Dividend policy
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Dividend policy Document Transcript

  • 1. Dividend policy:Dividend refers to that part of net profits of a company which is distributed among theshareholders as a return on their investment in the company. Dividend policy means thebroad approach according to which every year it is determined how much of the netprofits are to be distributed as dividend and how much are to be retained in the business.Factors affecting dividend policy:Stability of Earnings: The nature of business has an important bearing on thedividend policy. Industrial units having stability of earnings may formulate a moreconsistent dividend policy than those having an uneven flow of incomes because they canpredict easily their savings and earnings. Usually, enterprises dealing in necessities sufferless from oscillating earnings than those dealing in luxuries or fancy goods.Extent of share Distribution. Nature of ownership also affects the dividenddecisions. A closely held company is likely to get the assent of the shareholders for thesuspension of dividend or for following a conservative dividend policy. On the otherhand, a company having a good number of shareholders widely distributed and forminglow or medium income group, would face a great difficulty in securing such assentbecause they will emphasize to distribute higher dividend.Needs for Additional Capital. Companies retain a part of their profits forstrengthening their financial position. The income may be conserved for meeting theincreased requirements of working capital or of future expansion. Small companiesusually find difficulties in raising finance for their needs of increased working capital forexpansion programmers. They having no other alternative, use their ploughed backprofits. Thus, such Companies distribute dividend at low rates and retain a big part ofprofits.Trade Cycles. Business cycles also exercise influence upon dividend Policy. Dividendpolicy is adjusted according to the business oscillations. During the boom, prudentmanagement creates food reserves for contingencies which follow the inflationary period.Higher rates of dividend can be used as a tool for marketing the securities in an otherwisedepressed market. The financial solvency can be proved and maintained by thecompanies in dull years if the adequate reserves have been built up.Government Policies. The earnings capacity of the enterprise is widely affected bythe change in fiscal, industrial, labour, control and other government policies. Sometimesgovernment restricts the distribution of dividend beyond a certain percentage in aparticular industry or in all spheres of business activity as was done in emergency. Thedividend policy has to be modified or formulated accordingly in those enterprises.Taxation Policy. High taxation reduces the earnings of he companies andconsequently the rate of dividend is lowered down. Sometimes government leviesdividend-tax of distribution of dividend beyond a certain limit. It also affects the capital
  • 2. formation. N India, dividends beyond 10 % of paid-up capital are subject to dividend taxat7.5%tax.Legal Requirements. In deciding on the dividend, the directors take the legalrequirements too into consideration. In order to protect the interests of creditors anoutsiders, the companies Act 1956 prescribes certain guidelines in respect of thedistribution and payment of dividend. Moreover, a company is required to provide fordepreciation on its fixed and tangible assets before declaring dividend on shares. Itproposes that Dividend should not be distributed out of capita, in any case. Likewise,contractual obligation should also be fulfilled, for example, payment of dividend onpreference shares in priority over ordinary dividend.Regularity and stability in Dividend Payment . Dividends should be paidregularly because each investor is interested in the regular payment of dividend. Themanagement should, in spite of regular payment of dividend, consider that the rate ofdividend should be all the most constant. For this purpose sometimes companies maintaindividend equalization Fund.Dividend Policy Models: • Walter’s Model • Gordon’s Model • Modigliani and Miller modelWalter’s Model:According to this model, dividend decision is relevant which will affect the firm. If thefirm will distribute more dividends then market value of firm will increase. This approachexplains the relationship between internal rate of return and required rate of return. Thisapproach arises three situations: • r>K • r<K • r=KIf r > K, the firm should retain the earning rather than distributing it to the shareholdersbecause of the reason that the money is earning more profits in the hands of the firm thanit would if it was paid to the shareholders.If r < K, the firm should pay off the money to the shareholders in the form of dividendsbecause of the reason that the shareholders can earn higher return by investing it.If r = K, it is a matter of indifference whether the earning are retained or distributedamong the shareholders.Assumptions: • Constant return and cost of capital • Internal financing • 100% payout or retention
  • 3. • Constant Earning per share and dividend per share • Perpetual LifeCalculate the share price on the basis of Walter’s Model: P= D Ke – gWhere P= market price of share D= dividend per share Ke= cost of equity g = growth rateLimitation of Walter’s Model: • No external financing: it assumes that the firm’s investments are financed exclusively by retained earning and no external financing is used. • Constant rate of return: this is not a realistic assumption because when increased investments are made by firm, r also changes. • Constant equity capitalization rate: this is not a realistic assumption because equity capitalization rate changes directly with the change in risk complexion of the firm.Gordon’s Model:According to this model, Dividend policy is relevant which will affect the value of thefirm. This approach is also based on a bird in hand is better than two in bush i.e. what isavailable at present is preferable to what may be available in the future. The future isuncertain and more distant the future.Assumptions: • No external financing • All equity firm • No taxes • Perpetual life • Constant internal rate of return • Constant cost of capital • Constant retention ratio • Cost of capital is greater than growth rateArguments of this model: 1. Dividend policy of the firm is relevant and that investors put a positive premium on current incomes/dividends. 2. This model assumes that investors are risk averse and they put a premium on a certain return and discount uncertain returns. 3. Investors are rational and want to avoid risk. 4. The rational investors can reasonably be expected to prefer current dividend. They would discount future dividends. The retained earnings are evaluated by the investors as a risky promise. In case the earnings are retained, the market price of
  • 4. the shares would be adversely affected. In case the earnings are retained, the market price of the shares would be adversely affected. 5. Investors would be inclined to pay a higher price for shares on which current dividends are paid and they would discount the value of shares of a firm which postpones dividends. 6. The omission of dividends or payment of low dividends would lower the value of the shares.The Gordon’s model can be symbolically expressed as: P= E( 1-b ) Ke – br E= earning per share b= retention ratio 1-b= % of earning distributed as dividend br= g = growth rate Ke = cost of capitalExample: r = 12%, earning = Rs.20, Ke= 20%, D/P ratio= 10% calculate the value of share. P= Rs.20 (1- .9) 0.2 - 0.108 =Rs. 21.74Modigliani and Miller approach:Dividend decision is irrelevant which will not affect the market value of firm. Thisapproach can also be explained with the help of arbitrage process. It is that process inwhich the securities are purchased at lower prices and sold at higher prices.Assumptions of MM model: 1. Existence of perfect capital markets and all investors in it 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 and there are no floatation costs.
  • 5. 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. It implies that the financing of new investments out of retained earnings will not change the business risk complexion of the firm and thus there would be no change in the required rate of return. 4. Investors know for certain the future investments and profits of the firm (but this assumption has been dropped by MM later).Argument of this Model: 1. By the argument of arbitrage, MM Model asserts the irrelevance of dividends. Arbitrage implies the distribution of earnings to shareholders and raising an equal amount externally. The effect of dividend payment would be offset by the effect of raising additional funds. 2. MM model argues that when dividends are paid to the shareholders, the market price of the shares will decrease and thus whatever 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. 3. The cost of capital is independent of leverage and the real cost of debt is the same as the real cost of equity, according to this model. 4. That investors are indifferent between dividend and retained earnings implies that the dividend decision is irrelevant. With dividends being irrelevant, a firm’s cost of capital would be independent of its dividend-payout ratio. 5. Arbitrage process will ensure that under conditions of uncertainty also the dividend policy would be irrelevant.Limitations of MM model: 1. The assumption of perfect capital market is unrealistic. Practically, there are taxes, floatation costs and transaction costs. 2. Investors cannot be indifferent between dividend and retained earnings under conditions of uncertainty. This can be proved at least with the aspects of i) near Vs distant dividends, ii) informational content of dividends, iii) preference for current income and iv) sale of stock at uncertain price.