FINANCIAL MANAGEMENT

TOPIC- DIVIDEND POLICY

SUBMITTED TO – NIHARIKA LAKHERA MA’AM

SUBMITTED BY- VIBHUTI SHARMA

SAP ID – 500077337
ROLL NO. -R760219115
INDEX

1. MEANING
2. DIVIDEND POLICY
 Examples of Dividend Policy

3. Miller and Modigliani theory on Dividend Policy

 assumptions of Miller and Modigliani theory on Dividend Policy

 criticism of Miller and Modigliani theory on Dividend Policy

4. Gordan’s Model
 assumptions of Gordan’s model

 criticism of Gordan’s model

5. Walter’s Model
 assumptions of Walter model

 criticism of Walter model

MEANING
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 maximise their wealth. A company, on the other hand,
needs to provide funds to finance its long-term growth.

A company’s dividend policy dictates the amount of dividends paid out by the company to its
shareholders and the frequency with which the dividends are paid out. When a company
makes a profit, they need to make a decision on what to do with it. They can either retain the
profits in the company (retained earnings on the balance sheet), or they can distribute the
money to shareholders in the form of dividends.

The Dividend Policy is a financial decision that refers to the proportion of the firm’s earnings
to be paid out to the shareholders. Here, a firm decides on the portion of revenue that is to be
distributed to the shareholders as dividends or to be ploughed back into the firm. The amount
of earnings to be retained back within the firm depends upon the availability of investment
opportunities. To evaluate the efficiency of an opportunity, the firm assesses a relationship
between the rate of return on investments “r” and the cost of capital “K.”

As per the dividend models, some practitioners believe that the shareholders are not
concerned with the firm’s dividend policy and can realize cash by selling their shares if
required. While the others believed that, dividends are relevant and have a bearing on the
share prices of the firm. This gave rise to the following models:

DIVIDEND POLICY

1. Dividend relevance theory

 Miller and Modigliani Hypothesis
2. Dividend irrelevance theory
 Walter’s Model
 Gordon’s Model
As long as returns are more than the cost, a firm will retain the earnings to finance the
projects, and the shareholders will be paid the residual dividends that is the earnings left after
financing all the potential investments. Thus, the dividend pay-out fluctuates from year to
year, depending on the availability of investment opportunities.

Examples of Dividend Policy

The dividend policy used by a company can affect the value of the enterprise. The policy
chosen must align with the company’s goals and maximize its value for its shareholders.
While the shareholders are the owners of the company, it is the board of directors who make
the call on whether profits will be distributed or retained.

The directors need to take a lot of factors into consideration when making this decision, such
as the growth prospects of the company and future projects. There are various dividend
policies a company can follow such as

1. Regular dividend policy

Under the regular dividend policy, the company pays out dividends to its shareholders
every year. If the company makes abnormal profits (very high profits), the excess
profits will not be distributed to the shareholders but are withheld by the company as
retained earnings. If the company makes a loss, the shareholders will still be paid a
dividend under the policy.
The regular dividend policy is used by companies with a steady cash flow and stable
earnings. Companies that pay out dividends this way are considered low-risk
investments because while the dividend payments are regular, they may not be very
high.
2. Stable Dividend Policy
Under the steady profit strategy, the level of benefits delivered out as profits is fixed.
For instance, if an organization sets the pay-out rate at 6%, it is the level of benefits
that will be paid out paying little mind to the measure of benefits procured for the
monetary year.
Regardless of whether an organization makes $1 million or $100,000, a fixed profit
will be paid out. Putting resources into an organization that follows such an
arrangement is dangerous for speculators as the measure of profits changes with the
degree of benefits. Investors face a great deal of vulnerability as they don't know of
the specific profit they will get.
 3. Irregular Dividend Policy
Under the irregular dividend policy the organization is under no commitment to pay
its investors and the directorate can choose how to manage the benefits. On the off
chance that they a make an anomalous benefit in a specific year, they can choose to
disseminate it to the investors or not deliver out any profits whatsoever and rather
save the benefits for business extension and future activities.
The irregular dividend policy is utilized by organizations that loath a consistent
income or need liquidity. Speculators who put resources into an organization that
follows the arrangement face extremely high dangers as there is a chance of not
accepting any profits during the monetary year.
4. No dividend policy
Under the no dividend policy, the company doesn’t distribute dividends to
shareholders. It is because any profits earned is retained and reinvested into the
business for future growth. Companies that don’t give out dividends are constantly
growing and expanding, and shareholders invest in them because the value of the
company stock appreciates. For the investor, the share price appreciation is more
valuable than a dividend pay-out

Miller and Modigliani theory on Dividend Policy

According to Miller and Modigliani Hypothesis or MM Approach, dividend policy has no

effect on the price of the shares of the firm and believes that it is the investment policy that
increases the firm’s share value.

The investors are satisfied with the firm’s retained earnings as long as the returns are more
than the equity capitalization rate “Ke”. What is an equity capitalization rate? The rate at
which the earnings, dividends or cash flows are converted into equity or value of the firm. If
the returns are less than “Ke” then, the shareholders would like to receive the earnings in the
form of dividends.

Assumptions of Miller and Modigliani Hypothesis

 There is a perfect capital market, i.e. investors are rational and have access to all the
information free of cost. There are no floatation or transaction costs, no investor is
large enough to influence the market price, and the securities are infinitely divisible.
  There are no duties. Both the profits and the capital increases are charged at the
comparable rate.
 It is accepted that an organization follows a steady speculation strategy. This infers
that there is no adjustment in the business hazard position and the pace of profit for
the interests in new ventures.
 There is no vulnerability about the future benefits, all the financial specialists are sure
about the future ventures, profits and the benefits of the firm, as there is no danger
included.

Criticism of Miller and Modigliani Hypothesis

 It is accepted that an ideal capital market exists, which suggests no expenses, no

buoyancy, and the exchange costs are there, yet, nonetheless, these are unsound in the
genuine circumstances.
 The Floatation cost is caused when the capital is raised from the market and
consequently can't be overlooked since the endorsing commission, business and
different expenses must be paid.
 The exchange cost is brought about when the financial specialists sell their
protections. It is accepted that in the event that no profits are paid; the financial
specialists can offer their protections to acknowledge money. Yet, nonetheless, there
is a cost associated with making the offer of protections, for example the financial
specialists in the craving of current pay needs to sell a higher number of offers.
 There are charges forced on the profit and the capital additions. Be that as it may, the
assessment delivered on the profit is high when contrasted with the expense paid on
capital additions. The expense on capital additions is a conceded charge, paid just
when the offers are sold.
 The suspicion of certain future benefits is unsure. What's to come is brimming with
vulnerabilities, and the profit strategy gets influenced by the financial conditions.
 Accordingly, the MM Approach places that the investors are unconcerned between
the profits and the capital additions, i.e., the expanded estimation of capital resources.

Gordon’s Model
The Gordon’s Model, given by Myron Gordon, also supports the doctrine that dividends are
relevant to the share prices of a firm. Here the Dividend Capitalization Model is used to
study the effects of dividend policy on a stock price of the firm.

Gordon’s Model assumes that the investors are risk averse i.e. not willing to take risks and
prefers certain returns to uncertain returns. Therefore, they put a premium on a certain return
and a discount on the uncertain returns. The investors prefer current dividends to avoid risk;
here the risk is the possibility of not getting the returns from the investments. But in case, the
company retains the earnings; then the investors can expect a dividend in future. But the
future dividends are uncertain with respect to the amount as well as the time, i.e. how much
and when the dividends will be received. Thus, an investor would discount the future
dividends, i.e. puts less importance on it as compared to the current dividends.

According to the Gordon’s Model, the market value of the share is equal to the present value
of future dividends. It is represented as:

P = [E (1-b)] / Ke-br

Where, P = price of a share

E = Earnings per share
b = retention ratio
1-b = proportion of earnings distributed as dividends
Ke = capitalization rate
Br = growth rate

Assumptions of Gordon’s Model

 The firm is an all-equity firm; only the retained earnings are used to finance the
investments, no external source of financing is used.
 The rate of return (r) and cost of capital (K) are constant.
 The life of a firm is indefinite.
 Retention ratio once decided remains constant.
 Growth rate is constant (g = br)
 Cost of Capital is greater than br
Criticism of Gordon’s Model

 It is assumed that firm’s investment opportunities are financed only through the
retained earnings and no external financing viz. Debt or equity is raised. Thus, the
investment policy or the dividend policy or both can be sub-optimal.
 The Gordon’s Model is only applicable to all equity firms. It is assumed that the rate
of returns is constant, but, however, it decreases with more and more investments.
 It is assumed that the cost of capital (K) remains constant but, however, it is not
realistic in the real life situations, as it ignores the business risk, which has a direct
impact on the firm’s value.

Thus, Gordon model posits that the dividend plays an important role in determining the share

price of the firm.

Walter’s Model
According to the Walter’s Model, given by prof. James E. Walter, the dividends are relevant
and have a bearing on the firm’s share prices. Also, the investment policy cannot be separated
from the dividend policy since both are interlinked. Walter’s Model shows the clear
relationship between the return on investments or internal rate of return (r) and the cost of
capital (K). The choice of an appropriate dividend policy affects the overall value of the firm.
The efficiency of dividend policy can be shown through a relationship between returns and
the cost.

 If r>K, the firm should retain the earnings because it possesses better investment
opportunities and can gain more than what the shareholder can by re-investing. The
firms with more returns than a cost are called the “Growth firms” and have a zero
pay-out ratio.

 If r<K, the firm should pay all its earnings to the shareholders in the form of
dividends, because they have better investment opportunities than a firm. Here the
pay-out ratio is 100%.

 If r=K, the firm’s dividend policy has no effect on the firm’s value. Here the firm is
indifferent towards how much is to be retained and how much is to be distributed
among the shareholders. The pay-out ratio can vary from zero to 100%.
Assumptions of Walter’s Model

 All the financing is done through the retained earnings; no external financing is used.
 The rate of return (r) and the cost of capital (K) remain constant irrespective of any
changes in the investments.
 All the earnings are either retained or distributed completely among the shareholders.
 The earnings per share (EPS) and Dividend per share (DPS) remains constant.
 The firm has a perpetual life.

Criticism of Walter’s Model

 It is expected that the venture chances of the firm are financed through the held profit
and no outer financing, for example, obligation, or value is utilized. In such a case
either the speculation strategy or the profit strategy or both will be underneath the
principles.
 The Walter's Model is simply material to all value firms. Likewise, it is expected that
the pace of return (r) is consistent, yet, nonetheless, it diminishes with more
speculations.
 It is accepted that the expense of capital (K) stays steady, yet, nonetheless, it isn't
reasonable since it disregards the business danger of the firm, that directly affects the
association's worth.