DIVIDENDS

 Dividends refer to part of a company’s profit that are distributed

among its shareholders.
 These payments are usually made in cash (cash dividends) or stock
(stock dividends).Shareholders view dividends as part of their share
of company’s profit. It’s a reward of their investment in the company
as they expect maximum return on their investment.
 A company on the other hand, needs to provide funds to fund its long
term growth. If a company pays out most dividends out of what it
earns then the business will have to depend upon outside resources
such issue of debt or new shares to meet its requirement and
further expansion
 Dividends policy of a firm thus can affect both long term financing
and wealth of shareholders.
 Dividend policy therefore is the parameters used by board of
directors as the basis for its decision to issue dividends to investors
and a well define policy addresses ,the timing and the size of
dividends issuance what can be a major part of company’s outgoing
cash flows.
 This policy determines the division of earnings between payment to
shareholders and reinvestment in the firm .
 The dividends policy tries to explain why dividends are paid and this
is explain by various theory which determine the relevance of
payment being made. The theories include Walter’s model, passive
residual policy and Gordon’s model.
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GORDON GROWTH MODEL

The Gordon Growth Model – also known as the Gordon Dividend Model or
dividend discount model – is a stock valuation method that calculates a
stock’s intrinsic value, regardless of current market conditions. Investors can
then compare companies against other industries using this simplified
model. Major contributors to the model are Myron J. Gordon, Robert F.
Weise, and John Burr Williams.

Assumptions of the Gordon Growth Model

The Gordon Growth Model assumes the following conditions:

1.NO DEBT
The model assumes that the company is an all equity company with no
proportion of debt in capital structure.
2. NO EXTERNAL FINANCING.
The model assumes that all investment of the company is financed by
retained earnings and no external financing is required.
3.CONSTANT IRR.
The company assumes a constant internal rate of return, ignoring the
diminishing marginal efficiency of the investment.
4. CONSTANT COST OF CAPITAL.
The model is based on the assumption of a cost of capital (k),implying the
business risk of all the investment to be the same.
5. COPORATE TAXES.
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Corporate taxes are not accounted for in this model.

Gordon Growth Model formula

Three variables are included in the Gordon Growth Model formula: (1) D1
or the expected annual dividend per share for the following year, (2) k or
the required rate of return, and (3) g or the expected dividend growth rate.
With these variables, the value of the stock can be computed as:

Intrinsic Value = D1 / (k – g)

ILLUSTRATION
Company A’s stock is trading at $40 per share. Furthermore, Company A
requires a rate of return of 10%. Currently, Company A pays $2 dividend per
share for the following year and this is expected to increase by 4% annually.
Thus, the value of stock is computed as:

Intrinsic Value = 2 / (0.1 – 0.04)

Intrinsic Value = $33.33

This result indicates that Company A’s stock is overvalued since the model
suggests that the stock is only worth $33.33 per share.
ADVANTAGES OF GORDON GROWTH MODEL

 Gordon growth model is highly useful for stable Companies; the

Companies which have good cash flow and limited business
expenses.
 The valuation model is simple and easy to understand with its inputs
available or can be assumed from the financial statements and
annual reports of the Company.
 The model does not account for market conditions, hence can be
used to evaluate or compare Companies of different sizes and from
different industries.
 The model is widely used in real estate industry by real estate
investors, agents where the cash flows from rents and their growth is
known.
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DISADVANTAGES OF GORDONS GROWTH MODEL

 The assumption of constant dividend growth is the main limitation of

the model. It will be difficult for the Companies to maintain constant
growth throughout their life due to different market conditions,
changes in business cycles, financial difficulties etc.
 If the required rate of return is less than the growth rate, the model
may result in negative value thus the model is ineffective in such
cases.
 The model does not account for market conditions or other non-
dividend paying factors like size of the Company, the brand value of
the Company, market perception, local and geopolitical factors. All
these factors affect the actual stock value and hence, the model does
not provide a holistic picture of the intrinsic stock value.
 The model cannot be used for Companies which have irregular cash
flows, dividend patterns or financial leverage.
 The model cannot be used for Companies in the growing stage which
do not have any dividend history or it has to be used with more
assumptions.
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PASSIVE RESIDUAL POLICY

The passive residual policy suggests that a firm should retain its earnings as
long as it has investment opportunities that promise higher rates of return
than the required rate.
For example, assume that a firm’s shareholders could invest their dividends
in stocks of similar risk with an expected rate of return (dividends plus
capital gains) of 18 percent. This 18 percent figure, then, would constitute
the required rate of return on the firm’s retained earnings. As long as the
firm can invest these earnings to earn this required rate or more, it should
not pay dividends (according to the passive residual policy) because such
payments would require either that the firm forgo some acceptable
investment opportunities or raise necessary equity capital in the more
expensive external capital markets.

Interpreted literally, the residual theory implies that dividend payments will
vary from year to year, depending on available investment opportunities.
There is strong evidence, however, that most firms try to maintain a rather
stable dividend payment record over time. Of course, this does not mean
that firms ignore the principles of the residual theory in making their
dividend decisions because dividends can be smoothed out from year to
year in two ways. First, a firm can choose to retain a larger percentage of
earnings during years when funding needs are large. If the firm continues to
grow, it can manage to do this without reducing the cash amount of the
dividend. Second, a firm can borrow the funds it needs, temporarily raise its
debt -to-equity ratio, and avoid a dividend cut in this way.

Because issue costs are lower for large offerings of long -term debt, long
-term debt capital tends to be raised in large, lumpy sums. If many good
investment opportunities are available to a firm during a particular year,
this type of borrowing is preferable to cutting back on dividends.

The firm will need to retain earnings in future years to bring its debt-to-
equity ratio back in line. A firm that has many good investment
opportunities for a number of years may eventually be forced to cut its
dividend and/or sell new equity shares to meet financing requirements and
maintain an optimal capital structure.
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The residual theory also suggests that “growth” firms will normally have
lower dividend payout ratios than firms in mature, low-growth industries.
Companies with low growth rates tend to have rather high payout ratios.

ASSUMPTIONS
 Dividends should be paid only when the firm has ready access to new
equity market.
 Retained earnings, being the residual earnings of the firm, should
always be paid out to existing stockholders.
 Investment policy and dividends policy should always be made
independently
 Dividends should be paid out only if the firm does not have enough
acceptable investment projects to utilize all earrings internally.

CASE STUDY
Consider the case of Yellow Duck Distribution Group: Yellow Duck
Distribution Group is expected to generate $240,000,000 in net income
over the next year. Yellow Duck Distribution has forcasted a capital budget
of $85,000,000, and it wishes to maintain its current capital structure of
70% debt and 30% equity.30% equity and 70% debt if the company follows
strict passive residual policy and makes distribution in form of dividends,
what is its expected dividends payout ratio for the year this year? 75.97% O
93.85% O 89.38% 67.01% Most firms have earnings that vary considerably
from year to year and do not grow at a reliably constant pace. Furthermore,
their investment may change often .

ADVANTAGES OF PASSIVE RESIDUAL THEORY

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1. Saving on floatation costs

No need to raise debt or equity capital since there is high retention of
earnings which requires no floatation costs.

2. Avoidance of dilution of ownership

New equity issue would dilute ownership and control. This will be avoided if
retention is high.
A high retention policy may enable financing of firms with rapid and high
rate of growth.

3. Tax position of shareholders

High-income shareholders prefer low dividends to reduce their tax burden
on dividends income.
They prefer high retention of earnings which are reinvested, increase share
value and they can gain capital gains which are not taxable in Kenya.

DISADVANTAGES OF PASSIVE RESIDUAL THEORY.

1 .Results in variable dividends.
Many investors wont touch stocks that don’t pay regular same-sized
dividends on a monthly or quarterly basis.

2 .Sends conflicting signal.

Uncertainity because multiple interpretations are being conveyed at one
time .This can occur when all indications are positive for business
growth,yet profits continue to decline.

3.Increases risk.
This tends to reduce the residual earnings.

4.Doesn’t appeal to any specific clientele

It doesn’t involve any group of people who are regular customers or
investors due to substantial changes in company policies.
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WALTER’S MODEL
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According to the Walter’s Model, given by prof. James E. Walter, the

dividends are relevant and have a bearing on the firm’s share prices. Also,
the investment policy cannot be separated from the dividend policy since
both are interlinked.

Walter’s Model shows the clear relationship between the return on

investments or internal rate of return (r) and the cost of capital (K). The
choice of an appropriate dividend policy affects the overall value of the
firm. The efficiency of dividend policy can be shown through a relationship
between returns and the cost.

 If r>K, the firm should retain the earnings because it possesses better
investment opportunities and can gain more than what the
shareholder can by re-investing. The firms with more returns than a
cost are called the “Growth firms” and have a zero payout ratio.
 If r<K, the firm should pay all its earnings to the shareholders in the
form of dividends, because they have better investment
opportunities than a firm. Here the payout ratio is 100%.
 If r=K, the firm’s dividend policy has no effect on the firm’s value.
Here the firm is indifferent towards how much is to be retained and
how much is to be distributed among the shareholders. The payout
ratio can vary from zero to 100%.

ASSUMPTIONS OF WALTERS’ MODEL

 All the financing is done through the retained earnings; no external

financing is used.
 The rate of return (r) and the cost of capital (K) remain constant
irrespective of any changes in the investments.
 All the earnings are either retained or distributed completely among
the shareholders.
 The earnings per share (EPS) and Dividend per share (DPS) remains
constant.
 The firm has a perpetual life.

Walters’s model formula

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Walter evolved a mathematical formula in order to arrive at the

appropriate dividend decision to determine the market price of a share
which is reproduced as under:

Where,
P = Market price per share;
E = Earnings per share;
k = Cost of capital/capitalization rate.
D = Dividend per share;
r = Internal rate of return;

In this proposition it is evident that the optimal D/P ratio is determined by

varying ‘D’ until and unless one receives the maximum market price per
share.

Illustration 1
The following information relates to alpha limited .shows the effects of
divided policy on market price of the share using Walters model .When
equity capitalization rate , rate=11% ,earnings per share E=sh10 and the
rate of return on investment is assured to be 15% ,11% and 8% ,show the
eefect of dividends policy for the three different levels of returns taking the
dividends payout ratios as 25%.
Solution:
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r>k r=ko
r=15% r=11%
D/P=25% earnings.

=2.5+0.15/0.11(10-2.5) 2.5+0.11/0.11(10-2.5)

0.11 0.11

=115.70 =90.90

r<k

r=8%

2.5+0.08/0.11(10-2.5)

0.11

=72.3

Illustration 2

A company earns sh 5 per share and its capitalized at the rate of 10% while
the rate of return an investment is 12% .According to Walters model , which
should be the price per share at 75% dividends payout .Is this the optimum
dividend payout ratio according to Walters model? Justify.

Solution

At Optimum
r>k

3.75+0.12/0.10( 5-3.75) Po=0.12/0.10(5-0)

0.10 0.10
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=52.5 =60.0

CRITICISM OF WALTER’S MODEL

 No external financing.
It mixes dividends policy with investment policy of the firm .the
model assumes that retained earnings finances the investment
opportunities of the firm and no external financing – debt or
equity is used for purpose .

 Constant returns
This model is based on the assumption that returns is constant. In
fact returns decreases as more and more investment is made . this
reflects the assumption that the most profitable investments are
made first and then the poorer investment are made.

 Constant opportunity cost of capital K

A firm’s cost of capital or discount rate ,k , does not remain
constant , it changes directly with the firm’s risk , thus the present
value of the firm’s income moves inversely with the cost of
capital .By assuming that the discount rate k is constant , Walters
model abstract from the effect of risk on the values of the firm.

DIVIDENDS POLICY
Dividends policy of a company is the strategy followed to decide the
amount of dividends and the timing of payments. A firm’s dividend policy is
influenced by large number of factors.

FACTORS AFFECTING DIVIDENDS POLICY

1.Variation in dividends payments.

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Dividends policy varies among different industries in that there is a wide

variation in dividends payout ratios among industries . Likewise within a
given industry, though many industries have similar dividends payout ratio,
there can still be a considerable variation.
For example, as illustrated in the table below in the drug industry, the
dividend payout ratio from a low of 7 percent to a high of 77 percent.

Dividends payout ratio for firm in the drug industries

Company 2009 dividend

payout ratio
Abbot labs 42
Alergan inc. 7
Bioveil crop. 62
Bristol Myers Squibb Co. 77
GlaxoSmithKline 52
Medicis Pharmaceuticals Corp 9
Merck&Co.Inc 43
Novartis AG 47
Novo Nordisk 32
PDL BioPharma, Inc 63
Perrigo Company 11
Pfizer , Inc 64
Pharmaceuticals Product Development , Inc 43
Sanofi-Aventis 52
Teva Pharmaceuticals industries Limited 17

2.Liquidity and cash flow considerations.

Free cash flow represents the portion of a firm’s cash flow available to
service, new debt ,make dividends payments to shareholders and invest in
other projects.
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Since dividends payments represents cash outflow, the more liquid a firm is,
the more able it is to pay dividends unless it has sufficient liquid assets,
primary cash

3.Borrowing capacity and access to capital markets

Large well established firms are usually able to go directly to large credit
markets with either bond issue or sale of commercial paper. The more
access a firm has to this external sources of funds the better since it will be
able to make dividends payments.
A small firm whose stock is closely and infrequently traded often finds it
difficult (or undesirable) to sell now equity shares in the market. As a result
of retain earnings are only source of new equity .when a firm of this type is
with desirable investment opportunities the payment of dividends is often
inconsistent with the objective of
maximizing value of the firm.

4 Protection against dilution.

If a firm adapts a policy of paying out a large percentage of its annual
earnings as dividends , it may need to sell new share of stock from time to
time to raise equity capital needed to invest in potentially profitable
projects.
If the existing investors do not or cannot acquire a proportionate share of
new issue , their percentage ownership interest in the firm is diluted . Some
firm choose to retain more of their earnings and pay out lower dividends
rather than risk dilution.
One of the alternative to high earnings retention involves raising external
capital in the form of debt. This increases the financial risk of a firm
ultimately raising the cost of equity capital and at some point lower share
prices.

5.Inflation.
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In an inflationary environment , funds generated by depreciation often are

not sufficient to replace firms assets as they become obsolete under the
circumstance , a firm may be faced by earning power of its asset base.
Inflation also has impact on the firms working capital needs in that in an
atmosphere of raising prices actual amount increased in inventories and
account receivables lend to increase to support the some physical volumes
of business.

6.Share holders preferences.

In a closely held corporation with relatively few shareholders ,
management may be able to set dividends according to the preferences of
its shareholders.
In a large corporation whose shares are widely held, it’s nearly impossible
for a financial managers to take individual shareholders preferences into
accounts when setting dividends policy .
Some wealthy stakeholders who are in high marginal income tax brackets
may prefer that a company re-invest its earnings to generate long term
capital gains.
Other stockholders, such as retired individuals and those living on fixed
incomes may prefer dividends rate.
Large institutional investors that are in a zero income tax bracket , such as
pension funds , university endowment funds ,philanthropist organization
(e.g ford foundation) and trust funds may prefer high dividends yield.
It has been argued that firms tend to develop their own “clientele” of
investors. This clientele effect originally articulated by Marion Miller and
Frence Madigilian ; indicates that investors will tend to be attracted to
companies that have dividends policies consistent with the investor’s
objectives

CONCLUSION
The study investigated the various theories on why dividends are paid in
dividends policy. It mainly focused on the the walter’s model, gordon’s
model and passive residual theory. Though the study concludes that the
dividends policy both relevant and irrelevant Dividend policy is an
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important factor for shareholders to consider in stock selection process

because dividends are a major cash outflow for companies.

REFERENCES
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1.Andeson,G.J.(1983).The internal financing decisions of the industrial and

commercial sector: a re appraisal of the Lintner model of dividends
disbursements . Economica, 50(199), 235-248

2.Financial Management by IM Pandey 9th edition.

3.Fundarmentals of corporate finance 5th edition by Ross Westerfield and

Jordan 1998

4.https://efinancemanagement.com/dividend-decisions/factors-affecting-
dividend-policy

5.https://corporatefinanceinstitute.com/resources/knowledge/valuation/go
rdon-growth model/

6.https//businessjargons.com/walters-model.html
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