DIVIDEND POLICY

Dividends & Dividend Forms

 Dividend policy involves the balancing of the

shareholders’ desire for current dividends and
the firm’s needs for funds for growth.
 Forms of Dividends
 Cash
 Scrip or Bond
 Property
 Stock – Issue of Bonus shares
Dividend Payment Policies

1. Residual Dividend Payment

 Earnings not used to finance capital investment
are available for dividend payment
2. Constant Cash Dividend
 Same dividend each quarter
3. Constant payout ratio (%)
 Constant % of earnings
Examples for Div. Payment Policy
Dilemma: Should the firm use retained
earnings for:

a) Financing profitable capital investments?

b) Paying dividends to stockholders?

 If we retain earnings for profitable
investments
 dividend yield will be zero
 but the stock price will increase
 resulting in a higher capital gain.

Dividend
rs   growth rate
Stock Pr ice
 If we pay dividends

 stockholders receive immediate cash reward

for investing
 but this cash doesn’t get invested in the firm
 so the capital gain will decrease

Dividend
rs   growth rate
Stock Pr ice
So, dividend policy really involves 2
decisions:

1. Amount of earnings that should be

distributed to shareholders as dividends

2. How much should be retained for capital

investment?
Dividend Theories
 Dividends are irrelevant-Irrelevance theory

 Dividends matter-Relevance theory

 Low payout optimal
 High payout optimal
 Dividend Theories

Irrelevance Theories
Relevance Theories
(i.e. which consider
(i.e. which consider
dividend decision to be
dividend decision to be
irrelevant as it does not
relevant as it affects the
affects the value of the
value of the firm)
firm)

Modigliani and
Walter’s Model Gordon’s Model Miller’s Model
DIVIDEND IRRELEVANCE THEORY

A. RESIDUAL APPROACH

 1. Dividend decision has no effect on the

wealth of the shareholders
 2.A firm should retain earnings if it has
profitable investment and
 3.It should pay the dividends if no profitable
investment opportunities are present.
 DIVIDEND IRRELEVANCE
B.MM HYPOTHESIS
If a firm's investment policy does not change, the value of
the firm cannot change with dividend policy. If we ignore
personal taxes, investors have to be indifferent to
receiving either dividends or capital gains.

Possible situations:

 1. The firm has sufficient cash to pay dividends

 2.The firm does not have sufficient cash and hence it issues
new shares to finance the payment.
 3.The firm does not pay dividend but a shareholder needs
cash.
Assumptions of MM Hypothesis

 Perfect capital markets

 No taxes or rates of taxation is constant
 Firm has fixed investment policy
 Investors behave rationally
 There is no risk or uncertainty regarding
future
 Information about company is available to all
without any cost.
Modigliani & Miller’s Irrelevance Model

Value of Firm (i.e. Wealth of Shareholders)

Depends on

Firm’s Earnings
Depends on

Firm’s Investment Policy and not on dividend policy

Formulae of M-M Model

 According to M-M model the market price of

a share, after dividend declared, is calculated
by applying the following formula:
P1
P =+ D1
0

1 + Ke
Where,
P0 = Prevailing market price of a share
P1 = Market Price of a share at the end of the period one
D1 = Dividend to be received at the end of period one
Ke = Cost of equity capital
Formulae of M-M Model

 The number of shares to be issued to

implement the new projects is ascertained
with the help of the following:
ΔN = I – (E-nD1)

P1
Where,
ΔN = Change in the number of shares outstanding during the period.
I = Total Investment amount required for capital budget
E = Earning of net income of the firm during the period
n = Number of shares outstanding at the beginning of the period
D1 = Dividend to be received at the end of period one
P1 = Market price of a share at the end of period one
RELEVANCE THEORIES OF DIVIDEND

1. Walter’s Model:
• Choice of dividend policies affect the value of
the firm

• Assumptions:
• Internal financing
• 100% payout or retention
• Constant EPS and DPS
• Infinite time
Formula of Walter’s Model

D + r (E-D)
k
P= k
Where,
P = Current Market Price of equity share
E = Earning per share
D = Dividend per share
(E-D) = Retained earning per share
r = Rate of Return on firm’s investment or Internal Rate of Return
k = Cost of Equity Capital
Optimum Payout Ratio

 Growth Firms – Retain all earnings & Pay

out will be zero (r>k)

 Declining Firms – Distribute all earnings &

Pay out will be 100% (r<k)

 Normal Firms – No optimum dividend pay

out (r=k)

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 DIVIDEND RELEVANCE: GORDON’S MODEL

Gordon’s model is based on the following assumptions:

 All-equity firm
 No external financing
 Constant return
 Constant cost of capital
 Perpetual earnings
 No taxes
 Constant retention
 Cost of capital greater than growth rate

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Valuation
 Market value of a share is equal to the present
value of an infinite stream of dividends to be
received by shareholders.
Example: Application of Gordon’s Dividend Model

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It is revealed that under Gordon’s model:

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DIVIDEND AND UNCERTAINTY:
THE BIRD-IN-THE-HAND ARGUMENT

GOURDON’S REVISED MODEL

 Argument put forward, first of all, by
Kirshnan
 Investors are risk averters. They consider
distant dividends as less certain than near
dividends. Rate at which an investor
discounts his dividend stream from a given
firm increases with the futurity of dividend
stream and hence lowering share prices.
Determinants of Dividend policy

 Legal restrictions
 Desire and type of shareholders
 Age of the company
 Future financial requirements
 Taxation policy
 Inflation
 Requirements of Institutional investors
 Stability of dividends – constant payout ratio
 Liquid resources
Dividend policy summary
 No definite conclusion can be reached about the optimal
dividend policy
 Investors in aggregate cannot be shown to uniformly prefer
either high or low dividends
 Individual investors, however, have strong dividend
preferences and will tend to invest in companies whose
dividend policies match their preferences
 Regardless of the payout ratio, investors prefer a stable,
predictable dividend policy
 CONDITIONS FOR ISSUE OF BONUS SHARES

 1. Not to be issued in lieu of cash dividends.

 2. No bonus shares on partly paid up shares.
 3. Bonus issues to be made out of share premium and
free reserves.( excluding capital reserve on asset
revaluation).
 4. Bonus issue should not exceed the paid up capital.
 5. Bonus issue only once in a year.
 6. A resolution should be passed by the shareholders.
 7. No default in payment of dues to employees and
term loans
LIMIT ON ISSUE OF BONUS SHARES

 1. Residual reserve criterion.

 Reserve remaining after amount capitalized
for bonus issue should be equal to 40% of the
increased paid up capital.

 2. Profitability criterion:
 30% of the previous 3 years average PBT
should be equal to 10% of the increased paid
up capital
Share Split
 To make trading in shares attractive.

 Indication of higher future profits.

 Increased dividend
Shares Buyback

 Return of surplus cash to shareholders

 Increase in the value of the shares.
 Increase in the undervalued share price.
 Adjusting the capital structure.
 Increasing control.
 Tax savings by companies.
 Protection against hostile takeovers.