DIVIDEND POLICY DECISIONS

THEORY
The term 'dividend' refers to that part of profit (after tax) which is distributed
among the owners/shareholders of the company.
Furthermore, the profits earned can be used for:
1. Distribution of dividend or
2. Can be retained as surplus for future growth

Generally, Dividend Policy of a company is governed by:

(i) Long Term Financing Decision: When dividend decision is treated as a

financing decision, net earnings are viewed as a source of long term
financing. When the firm does not have profitable investment
opportunities, dividend will be paid. The firm grows at a faster rate when it
accepts highly profitable opportunities. External equity is raised to finance
investments. But retained earnings are preferable because they do not
involve floatation costs.
Payment of cash dividend reduces the amount of funds necessary to
finance profitable investment opportunities thereby restricting it to find
other avenues of finance. Thus earnings may be retained as part of long
term financing decision while dividends paid are distribution of earnings
that cannot be profitably re-invested.

(ii) Wealth Maximization Decision: Because of market imperfections and

uncertainty, shareholders give higher value to near dividends than future
dividends and capital gains. Payment of dividends influences the market
price of the share. Higher dividends increase value of shares and low
dividends decrease it. A proper balance has to be struck between the two
approaches.
When the firm increases retained earnings, shareholders' dividends
decrease and consequently market price is affected. Use of retained
earnings to finance profitable investments increases future earnings per
share. On the other hand, increase in dividends may cause the firm to

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 forego investment opportunities for lack of funds and thereby decrease the
future earnings per share.
Thus, management should develop a dividend policy which divides net
earnings into dividends and retained earnings in an optimum way so as to
achieve the objective of wealth maximization for shareholders. Such policy
will be influenced by investment opportunities available to the firm and
value of dividends as against capital gains to shareholders.

Relevance of Dividends: There are two school of thoughts based on relevance

of dividends. One school of thought says dividend are relevant i.e., they affect the
market price of a company’s share whereas the other says that dividends are
irrelevant as they have no impact on the market price of a company’s share.

Relevant Irrelevant
1. Dividend Capitalization Model a. Earnings Capitalization Model
2. Gordon’s Model b. Modigliani & Miller Approach
3. Walter’s Model
4. Graham & Dodd Model

PRACTICAL CONSIDERATIONS IN DIVIDEND POLICIES

A discussion on internal financing ultimately turns to practical considerations

which determine the dividend policy of a company. The formulation of dividend
policy depends upon answers to the questions:
(i) Whether there should be a stable pattern of dividends over the years or
(ii) Whether the company should treat each dividend decision completely
independent. The practical considerations in dividend policy of a company
are briefly discussed below:

(a) Financial Needs of The Company: Retained earnings can be a source of

finance for creating profitable investment opportunities. When internal rate
of return of a company is greater than return required by shareholders, it
would be advantageous for the shareholders to re-invest their earnings. A

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 comparison between growth companies and mature companies has been
given as follows:

Mature companies Growth Companies

Mature companies having few Growth companies, on the other
investment opportunities will show hand, have low payout ratios. They
high payout ratios are in need of funds to finance fast
growing fixed assets.
Share prices of such companies are Distribution of earnings reduces the
sensitive to any changes in dividend funds of the company. They retain
payout. all the earnings and declare bonus
shares to offset the dividend
requirements of the shareholders.
A small portion of the earnings are These companies increase the
kept to meet emergent and amount of dividends gradually as the
occasional financial needs profitable investment opportunities
start falling.

(b) Constraints on Paying Dividends

(i) Legal: As per the provisions of the Companies Act, 2013, dividend has to be
paid out of current profits or past profits after depreciation. Dividend is to
be paid in cash but a company is allowed to capitalize profits or reserves
(retained earnings) for issuing fully paid bonus shares.
(ii) Liquidity: Payment of dividends means outflow of cash. Ability to pay
dividends depends on cash and liquidity position of the firm. A mature
company does not have much investment opportunities, nor are funds tied
up in permanent working capital and, therefore has a sound cash position.
For a growth oriented company in spite of good profits, it will need funds
for expanding activities and permanent working capital and therefore it is
not in a position to declare dividends.
(iii) Access to the Capital Market: By paying large dividends, cash position is
affected. If new shares have to be issued to raise funds for financing
investment programs and if the existing shareholders cannot buy additional

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 shares, control is diluted. Payment of dividends may be withheld and
earnings are utilised for financing firm's investment opportunities.
(iv) Investment Opportunities: If investment opportunities are inadequate, it is
better to pay dividends and raise external funds whenever necessary for
such opportunities.

(c) Desire of Shareholders:

The desire of shareholders (whether they prefer regular income by way of

dividend or maximize their wealth by way of gaining on sale of the shares)
is also an important point to be considered by the companies. The small
shareholders are concerned with regular dividend income, hence; some
select group of companies paying regular and liberal dividend.

As compared to those shareholders who prefer regular dividend as source

of income, there are shareholders who prefer to gain on sale of shares at
times when shares command higher price in the market. However, capital
gain on sale of shares attracts tax on such gain. The tax rates vary on the
basis of holding period.

The dividend policy, thus pursued by the company should strike a balance
on the desires of the shareholders who may belong either of the group as
explained above. Also, the dividend policy once established should be
continued as long as possible without interfering with the needs of the
company to create clientele effect.

(d) Stability of dividends/Dividend Approaches

1. Constant Payout: The ratio of dividend to earnings is known as payout

ratio. Some companies follow a policy of constant payout ratio i.e. paying fixed
percentage on net earnings every year.

Such a policy envisages that the amount of dividend fluctuates in direct

proportion to earnings.

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Example: If a company adopts 40% payout ratio, then 40% of every rupee of net
earnings will be paid out. If a company earns ₹ 2/- per share, dividend per share
will be 80 paise and if it earns ₹ 1.50 per share, dividend per share will be 60
paise.

Hence, such a policy is related to company's ability to pay dividends. For losses
incurred, no dividend shall be paid. Internal financing with retained earnings is
automatic. At any given payout ratio, amount of dividends and any additions to
retained earnings increase with increased earnings and decrease with decreased
earnings.

This policy has a conservative approach and provides a guarantee against

over/underpayment. Management is not allowed to pay dividend if profits are not
earned in current year and at the same time, dividend is not allowed to forego if
profits are earned.

2. Constant Dividend per Share: Shareholders are given fixed amount of dividend
irrespective of actual earnings. The amount of dividend may increase or
decrease later on depending upon the financial health of the company but it is
generally maintained for a considerable period of time.

To maintain a constant dividend amount, it is necessary to create a reserve like

Dividend Equalization Reserve Fund earmarked by marketable securities for
accumulation of surplus earnings and to use it for paying dividends in those years
where the company's performance is not good.

This policy treats common shareholders at par with preference shareholders

without giving them any preferred opportunities within the firm. It is preferred by
persons and institutions that depend on dividend income to meet their living and
operating expenses.

3. Small constant dividend per share plus extra dividend:

The amount of dividend is set at high level and the policy is adopted for
companies with stable earnings. For companies with fluctuating earnings, the
policy is to pay a minimum dividend per share with a step up feature. The small
amount of dividend is fixed to reduce the possibility of missing dividend payment.
By paying extra dividend in period of prosperity, it enables the company to pay
constant amount of dividend regularly without default and allows flexibility for

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supplementing shareholders' income when company's earnings are higher than
usual, without committing to make larger payments as part of further fixed
dividend. This policy allows some shareholders to plan on set amounts of cash
and at the same time be pleased when extra dividends are announced.

# Stock Split
Stock split means splitting one share into many, say, one share of ₹500 in to 5
shares of ₹100. Stock split is a tool used by the companies to regulate the prices
of shares i.e. if a share price increases beyond a limit, it may become less
tradable, for e.g, suppose a company's share price increases from ₹500 to
₹1,00,000 over the years, it is possible that it might go out of range of many
investors.

Advantages & Disadvantages of Stock Splits:

Advantages Disadvantages
1. It makes the share affordable to 1. Additional expenditure needs to be
small investors. incurred on the process of stock split.
2. Low share prices may attract
2. Number of shares may increase the speculators or short term investors,
number of shareholders; hence the which are generally not preferred by
potential of investment may any company.
increase

# Forms of Dividends
Generally, dividend can take any of the following form:
Cash dividend: It is the most common Stock dividend (Bonus Shares): It is a
form of dividend. Cash here means distribution of shares in lieu of cash
cash, cheque, warrant, demand draft, dividend to existing shareholders.
pay order or directly through Electronic When the company issues further
Clearing Service (ECS) but not shares to its existing shareholders
in kind without consideration it is called bonus
shares. Such shares are distributed
proportionately thereby retaining
proportionate ownership of the
company. If a shareholder owns 100
shares at a time, when 10% dividend is
declared he will have 10 additional

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 shares thereby increasing the equity
share capital and reducing reserves and
surplus (retained earnings). The total
net worth is not affected by bonus
issue.

# Stock Dividend or Bonus

Bonus Shares are issued for the same reasons as Stock Split i.e., to make the share
affordable by reducing the share price. It also increases the number of shares
outstanding hence, it promotes more active trading.

Regulation of Bonus Issues

The regulations governing a bonus issue are as follows:
1. The bonus issue is made out of free reserves built out of the genuine profits or
share premium collected in cash only.

2. Pending conversion into shares, fully convertible debentures (FCDs) and partly
convertible debentures (PCs) are included for determining the eligibility to
receive bonus shares. The bonus entitlements of such shares should be kept
separately and allotted at the time of conversion of such FCDs / PCDs.

3. A bonus issue cannot be made on partly paid up shares.

4. The articles of association of the company should authorize a bonus issue.

#Modigliani and Miller Approach

Assumptions: The above approach is based on the following assumptions: -

1) Perfect Capital Markets:

• All the investors are rational

• Information is available to all free of cost
• Securities are infinitely divisible
• No investor is large enough to influence the market

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2) There are no taxes. Alternatively, there are no differences in the tayrates
applicable to capital gains and dividends.

3) There are no floatation costs or transaction cost

4) Home-made dividends and corporate dividends are perfect substitutes of each

other.

5) One discount rate is appropriate for all securities and all time periods.

Theory Questions (Discussed and written in Class work notebook)

Q1. What is PE Ratio? What are the factors affecting PE Ratio? (Interpretation of
PE Ratio)

Q2. What is basic valuation principle?

Q3. State the assumptions of various models.

(a) Gordon’s model

(b) Walter’s model
(c) Lintner’s model
(d) Modigliani & Miller approach

Q4. Give the derivation of:

(a) Gordon’s model

(b) Walter’s model
(c) Modigliani & Miller approach

Q5. When will dividend policy be irrelevant in determining share price in case of
Walter’s model?

Q6. Is the Modigliani and miller model realistic with respect to valuation? What
factors might mar its validity?

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PRACTICE QUESTIONS

Q1. Assume that ONGC Ltd., &Tata Steel Ltd, will exist for infinite period and their
expected dividend is ₹ 40 per share & ₹ 55 per share respectively. What should be
the current market price per share of the two companies if investors' expectation
is 20% p.a. from both the companies? What will be the market price per share if
both of the companies are planning to reduce their dividend payment by 10%?

Q2. Cost of equity of Reliance Industries Ltd. is 15.5%. The company had paid
dividend @ ₹2 per share last year. The estimated growth of the company is
approximately 5% per year.

(i) Determine the current market price of one share of the company.
(ii) Determine the estimated market price of the equity shares if the
anticipated growth rate of the company: (a) were 8% and (b) were 3%.
(iii) Calculate and comment on the current market price if the estimated
growth is 20%.
(iv) If Current Market price of the shares is ₹30, calculate Cost of Equity/
Required return by shareholders.

Q3. The MNC Ltd.'s available information is:

Cost of equity = 15%; EPS (for the first year) ₹30
ROE = (i)15%
Retention ratio = (i) 40% and (ii) 60%
Calculate Market Price of MNC Ltd.

What will be the market price if ROE changes to 16%?

Q4. SP Industries has been growing at the rate of 15% per year and this trend is
expected to continue for 5 more years. Thereafter it is likely to grow at the rate of

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8% which is the industry average. The investors expect a return of 12%. The
dividend paid per share last year (DO) corresponding to period 0 is 5.

Determine at what price an investor will be ready to buy the shares of the
Company at the end of year 0.

Q5. The earnings per share of a Co, is ₹16. The market capitalization rate
applicable 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 as per Walter's model?

Q6. Ding Dong Ltd. has 10 Lakhs equity shares outstanding at the beginning of the
accounting year 1997. The current market price of the shares is ₹150 each. The
Board of Directors of the company has recommended ₹8 per share as dividend.
The rate of capitalization, appropriate to the risk-class to which the company
belongs, is 12%.

(i) Based on M-M Approach, calculate the market price of the share of the
company when the recommended dividend is (a) declared; and (b) not declared.

(ii) How many new shares are to be issued by the company at the end of the
accounting year on the assumptions that the net income for the year is ₹2 crores
and the investment budget is ₹4 crores when (a) the above dividends are
distributed; and (b) dividends are not declared,

(iii) Show that the market value of the shares at the beginning and at the end of
accounting year will remain the same whether dividends are distributed or not
declared.

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Q7. AJ Ltd. has earnings of ₹4 per share this year, DPS last year was ₹1.5; Suppose
the target payout ratio and the adjustment factor for the firm are 0.6 and 0.5
respectively, what would be the dividend per share for the current year under the
Linter's model?

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