Meaning of Dividend, Dividend Policy & its Determinants, Theories of Dividend and related concepts

1. CA Shilpi Taparia

2.  Dividend - Part of Earnings which is distributed to
the shareholders of the company in proportion to
the paid up amount of capital held by them.
 Retained Earnings - Rest part which is retained
as reserve or for future uncertainties.
As per section 2(35) of the Companies Act 2013- The
term “Dividend” includes any interim dividend.

3.  One of the crucial aspects of Management
Decisions. It influences on the following matters-
1. Value of Firm
2. Availability of Capital
3. Cost of Capital
4. Cash flows available with the company
5. Capital Structure, etc.

4. Example - X Ltd. is paying dividend every year at a
normal growth rate of 7%.
If it Earns huge Profit this year – Management in
dilemma – whether to continue with the same rate of
dividend or increase the rate
If rate increased, what if the profit falls for the
subsequent year ?
If not, then company’s retained earnings will rise and
will remain idle if no opportunity exist.

5.  Optimum Dividend Policy:
Dividend payout ratio should be determined with reference
to two basic objectives
Maximizing shareholders providing sufficient funds
Wealth to finance growth plans
Hence, an optimum payout policy should strike balance
between current dividend and future growth.

6.  Financial Needs of the company:
Risk and financial obligation increases when company issues
new shares.
Higher payout
ratio
Firm is matured &
positive about
future profits
Firm doesn’t have
any investment
opportunities
Lower payout
ratio
Firm has high
growth
potential
It requires funds
to meet its growth
opportunities

7.  Constraints on paying dividends:
Legal Constraint: Section 123 of the Companies Act 2013
Dividend shall be declared after providing depreciation from
the profits of the company –
a) From the relevant financial year; or
b) From previous year or years in accordance of sec.123; or
c) Out of both; or
d) Out of money provided by govt. in pursuance of guarantee
given by govt.
Liquidity Position of the company: Ability to pay dividends
depends on the amount of cash flows available with the firm.

8. Access to Capital Markets: High dividend payout firms shall
always have wide access to capital markets unlike low
dividend payouts firms.
Investment opportunities : If investment opportunities are
inadequate, better to pay dividend and vice-versa.
 Shareholders Preferences:
Those who prefer to earn regular and high cash flows every
year go for high dividend payout firms and vice-versa. Thus,
dividend policy of the company should strike a balance on the
desires of shareholders.

9.  Stability of Dividends:
Regularity of dividends are described in following ways-
Constant DPS
Company pays a certain fixed
amount per share as dividend
every year
Constant Payout Ratio
Company pays a fixed percentage
on profit every year.
Constant DPS plus extra dividend
Company pays a fixed amount
plus an additional dividend
during good earnings.

10. Theories of Dividend
Irrelevance
theory
Relevance
theory
M.M.
Approach
Walter Model Gordon Model

11. .Company pays dividend
Share price increases to P1 expecting
better future earnings
Co.’s reserve reduces to the extent of
dividend paid
Need for funds arises for future projects
To meet the requirements, further equity is raised
Company’s no. of shares increases
Hence, EPS decreases share price decreases

12. Value of the firm= (n+m)P1-I1+E1
1+ke
Market Price per Share at T0 (P0)= P1+D1
1+Ke
No. of shares to be issued at the end of the year for meeting
funds requirements= I1-(E1-nD1)
P1
Where n= no. of shares outstanding at beginning of the period
m= no. of shares at the end of year,
P0= Market price at the beginning the year,
P1= Market Price at the end of the year,
D1= Dividend per share at the end of the year,
I1 = Investment at the end of the year,
E1= Earnings after tax for the year & Ke= Cost of Equity

13.  Dividend policy has an impact on share valuation by comparing
internal rate of return(retained earnings) with cost of capital
(dividend).
Hence, in growth firms, higher the retention ratio, higher is the
value of firm and vice-versa.
For Growth firm=
When retention is
higher, price
increases as
shareholders expect
the company to do
well with its reserves
For Declining Firm=
When retention is lower,
price increases as
shareholders prefer a
higher dividend so that
they can use their funds
elsewhere

14. Current Market price per share (Po)= D+r(E-D)/ke
ke
Where D= Dividends per share
E= Earnings per share
r= Rate of return on investment by company
ke= Cost of Equity

15.  If in a firm, retention rate is higher, the required rate of
return from investments to compensate all risks
increases. Thereby, boosting investors’ confidence and
holding strong share valuation.
Market Price (Po)= E(1-b)
ke-br
where E= EPS
b= retention ratio, (1-b)= payout ratio
r= rate of return on investment, br= growth rate or g

16.  It is a financial model that values share price at the
discounted value of the future dividend payments.
Zero Growth
Constant
Growth
Variable
growth
Po= D
Ke Po= D1
Ke-g