CHAPTER 4

Dividend Policy
 Dividend
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It refers to that portion of a firms net earnings

which are paid out to the shareholders
Inverse relationship between retained earnings and
dividend:
Larger retained earnings
Lesser dividend
Larger dividend
Lesser retained earnings
What is Dividend Policy?
 Dividend Policy
What is It?

Dividend Policy refers to the explicit or implicit

decision of the Board of Directors regarding the
amount of residual earnings (past or present) that
should be distributed to the shareholders of the
corporation.
This decision is considered a financing decision because the
profits of the corporation are an important source of
financing available to the firm.
Types of Dividends

DIVIDEND POLICY
 Types of Dividends
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Dividends are a permanent distribution of residual

earnings/property of the corporation to its owners.
Dividends can be in the form of:
Cash
Additional Shares of Stock (stock dividend)
Property
If a firm is dissolved, at the end of the process, a final dividend
of any residual amount is made to the shareholders this is
known as a liquidating dividend.
 Dividends a Financing Decision
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In the absence of dividends, corporate earnings accrue to the benefit of

shareholders as retained earnings and are automatically reinvested in the
firm.
When a cash dividend is declared, those funds leave the firm permanently
and irreversibly.
Distribution of earnings as dividends may starve the company of funds
required for growth and expansion, and this may cause the firm to seek
additional external capital.

Retained Earnings
Corporate Profits After Tax
Dividends
 Difference between dividend and interest
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Interest
Interest is a payment to lenders for the use of their funds for a given period of
time
Timely payment of the required amount of interest is a legal obligation
Failure to pay interest (and fulfill other contractual commitments under the bond
indenture or loan contract) is an act of bankruptcy and the lender has recourse
through the courts to seek remedies
Secured lenders (bondholders) have the first claim on the firms assets in the case
of dissolution or in the case of bankruptcy

Dividends
A dividend is a discretionary payment made to shareholders
The decision to distribute dividends is solely the responsibility of the board of
directors
Shareholders are residual claimants of the firm (they have the last, and residual
claim on assets on dissolution and on profits after all other claims have been fully
satisfied)
 Factors influencing Dividend Policy
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Stability of Earnings
Financing policy of the company
Liquidity of Funds
Competitive concerns
Past dividend rates
Debt obligation
Ability to borrow
Growth needs of the firm
Profit rate
Dividend Decision and the
Board of Directors

DIVIDEND POLICY
 Dividend Policy
Dividends, Shareholders and the Board of Directors
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There is no legal obligation for firms to pay dividends to

common shareholders
Shareholders cannot force a Board of Directors to declare a
dividend, and courts will not interfere with the BODs right to
make the dividend decision because:
Board members are jointly and severally liable for any damages
they may cause
Board members are constrained by legal rules affecting dividends
including:
Not paying dividends out of capital
Not paying dividends when that decision could cause the firm to
become insolvent
Not paying dividends in contravention of contractual commitments
(such as debt covenant agreements)
Theory of Dividend Policies

DIVIDEND POLICY
 Dividend Decision
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To choose between distributing the profits to the

profits to the shareholders and plouging back into
the business
Use the net profits for paying dividends to the
shareholders
Use the money for the maximization of the wealth of
owners.
So the relationship between dividend and value of
firm is dividend decision
Impact of dividend on value of firm
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 RESIDUAL APPROACH
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Dividend payment is part of financing decision

Depends on investment opportunities
sufficient Inadequate

Retain earnings Dividend

 Relationship
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Return on Investment (r) and cost of capital (k)

r > k a firm has acceptable investment opportunities
(retain for investments)
r < k raise from outside

Dividend payout ratio = ratio of dividend to net

earnings would be zero if more investment
opportunties
Modigliani and Millers Dividend Irrelevance
Theorem
 Modigliani and Miller Approach
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No effect on the share price of the firm

Assumptions
Perfect capital market
No taxes to be paid
No change in investment policy
Perfect certainty for every investor
Modigliani and Millers Dividend Irrelevance
Theorem
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The value of M&Ms Dividend Irrelevance

argument is that in the end, it shows where value
can be created with dividend policy and why.
 Argument of MM model
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Payment of dividend would be offset by the effect of

raising additional funds
Dividend paid to shareholders will decrease market
price of shares
Cost of capital is independent of leverage and real
cost of debt
Investors are indifferent between dividend and
retained earnings
Arbitrage process
 MM Argument
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To be more specific, the market price of a share in

the beginning of a period is equal to present value of
dividend paid at the end of the period plus market
price of shares.
 M&Ms Dividend Irrelevance Theorem
M&M, Dividends, and Firm Value
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Start with the single-period

D1 P1
P0
(1 Ke )

Where P0 Prevailing market price of shares

D1 Dividend to be received at the end of period 1
P1 Market price to be received at the end of period 1
k e- Cost of equity capital
 M&Ms Dividend Irrelevance Theorem
M&M, Dividends, and Firm Value
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Investment required by the firm on account of

payment of dividends is financed it by new issue of
equity shares
I ( E nD1 )
m
P1
 MM Theory
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Value of the firm can be ascertained with the help of

following formula

( n m) P1 ( I E
nP0
(1 Ke )
 MM theory
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Where m= number of shares to be issued

I = Investment required
E= Total earnings of the firm during the
period
P1 = Market price per share at the end of the
period
Ke= Cost of equity capital
n= no of shares outstanding
D1= dividend to be paid
nP0= value of the firm
 M&Ms Dividend Irrelevance Theorem
M&M, Dividends, and Firm Value
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Without debt, sources and uses of funds identity (sources = uses)

can be expressed as:

[ 22-3] X 1 nP1 I1 mD1

Where:
X represents cash flow from operations
I represents investment
XI is free cash flow
mD1 is dividend to current shareholders at time 1
 M&Ms Dividend Irrelevance Theorem
M&M, Dividends, and Firm Value
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Solving for dividends paid out (mD1 ):

mD1 X 1 nP1 I1
 M&Ms Dividend Irrelevance Theorem
M&M, Dividends, and Firm Value
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If a firm pays out dividends that exceeds its free cash flow (X I),
then it must issue new common shares to pay for these
dividends.
Substituting into Equation 22 2 we get:

X1 I1 [(m n) P1 V1 ]
[ 22-4] V0
(1 K )

The value of the firm is the value of the next periods free cash
flow (X1 I1) plus the next periods equity market value
 M&Ms Dividend Irrelevance Theorem
M&M, Dividends, and Firm Value
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The firm value is determined as the present value of the free cash
flows to the equity holders:

Value has
nothing

X t It
[ 22-5] V0 to do with
t 1 (1 K ) t dividends

The dividend is equal to the free cash flow each period, and
dividends are therefore a residual after the firm has taken care of
all of its investment requirements this is the Residual Theory
of Dividends
 M&Ms Dividend Irrelevance Theorem
Homemade Dividends
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Shareholders can buy or sell shares in an

underlying company to create their own cash flow
pattern.
They dont need management declare a cash dividend, they
can create their own.

Conclusion: under the assumptions of M&Ms model, the

investor is indifferent to the firms dividend policy.
Relevance Theory
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WALTER MODEL
 Walter model
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Prof James E Walter

The choice of dividend policies always affects the
value of the firm
It establishes the relationship between IRR (r)
and cost of capital (k) and its influence on the
dividend decisions to achieve wealth maximisation
 WALTER MODEL
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Assumptions
Uses only retained earnings for investment
opportunities, no debt or fresh equity issues
IRR ( r ) and cost of capital (k ) remain constant
Earnings and dividend do not change while
determining market value of shares
Life of the firm is infinite.
 Criticisms
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Investment opportunities are financed by retained

earnings only and no external financing
Assumption of cost of capital (K), dividend and
earning per share remains constant is also not
acceptable.
WALTER FORMULA FOR CALCULATING
MARKET VALUE
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P=D r (E-D)/ K
+
K K

P = Market price per share

D = Dividend per share
R = Internal rate of return
E= Earnings per share
K= Cost of capital
 Walter model types of firm
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If r>K - Growth firms

More returns on the firm
IF r=k Normal firms
Dividend policy will not have any influence on price
per share
If r< k Declining firms
No retained earnings
 The Bird-in-the-Hand
Argument OR GORDONS
MODEL

DIVIDEND POLICY
 GORDON MODEL
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Dividend policy affects value of the firm

Assumptions
1. All equity firm
2. r and ke are constant
3. Firm has perpetual life
4. Retention ratio is constant
 The GORDONS MODEL
M&Ms Assumptions Relaxed
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Investors are risk averse and put extra on certain

returns and discount if uncertain returns
Risk is a real world factor.
Firms that reinvest free cash flow, put that money
at risk there is no certainty of investment
outcome those forfeit dividends that are
reinvestedcould be lost!
If firm retain money then receive future dividend
 GORDON MODEL
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Future dividend is uncertain

So rational investor prefer current dividend
So if retained then market price of shares would
adversely be affected to avoid uncertainty
Pays higher price for current dividend
 The Bird-in-the-Hand Argument
M&Ms Assumptions Relaxed
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Bird in Hand Argument Bird in hand is better than two in

bush what is available at present is preferable than what
may be available in future
 Gordon Model Formula
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P = E (1-b )
ke br
Where P = Price per share
E = Earnings per share
b= Retention ratio or percentage of earnings retained
1-b = D/P i.e percentage of earnings distributed as dividend
Ke = Capitalisation rate/cost of capital
Br = growth rate = rate of return on investment
 The Bird-in-the-Hand Argument
M&M versus Gordons Bird in the Hand Theory
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Conclusions:
Firms cannot change underlying operational characteristics
by changing the dividend
The dividend should reflect the firms operations through
the residual value of dividends