Dividend Policy

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. The investors are interested in earning the maximum return on their investments and to
maximise their wealth. A company, on the other hand, needs to provide funds to finance its long-term
growth. If a company pays out as dividend most of what it earns, then the business requirements and
further expansion it will have to depend upon outside resources such as issue of debt or new shares.
Dividend policy of a firm, thus affects both the long-term financing and the wealth of shareholders. As a
result, the firms decision to pay dividends must be reached in such a manner so as to equitably apportion
the distributed profits and retained earnings. Since dividend is a right of shareholders to participate in the
profits and surplus of the company for their investments in the share capital of the company, they should
receive fair amount of profits. The company should, therefore distribute a reasonable amount as dividends
(which should include a normal rate of interest plus a return for the risks assumed) to its members and
retain the rest for its growth and survival.
DIVIDEND DECISION AND VALUATION OF FIRMS
The value of the firm can be maximised if the shareholders wealth is maximised. There are conflicting
views regarding the impact of dividend decision on the valuation of the firm. According to one school of
thought, dividend decision does not affect the share-holders wealth and hence the valuation of the firm.
ON the other hand, according to the other school of thought, dividend decision materially affects the
shareholders wealth and also the valuation of the firm. We have discussed below the views of the two
schools of thought under two groups.
1. The Relevance Concept of Dividend or the theory of Relevance, and
2. The Irrelevance Concept of Dividend or the Theory Of Irrelevance
1. The Relevance Concept of Dividend or the Theory of Relevance
The school of thought on dividend decision holds that the dividend decisions considerably affect the
value of the firm. The advocates of this school of thought include Myron Gordon, Jone Linter, James
Walter and Richardson. According to them dividends communicate information to the investors about the
firms profitability and hence dividend decision becomes relevant. Those firms which pay higher
dividends will have greater value as compared to those which do not pay dividends or have a lower
dividend pay out ratio. We have (i) Walters Approach
(II) Gordons Approach.
(i) WALTERS APPROACH
According to Prof. Walters dividend decisions are relevant and affect the value of the firm. The
relationship between the internal rate of return earned by the firm and its cost of capital is very significant
in determining the dividend policy and to attain the ultimate goal of maximising the wealth of the
shareholders. Prof. Walters model is based on the relationship between the firms (i) return on
investment, i.e. r, and (ii) the cost of capital or the required rate of return, i.e. k.
According to Prof. Walter, if r>k i.e. if the firm earns a higher rate of return on its investment than the
required rate of return, the firm should retain the earnings. Such firms are termed as growth firms and
the optimum pay-out would be zero in their case. This would maximise the value of shares.
In case of declining firms which do not have profitable investments, i.e. where r<k, the shareholders
would stand to gain if the firm distributes its earnings. For such firms, the optimum pay-out would be
100% and the firms should distribute the entire earnings as dividends.
In case of normal firms where r=k, the dividend policy will not affect the market value of shares as the
shareholders will get the same return from the firm as expected by them. For such firms, there is no
optimum dividend pay out and the value of the firm would not change with the change in dividend rate.
Assumption of Walters Model
1. The investment of the firm are financed through retained earnings only and the firm does not
use external sources of funds.

2. The internal rate of return (r) and the cost of capital (k) of the firm are constant.
3. While determining the value earnings and dividends do not change.
4. The firm has a very long life.
Walters Formula for determining the value of a share
Prof. Walter has given the following formula to ascertain the market price of a share:

P = D + r (E- D) /Ke
__ __________
Ke
Ke
Here,
P= market price per share
D= dividend per share
R= internal rate of return
E= earnings per share
Ke= cost of equity capital
This can be understand by the following illustration
The following information is available in respect of a firm:
Capitalisation rate
= 10%
Earning per share
= Rs.50
Assumed rate of return on investments:
(i)
12%
(ii)
8%
(iii)
10%
Show the effect of dividend policy on market price of share applying Walters formula when dividend pay
out ratio is (a) 0% (b) 20% (c) 40% (d) 80% (e) 100%
Note: for solution see the next slide.
Criticism of Walters Model
Walters model has been criticised on account of various assumptions made by Prof. Walter in formulating
his hypothesis:
1. The basic assumption that investments are financed through retained earnings only is seldom
true in real world. Firms do raise funds by external financing.
2. The internal rate of return, i.e., r, also does not, remain constant. As a matter of fact, with
increased investment the rate of return also changes.
3. The assumption that cost of capital (k) will remain constant also does not hold good. As a
firms risk pattern does not remain constant, it is not proper to assume that k will always
remain constant.
(ii) GORDONS APPROACH
Myron Gordon has also developed a model on the lines of Prof. Walter suggesting that dividends are
relevant and the dividend decision of the firm affects its value. His basic valuation model is based on the
following assumptions:
(i)
The firm is an all equity firm.
(ii)
No external financing is available or used. Retained earnings represent the only source of
financing investment programme.
(iii) The rate of return of the firms investment r is constant.
(iv) The retention ratio, b, once decided upon is constant. Thus, the growth rate of the firm g=
br, is also constant.

(v) The cost of capital for the firm remains constant and is greater than the growth rate, i.e.
(vi) The firm has perpetual life.
(vii) Corporate taxes do not exist.
According to Gordon, the market value of a share is equal to the present value of future stream of
dividends. Thus,
P = E (1 b)
Ke- br
Here,
P = Price of share
E= Earnings per share
b= Retention Ratio
Ke = Cost of equity capital
Br =g=growth rate in r, i.e. rate of return on investment of an all-equity firm
D= Dividend per share
The implications of Gordons basic valuation model may be summarised as below:
1. When the rate of return of firm on its investment is greater than the required rate of
return, i.e; when r > k, the price per share increases as the dividend payout ratio
decreases. Thus, growth firm should distribute smaller dividends and should retain
maximum earnings.
2. When the rate of return is equal to the required rate of return, i.e., when r=k, the price
per share remains unchanged and is not affected by dividend policy. Thus, for a normal
firm there is no optimum dividend payout.
3. When the rate of return is less than the required rate of return, i.e., when r < k, the
price per share increases as the dividend payout ratio increases. Thus, the shareholders
of declining firm stand to gain if the firms distribute its earnings. For such firms, the
optimum pay out would be 100%
This model can be better understood by taking an imaginary example
The following information is available in respect of the rate of return on investment (r), the cost
of capital (k) and earning per share (E) of ABC Ltd.
Rate of return on investment (r) = (i) 15%; (ii) 12%; and (iii) 10%
Cost of capital (k)
= 12%
Earning per share
= Rs.10
Determine the value of its share using Gordons Model assuming the following
D/p ratio (1-b)
(a)
(b)
(c)

Retention ratio (b)

100
80
40

Note: for the solution of this example see the separate slide.

2. The Irrelevance Concept of Dividend or The Theory of Irrelevance:

0
20
60

Modigliani and Miller Approach (MM Model)

The most comprehensive argument in support of the irrelevance of dividends is provided by the
MM hypothesis. Modigliani and Miller maintain that dividend policy has no effect on the share price of
the firm and is, therefore, of no consequence. What matters, according to them, is the investment policy
through which the firm can increase its earnings and thereby the value of the firm. Given the investment
decision of the firm, the dividend decision-spitting the earnings into packages of retentions and dividendsis a matter of detail and do not matter. 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 shares.
Assumptions: The MM hypothesis of irrelevance of dividends is based on the following critical
assumptions:
1. Perfect capital markets in which all investors 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; there are no flotation 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. The operational implication of this
assumption is that financing of new investments out of retained earnings will not change the
business risk complexion of the firm and, therefore, there would be no change in the required rate
of return.
4. There is a perfect certainty by every investor as to future investments and profits of the firm. In
other words, investors are able to forecast future prices and dividends with certainty. This
assumption is dropped by MM later.
Crux of the Argument The crux of the MM position on the irrelevance of dividend is the arbitrage
argument. Arbitrage refers to entering simultaneously into two transactions which exactly balance or
completely offset each other. The two transactions here are the acts of paying out dividends and raising
external funds-either through the sale of new shares or raising additional loans-to finance investment
programmes. Assume that a firm has some investment opportunity. Given its investment decision, the firm
has two alternatives: (i) it can retain its earnings to finance the investment programme; (ii) or distribute
the earnings to the shareholders as dividend and raise an equal amount externally through the sale of new
share/bonds for the purpose. If the firm selects the second alternative, arbitrage process is involved, in that
payment of dividends is associated with raising funds through other means of financing. The effect of
dividend payment on shareholders wealth will be exactly offset by the effect of raising additional share
capital.
When dividends are paid to the shareholders, the market price of the shares will decrease. What 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. The terminal value before and after the payment of dividend would be
identical. The investors, according to Modigliani and Miller, would, therefore, be indifferent between
dividend and retention of earnings. Since the shareholders are indifferent the wealth would not be affected
by current and future dividend decisions of the firm. It would depend entirely upon the expected future
earnings of the firm.
There would be no difference to the validity of the MM premise, if external funds are raised in the form of
debt instead of equity capital. This is because of their indifference between debt and equity with respect to
leverage. The cost of capital is independent of leverage and the real cost of debt is the same as the real
cost of equity.
That investors are indifferent between dividend and retained earnings imply that the dividend decision is
irrelevant. The arbitrage process also implies that the total market value plus current dividends of two
forms which are alike in all respects except D/P ratio will be identical. The individual shareholder can
retain and invest his own earnings as well as the firm would.

With dividends being irrelevant, a firms cost of capital would be independent of its D/P ratio. Finally, the
arbitrage process will ensure that under conditions of uncertainty also the dividend policy would be
irrelevant. When two firms are similar in respect of business risk, prospective future earnings and
investment policies, the market price of their shares must be the same. This, MM argues, is because of the
rational behaviour of investors who are assumed to prefer more wealth to less wealth. Differences in
current and future dividend policies cannot affect the market value of the two firms as the present value of
prospective dividends plus terminal value is the same.
Proof MM provides the proof in support of their argument in the following manner.
Step 1 The market price of a share in the beginning of the period is equal to the present value of dividends
paid at the end of the period plus the market price of share at the end of the period. Symbolically,
1
P0

(D1 +P1)
(1+ke)

Where,
P0 = Prevailing market price of a share,
Ke = Cost of equity capital,
D1 = Dividend to be received at the end of period 1, and
P1 = Market price of a share at the end of period 1
Step 2 Assuming no external financing, the total capitalised value of the firm would be simply the
number of shares (n) times the price of each share (p0). Thus,
1
nP0 =

(nD1 + nP1)
(1 + ke)

Step 3 If the firms internal sources of financing its investment opportunities fall short of the
funds required, and n is the number of new shares issued at the end of year 1 at price of P 1 ,
1
nP0 =

[( nD1 + (n + n) P1 - nP1 )]
(1+ Ke )

Where n= Number of shares outstanding at the beginning of the period, and

n = Change in the number of share outstanding during the period/ Additional shares issued
Step 4 If the firm were to finance all investment proposals, the total amount raised through new
shares issued would be given as follows.
nP1 = I (E nD1 )

nP1 = I E + nD1
Where,
nP1 = Amount obtained from the sale of new shares of finance capital budget,
I
= Total amount /requirement of capital budget,
E = Earnings of the firm during the period,
nD1 = Total dividends paid, and
(E nD1) = Retained earnings
Step 5 If we substitute step 4 divided by step 3
1
nP0

nD1 + ( n + n) P1 - ( I E + nD1 )
( 1 + Ke )

By solving the equation 5, we get,

(n + n) P1 I + E
nP0 =
(1+ ke)
DETERMINATION OF DIVIDEND POLICY
The payment of dividend involves some legal as well as financial considerations. It is difficult to
determine a general dividend policy which can be followed by different firms at different times
because the dividend decision has to be taken considering the special circumstances of an individual
case. The following are the important factors which determine the dividend policy of a firm.
1. Legal Restrictions. Legal provisions relating to dividends as laid down in sections 93,205,205A,
206 and 207 of the companies Act, 1956 are significant because they lay down a framework within
which dividend policy is formulated. These provisions require that dividend can be paid only
out of current profits or past profits after providing for depreciation or out of the money
provided by Government for the payment of dividends in pursuance of a guarantee given by
the Government. The Companies Rules, 1975 require a company providing more than ten per
cent dividend to transfer certain percentage of the current years profits to reserves. Companies
Act, further provides that dividends cannot be paid out of capital, because it will amount to
reduction of capital adversely affecting the security of its creditors.
2. Magnitude and Trend of Earnings. The amount and trend of earnings is an important aspect of
dividend policy. It is rather the starting point of the dividend policy. As dividends can be paid only
out of present or past years profits, earnings of a company fix the upper limits on dividends. The
dividends should, generally be paid out of current years earnings only as the retained earnings of
the previous years become more or less a part of permanent investment in the business to earn
current profits. The past trend of the companys earnings should also be kept in consideration
while making the dividend decision.
3. Desire and Type of Shareholders. The directors should give the importance to the desires of
shareholders in the declaration of dividends as they are the representatives of shareholders. Desires
of shareholders for dividends depend upon their economic status. Investors, such as retired
persons, widows and other economically weaker persons view dividends as a source of funds to
meet their day-to-day living expenses. To benefit such investors, the companies should pay regular
dividends. On the other hand, a wealthy investor in a high income tax bracket may not benefit by
high current dividend incomes. Such an investor may be interested in lower current dividends and

high capital gains. It is difficult to reconcile these conflicting interests of the different type of
shareholders, but a company should adopt its dividend policy after taking into consideration the
interests of its various groups of shareholders.
4. Nature of Industry. The dividend policy also affects nature of industry to which the company is
engaged. Certain industries have a comparatively steady and stable demand irrespective of the
prevailing economic conditions. For instance, people used to drink liquor both in boom as well as
in recession. Such firms expect regular earnings and hence can follow a consistent dividend policy.
On the other hand, if the earnings are uncertain, as in the case of luxury goods, conservative policy
should be followed. Such firms should retain a substantial part of their current earnings during
boom period in order to provide funds to pay adequate dividends in the recession periods. Thus
industries with steady demand of their products can follow a higher dividend payout ratio while
cyclical industries should follow a lower payout ratio.
5. Age of the Company. The age of the company also influences the dividend decision of a
company. A newly established concern has to limit payment of dividend and retain substantial part
of earnings for financing its future growth and development, while older companies which have
established sufficient reserves can afford to pay liberal dividends.
6. Future Financial Requirements. It is not only the desire of the shareholders but also future
financial requirements of the company that have to be taken into consideration while making a
dividend decision. The management of a concern has to reconcile the conflicting interests of
shareholders and those of the companys financial needs. If a company has highly profitable
investment opportunities it can convince the shareholders of the need for limitation of dividend to
increase the future earnings and stabilise its financial position. But when profitable investment
opportunities, do not exist then the company may not be justified in retaining substantial part of its
current earnings. Thus, a concern having few internal investment opportunities should follow high
payout ratio as compared to one having more profitable investment opportunities.
7. Governments Economic Policy. The dividend policy of a firm has to be adjusted to the
economic policy of the Government as was the case when the Temporary Restriction on Payment
of Dividend Ordinance was in force. In 1974 and 1975, companies were allowed to pay dividends
not more than 33 per cent of their profits or 12 per cent on the paid-up value of the shares,
whichever was lower.
8. Taxation Policy. The taxation policy of the Government also affects the dividend decision of a
firm. A high or low rate of business taxation affects the net earnings of company (after tax) and
thereby its dividend policy. Similarly, a firms dividend policy may be dictated by the income-tax
status of its shareholders. If the dividend income of shareholders is heavily taxed being in high
income bracket, the shareholders may forego cash dividend and prefer bonus shares and capital
gains.
9. Inflation. Inflation acts as a constraint in the payment of dividends. Profits as arrived from the
profit and loss account on the basis of historical cost have a tendency to be overstated in times of
rise in prices due to over valuation of stock in-trade and writing off depreciation on fixed assets
at lower rates. As a result when prices rise, funds generated by depreciation would not be adequate
to replace fixed assets, and hence to maintain the same assets and capital intact, substantial part of
the current earnings would be retained. Otherwise, imaginary and inflated book profits in the days
of rising prices would amount to payment of dividends much more than warranted by the real
profits, out of the equity capital resulting in erosion of capital.
10. Control Objectives. When the company pays high dividends out of its earnings, it may result
dilution of both control and earnings for the existing shareholders. As in case of a high dividend
pay-out ratio the retained earnings are insignificant and the company will have to issue new shares
to raise funds from the market for its future requirements. The control of the existing shareholder
will be diluted if they cannot buy the additional shares issued by the company. Similarly, issue of
new shares shall cause increase in the number of equity shares and ultimately cause a lower
earnings per share and their price in the market. Thus, under these circumstances to maintain

control of the existing shareholders, it may be desirable to declare lower dividends and retain
earnings to finance the firms future requirements.
11. Requirements of Institutional Investors. Dividend policy of a company can be affected by the
requirements of institutional investors such as financial institutions, banks insurance corporations,
etc. These investors usually favour a policy of regular payment of cash dividends and stipulate
their own terms with regard to payment of dividend on equity shares.
12. Stability of Dividends. Stability of dividends is another important guiding principle in the
formulation of a dividend policy. Stability of dividend simply refers to the payment of dividend
regularly and shareholders, generally, prefer payment of such regular dividends. Some companies
follow a policy of constant dividend per share while others follow a policy of constant payout ratio
and while there are some other who follows a policy of constant low dividend per share plus an
extra dividend in the years of high profits. A policy of constant dividend per share is most suitable
to concerns whose earnings are expected to remain stable over a number of years or those who
have built-up sufficient reserves to pay dividends in the years of low profit. The policy of constant
payout ratio, i.e., paying a fixed percentage of net earnings every year may be supported by a firm
because it is related to the firms ability to pay dividends. The policy of constant low dividend per
share plus some extra dividend in years of high profits is suitable to the firms having fluctuating
earnings from year to year.
13. Liquid Resources. The dividend policy of a firm is also influenced by the availability of liquid
resources. Although, a firm may have sufficient available profits to declare dividends, yet it may
not be desirable to pay dividends if it does not have sufficient liquid resources. Hence the liquidity
position of a company is an important consideration in paying dividends.
TYPES OF DIVIDEND POLICY
The various types of dividend policies are discussed as follows.
1.Regular Dividend Policy. Payment of dividend at the usual rate is termed as regular dividend. The
investors such retired persons, widows and other economically weaker persons to get regular dividends.
A regular dividend policy offers the following advantages.
a. It established a profitable record of the company.
b. It creates confidence amongst the shareholders.
c. It aids in long-term financing and renders financing easier.
d. It stablises the market value of shares.
e. The ordinary shareholders view dividends as a source of funds to meet their day-to-day living expenses.
f. If profits are not distributed regularly and are retained, the shareholders may have to pay a higher rate of
tax in the year when accumulated profits are distributed.
However, it must be remembered that regular dividends can be maintained only by companies of long
standing and stable earnings. A company should establish the regular dividend at a lower rate as compared
to average earnings of the company.
2. Stable Dividend Policy. The term stability of dividends means consistency or lack of variability
in the stream of dividend payments. In more precise terms, it means payment of certain minimum
amount of dividend regularly. A stable dividend policy may be established in any of the following
three forms.
a. Constant dividend per share. Some companies follow a policy of paying fixed dividend per
share irrespective of the level of earnings year after year. Such firms, usually, create a Reserve for
Dividend Equalisation to enable them to pay the fixed dividend even in the year when the
earnings are not sufficient or when there are losses. A policy of constant dividend per share is most
suitable to concerns whose earnings are expected to remain stable over a number of years.
b. Constant pay out ratio. Constant pay out ratio means payment of a fixed percentage of net
earnings as dividends every year. The amount of dividend in such a policy fluctuates in direct

proportion to the earnings of the company. The policy of constant pay out is preferred by the firms
because it is related to their ability to pay dividends.
c. Stable rupee dividend plus extra dividend. Some companies follow a policy of paying constant
low dividend per share plus an extra dividend in the years of high profits. Such a policy is most
suitable to the firm having fluctuating earnings from year to year.
Advantage of stable dividend policy
A stable dividend policy is advantages to both the investors and the company on account of the
following:
1. It is sign of continued normal operations of the company.
2. It stablises the market value of shares.
3. It creates confidence among the investors.
4. It provides a source of livelihood to those investors who view dividends as a source of funds to
meet day-to-day expenses.
5. It meets the requirements of institutional investors who prefer companies with stable dividends.
6. It improves the credit standing and makes financing easier.
7. It results in a continuous flow to the national income stream and thus helps in the stabilization of
national economy.
Dangers of Stable Dividend Policy
Inspite of many advantages, the stable dividend policy suffers from certain limitations. Once a stable
dividend policy is followed by a company, it is not easier to change it. If the stable dividends are not
paid to the shareholders on any account including insufficient profits, the financial standing of the
company in the minds of the investors is damaged and they may like to dispose off their holdings. It
adversely affects the market price of share of the company. And if the company pays stable dividends
in spite of its incapacity, it will be suicide in the long-run.
3. Irregular Dividend Policy. Some companies follow irregular dividend payments on account of
the following:
a. Uncertainty of earnings.

b.
c.
d.

Unsuccessful business operations.

Lack of liquid resources.
Fear of adverse effects of regular dividends on the financial standing of the company.

4. No Dividend Policy. A company may follow a policy of paying no dividends presently because of
its unfavorable working capital position or on account of requirements of funds for future
expansion and growth.

FORMS OF DIVIDEND
Dividends can be classified in various forms. Dividends paid in the ordinary course of business are known
as Profit dividends, while dividends paid out of capital are known as Liquidation dividends. Dividends
may also be classified on the basis of medium in which they are paid:
a. Cash Dividend. A cash dividend is a usual method of paying dividends. Payments of
dividends in cash results in outflow of funds and reduces the companys net worth, though
the shareholders get an opportunity to invest the cash in any manner they desire. This is
why the ordinary shareholders prefer to receive dividends in cash. But the firm must have
adequate liquid resources at its disposal or provide for such resources so that its liquidity
position is not adversely affected on account of cash dividends.

b. Scrip or Bond Dividend. A scrip dividend promise to pay the shareholders at a future
specified date. In case a company does not have sufficient funds to pay dividends in cash, it
may issue notes or bonds for amounts due to the shareholders. The objective of scrip
dividend is to postpone the immediate Payment of cash. A scrip dividend bears interest and
is accepted as a collateral security.
c. Property Dividend. Property dividends are paid in the form of some assets other than cash.
They are distributed under exceptional circumstances and are not popular in India.
d. Stock Dividend.