DIVIDEND

DECISIONS
 INTRODUCTION

• 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 investment made
by them in the shares of a company. The investors are interested in earning the maximum
return on their investment and to maximise their wealth .A company on the other hand,
needs finance for its long term growth.
• Dividend policy of a firm thus affects long term financing and the
wealth of a shareholders. The company should therefore distribute a reasonable amount
as dividend to its members and retain the rest for its growth and survival.
 DIVIDEND DECISION AND VALUATION
OF FIRMS
• THE IRRELEVANCE CONCEPT OF • THE RELEVANCE CONCEPT OF
DIVIDEND OR THEORY OF DIVIDEND OF DIVIDEND OR
IRRELEVANCE THEORY OF RELEVANCE
• 1. RESIDUAL APPROACH • 1. WALTER’S APPROACH
• 2. MODIGLIANI MILLER • 2, GORDON’S APPROACH
APPROACH
 RESIDUAL APPROACH

According to this theory, dividend decisions has no effect on the wealth of its shareholders
or the price of the shares.This theory regards dividend decision is irrelevant and no effect on
the valuation of the firm.Thus the decision to pay dividend or retain the earnings may be
taken as residual.
If the firm is not in a position to find profitable investment opportunities, the
investor would prefer to receive the earnings in the form of dividend. Thus the firm should
retain the earnings if it has profitable investment opportunities otherwise it pay them as
dividend.
 MODIGLIANI AND MILLER APPROACH
(MM APPROACH)
MM Approach suggest that dividend policy has no effect on the price of its share. Value of
the firm is determined by earning capacity of the firm. The assumptions of MM Approach is
discussed as below;-
1. There are perfect capital market.
2. Investors behave rationally.
3. Information about the company is available to all without any cost,
4. There is no floatation cost or transportation cost.
 ARGUMENT OF MM APPROACH

The argument given by MM in support of their hypothesis is that whatever increase in

the value of the firm result from the payment of dividend, will be exactly off set by the
decline in the market price of the shares, because of external financing. For example;-
If a company having investment opportunities distributes all its earnings among its
shareholders , it will have to raise additional funds from external sources. This will result in
the value of shares or payment of interest charges, resulting in fall in the earning per share
in the future.
 MM APPROACH

When Dividends are Paid ;- • When Dividends are not Paid ;-

Po= Market price of share in beg. Pi=Po(1+Ke)-Di
Ke= Cost of equity/rate of 100+(1+.10)-0
capitalization
=110
Pi= Market price of share at end of year
Pi=Po(1+ke)-Di
=100(1+.10)-6= 104
 MM APPROACH
Hence whether dividends are paid or not , the value of the firm remains the same.
 RELEVANCE CONCEPT
1. (WALTER’S APPROACH)
Prof. Walter’s approach supports that dividend decisions are relevant and affect the
value of the firm,The relationship between internal rate of return earned by the firm and
cost of capital is very significant in determining the dividend policy.
Prof. Walter’s model is based on the relationship between the firm’s
Return on Investment i.e r
Cost of capital i.e k.
 WALTER’S APPROACH

1. If r>k i.e if the firm is earning a higher rate of return on its investment than the
required rate of return, the firm should retain its earnings. Such firms are known as growth
firm . Pay- out ratio will be zero in this case.
2. If r<k, in case the firm has no profitable investment opportunities in such a case
optimum pay out ratio will be 100 %. And the firm should distribute all its earnings as
dividends.
3. If r=k, in case of normal firms, dividend decision will not affect the market value of
shares, value of the firm would not change with change in dividend rate.
 GORDON’S APPROACH

Gordon suggest that dividend are relevant and the dividend decisions affect its value.
The Gordon model is based on the following assumptions :-
1. The firm is an all equity firm.
2. The rate of return on investment is constant.
3. The cost of capital for the firm is also constant,
4. Corporate taxes do not exist.
5. The firm has perpetual life.
 IMPLICATIONS OF GORDON’S APPROACH

1. WHEN r>k, the firm should distribute smaller dividends, and should retain maximum
earnings.
2. WHEN r=k, it does not affect dividend policy.
3. WHEN r<k , the firm should distribute higher earnings and pay out ratio will be 100%.
FORMULA FOR VALUATION OF SHARES
P=E(1-b)/Ke-br
P=Price of the share, E=Earning per share,b= Retention ratio, Ke=cost of capital, br= geowth
rate
 FORMS OF DIVIDEND

• 1. REGULAR DIVIDEND ;- Normal rate of return, it creats confidence among investor, retired persons basically
invest, stabilizes market value of shares.
• 2, STABLE DIVIDEND :- it means stable dividend, lack of variations it means payment of minimum amount of
dividend at regular intervals.
• 3. IRREGULAR DIVIDEND ;- due to lack of resources, adverse effect on the financial position of the company.
• 4. NO DIVIDEND POLICY ;- due to unfavourable working capital position or on account of requirements of not
proper funds.

• ;-
 ISSUES IN DIVIDEND DECISIONS

1. LEGAL RESTRICTIONS :- According to Company Act, every company has to transfer

atleast 10% to general reserve, dividend can not paid out of capital.
2. MAGNITUDE AND TRENDS OF EARNINGS :- The past trend of the company’s
earnings should be kept in mind while deciding dividend decisions.
3. NATURE OF INDUSTRY:- The industry which have high demand of the product can
follow a higher dividend pay out ratio, cyclical industries should follow a lower pay out
ratio.
4. AGE OF THE COMPANY:- A new company has to limit payment of dividend , older
company can easily provide higher dividend pay out ratio.
• 5. DESIRE AND TYPE OF SHAREHOLDER :- investors such as retired persons or
weaker section of the society wants regular dividend on the other hand rich investor is
interested in low dividend but high capital gains.
• 6. FUTURE FINANCIAL REQUIREMENT ;- if a company has profitable investment in
future then dividend pay out ratio zero, if company not having any investment planning
then dividend pay out ratio will be high.