2

DIVIDEND & DIVIDEND

POLICY
 A firm earns for its shareholders.
 The income generated after meeting all obligations
by the firm belongs to the shareholders.
 The part of earning that is distributed is called
dividend.
 The optimum dividend policy would be one that
maximizes the value of the firm.
 The question of in what ratio to retain or distribute
the earned income, is referred as dividend decision
or policy.
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RELEVANCE AND
IRRELEVANCE
 There are two schools of thought regarding
dividend policy.
IRRELEVANCE OF DIVIDEND
 Dividend policy affects the value of the firm.
Walter’s Model and Gordon’s Model:
 These models of valuation of the firm link the
dividend policy to the
 investment opportunities available.
 rate of return on investment opportunities as
compared with expectations of the shareholders
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WALTER’S MODEL

 Walter’s model considers the value of the firm as

sum of two components;
1. an infinite stream of dividend, D and
2. an infinite stream of retained earning, E – D reinvested at
constant rate of k, which are generated each year for
infinite length of time.
 Walter’s Model links the value of the firm to
 the earning level,
 dividend level,
 reinvestment rate, and
 the shareholders’ expectations
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ASSUMPTIONS AND
LIMITATIONS
 Funding of new projects is done through the
earnings alone.
 The growth opportunities do not alter the risk
profile of the firm as a whole, and therefore the
market capitalisation rate remains constant.
 The firm is a going concern and the pricing model
assumes perpetual earnings.
 Implied assumption that the reinvestment rate
‘k’ remains constant.
 Walter’s model assumes inter-dependence of the
investment and dividend decisions.
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WALTER’S MODEL

The optimum dividend policy is determined on

the basis of reinvestment rate, r.
 If firm’s reinvestment rate, r exceeds shareholders
expectations k, then optimum dividend policy is
100% retention,
 if k > r then optimum is 100% pay out, and
 when k = r the dividend policy is immaterial.
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WALTER’S MODEL-
OUTCOME
 The optimum dividend policy is determined on the basis
of reinvestment rate, r. If firm’s reinvestment rate, k
exceeds shareholders expectations, r then optimum
dividend policy is 100% retention, if k < r then optimum is
100% pay out and when k = r the dividend policy is
immaterial.
Reinvestment Reinvestment Reinvestment
Rate r > k Rate r < k Rate k = r
If dividend pay If dividend pay Price remains
out increases out increases same
the price the price irrespective of
decreases increases dividend pay
out
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GORDON’S MODEL

 Another model that supports the view that

dividend policy is relevant is Gordon’s
Model.
 Its assumptions and conclusions are similar
to Walter’s model.
D1
P0 
k -g
E1 x (1 - b)
P0 
k - br
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GORDON’S MODEL
THE OUTCOME
 Like Walter’s model the value of the firm under Gordon’s
model is also dependent upon the reinvestment rate and
shareholders’ expectations.
 Walter’s model keeps the dividend amount constant in each
period while Gordon’s model assumes growing dividend in
each period.
Reinvestment Reinvestment Reinvestment
Rate r > k Rate r < k Rate r = k
If dividend pay If dividend pay Price remains
out increases out increases same
the price the price irrespective of
decreases increases dividend pay
out
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BIRD- IN-THE-HAND
THEORY
 Bird-in-the-hand argument suggests that
increased dividend means increased
certainty of the cash flows.
 Since this helps in reducing the discount
rate the value of the firm must increase
with increased dividend.
D1
r g
P0
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IRRELEVANCE OF
DIVIDEND
Miller & Modigliani Theory of Irrelevance
 MM argument of irrelevance of dividend rests
on the assumption that
 earnings and the investment policy determine
the value of the firm, and
 Distribution of earning is irrelevant.
 Increased dividends today are compensated by
reduced dividends tomorrow and vice-versa.
 To keep the investment policy same the firm
would have to issue larger number of new
shares in case they increase the dividend.
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ASSUMPTIONS
IRRELEVANCE OF DIVIDEND
 Given investment policy
 Indifference to dividend and capital gains
 No/uniform taxes
 Absence of flotation costs
 Uniform/homogeneous expectations
 Perfect capital markets
 there were no transaction (brokerage) costs involved
 the shares were infinite small divisible
 buying/selling actions does not influence the price
 investors are equally well informed
 they incur no cost of information, and
 interpret the information in homogeneous way.
13 MM’S THEORY OF IRRELEVANCE

Value of the Firm Old Shareholders New Shareholders

900
800 -
700 200
Value (Rs. 000s)

600
500
400 800
300 600
200
100
-
No Dividend
1 2
With Dividend
14 MM’S THEORY OF IRRELEVANCE

Dividend Irrelevance: Earnings and Investment Determine Value

Shareholders

Adjustable Pipe

Dividend New Shares

Constant Constant
Earnings
Value Investment
of the
Firm
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MM AND BIRD-IN-HAND

MM vs. Gordon MM vs. Gordon

Discount Rate Value of the Firm

Discount Rate Value

Gordon’s Bird-in-Hand

MM’s Irrelevance MM’s Irrelevance

Gordon’s Bird-in-Hand

Dividend Dividend
 INFORMATION CONTENT OF DIVIDEND
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(SIGNALLING THEORY)

 Signaling hypothesis emphasizes that

dividends convey plenty of information
that is tangible besides providing returns.
 Therefore change in dividend policy is
important for revaluation of the firm.
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CLIENTELE EFFECT

 Investors can be grouped according to

their preference of dividend and capital
gains.
 These groups are referred as clienteles.
 Change in dividend policy would cause
the clienteles to shift investment.
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ALTERNATIVE FORMS OF
DIVIDEND
 Besides cash dividend the firms can also reward
its shareholders with non-cash tools of bonus
shares and split shares.
 The rationale for such measures is to bring the
price to more trading friendly zone and increase
investors’ participation.
 Bonus shares and stock splits increase the
number of shares yet keep the same
shareholding pattern.
 They increase proportionately the number of
shares and liquidity but keeps the total wealth of
the shareholders same.
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SHARE BUYBACK

 Share buyback is a substitute for dividend

payment when it is large.
 It provides an option to shareholders to
continue or exit the investment in the
desired ratio.
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ADVANTAGES OF SHARE
BUYBACK
 Indicative of worth of the firm.
 Reduce information asymmetry.
 Control shareholding pattern and threat of take-
over.
 Control the capital structure .
 Provide a choice to shareholders.
 Preserve the information content of the dividend.
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DISADVANTAGES OF
BUYBACK
 It can’t be recurring
 Excessive pricing