DIVIDEND POLICY

Unit III
Introduction
• Dividend refers to that part of profits of a company which is distributed by the
company among its shareholders.

• Investors (SH) are interested to earn maximum returns to maximize there

wealth.

• A company needs to provide funds to finance its long term growth.

• If company pays out a large potion as dividend then it has to depend on outside
resources for more funds.

• Dividend policy thus affects both long-term financing and wealth of

shareholders.
Dividend policy and valuation of firm

• Value of the firm can be maximized if shareholders wealth is

maximized.

• There are two conflicting views regarding the impact of dividend

decision on valuation of firm.

(i) The irrelevance concept of dividend or the theory of irrelevance

(ii) The relevance concept of dividend or the theory of relevance

 (i) The irrelevance concept of dividend or
the theory of irrelevance
A. Residual Approach:

• According to this, dividend decisions have no effect on the

wealth of shareholders (Earnings)

the prices of shares (Earnings ) and

Value of the firm (Earnings)

• Company may make decisions on whether to retain earning or distribute profits.

• In case if the firm has profitable investment opportunities giving rise to higher rate of return than the cost of earnings,
an investor would content with the firm retaining the earnings to finance the same.

• However if the firm is not finding a profitable investment opportunity then the investor will want to receive dividends.
B. Modigliani and Miller Approach (MM Model)
• Dividend policy has no effect on the market price of the shares and
the value of the firm

• The value of the firm is determined by the earnings capacity of the

firm or its investment policy.
 Assumptions of MM Hypothesis
• There are perfect capital markets (large no of buyers and sellers, rational behavior, equal access of info and no
tax)

• Investors behave rationally(not ready to take up more risk)

• Information about the company is available to all without cost (free flow of information to all buyers and
sellers).

• There are no floatation cost (cost incurred at the time of selling shares to the SH, Printing of prospectus,
printing of share application, Allot the shares, Share Certificate) or transaction costs (No brokerage)

• No investors is large enough to affect the market price of the shares (All investors are equal).

• No Taxes

• The firm has a rigid investment policy

The Argument of MM
The argument given by MM in support of their hypothesis is that
whatever increase in the value of the firm results from the payment of
dividend, will be exactly offset by the decline in the market price of the
shares because of external financing and there will be no change in
total wealth of the share holders

Co A pays Rs.10 as dividend the total value of share= 100+10= 110

Declined because co, borrows money from external sources

• Argument of MM Approach:
Eg:
• If the company has investment opportunities, distributes all the
earnings to the SH. In such case, the company should raise additional
funds from external sources.
• This will increase in number of shares or payment of interest which
results in the fall of EPS (Earnings per Share).
• So, Whatever the SH earns in the form of dividend that is off set by
the fall in Share Prices.
•Thus,
  The MP in the beginning of period is equal to MP at the end of the period
plus dividend paid.
 

P0= MP at the beginning of the period

D1= Dividend at the end of the period
P1= MP at the end of the period
Ke= Cost of Equity
 
Therefore the MP at the end of the period can be acquired by cross multiplication
of the above formula.
 
P1= P0 (1+Ke)- D1
The MM hypothesis can be explained in another form also presuming
that investment required by the firm on account of payment of
dividend is financed out of new issue of equity shares. In such case no
of shares to be issued can be computed with the help of following
equation.
Criticism of MM Approach
• Perfect capital markets do not exist in reality

• Information about the company is not available to all the persons

• Firms have to incur floatation cost while issuing securities

• Taxes do exist and there is normally different tax treatment for dividends and capital gains.

• Firms do not follow a rigid investment policy

• Investors have to pay brokerage fees etc. while doing any transaction.

• Shareholders may prefer current income as compared to further gains

 (II) The relevance concept or dividend or
the theory of relevance
• The other school of thought on dividend decision holds that the dividend decisions
considerably affect the value of the firm.

• The advocates of this school – Myron Gordon, Jone Linter, James Walter and
Richardson.

• Those who pay higher dividend will have greater value as compared to those which do
not pay dividends or have a lower dividend pay out ratio.

• Two theories representing this notion:

(a) Walter’s Approach, and (b) Gordon’s Approach

(a) Walter’s Approach
• This model is based on the relationship between the firms (i) return on investment i.e. r, and (ii) the cost of capital

or the required rate of return, i.e. k.

• If r>k i.e. if the firm earns a higher rate of return on its investments than the required rate of return the firm

should retain the earnings. They are known as growth firms, optimum pay out ratio (DP) is zero. This would

maximize the wealth of the shares

• If r<k i.e. declining firms which do not have profitable investments, shareholders would stand to gain if the firm

distributes its profits. The optimum pay out ratio would be 100% if the firm distributes the entire earnings as

dividends

• If r=k i.e. incase of normal firms the dividend policy will not affect the market value of shares as the

shareholders will get the same return from the firm as expected by them. For such firms there will be no

optimum dividend payout and the value of the firm will not change with the change in dividend.
Assumptions of Walter’s model

• The investments of the firm are financed through retained earnings

only and the firm does not use external source of funds.

• The IRR (r) and the cost of capital (k) of the firm are constant.

• Earnings and dividend do not change while determining the value.

• Firm has a very long life.

Walters
formula for
determining
the share
value
Criticism of Walter’s Model

• The basic assumption that investments are financed through retained

earnings only seldom true in real world. Firms do raise funds by external
financing.

• The IRR also does not remain constant. With increased investment the IRR
also changes.

• The assumption that cost of capital remains constant does not hold good.
(b) Gordons Approach - Assumptions
• The firm is an all equity firm (only equity shares)

• No external financing is available or used (no borrowings)

• The rate of return on firm's investment ( r), is constant

• The retention ratio( b) once decided upon is constant. Thus the growth of the firm g=br is also constant.

• Cost of capital (K)for the firm also remains constant and it is greater than the growth rate.

• r, k, b and g (constant)

• The firm has perpetual life

• Corporate taxes do not exist.

 Implications of Gordon’s basic model
Rate of return/ return on investments = r.

required rate of return / cost of equity/ capitalization rate= k.

When r>k (Growth Firms)the price per share increases as the dividend pay out ratio decreases.
Growth firm should distribute smaller dividends and should retain maximum earnings.(LESS
DIVIDEND)

When r=k (Normal Firms)price per share remains unchanged and is not affected by dividend
policy. Thus for normal firm there is no optimum dividend payout. (ANY %)

When r<k (Decline firms) dividend pay out ratio increases. Shareholders of declining firm
should stand to gain if the firm distributes its earnings. Optimum payout ratio would be 100%
(100%)
Gordon’s Revised Model
• Basic valuation model is not true in practice.

• So revised the basic model to consider risk and uncertainty.

• Suggested that even 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.

Two assumptions

(a) Investors are risk averse

(b) They put premium on certain return and discount/penalise on certain returns.

• Investors are rational prefer near dividend than future dividend to avoid risk.

• Bird in the hand argument

Determinates of dividend policy
• Legal restrictions (Govt restrictions)
• Magnitude and trend of earnings
• Desire and type of share holders
• Nature of industry
• Age of the company
• Future financial requirements
• Government economic policy (not pay
more than 33% of dividend to SH)
• Taxation policy
• Inflation
• Control objectives
• Requirement of financial investors
• Stability of dividends
• Liquid resources
Types of dividend policy
(i) Regular dividend policy(Business org pays regular dividends to the SH, Retired ppl)

(ii) Stable dividend policy (Fixed amount) (no variability)

• Constant dividend per share(Eg: Par value of share is Rs.100, co decides Rs.10)

• Constant pay out ratios (10%)

• Stable rupee dividend plus extra dividend(Rs10 as confirm dividend + another Rs.5 extra)

(iii) Irregular dividend policy

(iv)No dividend policy (capital appreciation)

Forms of dividend

• Cash dividend

• Scrip or bond dividend

• Property dividend

• Stock dividend (Bonus shares)