DIVIDEND THEORIES

APPROACH

OVERVIEW OF
DIVIDEND

DIFFERENT
DIVIDEND
THEORIES
DIVIDEND
OVERVIEW
 WHAT IS DIVIDEND ?

 Payments made to stockholders from the firm’s earnings,

whether those earnings were generated in the current
period or in previous periods.

 Portion of profit (after tax) distributed among owners/

shareholders of the firm.

 May be distributed in form of cash, scrip, property

dividend or bonus shares.
DIVIDEND DECISION

 One of the three basic decisions of a financial manager,

the other two being investment decision and financing
decision.

 Decision as to whether the firm’s profits should be paid

as dividend or retained and in what amount.

 Objective : Maximize wealth of shareholders,

Increase the goodwill of the firm,
Satisfy the obligations to shareholders.
Factors influencing Dividend
Policy
 Stability of Earnings
 Financial Policy of the Company
 Liquidity of Funds
 Dividend policy of Competitive concerns
 Past Dividend Rates
 Debt Obligations
 Ability to borrow
 Growth needs of the company
 Profit Rate
 Legal Requirements
 Policy of Control
 Corporate Taxation Policy
 Tax position of Shareholders
 Effects of Trade Cycle
 Attitude of Interested Group
Types of Dividend

 Scrip dividend
 Bond dividend

 Property dividend
 Cash dividend
 Stock dividend – Bonus shares
Types of Dividend Policies

 Regular / stable Dividend Policy

 1. constant dividend per share – fixed amount per share
 2. constant percentage of net earnings
 3. small constant dividend per share plus extra dividend
 4. Dividend as a fixed percentage of market value
 Irregular Dividend Policy
 No Dividend Policy
Significance of Stable
Dividend Policy
 Confidence among shareholders
 Investor’s desire for current income
 Institutional Investors
 Stability in market price of shares
 Rising additional finance
 Spreading of ownership of outstanding share
 Reduces the chances of loss of control
 Market for debentures and preference shares
Bonus shares / stock dividend

 It is the dividend which is paid to the shareholders in

kind. When stock dividends are paid, a portion of the
surplus is transferred to the capital account from
reserves and surplus and SH are issued share
certificates.
 Such shares are known as bonus shares and this process
is known as capitalisation of profits.
  Advantages for issuing
company
 Maintenance of liquidity
position
 Satisfaction of shareholders
 Economical issue of
BONUS capitalization
 Remedy for under
SHARES capitalization
 Enhanced prestige
 Widening the share for
market
 Finance for expansion
 Conservation of control
 Advantages to the investors
 1. Increases number of shares held by the shareholders
 2. Increases the marketability of shares
 3. Increases the future income of the shareholders
 4. Increase the demand for shares held by the
shareholders.
 Disadvantages of Bonus shares for company
 1. It will result in more liability on the company in
respect of future dividends.
 2. Fall in the rate of dividend results in the fall of
market price of shares
 Reserves shall decline and leave lesser security to
investors.
 Control over the management of the company is not
diluted and the present management may misuse its
position.
 For Investors:
 Some shareholders prefer cash dividends instead of
bonus shares. Such shareholders may be disappointed.
 Issue of bonus shares lowers the market value of
existing shares too.
DIFFERENT TYPES
OF DIVIDEND
THEORY
TYPES OF THEORIES

DIVIDEND THEORIES

RELEVANCE THEORY IRRELEVANCE THEORY

MODIGILANI
WALTER’S GORDON’S RESIDUAL
AND MILLER
MODEL MODEL MODEL
MODEL
RELEVANCE THEORY

 Dividend policy is very essential for any business firm

as it affects the overall value of the firm.
 Dividend policy is relevant & dividend decision form a
very integral part of the investment and financing
decision of the firm.
 Shareholders prefer current dividends & hence there
is a direct relationships between the dividend policy
& the market value of the firm
WALTER MODEL
 Dividend policy affects the value of the firm.
 Together, the cost of capital (k) and rate of return (r)
determine the dividend policy that will maximize the
shareholders wealth.
COST OF
CAPITAL
(k)

VALUE OF DIVIDEND
THE FIRM POLICY

RATE OF
RETURN
(r)
 WALTER MODEL -- assumption

 The firm finances all investment through retained

earnings while debt and new equity is not used.

 Business risk remains constant i.e., r & k are also

constant.

 The firm has infinite life.

 The firm either goes for a 100 % pay-out or a 100 %

retention.
 WALTER MODEL -- decisions
CONDITION

r>k r<k r =k
EVALUATION

TYPE OF FIRM Growth firm Declining firm Normal firm

PAY-OUT RATIO Zero 100 % Indifferent
INVESTMENT
OPPORTUNITIES Abundant None / very few Optimal

Company Company should Dividend does

DECISION should retain all distribute all not affect
earnings for earnings in the market price
investment form dividends of share
According to this model, dividend decision is relevant which will affect the firm. If the
firm will distribute more dividends then market value of firm will increase. This
approach explains the relationship between internal rate of return and required rate of
return. This approach arises three situations:
 r>K
 r<K
 r=K
If r > K, the firm should retain the earning rather than distributing it to the shareholders
because of the reason that the money is earning more profits in the hands of the firm
than it would if it was paid to the shareholders.
If r < K, the firm should pay off the money to the shareholders in the form of dividends
because of the reason that the shareholders can earn higher return by investing it.
If r = K, it is a matter of indifference whether the earning are retained or distributed
among the shareholders.
Calculate the share price on the basis of Walter’s Model:

P= D + r(E-D)/Ke
Ke Ke
Where P= market price of share
D= dividend per share
Ke= cost of equity
E = Earning per share
r = Internal Rate of Return
Problem

 Given the following information about the ZED Ltd.,

show the effect of the dividend policy on the market
price of its shares using the Walter’s Model.
 A. Equity capitalization rate = 12%
 B. EPS Rs. 8
 C. Assumed return on investment (r) are as follows:
 i. r = 15%
 Ii r = 10%
 III r = 12%
 The company is considering a payout of 25%, 50% and
75%.
 WALTER MODEL -- criticisms

 It ignores the benefit of optimal capital structure. No

external financing.
 Assumption that ‘K’ remains constant does not hold
good in practice.

 It ignores that market price is affected by many factors.

Gordon’s Model:
According to this model, Dividend policy is relevant which will affect the value of the
firm. This approach is also based on a bird in hand is better than two in bush i.e. what
is available at present is preferable to what may be available in the future. The future is
uncertain and more distant the future.

Assumptions:
• No external financing
• All equity firm
• No taxes
• Perpetual life
• Constant internal rate of return
• Constant cost of capital
• Constant retention ratio
• Cost of capital is greater than growth rate
Arguments of this model:
1. Dividend policy of the firm is relevant and that investors put a positive premium
on current incomes/dividends.
2. This model assumes that investors are risk averse and they put a premium on a
certain return and discount uncertain returns.
3. Investors are rational and want to avoid risk.
4. The rational investors can reasonably be expected to prefer current dividend.
They would discount future dividends. The retained earnings are evaluated by
the investors as a risky promise. In case the earnings are retained, the market
price of the shares would be adversely affected. In case the earnings are retained,
the market price of the shares would be adversely affected.
5. Investors would be inclined to pay a higher price for shares on which current
dividends are paid and they would discount the value of shares of a firm which
postpones dividends.
6. The omission of dividends or payment of low dividends would lower the value
of the shares.
The Gordon’s model can be symbolically expressed as:
P= E( 1-b )
Ke – br
E= earning per share
b= retention ratio
1-b= % of earning distributed as dividend
br= g = growth rate
Ke = cost of capital
GORDON’S MODEL

 Also known as the ‘bird in hand argument.

 Dividend policy is relevant as the investors prefer

current dividends as against the future uncertain
capital gains.

 Investors discount the firm’s earnings at lower rate

when they are certain about returns, placing a higher
value for the share and that of the firm.
GORDON’S MODEL - assumptions
 No external financing is available.

 Corporate tax does not exist.

 The firm has infinite life.

 Investors are basically risk-averse.

 The growth rate of firm ‘g’ is the product of its retention

ratio ‘b’ and its rate of return ‘r’ i.e., g = br.

 The cost of capital is constant and also more than

growth rate, i.e., k > g.
GORDON’S MODEL -- decisions

 If r > k > g :- Company should distribute less dividend

and retain high profit.

 If r < k :- Company should distribute more profits as

dividend.

 If r = k :- Pay-out ratio is not effected by retention ratio.

IRRELEVANCE THEORY

 Dividend policy is irrelevant to maximizing the

shareholders wealth.

 Value of the firm is affected by the earning capacity

of the firm i.e., investment policy and not the dividend
policy.

 Whether the firm retains its earnings or pays dividend,

the market price of the share is indifferent towards it.
MODIGILANI & MILLER
MODEL -- concept
 Crux of MM position is arbitrage argument. Arbitrage is
entering simultaneously in two transactions which
balance each other.

 Between dividend and retention of earnings the investors

would be indifferent due to balancing nature of internal
financing and external financing.

 So, the firm is indifferent towards the dividend decision.

MODIGILANI & MILLER
MODEL

 Modigilani and Miller were two staunch supporters

of the irrelevance concept.

 The value of the firm is not affected by the decision

of pay-out or plough-back.

Firm’s dividend policy have no influence on the market

prices of the shares.
 M-M MODEL -- assumptions

 Perfect capital market.

 Investors behave rationally.

 There are no taxes.

 No floating cost on issue of shares.

 M-M MODEL -- criticisms

 It is wrong to assume that there are no taxes, floating

costs do not exist and there is absence of transaction
costs.

 The perfect capital market condition is not always true.

 RESOURCES
 Financial Management – I.M. PANDEY

 Financial Management – KHAN &JAIN

THE END