Dividend Decision Dividend Meaning: Dividend is that part of the profits of a company which is distributed amongst its shareholders.

Definition: According to ICAI, "Dividend is a distribution to shareholders out of profits or reserves available for this purpose." Nature of Dividend Decision The dividend decision of the firm is crucial for the finance manager because it determines: 1. the amount of profit to be distributed among the shareholders, and 2. the amount of profit to be retained in the firm. There is a reciprocal relationship between cash dividends and retained earnings. While taking the dividend decision the management take into account the effect of the decision on the maximization of shareholders' wealth. Maximizing the market value of shares is the objective. Dividend pay out or retention is guided by this objective. Dividend Policy Factors Affecting Dividend Policy: 1. External Factors 2. Internal Factors External Factors Affecting Dividend Policy 1. General State of Economy: In case of uncertain economic and business conditions, the management may like to retain whole or large part of earnings to build up reserves to absorb future shocks. In the period of depression the management may also retain a large part of its earnings to preserve the firm's liquidity position. In periods of prosperity the management may not be liberal in dividend payments because of availability of larger profitable investment opportunities. In periods of inflation, the management may retain large portion of earnings to finance replacement of obsolete machines. 2. State of Capital Market: Favourable Market: liberal dividend policy. Unfavourable market: Conservative dividend policy. 3. Legal Restrictions: Companies Act has laid down various restrictions regarding the declaration of dividend: Dividends can only be paid out of: ** Current or past profits of the company. Money provided by the State/ Central Government in pursuance of the guarantee given by the Government. Payment of dividend out of capital is illegal. A company cannot declare dividends unless: ** It has provided for present as well as all arrears of depreciation. Certain percentage of net profits has been transferred to the reserve of the company. Past accumulated profits can be used for declaration of dividends only as per the rules framed by the Central Government 4. Contractual Restrictions: Lenders sometimes may put restrictions on the dividend payments to protect their interests (especially when the firm is experiencing liquidity problems)

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Example: A loan agreement that the firm shall not declare any dividend so long as the liquidity ratio is less than 1:1. The firm will not pay dividend more than 20% so long as it does not clear the loan.

Internal Factors affecting dividend decisions 1. Desire of the Shareholders: Though the directors decide the rate of dividend, it is always at the interest of the shareholders. Shareholders expect two types of returns: [i] Capital Gains: i.e., an increase in the market value of shares. [ii] Dividends: regular return on their investment. Cautious investors look for dividends because, [i] It reduces uncertainty (capital gains are uncertain). [ii] Indication of financial strength of the company. [iii] Need for income: Some invest in shares so as to get regular income to meet their living expenses. 2. Financial Needs of the Company: If the company has profitable projects and it is costly to raise funds, it may decide to retain the earnings. 3. Nature of earnings: A company which has stable earnings can afford to have an higher divided payout ratio 4. Desire to retain the control of management: Additional public issue of share will dilute the control of management. 5. Liquidity position: Payment of dividend results in cash outflow. A company may have adequate earning but it may not have sufficient funds to pay dividends

Stability of Dividends The term stability of dividends means consistency in the payment of dividends. It refers to regular payment of a certain minimum amount as dividend year after year. Even if the company's earnings fluctuate from year to year, its dividend should not. This is because the shareholders generally value stable dividends more than fluctuating ones. Stable dividend can be in the form of: 1. Constant dividend per share 2. Constant percentage 3. Stable rupee dividend plus extra dividend

Significance of Stability of Dividend 1. Desire for current income 2. Sign of financial stability of the company 3. Requirement of institutional investors 4. Investors confidence in the company

Danger of Stable Dividend Policy Stable dividend policy may sometimes prove dangerous. Once a stable dividend policy is adopted by a company, any adverse change in it may result in serious damage regarding the financial standing of the company in the mind of the investors.

Forms of Dividend 1. Cash Dividend: The normal practice is to pay dividends in cash. The payment of dividends in cash results in cash outflow from the firm. Therefore the firm should have adequate cash resources at its disposal before declaring cash dividend. 2. Stock Dividend: The company issues additional shares to the existing shareholders in proportion to their holdings of equity share capital of the company. Stock dividend is popularly termed as 'issue of bonus shares.' This is next to cash dividend in respect of its popularity. 3. Bond Dividend: In case the company does not have sufficient funds to pay dividends in cash it may issue bonds for the amount due to shareholders. The main purpose of bond dividend is postponement of payment of immediate dividend in cash. The bond holders get regular interest on their bonds besides payment of the bond money on the due date. [Bond dividend is not popular in India] 4. Property Dividend: This is a case when the company pays dividend in the form of assets other than cash. This may be in the form of certain assets which are not required by the company or in the form of company's products. [This type of dividend is not popular in India]

Bonus Shares When the additional shares are allotted to the existing shareholders without receiving any additional payment from them, is known as issue of bonus shares. Bonus shares are allotted by capitalizing the reserves and surplus. Issue of bonus shares results in the conversion of the company's profits into share capital. Therefore it is termed as capitalization of company's profits. Since such shares are issued to the equity shareholders in proportion to their holdings of equity share capital of the company, a shareholder continues to retain his/ her proportionate ownership of the company. Issue of bonus shares does not affect the total capital structure of the company. It is simply a capitalization of that portion of shareholders' equity which is represented by reserves and surpluses. It also does not affect the total earnings of the shareholders

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1. Stability of Earnings. The nature of business has an important bearing on the dividend policy. Industrial units having stability of earnings may formulate a more consistent dividend policy than those having an uneven flow of incomes because they can predict easily their savings and earnings. Usually, enterprises dealing in necessities suffer less from oscillating earnings than those dealing in luxuries or fancy goods. 2. Age of corporation. Age of the corporation counts much in deciding the dividend policy. A newly established company may require much of its earnings for expansion and plant improvement and may adopt a rigid dividend policy while, on the other hand, an older company can formulate a clear cut and more consistent policy regarding dividend. 3. Liquidity of Funds. Availability of cash and sound financial position is also an important factor in dividend decisions. A dividend represents a cash outflow, the greater the funds and the liquidity of the firm the better the ability to pay dividend. The liquidity of a firm depends very much on the investment and financial decisions of the firm which in turn determines the rate of expansion and the manner of financing. If cash position is weak, stock dividend will be distributed and if cash position is good, company can distribute the cash dividend. 4. Extent of share Distribution. Nature of ownership also affects the dividend decisions. A closely held company is likely to get the assent of the shareholders for the suspension of dividend or for following a conservative dividend policy. On the other hand, a company having a good number of shareholders widely distributed and forming low or medium income group, would face a great difficulty in securing such assent because they will emphasise to distribute higher dividend. 5. Needs for Additional Capital. Companies retain a part of their profits for strengthening their financial position. The income may be conserved for meeting the increased requirements of working capital or of future expansion. Small companies usually find difficulties in raising finance for their needs of increased working capital for expansion programmes. They having no other alternative, use their ploughed back profits. Thus, such Companies distribute dividend at low rates and retain a big part of profits. 6. Trade Cycles. Business cycles also exercise influence upon dividend Policy. Dividend policy is adjusted according to the business oscillations. During the boom, prudent management creates food reserves for contingencies which follow the inflationary period. Higher rates of dividend can be used as a tool for marketing the securities in an otherwise depressed market. The financial solvency can be proved and maintained by the companies in dull years if the adequate reserves have been built up. 7. Government Policies. The earnings capacity of the enterprise is widely affected by the change in fiscal, industrial, labour, control and other government policies. Sometimes government restricts the distribution of dividend beyond a certain percentage in a particular industry or in all spheres of business activity as was done in emergency. The dividend policy has to be modified or formulated accordingly in those enterprises. 8. Taxation Policy. High taxation reduces the earnings of he companies and consequently the rate of dividend is lowered down. Sometimes government levies dividend-tax of distribution of dividend beyond a certain limit. It also affects the capital formation. N India, dividends beyond 10 % of paid-up capital are subject to dividend tax at 7.5 %. 9. Legal Requirements. In deciding on the dividend, the directors take the legal requirements too into consideration. In order to protect the interests of creditors an outsiders, the companies Act 1956 prescribes certain guidelines in respect of the distribution and payment of dividend. Moreover, a company is required to provide for depreciation on its fixed and tangible assets before declaring dividend on shares. It proposes that Dividend should not be distributed out of capita, in any case.

Likewise, contractual obligation should also be fulfilled, for example, payment of dividend on preference shares in priority over ordinary dividend. 10. Past dividend Rates. While formulating the Dividend Policy, the directors must keep in mind the dividend paid in past years. The current rate should be around the average past rat. If it has been abnormally increased the shares will be subjected to speculation. In a new concern, the company should consider the dividend policy of the rival organisation. 11. Ability to Borrow. Well established and large firms have better access to the capital market than the new Companies and may borrow funds from the external sources if there arises any need. Such Companies may have a better dividend pay-out ratio. Whereas smaller firms have to depend on their internal sources and therefore they will have to built up good reserves by reducing the dividend pay out ratio for meeting any obligation requiring heavy funds. 12. Policy of Control. Policy of control is another determining factor is so far as dividends are concerned. If the directors want to have control on company, they would not like to add new shareholders and therefore, declare a dividend at low rate. Because by adding new shareholders they fear dilution of control and diversion of policies and programmes of the existing management. So they prefer to meet the needs through retained earing. If the directors do not bother about the control of affairs they will follow a liberal dividend policy. Thus control is an influencing factor in framing the dividend policy. 13. Repayments of Loan. A company having loan indebtedness are vowed to a high rate of retention earnings, unless one other arrangements are made for the redemption of debt on maturity. It will naturally lower down the rate of dividend. Sometimes, the lenders (mostly institutional lenders) put restrictions on the dividend distribution still such time their loan is outstanding. Formal loan contracts generally provide a certain standard of liquidity and solvency to be maintained. Management is bound to hour such restrictions and to limit the rate of dividend payout. 14. Time for Payment of Dividend. When should the dividend be paid is another consideration. Payment of dividend means outflow of cash. It is, therefore, desirable to distribute dividend at a time when is least needed by the company because there are peak times as well as lean periods of expenditure. Wise management should plan the payment of dividend in such a manner that there is no cash outflow at a time when the undertaking is already in need of urgent finances. 15. Regularity and stability in Dividend Payment. Dividends should be paid regularly because each investor is interested in the regular payment of dividend. The management should, inspite of regular payment of dividend, consider that the rate of dividend should be all the most constant. For this purpose sometimes companies maintain dividend equalization Fund.

Walter's model supports the principle that dividends are relevant. The investment policy of a firm cannot be separated from its dividend policy and both are inter-related. The choice of an appropriate dividend policy affects the value of an enterprise. Assumptions of this model: 1. Retained earnings are the only source of finance. This means that the company does not rely upon external funds like debt or new equity capital. 2. The firm's business risk does not change with additional investments undertaken. It implies that r(internal rate of return) and k(cost of capital) are constant. 3. There is no change in the key variables, namely, beginning earnings per share(E), and dividends per share(D). The values of D and E may be changed in the model to determine results, but any given value of E and D are assumed to remain constant in determining a given value. 4. The firm has an indefinite life. Formula: Walter's model P= D Ke g

Where:P = Price of equity shares

D = Initial dividend Ke = Cost of equity capital g = Growth rate expected After accounting for retained earnings, the model would be: P= D Ke rb

Where:r = Expected rate of return on firms investments b = Retention rate (E - D)/E Equation showing the value of a share (as present value of all dividends plus the present value of all capital gains) Walter's model: P= D+ r/ke (E D) ke Where:D = Dividend per share and E = Earnings per share

Example: A company has the following facts: Cost of capital (ke) = 0.10 Earnings per share (E) = $10 Rate of return on investments ( r) = 8% Dividend payout ratio: Case A: 50% Case B: 25% Show the effect of the dividend policy on the market price of the shares. Solution: Case A: D/P ratio = When EPS = $10 and D/P ratio is 50%, D = 10 x 50% = $5 5 + [0.08 / 0.10] [10 - 5] 0.10 Case B: D/P ratio = 25% When EPS = $10 and D/P ratio is 25%, D = 10 x 25% = $2.5 2.5 + [0.08 / 0.10] [10 - 2.5] 0.10

50%

P=

=> $90

P=

=> $85

Conclusions of Walter's model: 1. When r > ke, the value of shares is inversely related to the D/P ratio. As the D/P ratio increases, the market value of shares decline. Its value is the highest when D/P ratio is 0. So, if the firm retains its earnings entirely, it will maximize the market value of the shares. The optimum payout ratio is zero. 2. When r < ke, the D/P ratio and the value of shares are positively correlated. As the D/P ratio increases, the market price of the shares also increases. The optimum payout ratio is 100%. 3. When r = ke, the market value of shares is constant irrespective of the D/P ratio. In this case, there is no optimum D/P ratio. Limitations of this model: 1. Walter's model assumes that the firm's investments are purely financed by retained earnings. So this model would be applicable only to all-equity firms. 2. The assumption of r as constant is not realistic. 3. The assumption of a constant ke ignores the effect of risk on the value of the firm.

Gordon's theory contends that dividends are relevant. This model is of the view that dividend policy of a firm affects its value. Assumptions of this model: 1. The firm is an all equity firm. No external financing is used and investment programmes are financed exclusively by retained earnings. 2. Return on investment( r ) and Cost of equity(Ke) are constant. 3. The firm has perpetual life. 4. The retention ratio, once decided upon, is constant. Thus, the growth rate, (g = br) is also constant. 5. Ke > br 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.

Dividend Capitalization model: According to Gordon, the market value of a share is equal to the present value of the future streams of dividends. P= E(1 - b) Ke - br

Where: P = Price of a share E = Earnings per share b = Retention ratio 1= Dividend payout ratio b

Ke = Cost of capital or the capitalization rate br - Growth rate (rate or return on = g investment of an all-equity firm) Example: Determination of value of shares, given the following data: Case A 40 Case B 30 70 18% 12% $20

D/P Ratio Retention 60 Ratio Cost of capital 17% r 12% EPS $20

$20 (1 0.60) $81.63 P= => 0.17 (0.60 (Case A) x 0.12) $20 (1 0.70) $62.50 P= => 0.18 (0.70 (Case B) x 0.12) Gordon's model thus asserts that the dividend decision has a bearing on the market price of the shares and that the market price of the share is favorably affected with more dividends.

Miller and Modigliani Model (MM Model) Miller and Modigliani Model assume that the dividends are irrelevant. Dividend irrelevance implies that the value of a firm is unaffected by the distribution of dividends and is determined solely by the earning power and risk of its assets. Under conditions of perfect capital markets, rational investors, absence of tax discrimination between dividend income and capital appreciation, given the firms investment policy, its dividend policy may have no influence on the market price of the shares, according to this model. Assumptions of MM model 1. Existence of perfect capital markets and all investors in it are rational. Information is available to all free of cost, there are no transactions costs, securities are infinitely divisible, no investor is large enough to influence the market price of securities and there are no floatation costs. 2. There are no taxes. Alternatively, there are no differences in tax rates applicable to capital gains and dividends. 3. A firm has a given investment policy which does not change. It implies that the financing of new investments out of retained earnings will not change the business risk

complexion of the firm and thus there would be no change in the required rate of return. 4. Investors know for certain the future investments and profits of the firm (but this assumption has been dropped by MM later). Argument of this Model 1. By the argument of arbitrage, MM Model asserts the irrelevance of dividends. Arbitrage implies the distribution of earnings to shareholders and raising an equal amount externally. The effect of dividend payment would be offset by the effect of raising additional funds. 2. MM model argues that when dividends are paid to the shareholders, the market price of the shares will decrease and thus whatever is gained by the investors as a result of increased dividends will be neutralized completely by the reduction in the market value of the shares. 3. The cost of capital is independent of leverage and the real cost of debt is the same as the real cost of equity, according to this model. 4. That investors are indifferent between dividend and retained earnings implies that the dividend decision is irrelevant. With dividends being irrelevant, a firms cost of capital would be independent of its dividend-payout ratio. 5. Arbitrage process will ensure that under conditions of uncertainty also the dividend policy would be irrelevant.

MM Model: Market price of the share in the beginning of the period = Present value of dividends paid at the end of the period + Market price of share at the end of the period. P0 = 1/(1 + ke) x (D1 + P1) Where:P0 = Prevailing market price of a share ke = cost of equity capital Dividend to be D1= received at the end of period 1 and Market price of a share P1 = at the end of period 1. (n + n) P1 I + E (1 + ke)

Value of the firm, nP0

Where:n =

number of shares outstanding at the beginning of the period change in the number of shares outstanding = n during the period/ additional shares issued. I = Total amount required for investment E = Earnings of the firm during the period.

Example: A company whose capitalization rate is 10% has outstanding shares of 25,000 selling at $100 each. The firm is expecting to pay a dividend of $5 per share at the end of the current financial year. The company's expected net earnings are $250,000 and the new proposed investment requires $500,000. Prove that using MM model, the payment of dividend does not affect the value of the firm. Solution: 1. Value of the firm when dividends are paid: i. Price per share at the end of year 1:

ii.

P0 = 1/(1 + k e) x (D1 + P1) $100 = 1/(1 + 0.10) x ($5 + P1) P1 = $105 Amount required to be raised from the issue of new shares: n P1 = I (E => $500,000 ($250,000 => $375,000 Number of additional shares to nD1) $125,000) be issued:

iii.

iv.

n = $375,000 / 105 => 3571.42857 shares (unrounded) Value of the firm:

=> (25,000 + 3571.42857) (105) - $500,000 + $250,000 (1 + 0.10) => $2,500,000 2. Value of the firm when dividends are not paid: i. Price per share at the end of year 1:

ii.

P0 = 1/(1 + k e) x (D1 + P1) $100 = 1/(1 + 0.10) x ($0 + P1) P1 = $110 Amount required to be raised from the issue of new shares: => $500,000 ($250,000 -0) = $250,000 Number of additional shares to be

iii.

issued:

iv.

=> $250,000/$110 = 2272.7273 shares (unrounded) Value of the firm: => (25,000 + 2272.7273) (110) - $500,000 + $250,000 (1 + 0.10) => $2,500,000

Thus, according to MM model, the value of the firm remains the same whether dividends are paid or not. This

example proves that the shareholders are indifferent between the retention of profits and the payment of dividend. Limitations of MM model: 1. The assumption of perfect capital market is unrealistic. Practically, there are taxes, floatation costs and transaction costs. 2. Investors cannot be indifferent between dividend and retained earnings under conditions of uncertainty. This can be proved at least with the aspects of i) near Vs distant dividends, ii) informational content of dividends, iii) preference for current income and iv) sale of stock at uncertain price.

Gordons Model : A n o t h e r t h e o r y w h i c h c o n t e n d s t h a t dividends are relevant is Gordonsmodel. This model, which opines thatdividend policy of a firm affects itsvalue, is based on the followingassumptions :

1. The firm is an all-equity firm. No externalfinancing is used and investmentprogrammes are financed exclusivelyby retained earnings. 2.

r and k e are constant. 3. The firm has perpetual life. 4. The retention ratio, once decided upon,is constant. Thus, the growth rate, (g= br) is also constant. 5. k e >br.

According to Gordon model,mathematical formula for calculation of expectedmarket price

per share MP = E (1 b) ke br MP = Market price per share b = retention ratio E = Earnings per share k = cost of capital r = rate of return

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