Dividend Policy

PRESENTED BY: MANMEET SINGH KAWALPREET KAUR AMANPREET KAUR EKTA VERMA

WHAT IS DIVIDEND?
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.

DIVIDEND POLICY
The dividend policy of a firm determines what proportion of earnings is paid to shareholders by way of dividends and what proportion is ploughed back in the firm for reinvestment purposes. The most controversial issue arises is what is the relationship between dividend policy and market price of equity shares.

Models
In which investment and dividend decision are related or theory of relevance. In which investment and dividend decisions are not related or theory of irrelevance.

Theory of relevance
It holds that the dividend decisions considerably affect the value of the firm. The 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

Theory of relevance
Walter model Gordon model

Walters approach
James Walter has proposed the model. It is based on the relationship between the firms Return on investment i.e., r Cost of capital, i.e., k 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 their payout ratio is zero.

Assumptions
The firm is an all- equity financed entity. Further it will rely only on retained earnings to finance its future investments. This means that the investment decision is dependent on the dividend decision. The rate of return on investment is constant. The firm has an infinite life

Implications
R>k ,the price per share increases as the dividend payout ratio decreases. The optimum payout ratio for a growth firm is nil. R = k, the price per share does not vary with changes in dividend payout ratio. The optimum payout ratio for a normal firm is irrelevant. R < k, the price per share increases as the dividend payout ratio decreases. The optimum payout ratio for a firm is 100% .

Gordon model
Myron Gordon proposed a model of stock valuation using the dividend capitalization approach.

Assumptions
Retained earnings represent the only source of financing for the firm. The rate of return on firm investment is constant. The growth rate of the firm is the product of its retention ratio and its rate of return.

 The firm has a perpetual life. Tax does not exist. The cost of capital for the firm remains constant and it is greater than the growth rate.

Implications
R>k ,the price per share increases as the dividend payout ratio decreases. The optimum payout ratio for a growth firm is nil. R = k, the price per share does not vary with changes in dividend payout ratio. The optimum payout ratio for a normal firm is irrelevant. R < k, the price per share increases as the dividend payout ratio decreases. The optimum payout ratio for a firm is 100% .

TRADITIONAL THEORY
It is given by Graham and Dodd. Acc to this approach in the valuation of shares the weight attached to its dividend is equal to four times the weight attached to retained earnings. The major contention of the traditional position is that a liberal payout policy has a favorable impact on stock price

Empirical evidence
The traditional position can be expressed in the form of regression equation a) Price= a+ b Dividends+ c retained earnings The dividend coefficient b is much higher than the retained earnings coefficient c.

Criticism
The equation a) is misspecified because it omits risk which is an important determinant of price. The omission of risk imparts an upward bias to b, the coefficient of dividend and downward bias to c, the coefficient of retained earnings.

Theory of Irrelevance
Dividend decision has no effect on the wealth of the shareholders or the prices of shares. Dividend decisions are merely part of financing decisions. It has two approaches :1. Residual approach 2. Modigliani and miller approach(MM model)

Residual approach
This theory assumes that investors do not differentiate between dividends and retentions by the firm. Their basic desire is to earn higher return on their investment. In case the firm has profitable investment opportunities giving a higher rate of return than the cost of retained earnings, the investors would be content with the firm retaining the earnings to finance the same.

 However, if the firm is not in a position to find profitable investment opportunities, the investors would prefer to receive the earnings in the form of dividends. Thus, a firm should retain the earnings if it has profitable investment opportunities, otherwise it should pay them as dividends.

MILLER AND MODIGLIANI MODEL

Dividend policy has no effect on the market price of the shares and the value of the firm is determined by the earning capacity of the firm or its investment policy. The splitting of earnings between retentions and dividends, may be in any manner the firm likes, does not effect the value of the firm.

 MM have stated that the value of firm depends solely on its earning power and it is not influenced by the manner in which its earnings are split into dividend and retained earnings. It does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is.

Assumptions
Investment opportunities and future profits of the firm are known with certainty. There are no taxes. Floatation costs are nil. Investment and financing decisions are independent. Information is freely available to everyone equally.

Criticism
Regarding issue cost or floatation cost. Regarding tax position. Informational content. Uncertainty and fluctuations.

IMPLICATIONS
MM dividend irrelevance theorem. Exist on their leverage irrelevance theorem. There is no conflict between dividend capitalization approach.

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