DIVIDEND DECISIONS

What is dividend ?
• The term dividend refers to that part of profits
of a company which is distributed by the
company among its shareholders.
• It is the reward of the shareholders for
investments made by them in the shares of
the company.
 Dividend Policy
• It refers to the policy that the management
formulates in regard to earnings for
distribution as dividends among shareholders.
• It determines the division of earnings between
payments to shareholders and retained
earnings.
• Retained earnings (RE) is the amount of net
income left over for the business after it has
paid out dividends to its shareholders.
Retained Earnings vs Dividend Decision

PROFIT/ EARNING

RETAINED
DIVIDEND TO EARNING FOR
SHAREHOLDERS FURTHER
INVESTMENT
 Retained Earnings vs Dividend Decision
• The Dividend Decision is one of the crucial decisions
made by the finance manager relating to the
payouts to the shareholders.
• The companies can pay either dividend to the
shareholders or retain the earnings within the firm.
The amount to be disbursed depends on the
preference of the shareholders and the investment
opportunities prevailing within the firm.
• The optimal dividend decision is when the wealth of
shareholders increases with the increase in the
value of shares of the company.
 Which one do you choose? A company that
declares dividend or a company that retains the
profit???
• The general perception people have is that by not
paying dividends or not increasing the dividend policy the
company is doing no good for the investors. This may or may
not be true.
• From the Point of view of shareholders , dividend is a key
variable from which the shareholders determine the share
value.
• The good side about retaining the money is that the company
may be investing the money in a fruitful project which may
give you better returns a little later. The company may have
intentions of launching a new product/service or building a
new plant or probably is going in for expansion.
• If attractive investment opportunities exist within
the firm, then the shareholders must be convinced
to forego their share of dividend and reinvest in the
firm for better future returns. At the same time, the
management must ensure that the value of the
stock does not get adversely affected due to less or
no dividends paid out to the shareholders.
 Types of Dividend Theories
DIVIDEND
THEORIES

Relevance Theories (i.e. Irrelevance Theories (i.e.

which consider dividend
decision is relevant and
has an effect on market
value of share and value
of firm
which consider dividend
decision is not relevant
and has no effect on
market value of share and
value of firm

Modigliani and
Walter Model Gordon Model Miller Model
 WALTER MODEL
• Prof James E. Walter considers dividend as one of
the important factors determining the market value
of the firm.
• His model shows clearly the importance of the
relationship between the firm’s internal rate of
return (r) and its cost of capital (k) in determining
the dividend policy that will maximize the wealth of
shareholders.
 Assumptions of Walter Model

• Retained earning are only source of financing

investment in firm; that is debt or new equity is not
issued;
• The cost of capital (Ke), and rate of return on
investment (r ), are constant
• All earnings are either distributed as dividend or
reinvested internally immediately.
• Firms life is endless.
 What does Walter say ?
• Situation 1 -
Dividend paid to shareholder

They Reinvest it to get higher returns{cost of capital (Ke)}

• Situation 2
Firm do not pay out dividends

Firm Invests retained earnings in profitable investments to

earn return (r)
 As per Walter ….
 if r>Ke , the company should retain all earnings and
invest in available projects;

 If r<Ke , the company should distribute all the

earnings as the shareholders can earn more than
what the company can with retained amount;

 if r=Ke , the dividend is irrelevant and the dividend

policy would not affect market value of the firm.
 As per Walter ….
r>Ke r <Ke r = Ke
Rate Of Return (r) > Rate Of Return (r) < Rate Of Return (r) =
Cost Of Capital (Ke) Cost Of Capital (Ke) Cost Of Capital (Ke)

Firm Should Retain all Firm Should Distribute Firm Can Distribute
Their Earning all Their Earning as Their Earning Or Can
dividends Retain Their Earning

Payout Should Be Zero Payout 100% No Optimum

(These are known as (These are known as Dividend Payout
growth firms) declining firms) (These are known as
Normal firms)
 Walter’s Formula

• P = D + (r/Ke )(E-D)
Ke Ke
• P = Current Market Price of equity share
• E = Earning per share
• D = Dividend per share
• (E-D) = Retained earning per share
• r = Rate of Return on firm’s investment or Internal
Rate of Return
• Ke = Cost of Equity Capital
 Question
• Following information is available in respect of ABS
ltd:
• Earning per share (EPS) = Rs. 10
• Cost of capital (Ke) = 10%
Find out the market price if r = 8% and
Payout ratios = 0%, 40% and 80%.
(Payout ratio is the percentage of earning (EPS) that
will be distributed as dividends to sharehlders)
 Solution
• P= D + (r/Ke )(E-D)
Ke Ke
I. When r=8% and payout ratio = 0%
• EPS (E) =10
• DPS (D) = 0
• R=8%
• Ke = 10%
• P = 0/0.10 + { (.08/.10)(10-0) } / 0.10
• = (80/10) = 8/.10 = 80
.10
II. When r=8% and payout ratio = 40 %
• EPS (E) =10
• DPS (D) = 40% of EPS = Rs. 4
• R=8%
• Ke = 10%
• P = 4/0.10 + { (.08/.10)(10-4) } / 0.10
• P= 40 + (8 X 6)/10
0.10
P = 40 + (4.8/.10)
P = 40 + 48
P = Rs 88
Find for
. When r=8% and payout ratio = 100%
• EPS (E) =10
• DPS (D) = 100% of 10 = Rs. 10
• R=8%
• Ke = 10%

When r= 8%
Payout Ratio is 0% Rs. 80
Payout Ratio is 40% Rs. 88
Payout Ratio is 100% Rs. 100
 Self Help Question
• The earning per share of the face value of Rs. 100 of
PQR ltd is Rs. 20. It has a rate of return of 25%.
Capitalization rate of risk class is 12.5%. If the
Walter Model is used :
1. What should be the optimum payout ratio?
2. What should be the market price per share if the
payout ratio is 0?
3. Suppose the company has a payout ratio of 25% of
EPS, what would be the price per share?
Hints
• P= D + (r/Ke )(E-D)
Ke Ke
• P= 100
• EPS = 20
• r= 25%
• Ke= 12.5%
• Sol (1. Sine Ke<r, hence 100 % retention ratio and
0% payout ratio, hence D = 0
2. P= Rs. 320
3. P= Rs 280)
 Criticism of Walter Model
• Only Retained Earnings And No External Financing.
• R Is Constant.
• K Is Constant.
All of these assumptions are not possible in the real
world.
 Gordon Model
• Myron Gordon consider dividends are relevant and
the dividend decision of the company affects its
value.
• This model is only for the firms that pay dividend.
• Assumptions of Gordon Model in addition to the
assumptions of Walter Model.
1. The product of retention ratio and rate of return
gives us growth of firm(b*r = g). Growth rate g Is
constant
2. Cost of capital is greater then growth rate
(k > b*r = g)
 Gordon Explains the same as Walter

• Gordon argues that the investors do have a

preference for current dividends and a direct
relationship between the dividend policy and the
market price per share.
• Investors have a bird-in-the-hand preference.
Investors are risk averse

Future capital gain to be more risky

Discount the future capital gain at a higher rate than

the firms earning (ke>g)
• Hence when retention rate i.e. ‘b’ increases,
investors require higher rate i.e. Ke.
• When firm distributes the earnings in the form of
dividends, investors require lower rate i.e. Ke
• It also says that if the payout ratio is 0, then the
shareholders don’t accept it and hence the price at
0% payout or No dividend is 0.
 Formula for Gordon Model
P = E (1 – b)
Ke – br
Where,
P = Price
E = Earning per Share
b = Retention Ratio
Ke = Cost of Capital
br = g = Growth Rate
 Question
• The following information is available in respect of
XYZ Ltd:
• Earning Per share (EPS or E) = Rs. 10
• Cost of Capital, Ke = 10%
• Find out the market price of the share if r = 15% for
different payout ratios of 40%, 80% and 100%
 Solution
• E = Rs 10
• If r=15%
• Payout ratio = 40% , then
b= Retention ratio is (1-0.4 ) = 0.6
• Ke = 10%
P = E (1 – b)
Ke – br
P = 10(1-0.6)/ .10 – (0.6)(.15)
P = 4 / .01
P = Rs 400
• Similarily, find it out for 80% and 100% payout ratio

When r= When r= 8%
15%
Payout Ratio is 0 0
0%
Payout Ratio is Rs. 400 Rs 77
40%
Payout Ratio is Rs. 114.30 Rs. 95
80%
Payout Ratio is Rs. 100 Rs 100
100%
 MODIGLIANI & MILLER MODEL
• He gave the irrelevancy theory of dividend policy.
• Dividends are not relevant to investors
• dividend policy has no effect on the price of the
shares of the firm and believes that it is the
investment policy that increases the firm's share
value.
• This theory is in direct contrast to the ‘Dividend
Relevance’ theory which deems dividends to be
important in the valuation of a company.
 Assumptions to MM Approach
• Capital Markets are perfect, i.e.
 Information is freely available to all
 No transaction/floatation costs
 No investor large enough to affect the market
• Investors behave rationally
• There are no taxes
• The firm has a fixed investment policy
• Infinitely divisible securities
• No floating cost
• No Transaction Cost
• Investor is indifferent between dividend income and capital gain
income
Value of the Firm (i.e. Wealth of
shareholders
Depends
on

Firm’s Earnings
Depends
on

Firm’s investment Policy and not

the dividend policy
• Irrespective of whether a company pays a dividend or
not, the investors are capable enough to make their
own cash flows from the stocks depending on
their need for the cash. 
• If the investor needs more money than the dividend
he received, he can always sell a part of his
investments to make up for the difference. Likewise, if
an investor has no present cash requirement, he can
always reinvest the received dividend in the stock. 
• Under this model, he argues that neither the firm
paying the dividends nor the shareholders receiving
the dividend will be effected by paying too much
dividend or too little dividend.
 M-M’s Argument for Shareholders
• If a company retains earnings instead of giving it out as
dividends, the shareholder enjoy capital
appreciation(increase in the value of shares due to
investment by firm in more profitable investment) equal
to the amount of earnings retained.
• If it distributes earnings by the way of dividends instead of
retaining it, shareholder enjoys dividends equal in value to
the amount by which his capital would have appreciated
had the company chosen to retain its earning.
• Hence, the division of earnings between dividends and
retained earnings is IRRELEVANT from the point of view of
shareholders.
 M-M’s Argument for the company
• MM used the arbitrage process to show the
irrelevance of dividend for a company that has to
pay dividend.
• They said, a firm will finance its investments either
through retaining (ploughing back) the profits.
• Or if it pays dividend to the shareholders then it
will replace this capital by selling new shares.
Hence, the amount of dividend paid will be
replaced by the new shares raised externally.
 MM Formula
• P0 = D1 + P1
1+Ke
Where,
P0 = Market price per share at the beginning of the
year
D1 = Expected dividend at the end of the period
P1 = Market price per share at the end of the year
Ke = Cost of Equity capital
 Question to understand the process of arbitrage

a). A firm has 1,00,000 shares outstanding and is planning to

declare a dividend of Rs. 5 at the end of the current financial
year. The present market price is Rs. 100. The cost of equity,
Ke is 10%. Find the expected price at the end of year 1, if
i) Dividend of Rs. 5 is paid
ii) If Dividend of Rs. 5 is not paid.
b) How many new shares must the company issue at the end
of the year, if the net profit for the year is Rs. 10,00,000
and the company is planning to make an investment of Rs.
20,00,000 at the end of the year, if
iii) Dividend of Rs. 5 is paid
iv) If Dividend of Rs. 5 is not paid
 Solution
a
Dividend of Rs. 5 is paid Dividend of Rs.5 is not paid
D1 = Rs 5 D1 = 0
P0 = Rs 100 P0 = Rs 100
Ke = 10% Ke = 10%
P0 = D1 + P1 P0 = D1 + P1
1+Ke 1+Ke
P0 = (5 + P1)/ (1+0.10) P0 = (0 + P1)/ (1+0.10)
100 = (5 + P1) / 1.10 100 = (0 + P1) / 1.10
100 X 1.10 = 5 + P1 100 X 1.10 = P1
110 -5 = P1 110 = P1
P1 = Rs 105 P1 = Rs 110
The position of shareholders in both the case is same. They will be indifferent
• If dividend is paid, he recieves Rs. 5 as dividend and Market price of share would be
Rs. 105, giving total worth of Rs. 110
•If dividend is not paid, then the market price of the share itself is Rs. 110,
 Solution b
Dividend of Rs. 5 is paid Dividend of Rs.5 is not paid
Total Earnings = 10,00,000 Total Earnings = 10,00,000
Dividend paid = (5,00,000) Dividend paid = 0
(1,00,000 X 5) Retained earnings 10,00,000
Retained earnings 5,00,000
Total investment required is Rs.
Total investment required is Rs. 20,00,000
20,00,000
fresh funds required 10,00,000
fresh funds required 15,00,000 Market price (year end) Rs. 110
Market price (year end) Rs. 105 fresh shares issued 9,090.909
No. of fresh shares issued 14,285.7 (10,00,000/110)
(15,00,000/105) Total No. of shares 1,09,090.909
Total No. of shares 1,14,285.7 (10,00,000+ 9,090.909)
(10,00,000+14285.7 ) Total value = 1,09,090.909 x 110
Total firm value = 1,14,285.7 x 105 = Rs. 1,20,00,000
= Rs. 1,20,00,000
THANK YOU