WHAT IS DIVIDEND ? Payments made to stockholders from the firm’s earnings, whether those earnings were generated in the current period or in previous periods. Portion of profit (after tax) distributed among owners/ shareholders of the firm. May be distributed in form of cash, scrip, property dividend or bonus shares.
DIVIDEND DECISION One of the three basic decisions of a financial manager, the other two being investment decision and financing decision. Decision as to whether the firm’s profits should be paid as dividend or retained and in what amount. Objective : Maximize wealth of shareholders, Increase the goodwill of the firm, Satisfy the obligations to shareholders.
TYPES OF THEORIES DIVIDEND THEORIES RELEVANCE THEORY IRRELEVANCE THEORY MODIGILANIWALTER’S GORDON’S RESIDUAL AND MILLER MODEL MODEL MODEL MODEL
RELEVANCE THEORY Dividend policy is very essential for any business firm as it affects the overall value of the firm. Dividend policy is relevant & dividend decision form a very integral part of the investment and financing decision of the firm. Shareholders prefer current dividends & hence there is a direct relationships between the dividend policy & the market value of the firm
WALTER MODEL Dividend policy affects the value of the firm. Together, the cost of capital (k) and rate of return (r) determine the dividend policy that will maximize the shareholders wealth. COST OF CAPITAL (k) VALUE OF DIVIDEND THE FIRM POLICY RATE OF RETURN (r)
WALTER MODEL -- assumption The firm finances all investment through retained earnings while debt and new equity is not used. Business risk remains constant i.e., r & k are also constant. The firm has infinite life. The firm either goes for a 100 % pay-out or a 100 % retention.
WALTER MODEL -- decisions CONDITION r>k r<k r =kEVALUATIONTYPE OF FIRM Growth firm Declining firm Normal firmPAY-OUT RATIO Zero 100 % Indifferent INVESTMENTOPPORTUNITIES Abundant None / very few Optimal Company Company should Dividend does DECISION should retain all distribute all not affect earnings for earnings in the market price investment form dividends of share
WALTER MODEL -- criticisms It ignores the benefit of optimal capital structure. Assumption that ‘K’ remains constant does not hold good in practice. It ignores that market price is affected by many factors.
GORDON’S MODEL Also known as the ‘bird in hand argument. Dividend policy is relevant as the investors prefer current dividends as against the future uncertain capital gains. Investors discount the firm’s earnings at lower rate when they are certain about returns, placing a higher value for the share and that of the firm.
GORDON’S MODEL - assumptions No external financing is available. Corporate tax does not exist. The firm has infinite life. Investors are basically risk-averse. The growth rate of firm ‘g’ is the product of its retention ratio ‘b’ and its rate of return ‘r’ i.e., g = br. The cost of capital is constant and also more than growth rate, i.e., k > g.
GORDON’S MODEL -- decisions If r > k > g :- Company should distribute less dividend and retain high profit. If r < k :- Company should distribute more profits as dividend. If r = k :- Pay-out ratio is not effected by retention ratio.
IRRELEVANCE THEORY Dividend policy is irrelevant to maximizing the shareholders wealth. Value of the firm is affected by the earning capacity of the firm i.e., investment policy and not the dividend policy. Whether the firm retains its earnings or pays dividend, the market price of the share is indifferent towards it.
MODIGILANI & MILLER MODEL -- concept Crux of MM position is arbitrage argument. Arbitrage is entering simultaneously in two transactions which balance each other. Between dividend and retention of earnings the investors would be indifferent due to balancing nature of internal financing and external financing. So, the firm is indifferent towards the dividend decision.
MODIGILANI & MILLERMODEL Modigilani and Miller were two staunch supporters of the irrelevance concept. The value of the firm is not affected by the decision of pay-out or plough-back.Firm’s dividend policy have no influence on the market prices of the shares.
M-M MODEL -- assumptions Perfect capital market. Investors behave rationally. There are no taxes. No floating cost on issue of shares.
M-M MODEL -- criticisms It is wrong to assume that there are no taxes, floating costs do not exist and there is absence of transaction costs. The perfect capital market condition is not always true.