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.
Firm has 2 choices • Pay dividend • Reinvest funds instead of paying out
• 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
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 BOD’s right to make the dividend decision.
THEORY OF IRRELEVANCE 1. Residual approach 2. Miller and Modgilani approach THEORY OF RELEVANCE 1. Walter’s approach 2. Gorden approach
Dividend irrelevance theory is one of the major theories concerning dividend policy in an enterprise. It was first developed by Franco Modigliani and Merton Miller in a famous seminal paper in1961. The authors claimed that neither the price of firms stock nor its cost of capital are affected by its dividend policy. This theory contain two theories.
According to M-M, under a perfect market situation, the dividend policy of a firm is irrelevant, as it does not affect the value of the firm.
Dividend received at the end of the year D1 P1 Market price P0 of share at the (1 Ke ) end of yearMarket priceof the share atthe beginning Cost of equityof period
Market price Dividend of the share at received at the beginning the end of the of period year P1 P 0(1 ke) D1Market priceof share at the Cost of equityend of year
Market total earningInvestment of the firm Number ofrequire shares which Dividend received at the end of the year I ( E nD1) m P1 Number of shares Market price outstanding at the of share at the beginning of the end of year period
Investment Market price require Market totalValue of the of share at the earning of thefirm end of year firm (n m) P1 ( I E ) mP0 Cost of (1 Ke ) equity Number of Number of shares share issue outstanding at the beginning of the period
There is perfect capital market investor are rational Information about company is freely available there is no transaction cost No investor is large enough to effect there are no taxes
o According to relevant theory payment of dividendaffect the firms stock and its cost of capital. thistheory is based on rate of interest and cost of capital.
Waltersmodel supports the principle that dividends are relevant. The investment policy of a firm cannot be separated from its dividend policy and both are inter-related. The choice of an appropriate dividend policy affects the value of an enterprise.
Price of equity dividend D P Expected Ke g growth rate of earning dividendCost of equity
market priceper share Earning per share r ( E D) / ke P D Ke Internal rate of Cost of equity return capital
The investment of the firm are financed through internal financing or retain earning only. Rate of interest and cost of equity are constant. Earning & dividend don’t change while determining the value of the firm. Firm has very long life.
If r>k than firm retain the whole income If r<k than firm can pay 100% dividend r = rate of interest k = cost of equity
When r > ke, the value of shares is inversely related to the D/P ratio. As the D/P ratio increases, the market value of shares decline. It’s value is the highest when D/P ratio is 0. So, if the firm retains its earnings entirely, it will maximize the market value of the shares. The optimum payout ratio is zero. When r < ke, the D/P ratio and the value of shares are positively correlated. As the D/P ratio increases, the market price of the shares also increases. The optimum payout ratio is 100%. When r = ke, the market value of shares is constant irrespective of the D/P ratio. In this case, there is no optimum D/P ratio.
A model for determining the intrinsic value of a stock, based on a future series of dividends that grow at a constant rate. Given a dividend per share that is payable in one year, and the assumption that the dividend grows at a constant rate in perpetuity, the model solves for the present value of the infinite series of future dividends. Gordons theory contends that dividends are relevant. This model is of the view that dividend policy of a firm affects its value. According to Gordon, the market value of a share is equal to the present value of the future streams of dividends means (ke = g)
D P Ke gWhere:D = Expected dividend per share one yearfrom nowk = Required rate of return for equityinvestorG = Growth rate in dividends (in perpetuity)
Assumptions of this model The firm is an all equity firm. No external financing is used and investment programmes are financed exclusively by retained earnings. Return on investment( r ) and Cost of equity(Ke) are constant. The firm has perpetual life. The retention ratio, once decided upon, is constant. Thus, the growth rate, (g ) is also constant. Ke > g