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    of 17
    chapter = a Dividend Decisions ° the owners of the com some return on their ir recommended by pany. They are the suppliers of capital in a company. investment. This return on shareholders’ investment is the directors in the board meeting and declared in the Shareholders are Naturally they expect called dividend. It is general meeting, Meaning of Dividend A firm’s earnings belon, distributed to shareholders, distributed. This decision is ci made by management on beh there are only two alternative in the business. Both op as dividend, it will add to th for investment in the b the future. The shareholders get dividend gives current earnings will not be ‘earnings should be on is actually a choice jings. Theoretically, ed for reinvestment gsare distributed ngs are retained Financial Managemen, 284 Types / Forms of Dividend forms Ca Dividend may take several forms. The following are the important types / forms of dividen, 1, Cash dividend: This is the most popular form of dividend. Itis the dividend paid to shareholders in cash. The cash dividend may be of the following two types: : (a) Regular or final dividend:It is the dividend declared and paid at the end of trading period after final accounts have been prepared. 4 (b) Interim dividend: Its the dividend declared before the deslaration of the final dividend, This is declared at any time between the two annual general meeting. 2. Stock dividend: Companies not having sufficient cash generally pay dividend in the form of shares by capitalising the past reserves and profits. Such shares are called bonus shares, 3. Scrip dividend: In case a company does not have sufficient funds to pay dividend in cash, it may issue transferable promissory notes for a shorter maturity period for amounts due to shareholders. This is called scrip dividend. The payment of dividend in this form takes place only when the company is suffering from shortage of cash or weak liquidity position. The objective of scrip dividend is to postpone the immediate payment of cash. Thus scrip dividend Promises to pay the shareholders at a future specific days. But now companies are not allowed to distribute scrip dividend, 4. Bond dividen 6S, dividends are paid in the form of debentures or bonds or notes for a long term pe aring at fix {company issues bonds by way of dividend when it e enough funds to pay fidend. 5. Property divide in cash. z Mechanics and asset instead of paying dividend Pay dividends, liability and the firm is Tesponsible for lent may be understood from the follo 1. Declaration d of Directors meets to ae pividend Decisions 285 dividend remains with th he stock w See buys the stock on or after the e: f-record date il two days before the holder idend date does not get the dividend. d to shareholders on the 5, Payment date: The dividend cl ee eae lend cheques or dividend warrants are mi Meaning of Dividend Policy at tee question before the Board of Directors is how much pro! among a holders and how much to be retained in the business as feats ones ee oon and dividend is an important function of jecisi ay have a critical impact on the ki is policy to be followed by the onnell eaeatoa tia Fim, Hens a iden policy refers to the policy which determines the allocation of earnings into retained earnings a a iv idend. Acompany’s dividend policy influences the divisions ofits net earnings into two parts —dividend and retained: ‘earnings. In the words of Weston and Brighem, "Dividend policy determines the division of earnings between payments fo shareholders and retained earnings”. 1p the words of Gitman, “The firm’s dividend policy represents the plan of action to be followed ‘whenever the dividend decision must bem ie ici In short, dividend policy refers r What amount is to be retained and ho} Importance of Dividend Policy © Formulation of dividend polies desires to have a sound dividend objective of the business, 1-6 the firm has far reaching CO! business and the wealth of the | the shares which in turn depends: price of the shares and vice r business and to that extent nal sources policy all fit should be divided 1s, Hence allocation of management. This .s a sound dividend ofits as dividend. F Financial Managemen A. Internal Factors Following are the important internal factors affecting dividend policy. 1. Stability and size of earnings: Dividend is dependent on the earnings of the firm. If the ‘earnings are relatively stable a firm is able to predict what its future earnings will be. Therefore it can follow a liberal dividend policy. A rational dividend policy should take into account both the amount and nature of earnings from year to year. 2. Liquidity of funds: The liquidity position is an important consideration in dividend decision. Payment of dividend involves outflow of cash, Even if the earnings are greater, a company may not be able to pay cash dividend because of inadequate cash balance. A fast growing firm requires more funds in the near future. The greater the future needs for funds, the more likely the firm is to retain earnings rather than to pay them out. 3. Investment opportunities and shareholders' preference: Management should adopt that dividend policy which strikes a balance between the shareholders’ preference for dividends and investment opportunities with retained earnings. If there are large number of profitable investment opportunities, it should give preference to retention of earnings over payment of dividends. In short, management should follow that policy which suits to shareholders’ interest and company’s interest. important variable in dividend policy. tthe firm will not much depend on the end payout policy. tors will have to consider the rate eof dividend being declared by rival have better access to the capital ‘can arrange funds from external er and older firms. ikely to retain more profits. It repay huge debts. . For example, during > pwvidend Decisions 287 corporate tax: Corporate cation reduce the spas aes hiro rey + a nsirotiy. HesVE eae area it available to shareholders. Consequently the rate of dividen general state of i ee ‘ . amine ces When state of economy is uncertain, the firm may maintain @ oe yyout policy, to withstand to the business risks. ition: s 5. oe aaa ie expla market: If the conditions in the capital market are comfortable anne crate oe from different sources without much difficulty by maintaining @ ances a jend and retains larger profits the company may follow liberal dividend policy: mn er hand, if there is a slump in capital market, the management may follow conservative : Coe policy: The earning capacity ofthe company sa widely affected by the change in fiscal, industrial, labour control, and other government policies. Hence the dividend policy is formulated or modified after taking into consideration the changes in government Policies: types of Dividend Poli ‘Accompany may follow a wide variety of dividend policies. The various types of divi policies are discussed as follows: 1. Stable Dividend Policy Stability of dividend means consistency in dividend payment. that maintains regularity in paying some dividend even tho year. In short, stable dividend means payment of certain min can take the following three di z (a) Constant end per share: share every year irrespective of tl that the dividend per share will earnings and expects 10 maintai This policy is easy to follow can follow this policy by mal (b) Constant percentage of eal profit as dividend every year. adopts 30% payout rat io, the transferred to reserves), Int (©) Constant dividend per 8) minimum rate of dividend per ‘Advantages of Stable Dividen Stable dividend policy off idend 288 Financial Managemen, (ii) A.stable dividend policy meets expectations of investors who are generally income conscious ii) A stable dividend policy attra stable rate of dividend, (iv) It stabilises the market value of shares. s investments from institutional investors who wishes always B, Advantages to company (i) Itincreases the goodwill and credit worthiness of the company. i Ithelps in preparing financial planning easily. (ii) It is a sign of continued normal operations of the company. Dangers of Stable Dividend ‘The stable dividend policy suffers from the following limitations: (i) Once a stable dividend is followed by a company, it is not easy to change it. (ii) Ifthe company cannot pay stable dividend in one year, the investors may lose confidence in the company and they may dispose off their holdings. (iii) If the company pays stable dividend in spite of its incapacity, it will be suicidal in the longrun, 2. Regular and Ext ividens Policy Under this poliey share r {rupee dividend as a fixed percentage (called regular dividend) ala ic e e higher than normal earnings in any year, the company 1 addition to regular dividend. By giving extra dividend (or in addition to) cash dividend e number of outstanding shares : = 289 optimal Dividend Policy Dividend policy isa controversia) ; some firms pay 60%. Some Bae ial issue. Some firms pay 20% of their earings as dividends. pay aividends. Thus there is great cere Pt) "© dividends tall For example, Microsoft does not As regards optimal dividi Variability in dividend payouts. n short, dividend is a puzzle. optimal dividend policy, Others nd policy a controversy exists. Some people say that there is no or optinal vide eae that there is an optimal dividend policy, Let us accept that there ji darepacearee onal eee dividend policy is one that maximizes the firm’s value or y ‘end policy can be studied with the help of the following graph: nd Policy is Relevant Risen Ps icy is Irrelevant Value of Firm In the above graph, the horize value. We get the horizontal line value, ie., dividend policy is irrele payout occurs at point p because have a curve with a different sh optimal dividend policy. ividend Payout Ratio Dividend payout ratio is 0 the earnings, a company pa} The balance of profit will be tothe earnings. In other words, as dividends. In short, it i mn Financial Mandgemey For example, if EPS is € 10 and DPS is €4, then dividend payout ratio ve a 40%) and the retention ratio is 0.6 (or 60%). The payout ratio can be larger than 1. If is [10 but the company pays & 15 per share asa cash dividend (€ 10 from current carne and &5 from retained earnings), then the payout ratio is 1.5 (or 150%), which is larger than Theories On Dividend Policies (Divident Models) ’ There are a number of theories on dividend policies. Only important theories are briefly discussed here: 1, Modigliani and Miller- Irrelevancy Theory: This theory states that a firm's dividend policy has no effect on value of the firm or sharehoders' wealth. Modigliani and Miller state that When a company pays dividend, (retention of earnings decreases) the market price of its share increases. Hence the value of firm increases. But due to payment of dividend, the cash balance decreases. Consequently funds to finance the projects decrease. Now the company would issue new equity shares. As a result, supply of shares increases in the market. Consequently the price of the shares decreases. Value of firm also decreases. Thus whatever increase took place in the price of the shares through payment of dividend gets nullified due to increase in supply of shares. In short, the market value of the shares is not affected by the dividend payment. Hence shareholders would be indifferent between dividend and retention of earnings. As far as shareholders are concerned whether the company pays dividend or retains earnings, it would not affect them. If the company does not issue equity shares for financing its project and instead it raises company raises b b crease the perception of the shareholders aresult, cost of et Qu ae market value of equity. Finally the total valueo dividend, he can either spend for not paid, even then the market gs increase and the company market value means capital ‘consumption, his earnings 's income now, he can sell »f the company. Thus the s in any way. In short, the Pa juend Decisions 291 Investors behave rationally. ne 7 ey no taxes or there are no differences in the tax rates applicable to capital gains nd dividend. 4, There are no floatation and transaction costs. The firm has fixed investment policy. 6, No investor large enough to affect the market price of shares. Mathematical Proof of MM Approach The market price of equity share is given as D+P 1+k, where, P, = Market price atthe beginning ofthe period (ie. current market price). D, = Dividend to be received at the end of the year P, = Market price at the end ofthe period. Cost of equity capital (oreapi x 4 From the above equation, we ean find Py P,=P,(1+k)-D, Market value of firm or simply value of formula: V=(n+m)xP, where, V_ = Value of firm shares ol The number of shares to be i _1= =) BR ‘m= Number of sha ie pividend Decisions a iy Number of shares (new or additional) to be issued _ 1-(E-np,) P, Zz 5,00,000—(2,50,000 —15,0000) 140 _ 5,00,000~(2,50,000 — 0) _ 5,00,000-2,50,000 140 4 A cs. _ 2,50,000 _ 140 «785-71 (iii) Value of firm when dividends are not paid: V = (n+m)xP, (15,000 + 1,785.71) x 140 = %2,35,000 approx. 4 wins r Thus, whether dividends are paid or} he! ie same i.e. € 2,35,000. Criticisms of the Theory 0 1. Perfect capital market does not ¢ 2. While issuing shares the company” 3. Taxes do exist. Usually capital 4, While selling shares investors 5. Most of the shareholders prefer © 6. Firms need not follow a fixed in ‘Thus the assumptions are fi assumptions hold good, MM tho 2. Walter’s Dividend Model! adividend model. In this theory relevant. Hence this is a theory of price of the share. Thus dividen investment policy (investment d Thats, the investment decision 294 Financial Managemen, ‘When a firm pays dividends to shareholders, they will invest this income to get further returns This expected return to shareholders is the cost of capital (k,) to the firm. If the firm does not pa dividends, and instead retains, then these retained earnings will be reinvested by the firm to Ret return on this investment. This rate of return on the investment of the firm (F) must be at least equal to the cost of capital (k,). If r= k, the firm is earning a return just equal to what the shareholders could have earned had the dividends been paid to them. Ifr is more than ke, the finn can earn more by retaining the profits, than the shareholders can earn by investing their income, Thu’ Walter’s model says that if firm can earn more than what the shareholders can earn (ie,r is greater than k), the company should not pay dividend i.e. it should retain the entire earnings, The higher the retention ratio, the higher will be the market price of the shares and value of the firm (or shareholders’ wealth), However, if shareholders can earn more than what company can eam, (i.e., k, is greater than r), the company should distribute the entire profits. This will give opportunity to shareholders to reinvest their dividend income and get higher returns. This happens because the approach is based on the basic objective of financial management, i.e., maximisation of shareholders’ wealth. Therefore the wealth should flow to that side where it can grow ata higher rate, In short, the dividend policy ofa firm depends upon the relationship between r and k,.Ifr> , Ge, in case of a growth firm)the firm should have zero payout (i.e. no dividend) and reinvest the entire profits to earn more than the investors, Ifhowever, r k, the p pividend Decisions 295 Mathematical Formula Walter’s formula is based on the following share valuation model: D k.-g where, P= Price of equity share. Initial dividend pre share. k, = Cost of equity capital. 8 = Expected growth rate of dividend, Walter has derived a formula to decide the effect of payment of dividend on the share price (ie. to arrive at the approximate dividend decision). The formula is as follows: _ D+ tk, (E-D) k, where, P_ = Market price per share. D = Dividend per share. r= Internal rate of return. k, = Cost of equity capital. = Earnings per share, Example 2 ‘The following information is available’ Capitalisation rate. = 10% Earnings per share = %12 ‘Assumed rate of return on investmet (i) 16%, (ii) 8%, (iii) 10% ‘Show the effect of dividend policy following payout ratios: (a) 0%, (b) 50%, Solution D + tk, (E-D) eee k, 4 (r= 16% Gir= (a When dividend payout ratio is 0° 0+.16/.10(12-0) , _ yey 0.10 192 4 Financial Managemen, (®) When dividend payout ratio is 50%: D = 12 x 50/100 = 6 p= S4.16.10(12-6) , _ 6+.08/10(12-6) p _ 6 +.10/.10(12=6) 0.10 0.10 0.10 =%156 =F 108 =7120 (©) When dividend payout ratio is 759%: D = 12 x 75 1100 = 9 p = S+:16.10(12-9) 5, _ 6+.08/10(12-9) , _ 9 +.10/.10(12-9) 0.10 0.10 0.10 =U138 0 =T114 =%120 (@) When dividend payout ratio is 100%: D = 12 12+.16/.10(12-12) , _ 12+.08.10(12-12) , _ 12 +.10/.10(12-12) p= 2eSiSOUZe eevee 0.10 0.10 0.10 120 =%120 =% 120 From the above analysis, the following conclusions can be drawn: (@) When r>k, the frm should retain the profits (zero dividend payout ratio). When r= 16% and, = 10% the market value of share is highest 192), in case of zero dividend payout ratio (of 100% retention ratio). (i) Whenr

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