Theories of Dividend

I Irrelevance Concept of Dividend/

Theory of Irrelevance
A Residual Approach
• According to this theory dividend decisions, has
no effect on the wealth of shareholders or the
price of share and hence it is irreverent so far as
the valuation of the firm is concerned.
• This theory regards dividend decision merely as a
part of financing decision because the earnings
available may be retained in the business for
re-investment.
• But, if the funds are not required in the business
they may be distributed as dividends.
 B. Modigliani and Miller Approach
(MM Model)
• Under conditions of perfect capital markets,
rational investors, absence of tax
discrimination between dividend income and
capital appreciation, given the firms
investment policy, its dividend policy may have
no influence on the market price of the
shares.
 Assumptions
• There are perfect capital markets
• Investors behave rationally
• Information about the company is available to all
without any cost
• There are no flotation and transactions costs
• No investor is large enough to effect the market price
of shares
• There are either no taxes or there are no differences in
the tax rates applicable to dividends and capital gains
• The firm has a rigid investment policy
• There is no risk or uncertainity
Market price of share
• P 0 = D1 + P 1
1 + Ke
Where,
• Po = Prevailing market price of a share at the
beginning
• Ke = Cost of equity capital or rate of capitalisation
• D1 = Dividend to be received at the end of period
• P1 = Market price of the share at the end of period
one
The value of P1
• P1 = Po (1+Ke) – D1
 Another form – payment of dividend is
financed out of new issue of equity shares
• m = I (E –nD1)
• P1
Value of the firm

• nPo = (n+m)P1 - ( I – E)
• 1 + Ke
• M = Number of new share to be issued.
• P1 = Price at which new issue is to be made
• I = Amount of investment required
• E = Total Earnings
• Ke = Cost of equity capital
• n = no of shares outstanding at the beginning
• D1= Dividend to be paid at the end of the period
• nPo Value of the firm
 Relevance Concept
• Dividend decision are relevant and affect the
firm.
• Dividend communicate information to the
investors about the firms profitability and
hence dividend decision becomes relevant.
• Those firms which pay higher dividends, will
have greater value as compared to those
which do not pay dividends or have lower
dividend pay out ratio.
 WALTER’S APPROACH
• The relationship between the internal rate of
return earned by the firm and its cost of
capital is significant in determining the
dividend policy
• Ultimate goal of maximising the wealth of the
shareholders
• Return on investment - r
• Cost of capital or required rate of return - k
• If r>k
• = firm earns higher rate of return on its
investment than the required ate of return
• Firm should retain the earnings
• Growth firms
• Optimum pay out would be zero
• Maximise the value of shares
• r <k
• = firm earns lower rate of return on its
investment than the required rate of return
• Declining firm – do not have profitable
opportunities
• Distributes entire earnings as dividend
• Optimum pay out would be 100%
• r=K
• Firm gets same return as expected
• Normal firms
• Dividend policy will not affect the value of the
firms
• No optimum dividend pay out ratio.
 Assumptions
• The investment of the firm are financed
through retained earnings only.
• The firm does not use external sourcing
• r and k of the firm are constant
• Earnings and dividends do not change while
determining the value
• The firm has very long life.
 To ascertain market price of a share
• P=D
Ke - g
• p= price of equity share
• D=Initial dividend per share
• Ke = Cost of equity capital
• g= Expected growth rate of earnings
• P = D + r (E-D)/ke
Ke ke
 Gordon’s Approach
• Dividends are relevant and the dividend
decision of the firm affects its value
 Assumptions
• The firm is an all equity firm.
• No external financing is used and investment
programmes are financed exclusively by retained
earnings.
• r and ke are constant.
• ke >br
• The firm has perpetual life.
• The retention ratio, once decided upon, is constant.
Thus, the growth rate, (g=br) is also constant.
• Corporate taxes do not exist
According to gordon, the market value of a share
is equal to the present vaue of future stream
of dividends
Thus,
p = D1 + D2 + ………..
(1+k) (1+k)2
Symbolically: -
p= E (1-b)
ke –br

or
p 0 = D1
ke – g
D1 = D0 (1+g)

where P = Market price of equity share E = Earnings per share of firm.

b = Retention Ratio r = Rate of Return on Investment of the firm.
Ke = Cost of equity share capital. br = g =. growth rate of firm in r.
 Gordon’s Revised Model
• Basic Assumption: K is constant is not true in
practice
• Revised his model to consider risk and
uncertainty
• When r=k, dividend policy affects the value of
shares on account of uncertainty of future,
shareholders discount future dividends at a
higher rate than they discount near dividends.
• Assumption:
– Investors are risk averse
– They put a premium on a certain return and
discount uncertain returns
Dividend can be distributed from profits as below:
• -Out of the profits of the Company of that financial
year; or
• Out of the profits of the Company earned in previous
year or years; or
• Out of both of the above;
• Out of money provided by the state government or
central government for payment of dividend in
pursuance of a guarantee given by that government.
• Depreciation must be provided first from the Profit of
the Company, which is to be calculated as per
Schedule II.
Eligibility of distribution of Dividend:
• If the Articles of Association of the Company does not
bear any contrary provisions to pay dividend then the
company can distribute dividend in proportion of the
Paid up Share Capital of the Company.
• However, question may arise as what will happen if all
the share of the Company are not equally paid up. In
that case dividend will declared in pro rata basis i.e. in
proportion of the paid up capital.
Dividend Payable in Cash Only:
• As per Section 123(5) of the Companies Act, 2013
Dividend shall always be payable in cash. Payable in
cash include paid by cheque or warrant or any
electronic mode.
PROCEDURE OF PAYMENT OF FINAL DIVIDEND
Procedure of Declaration of Final Dividend:
1) Board Meeting: A meeting of the Board of Directors will be
convened.
2) Agenda of the meeting shall mention, amongst others, the
following:
• a) Approval of Annual Accounts;
• b) Recommendation of Payment of Dividend to the shareholders
at the proposed rate at the forthcoming Annual General Meeting;
• c) To decide the Book Closure period/Record Date to determine
the eligible holders of shares for the purposes of declaration of
Dividend;
• d)Approving the date, time place of AGM and draft Notice of AGM,
including authorizing Company Secretary or where is no Company
Secretary is appointed or available then the Chairman of the Board
or any other authorized person as the Board feel competent, to
issue Notice on behalf of the Board of Directors.
• 3)Director’s Report: As per Section 134(3)(k) the Director’s Report should
mention the amount proposed to be declared as Dividend. However if no
dividend are proposed for declaration then a statement to that effect shall
be mentioned.
• 4) AGM: Conduct the AGM at the schedule time and place. Required
quorum must be present at the meeting. Shareholders has the right to
reschedule the amount of Divided as proposed by the Board of Directors.
However, the Shareholders has no right to increase the rate of Dividend as
originally proposed by the Directors. They can only reduce the same.
Shareholders shall pass Ordinary Resolution approving the Dividend.
• 5) Opening of Special Account: Immediately on approving of Dividend by
the Shareholders a Special Account with Schedule Bank will be opened for
depositing the total amount of Dividend.
• 6) Credit of Total Amount Payable to Dividend Account: Within 5 days of
declaration of Dividend, total amount of Dividend payable shall be
credited with the special bank account opened for distribution of Dividend
to eligible shareholders;
• 7) Distribution of Dividend: Prepare a list of eligible shareholders and
statement of dividend thereon. Dividend must be distributed with in 30
days of declaration. Necessary arrangement with Bank should be made for
payment of Dividend.
 Additional Compliances for Listed Companies while
distribution of Dividend(Final /Interim) under SEBI (ICDR)
2015:
AGM:
• Intimation to Stock Exchange of annual general
meeting or extraordinary general meeting or
postal ballot that is proposed to be held shall be
given
Record Date:
• The listed entity shall give notice in advance of
record date specifying the purpose of the record
date of at least seven working days (excluding the
date of intimation and the record date) to stock
exchange(s)
 Bonus Share (Stock Dividend)
• Dividend must be paid in cash under section
205(3).But if the Articles of Association of the
company permit then a company can issue
fully paid-up bonus shares (also known as
stock dividend) to its existing shareholders by
utilising realised accumulated profits which is
free from any liability, after approval of the
controller of capital issues under section 3 of
the Capital Issues(control) Act, 1947.
• There should be provision in the Articles of
Association of the company for capitalisation
of reserves, etc. if not,the company should
produce a resolution passed at the general
body meeting making provisions in the
Articles of Association for capitalisation.
• Consequent to the issue of bonus shares if the
subscribed and paid-up capital exceeds the
authorised capital, a resolution passed at the
general body meeting in respect of increase in
the authorised capital is necessary.
• The company should furnish a resolution
passed at the general body meeting for bonus
issue before an application is made to the
Controller of Capital Issues.
• The bonus issue is permitted to be made out
of free reserves built out of the genuine
profits or share premium collected in cash
only.
• Reserves created by revaluation of fixed
assets are not permitted to be capitalised.
• Development rebate reserve/investment
allowance reserve is considered as free
reserve
• All applications for bonus issue should be
signed by a person not below the rank of with
a certificate. Directors/Secretary together
• A certificate from auditors of the company
relating to bonus issue should also be
furnished.