notes
promising to pay
dividend at a future date. The scrip usually bears a definite date of maturity or
sometimes
maturity date is not stipulated and its payment is left to the discretion of the
Board of Directors.

Scrips may be interest-bearing or non-interest bearing. Such dividends are

relatively scarce. The issue of scrip dividends is justified in the following
circumstances:
1. When a company has plentitude of earnings to distribute dividends but
cash position is temporarily meager because bulk of the sale proceeds
which are tied in receivable

56
 for time being will be released very shortly, the management in such a
situation may issue certificates to the stockholders promising them to pay
dividend in the near future.
2 . When a company wants to maintain an established dividend record
without paying out cash immediately, it may take recourse to scrip
dividend.
3 . When the management believes that stock dividends will not be useful
because further earnings of the company will not increase sufficiently to
maintain dividend rate on increased shareholding, issue of promissory
notes to pay dividends in future would be a wise step.
4 . When the company does not wish to borrow to cover its dividend
requirements the danger lies in their use as a sop to stockholders when
business earnings are inadequate to make dividend payments.
Such a form of dividend is non-existent in
India.

5 . Bond
Dividend
As in scrip dividends, dividends are not paid immediately in bond dividends.
Instead the
company promises to pay dividends at a future date and to that effect bonds
are issued to
stock holders in place of cash. The purpose of both the bond and scrip dividends
is alike, i.e.,
postponement of dividend payments. Difference between the two is in respect of
the date of
payment and their effect is the same. Both result in lessening of surplus and
addition to the
liability of the firm. The only difference between bond and scrip dividends is that
the former
carries longer maturity than the latter. Thus, while issue of bond dividend
increases long-
term obligation of the company, current liability of the company would rise as a
consequence
of the issuance of the scrip-dividends. In bond dividends stockholders have
stronger claim
against the company as compared to
dividends.

Bond used to pay dividends carry interest. This means that the company
assumes fixed obligation of interest payments annually and principal amount of
bond at maturity date. It should be remembered that the company is assuming
this obligation in return for nothing except credit for declaring dividends.
How far the company will be able to satisfy this obligation in future, is also
difficult to predict at the time of issue of bonds. The management should,
therefore, balance cost of issuing bond dividends against benefits resulting from
them before deciding about distribution of dividends in the form of bonds. Bond
57
dividends are not popular in India.

6 . Property
Dividends
In property dividend the company pays dividends in the form of assets other
than cash.
Generally, asses which are superfluous for the company are distributed as
dividends to the
stockholders. Sometimes the company may use its products to pay dividends.
Securities of
the subsidiary companies owned by the company may also take the form of
property dividends.
This kind of dividend payment is not in vogue in
India.

FACTORS AFFECTING DIVIDEND

POLICY :
There is a controversy amongst financial analysts regarding impact of dividends
on market price of a company’s shares. Some argue that dividends do not
have any impact on such

58
price while others hold a different opinion. However, preponderance of
evidence suggests that dividend policies do have a significant effect on the
value of the firm’s equity shares in the stock exchange. Having accepted this
premise, it will now be appropriate to consider those factors which affect the
dividend policy of a firm.

The factors affecting the dividend policy are both external as well
as internal.

Following are the external factors which affect the dividend policy
of a firm:
1. General state of economy - The general state of economy affects to a
great extent the
management’s decision to retain or distribute earnings of the firm. In case
of uncertain
economic and business conditions, the management may like to retain the
whole or a
part of the firm’s earnings to build up reserves to absorb shocks in the
future. Similarly
in periods of depression, the management may also withhold-dividends
payment to
retain a large part of its earnings to preserve the firm’s liquidity position. In
periods of
prosperity the management may not be liberal in dividend payments
though the
earning power of a company warrants it because of availability of larger
profitable
investment opportunities.

Similarly in periods of inflation, the management may withhold dividend

payments in order to retain larger proportion of the earnings for
replacement of worn-out assets.

2. Legal restrictions - A firm may also be legally restricted from declaring

and paying dividends. For example, in India, the companies Act, 1956 has
put several restrictions regarding payments and declaration of dividends.
Some of these restrictions are as follows:

(i) Dividends can only be paid out of (a) the current profits of the
company, (b) the past accumulated profits or (c) money provided
by the Central or State Governments for the payment of
dividends in pursuance of the guarantee given by the
Government. Payment of dividend out of capital is illegal.
(ii) A company is not entitled to pay dividends unless (a) it has provided
for present as well as all arrears of depreciation, (b) a certain
59
 percentage of net profits of that year as prescribed by the Central
Government not exceeding 10%, has been transferred to the
reserves of the company.
(iii) Past accumulated profits can be used for declaration of dividends
only as per the rules framed by the Central Government in this
behalf.

Similarly, the Indian Income Tax Act also lays down certain restrictions on
payment of dividends. The management has to take into consideration all the
legal restrictions before taking the dividend decision otherwise it may be
declared as ultra vires.

60
The following are the internal factors which affect the dividend policy of a firm:
1. Desire of the shareholders - Of course, the directors have
considerable liberty
regarding the disposal of the firm’s earnings, but the shareholders are
technically the
owners of the company and, therefore, their desire cannot be
overlooked by the
directors while deciding about the dividend
policy.

Shareholders of a firm expect two forms of return from their investment

in a firm:
(i) Capital gains - The shareholders expect an increase in the market
value of the
equity shares held by them over a period of time. Capital gain
refers to the
profit resulting from the sale of capital investment i.e., the equity
shares in
case of shareholders. For example, if a shareholder purchases a
share for Rs.
40 and later on sells it for Rs.60 the amount of capital gain is a sum
of Rs. 20.
(ii) Dividends - The shareholders also expect a regular return on their
investment
from the firm. In most cases the shareholders’ desire to get
dividends takes
priority over the desire to earn capital gains because of the following
reasons:
(a) Reduction of uncertainty - Capital gains or a future
distribution of earnings
involves more uncertainty than a distribution of current earnings.
(b) Indication of strength - The declaration and payment of
cash dividend
carries an information content that the firm is reasonably strong and
healthy.
(c) Need for current income - Many shareholders require
income from the
investment to pay for their current living expenses. Such
shareholders are
generally reluctant to sell their shares to earn capital gain.

2. Financial needs of the company - The financial needs of the

company are to be considered by the management while taking the
dividend decision. Of course, the financial needs of the company may
be in direct conflict with the desire of the shareholders to receive large
dividends. However, a prudent management should give more weightage
61
 to the financial needs of the company rather than the desire of the
shareholders. In order to maximize the shareholders’ wealth, it is
advisable to retain earnings in the business only when company has
better profitable investment opportunities as compared to the
shareholders. However, the directors must retain some earnings, whether
or not profitable investment opportunity exists, to maintain the company
as a sound and solvent enterprise.

3. Desire of control - Dividend policy is also influenced by the desire of

shareholders or the management to retain control over the company.
The issue of additional equity shares for procuring funds dilutes control
to the detriment of the existing equity shareholders who have a
dominating voice in the company. At the same time, recourse to long-term
loans may entail financial risks and may prove disastrous to the interests of
the shareholders in times of financial difficulties.

In case of a strong desire for control, the management may be

reluctant to pay substantial dividends and prefer a smaller dividend pay
out ratio. This is particularly true in case of companies which need
funds for financing profitable investment

62
 opportunities and an outside group is seeking to gain control over the
company. However, where the management is strongly in control of the
company either because of substantial shareholdings or because of the
shares being widely held, the firm can afford to have a high dividend pay
out ratio.

4. Liquidity position - The payment of dividends results in cash outflow

from the firm. A firm may have adequate earnings but it may not have sufficient
cash to pay dividends. It is, therefore, important for the management to take
into account the cash position and the overall liquidity position of the firm
before and after payment of dividends while taking the dividend decision. A firm
may not, therefore, be in a position to pay dividends in cash or at a higher rate
because of insufficient cash resources. Such a problem is generally faced by
growing firms which need constant funds for financing their expansion
activities.

STABILITY OF DIVIDEND
:
Another important diemention of a dividend policy is the stability of dividends
i.e. how stable, regular or steady should the dividend stream be, over time? It
is generally said that the shareholders favour stable dividends and those
dividends, which have prospects of steady upward growth. If a firm develops
such a pattern of paying stable and steady dividends, then the
investors/shareholders may be willing to pay a higher price for the shares. So
while designing a dividend policy for the firm, it is also to be considered as to
whether the firm will have a consistency in dividend payments or the dividends
will fluctuate from one year to another. In the long run, every firm will like to
have a consistent dividend policy, yet fluctuations from one year to another
may be unfavourable.
Rationale for stability or
dividend
Most of the firms follow stable dividends or gradually increasing dividends due to
following reasons —
a. Many investors consider dividends as a part of regular income to meet their
expenses.
Hence, they prefer a predictable pattern of dividends rather than
fluctuating pattern.
A fall in the dividend inocme may lead to sale of some shares. On the
other hand
when the dividend income increases, an investor may invest some of the
proceeds as
reinvestment in shares. Both the cases involve transaction cost and
inconvenience for
investor. Hence, they prefer regular
dividends.
b. The dividend policy of firms conveys a lot to the investors. Increasing
63
 dividends means better prospects of the company. On the contrary,
decreasing dividends suggest bad earnings expectations. In addition,
stable dividends are sings of stable earnings of the company. On the other
hand, varying dividends lead to uncertainty in the mind of shareholders.
c. Certain investors mainly institutional, consider the stability of
dividends as an important criterion before they decide on the investment
in that particular firm.
SHARE BUYBACK
(REPURCHASE) :
When companies have sufficient liquid assets they resort to share buy back or
share repurchase, wherein they cancel or retire a part of its outstanding shares
by purchasing from the market or directly from the shareholders. This is
particularly relevant when the shares are available

64
in the market much below its book value. When the shares are repurchased, the
underlying motive is to distribute the excess cash to the shareholders. The
cancellation of shares means the shareholders will receive cash for their shares,
reduced outstanding number of shares in the books of the coampany, earnings
per share increase and also market price of the share increases.
There are three methods of shares repurchase :
a. Repurchase Tender Offer : Here the firm specifies the number of
shares it proposes to buy back, the price it would pay and the time period
for which the offer would be open for the shareholders to tender their
shares. The firm may retain the flexibility to withdraw the offer if
insufficient number of shares are submitted for repurchase.
b. Open Market Repurchase : Here the firm buys from the market at
the prevailing price. The time period is generally longer than that is
adopted for Tender Offers. In terms of flexibility, the open maket
repurchase provides the firm more fredom in deciding when to
repurchase and how many shares to be repurchased.
c. Negotiated Repurchase : In this case the firm may buy shares from a
large shareholder at a negotiated pice. This is adopted only when a
large shareholder groups viz. promoters, are willing to sell their stake.
Let S denote the number of outstanding shares. Po be the current market price
and le N be the number of shares that would be bought back by the company
then
S×
=
P0
Theoretical post Buy Back price (P1) is . As it can be seen the price after
S−N
given as buy
back would increase, as the number of shares outstanding gets reduced.
Advantages of Shares Repurchase over Dividends
1 . Cash dividend implies a commitment on the part of a company to
continue payments in future, as investors keep expectivng them.
However, share repurchase is an one time affair.
2 . The decision to repurchase the shares offers a company more flexibility
as to number of shares, the period etc.
3 . Share repurchase are more focused in terms of paying out cash
only to those shareholders who need it. However, dividends are paid to
all.
4 . Share buy back provide a way of increasing insiders control in the firm. If
only outsiders tender their shares, automatically insiders control
increases.
When Share buyback is adopted by the companies?
a . If excess cash flows are temoporary, share repurchase can be adopted.
If cash flows are stable, then the firm may prefer to give dividends.
b. Firms uncertain about their future investment opportunities in the
business are more likely to use share repurchase as a means of returning
65
 cash to shareholders.
c. The share repurchase is relevant especially when the shares of the firm are
undervalued. d. When the promoters want to increase their control in the
firm they use share buyback
to the maximum effect.

66
Clientele
effect
Investors have diverse preferences. Some want more dividend income; others
want more capital gains; still others want a balanced mix of dividend income
and capital gains. Over a period of time, investors naturally migrate to firms
which have a dividend policy that matches their preferences. The concentration
of investors in comapanies with dividend policies that are matched to their
preferences is called the clientele effect. The existence of a clientele effect
implies that (a) firms get investors they deserve and (b) it will be difficult for a
firm to change and established dividend policy.

PROBLEMS AND
SOLUTIONS: Illustration 1
A company has following
capital:
7% Preference Shares of Rs.100 6,00,00
each 0
Ordinary Shares of Rs.10 each 16,00,00
0
22,00,0
00
The following information are available relating to its financial year ending 31-
12-84:
i) Profit, after taxation @ 40%,
Rs.5,42,000 ii) Ordinary dividend paid
20%.
iii) Depreciation Rs.1,20,000
iv) Market price of Ordinary Shares
Rs.40 v) Capital Commitment
Rs.2,40,000.
You are required to calculate the following:
a) The dividend yield on the Ordinary Shares.
b) The cover for the preference and Ordinary
dividends. c) The earnings yield,
d) The price-Earning
ratio, e) The Net Cash
Flow,
f) The reason for the comparison of net cash flow with capital
commitment.
Solution :
a) Dividend yield on ordinary shares (or) dividend yield ratio
= (DPS / market price) x 100
 = (10 x 20% / 40) x 100
= 5%
[Market price = Capitalized value of
dividend]
 b) Dividend coverage ratio:
preference = (PAT / Preference
dividend)
= 542000 /
42000
= 12.9
times
=> Equity = (PAT – Preference dividend) / equity dividend
= 500000 /
320000
= 1.5625
times
c) Earnings yield ratio = (EPS / market price ) x 100
= (3.125 / 40) x
100
= 7.8125
%
[EPS = 500000 / 160000 = Rs 3.125]
d) Price Earning Ratio = [(40 / 3.125)] = 12.8 times
(Market price / EPS)
e) Net cash flow Rs
PAT 54200
0
(+) depreciation 12000
0
6 6200
(-) preference dividend 0 4200
(-) equity dividend 0
32000
Net cash flow 0
30000
0 shows the firms ability to meet the capital
f) Since the cash flow position
expenditure
/ capital commitment.
Illustratio
n 2
ABC Ltd. has a capital of Rs.10 lakhs in equity shares of Rs.100 each. The
shares currently quoted at par. The company proposes declaration of a dividend
of Rs.10 per share at the end of the current financial year. The capitalisation
rate for the risk class to which the company belongs is 12%.
What will be the market price of the share at the end of
the year, if i) A dividend is not declared?
ii) A dividend is declared?
iii) Assuming that the company pays the dividend and has net profits of
Rs.5,00,000 and makes new investments of Rs.10 lakhs during the
period, how many new shares must be issued? Use the M.M. model.
Solution :
Modigliani – Miller Approach
n = no of shares = 10000
P0 = market price = Rs100
D1 = Expected dividend = Rs10
Ke = cost of capital = 12%
i. Market price of share ( P1) if dividend not declared
Given D1 = 0
We know,
P0 = (D1+P1)/ (1+K e)
P1 = 112
ii. P1 if dividend declared
D1 = Rs10
P0 = (D1+P1) / (1+
Ke ) P1 = Rs.102
iii. No of shares to be issued:
n = (I – E + n1 )/ P
1
D
= (1000000 – 500000 + 100000) / 102
= 5882 shares

Illustration
3
A textile company belongs to a risk-class for which the appropriate PE ratio is 10.
It currently has 50,000 outstanding shares selling at Rs.100 each. The firm is
contemplating the declaration of Rs.8 dividend at the end of the current fiscal
year which has just started. Given the assumption of MM, answer the
following questions.
i) What will be the price of the share at the end of the year: (a) if a
dividend is not declared, (b) if its is declared?
ii) Assuming that the firm pays the dividend and has a net income of
Rs.5,00,000 and makes new investments of Rs.10,00,000 during the
period, how many new shares must be issued?
iii) What would be the current value of the firm: (a) if a dividend is
declared, (b) if a dividend is not declared?
Solution :
Given
,
P/E ratio = 10
n = 50,000shares
P0 = Rs. 100
D 1
= Rs. 8
E = Rs. 5,00,000
I = Rs. 10,00,000
Ke = 1 / (P/E ratio)
1. Calculation of P1
1 . if dividend not declared:
P0 = (D1+ P1) /
(1+Ke) P1 = Rs110
2. if dividend
declared: P0 =
(D1+ P1) / (1+Ke)
P1 = Rs.102
3. If the company pay dividend:
P1 = Rs. 102
n = (I – E +nD
1
) /1 P
No of new shares, n = 900000 / 102 = 8823.5294 shares
4. Value of the firm:
a) If the company pay dividend:
V = (n + n)1 = (58823.5294) 102
P
= Rs. 6000000
b) If the company does not pay dividend:
V = (n+ n) 1 = 54545.4545 x 110
P
= Rs. 6000000
Working notes:
n = (1000000 - 500000) / 110 = 4545.4545
Illustratio
n 4
(i) From the following information supplied to you, ascertain whether the firm’s
D/P ratio is optimal according to Walter. The firm was started a year ago with an
equity capital of Rs. 20 lakh.
Earnings of the firm Rs. 2,00,000.00
Dividend paid 1,50,000.00
P/E ratio 12.50
Number of shares outstanding, 20,000 @ Rs.100 each. The firm is expected to
maintain its current rate of earnings on investment.
ii) What should be the P/E ratio at which the dividend payout ratio will have no
effect on the value of the share?
iii) Will your decision change if the P/E ratio is 8, instead of 12.5?
Solution :
i. Ke = (EPS / market price) = 1 /(12.5) = 8 %
r = (200000 / 2000000) x 100 = 10 %
Payout ratio = (150000/200000) x 100 = 75%
It is the growth firm (r > Ke), as per WALTER’s model the optimum payout
ratio is Zero. So in the given case pay out ratio is not optimum.
Proof:
a). Market price at 75% payout ratio
EPS =
Rs10

DPS =Rs7.5
r = 10 % & Ke = 8%
r
DPS + (EPS DPS)
Market Price = Ke
Ke
0.1
7.5+
(2.5)
Market Price = 0.08 = Rs. 132.81
0.0
8
b). Market price at zero

Fianancia l Managemen t & internationa l finance 63

 payout:
EPS = Rs10
DPS = Rs0
r = 10 % & Ke = 8 %
r
DPS + −
(EPS DPS)
Market Price = Ke = 156.25
Ke

64
Therefore Zero Payout is optimum.
i. The payment of dividend in case of normal firms(r = Ke) has no effect on
the market value of the share.
Ke = r = 10%
P/E ratio = 10times i.e [ 1 / Ke]
ii. If P/E ratio = 8 , Ke= 12.5 %
r = 10%
When r < Ke the firm is Decline firm as per WALTER and its Optimum payout
ratio is
100%.
So in the given case it is 75% payout only, it is not optimum payout.
Proof:

Market price at 75% payout:

r
DPS + (EPS
Market Price = Ke
Ke
At 100% payout.

r
DPS + (EPS
Market Price = Ke
Ke
Illustratio
n 5

Excellence Ltd registered earnings of Rs. 800,000 for the year ended 31st March.
They finance all investments from out of retained earnings. The opportunities
for investments are many. If such opportunities are not availed their earnings
will stay perpetually at Rs. 800,000. Following figures are relevant.

Policy Retention Growth Cost of equity on all

(%) (%) investments.
A 0 0 14
B 2 5 15
5
C 4 7 16
0
The returns to shareholders are expected to rise if the earnings are retained
because of the risk attached to new investments. As for the current year,
dividend payments will be made with or without retained earnings. What
according to you, should be retained ?
Solution :

GORDAN ) Market PriceD=(1 0g

K0 g
Model:

Evaluation of different dividend policies:

Policy A Policy B Policy C

Retention ratio 0% 25 % 40%
Payout ratio 100% 75% 60%
g 0% 5% 7%
Dividend (D0) 800000 600000 480000
D1 800000 630000 513600
Ke 14 % 15% 16%
Value of firm [(D 1)/ (Ke-g)] 5714286 6300000 5706667
(Add) dividend 800000 630000 513600
Cum dividend Value of firm 6514286 6930000 6220267

From the above policies, policy B gives more value to the share holders. Hence it
is advisable
to adopt the policy B.

Illustration 6
X Ltd. has 1000 shares of Rs 10 each raised at a premium of Rs. 15 per share.
The company’s retained earnings are Rs. 552500. The Company’s stock sells
for Rs. 20 per share.
a . If a 10% stock dividend is declared how may new shares would be issued?
b. What would be the market price after the stock dividend?
c. How would the equity account change?
d. If a 25% stock dividend is declared what changes will take place?
e. If the company instead declares a 5:1 stock split, how many shares will be
outstanding?
What would be the new part value? What would be the new market price?
f. If the company declares a 1:4 reverse split, how many shares will be
outstanding? What would be the new par value? What would be the new
market price?
g. If the company declares a dividend of Rs. 2 per share and the stock goes
ex dividend tomorrow, what will be the price at which it will sell?
65
Solution :
a) If 10% stock dividend declared:
No of new shares issued as bonus = 100
b) Market price after bonus issue = [(1000 x 20) + (100 x 0 )] / 1100
=
Rs.18.18
c) Change in equity account
Equity share capital increased by Rs1000
Reserves decreased by Rs1000.
Hence, there is no change in the Net Equity
d) If 25% stock dividend declared
1) No new shares issued = 1000 @ 25 % = 250 shares
2) Market price after stock dividend = [(1000 x 20) + (250 x 0)] / 1250
=
Rs.16
3) Change in EQUITY
account: Capital increased
by Rs. 2500
Reserve decreased Rs.2500
There is no change in Net Equity.
e) If the company declares 5 : 1 stock split i.e. 5 shares issued in
exchange of 1 share each.
No of shares outstanding = 5000
New face value of share = 10/ 5 = Rs.2
New market price = 20 / 5 = Rs.4
f) If the company declares 1: 4 reverse split i.e 1 share issued in
exchange of every 4 shares.
No of shares outstanding = 250
New face value = 4 x 10 = Rs.40
Market price = 20 x 4 = Rs.80
g) Cum dividend market price =
Rs. 20 (-) dividend = 2
Ex-dividend market price Rs. 18

Illustration 7
Following is the capital structure of Progressive Co. Ltd. as on 31st March, 2003.
Rs.
Equity Share Capital (1,00,000 shares of Rs. 10 10,00,0
each)
Share premium 00
15,00,0
Reserves & Surpluses 00
5,00,0
Net worth 00
30,00,0
00
On 1st April, 2001, the company made a bonus issue of two shares for every
five held. The market price at the time of bonus issue was Rs. 40 per share.
X holds 100 shares of the Progressive Co. Ltd. purchased on 1st April, 1997 a
market price of Rs. 30. He sold these shares on 31st March, 2003 at Rs. 50 per
share. The income – tax rate for X is 20% and capital gain tax is 15% for him.
If the company pays a regular dividend of 10% on par before transferring
earnings to reserves and surpluses, state whether X was able to earn his re-
quired rate of return of 10% on his investment? (The PV at 10% 1st year 0.91;
2nd year 0.83;
3rd year 0.75; 4th year 0.68; 5th year 0.62 and 6th
year 0.56).
Solution
:
Appraisal of Investment decision: [NPV
method ]
1) Initial Investment (out
flow):
100 shares @ 30 each = 3000
2) Present value recurring cash
inflows
Year Dividend Tax Net Pv Present
cash factor value
inflow @
1 10 2 8 0.91 72.8
0 0 0 0
2 10 2 8 0.83 66.4
0 0 0 0
3 10 2 8 0.75 60.0
0 0 0 0
4 14 2 11 0.68 76.1
0 8 2 6
5 14 2 11 0.62 69.4
0 8 2 4
6 14 2 11 0.56 62.7
0 8 2 2
386.00

3) Present value of terminal cash inflow:

Sale proceeds 140shares@ 50 each =
7000 (-) capital gain tax
4000@ 15% =
600
640
0
Its present value = 6400 x 0.56 = 3584

4) NET PRESENT VALUE:

 Present value of cash inflow (386+3584) =
3970 (-) outflow
3000
Net present value 970
The investment yields more than 10 % return to the
investor.