D iv id e n d P o licy

1
 Learning Points
• Dividend
• Classification
• Distribution Procedure
• Some Dividend Policies
• Formulating A Dividend Policy :
Factors
• Dividend Theories
•
 D IV ID E N D S ?

Retained

Profits

Paid out
 Classification

3 Bases


S o u rce s M e d iu m
R e g u la rity
Dividends to be paid out of Profits


– For the year

– Of any previous years
– Out of both
– Out of money provided by the Govt.
Dividend Distribution
Procedure
BO D
R e so lu tio n

H o ld e r o f re co rd d a te
R a te o f a m o u n t to b e p a id
D a te o f P a y m e n t
M e d iu m o f P a y m e n t
Some Dividend Policies

 1. Constant Percentage of
Earnings
 Some Dividend
Policies…

2 . C o n sta n t D iv id e n d
R a te
Some Dividend
Policies…

3. Steadily Changing
Dividends
KEY CONSIDERATIONS IN FORMULATING THE
DIVIDEND POLICY

Ownership Factors
•Current Income Requirement
•Alternative use of Funds
•Tax Consideration

Firm Oriented Factors

•Legal
•Liquidity
•Expansion Scheme
•Business Cycle
•Inflation
Dividend Theories
 Walter Model
 Dividend Policy must be evaluated in
the light of objective of the firm – to
maximize share price
 Assumptions
1.All financed through retained earnings.
2.The firm's internal rate of return, r, and
the cost of capital, k, are constant so
that business risk is not changed
with additional investment proposals.
3.All earnings are either reinvested
internally or distributed as dividends.
4.There is no change in the key factors,
namely, the earnings per share, E,
and the dividends per share, D.
5.The firm has a very long or perpetual
life.
•
 WALTER MODEL
D + (E – D) r/k
P =
k
where : P = price per equity share
E = earnings per share
D = dividend per share
r = rate of return on investments
k = cost of equity capital
 IMPLICATIONS OF THE WALTER MODEL

optimal payout ratio for a growth firm ( r > k ) is nil

e optimal payout ratio for a normal firm ( r = k ) is

rrelevant

e optimal payout ratio for a declining firm ( r < k )

00 percent
 Criticism
• it is assumed that all investments are financed by the
firm through retained earnings. Thus, the model
ignores the benefits of an optimum capital structure
•
• it is assumed in Walter's model that the internal rate
of return, r, will remain constant. This stands against
real world situations as r generally declines when
more and more investment proposals are taken up
by the firm. The internal productivity of the retained
earnings, r, is also not precisely quantifiable.
•
• the assumption that cost of capital also remains
constant may not hold good in practice. If the risk
complexion of the firm changes, the cost of capital
also changes.
•
 GORDON MODEL
 As in the case of Walter, Gordon too
contends that dividends are relevant
and that dividend policy affects the
value of the firm. Gordon's model is
based on the following assumptions:
•
earnings are used for financing acceptable investment opportu
f capital, or the capitalization rate, k, are constant.
 GORDON MODEL
E (1 – b)
P0 =
k – br
where P 0 = price per share
E = earnings per share
( 1 – b ) = dividend payout ratio
b = ploughback ratio
return ( Cost kof = shareholders
Capital ) ’ required rate of
r =by rate
investments made of return earned on
the firm
 IMPLICATIONS
• The optimal payout ratio for a growth firm ( r >
k ) is nil

• The payout ratio for a normal firm is

irrelevant

• The optimal payout ratio for a declining firm

( r < k ) is
100 percent
 MILLER AND MODIGLIANI ( MM ) POSITION
MM have argued that the value of a firm
depends solely on its earning power and is not
influenced by the manner in which earnings are
split between dividends and retained earnings

Current
Dividends Income

Earnings

Retained Capital
Earnings Apprec’n
 Cond…

 The crux of Modigliani and Miller's

argument is that the effect of
dividends on the wealth of the
shareholders is exactly offset by
the effect of other means of
financing.
 MM ASSUMPTIONS
•
•
•The firm operates in perfect capital markets.
•All investors are rational.
•Taxes do not exist or there is no tax advantage or
disadvantage
associated with dividends.
•The investment policy of the firm is fixed. Investment
and dividend
decisions are independent.
•All investors are perfectly certain about the future
investment
programmes and future profits of all firms
• Firms can issue stock without incurring any floatation
or
transaction costs.
 CRITICISMS OF MM POSITION

Modigliani and Miller assumed a perfect capital

market. But this assumption does not usually hold good
in many countries. This is more so in developing
countries like India.

Transaction costs such as commission, brokerage,

stamp duty, etc. can be quite substantial for small
transactions.

The assumption with regard to taxation is also

unrealistic. In fact, taxes do exist and there is tax
differential between dividends and retained earnings or
between dividends and capital gains. Thus, the presence
of a tax differential which has a favourable bias on
capital gains vis-a-vis dividends vitiates the validity
of the M-M hypothesis.
 Residual Theory of
Dividend
 Dividend, investment and financing
decisions are interdependent and, in
the long run, a trade­off must be made,
because a firm cannot afford to:
1.forego profitable investments;
2.operate with a non-optimal capital
structure; and
3.finance dividends by issuing new
shares.
4.The only policy that avoids one of the
choices is to treat dividends as a
residual.
 Contd..
• The residual theory of dividend assumes that if the
firm has retained earnings 'left over‘ after
financing all acceptable investment opportunities,
these earnings would then be distributed to
shareholders in the form of cash dividends.
•
• If no fund is left, no dividend will be paid.
•
• In such a case, the dividend policy is strictly a
financing decision. When the dividend policy is
treated as a financing decision, the payment of
cash dividends is a passive residual. The
treatment of dividend policy as a passive residual
determined strictly by the availability of
acceptable investment proposals implies that
dividends are irrelevant; the shareholders are
 Question – using Walter
Model
 A company has 100,000 equity
shares of Rs. 10 each. The company
expects its earnings at Rs. 750,000
and cost of capital at 10% for the
next financial year. Using Walter's
model, what dividend policy will you
recommend when the rate of return
on investment of the company is
estimated at 8% and 12%,
respectively? What will be the price
of equity share if your
 Question - using Gordon's
Model
 A company's total investment in
assets is Rs. 100,000. It has 100,000
shares of Rs. 100 each. Its expected
rate of return on investment is 30%
and the cost of capital is 18%. The
company has a policy of retaining
25% of its profits. Determine the
value of the firm using Gordon's
Model.
•
Ends..