By AMIT KUMAR ARORA

What is Dividend Policy

 Dividend Policies involve the decisions, whether-
 To retain earnings for capital investment and other
purposes; or
 To distribute earnings in the form of dividend among
shareholders; or
 To retain some earning and to distribute remaining
earnings to shareholders.
 Equity Dividend
Type of Security
Preference Dividend

Interim
Dividend
Based on Time
Regular Dividend

Dividend
Cash Dividend

Stock Dividend

Scrip / Bond dividend

Mode of Payment Property Dividend

Composite Dividend

Optional Dividend

Special Dividend
Determinant or Factors affecting Dividend
Policy
 Legal Restrictions
 Magnitude and Trend of Earnings
 Desire and Type of Shareholders
 Nature of Industry
 Age of the Company
 Future Financial Requirements
 Taxation Policy
 Policy of Control
 Stage of business Cycle
 Cost of Capital
 Regularity
 Liquid Resources
 Requirements of Institutional Investors
TYPES OF DIVIDEND POLICY

Dividend Policy

Regular Dividend Stable Dividend Irregular Dividend No Dividend

 REGULAR DIVIDEND POLICY
 STABLE DIVIDEND POLICY
 Constant Dividend Policy
 Constant pay out Ratio
 Stable Rupee Dividend Plus Extra Dividend
 IRREGULAR DIVIDEND POLICY
 NO DIVIDEND POLICY
ESSENTIALS OF A SOUND DIVIDEND
POLICY
Stability
Gradually Rising Dividends
Distribution of Cash Dividend
Moderate Start
Other factors
 Dividend Theories

Irrelevance Theories
Relevance Theories
(i.e. which consider
(i.e. which consider
dividend decision to be
dividend decision to be
irrelevant as it does not
relevant as it affects the
affects the value of the
value of the firm)
firm)

Modigliani and
Walter’s Model Gordon’s Model Miller’s Model
Walter’s Valuation Model
 Prof. James E Walter argued that in the long-run the
share prices reflect only the present value of expected
dividends. Retentions influence stock price only
through their effect on future dividends. Walter has
formulated this and used the dividend to optimize the
wealth of the equity shareholders.
Formula of Walter’s Model
D + Ra (E-D)
P= Rc
Rc
Where,
P = Current Market Price of equity share
E = Earning per share
D = Dividend per share
(E-D) = Retained earning per share
Ra = Rate of Return on firm’s investment or Internal Rate of Return
Rc = Cost of Equity Capital
Assumptions of Walter’s Model
 All financing is done through retained earnings and
external sources of funds like debt or new equity capital are
not used. Retained earnings represents the only source of
funds.
 With additional investment undertaken, the firm’s
business risk does not change. It implies that firm’s IRR
and its cost of capital are constant.
 The return on investment remains constant.
 The firm has an infinite life and is a going concern.
 All earnings are either distributed as dividends or invested
internally immediately.
 There is no change in the key variables such as EPS or DPS.
Effect of Dividend Policy on Value of Share
Case If Dividend Payout If Dividend Payout
ratio Increases Ration decreases
1. In case of Growing firm Market Value of Share Market Value of a share
i.e. where r > k decreases increases
2. In case of Declining Market Value of Share Market Value of share
firm i.e. where r < k increases decreases
3. In case of normal firm No change in value of No change in value of
i.e. where r = k Share Share
Criticisms of Walter’s Model
 No External Financing
 Firm’s internal rate of return does not always remain
constant. In fact, r decreases as more and more
investment in made.
 Firm’s cost of capital does not always remain constant.
In fact, k changes directly with the firm’s risk.
Illustration:
 The earnings per share of a company are Rs.16. The
market rate of discount (capitalization rate) to the
company is 12.5%. Retained earnings can be employed
to yield a return of 10%. The company is considering a
payout of 25%, 50% and 75%. Which of these would
maximize the wealth of shareholders?
 108.80, 115.20, 121.6……….100%-128
Illustration
 The earnings per share of a company are Rs.8 and the
rate of capitalization applicable to the company is 10%.
The company has before it an option of adopting a
payout ratio of 25% or 50% or 75%. Using Walter’s
formula of dividend payout, compute the market value
of the company’s share if the productivity of retained
earnings is (A) 15%, (B) 10% and (C) 5%. Explain fully
what inference can be drawn from the above exercise.
 1- 110,100,90
 2- 80,80,80
 3- 50,60,70
Illustration 1 (In case of Growing Firm)
 The earnings per share of a company are Rs. 10. The
Equity Capitalization rate is 10%. Internal Rate of
return on retained earnings is 20%. Using Walter’s
formula:
 What should be the optimum payout ratio of the
company?
 What should be the price of share at optimum payout
ratio?
 How shall this price be affected if different payout (say
80%) were employed?
Illustration 2 (In case of Normal Firm)
 The earnings per share of a company are Rs. 10. The
Equity Capitalization rate is 10%. Internal Rate of
return on retained earnings is 10%. Using Walter’s
formula:
 What should be the optimum payout ratio of the
company?
 What should be the price of share at optimum payout
ratio?
 How shall this price be affected if different payout (say
80%) were employed?
Illustration 3 (In case of Declining Firm)
 The earnings per share of a company are Rs. 10. The
Equity Capitalization rate is 20%. Internal Rate of
return on retained earnings is 10%. Using Walter’s
formula:
 What should be the optimum payout ratio of the
company?
 What should be the price of share at optimum payout
ratio?
 How shall this price be affected if different payout (say
80%) were employed?
Modigliani & Miller’s Irrelevance Model
 According to M-M, under a perfect market situation,
the dividend policy of a firm is irrelevant as it does not
affect the value of the firm. They argue that the value
of the firm depends on the firm’s earnings and firm’s
earnings are influenced by its investment policy and
not by the dividend policy
Modigliani & Miller’s Irrelevance Model
Value of Firm (i.e. Wealth of Shareholders)

Depends on

Firm’s Earnings

Depends on

Firm’s Investment Policy and not on dividend policy

Assumption of M-M Model
 Perfect Capital Market: This means that:
 The investors are free to buy and sell securities.
 The investors behave rationally.
 There are no transaction cost/ flotation cost.
 They are well informed about the risk-return on all types of
securities.
 No investor is large enough to affect the market price of a
share.
 No Taxes
 Fixed Investment Policy
 No Risk
Formulae of M-M Model
 According to M-M model the market price of a share,
after dividend declared, is calculated by applying the
following formula:
P1 + D1
P0 =
1 + Cr
Where,
P0 = Prevailing market price of a share
P1 = Market Price of a share at the end of the period one
D1 = Dividend to be received at the end of period one
Cr = Cost of equity capital
Formulae of M-M Model
 The number of shares to be issued to implement the
new projects is ascertained with the help of the
following:
I – (E-nD1)
ΔN =
P1
Where,
ΔN = Change in the number of shares outstanding during the period.
I = Total Investment amount required for capital budget
E = Earning of net income of the firm during the period
n = Number of shares outstanding at the beginning of the period
D1 = Dividend to be received at the end of period one
P1 = Market price of a share at the end of period one
Criticism of M-M Model
 No perfect Capital Market
 Existence of Transaction Cost
 Existence of Floatation Cost
 Lack of Relevant Information
 Taxes Exist
 No fixed investment Policy
 Investor’s desire to obtain current income
Illustration
 Show that the payment or non-payment of dividend does
not affect the value of the firm as per MM app.
 A company belongs to a risk class for which the appropriate
rate of capitalization is 10%. The total number of equity
shares is 30,000. The current market price of an equity
share is Rs.80. The company is thinking to declare a
dividend of Rs.4 per share at the end of the current year.
The company expects to have a net income of Rs.3,00,000.
It has proposal of making investment of Rs.6,00,000 in new
proposals. If MM approach is adopted, show that payment
or non-payment of dividend does not affect the value of
equity shares of the company.
GORDON’S MODEL OF DIVIDEND
POLICY
• According to Prof. Gordon, Dividend Policy almost
always affects the value of the firm. He Showed how
dividend policy can be used to maximize the wealth of
the shareholders.
• The main proposition of the model is that the value of
a share reflects the value of the future dividends
accruing to that share. Hence, the dividend payment
and its growth are relevant in valuation of shares.
• The model holds that the share’s market price is equal
to the sum of share’s discounted future dividend
payment.
Assumptions of Gordon Growth
Valuation Model.
• The firm is an all equity firm and has no debt
• External financing is not used in the firm. Retained earnings
represent the only source of financing.
• The internal rate of return is the firm’s cost of capital ’k’. It
remains constant and is taken as the appropriate discount rate.
• Future annual growth rate dividend is expected to be constant.
• Growth rate of the firm is the product of retention ratio and its
rate of return.
• Cost of Capital is always greater than the growth rate.
• The company has perpetual life and the stream of earnings are
perpetual.
• Corporate taxes does not exist.
• The retention ratio ‘b’ once decided upon, remain constant.
Therefore, the growth rate g=br, is also constant forever.