Dividend decision

Financial Management Unit 15

Unit 15 Dividend Decision

Structure

15.1 Introduction
15.2 Traditional Approach
15.3 Dividend Relevance Model
15.3.1 Walter Model
15.3.2 Gordon’s Dividend Capitalization Model
15.4 Dividend Irrelevance Theory: Miller and Modigliani Model
15.5 Stability of Dividends
15.6 Forms of Dividends
15.7 Stock Split
15.8 Summary
Terminal Questions
Answers to SAQs and TQs

15.1 Introduction
Dividends are that portion of a firm’s net earnings paid to the shareholders. Preference shareholders
are entitled to a fixed rate of dividend irrespective of the firm’s earnings. Equity holders’ dividends
fluctuate year after year. It depends on what portion of earnings is to be retained by the firm and what
portion is to be paid off. As dividends are distributed out of net profits, the firm’s decisions on retained
earnings have a bearing on the amount to be distributed. Retained earnings constitute an important
source of financing investment requirements of a firm. However, such opportunities should have
enough growth potential and sufficient profitability. There is an inverse relationship between these
two – larger retentions, lesser dividends and vice versa. Thus two constituents of net profits are
always competitive and conflicting.

Dividend policy has a direct influence on the two components of shareholders’ return – dividends and
capital gains. A low payout and high retention may have the effect of accelerating earnings growth.
Investors of growth companies realize their money in the form of capital gains. Dividend yield will
be low for such companies. The influence of dividend policy on future capital gains is to happen in

Sikkim Manipal University 231


distant future and therefore by all means uncertain. Share prices are a reflection of many factors
including dividends. Some investors prefer current dividends to future gains as prophesied by an
English saying – A bird in hand is worth two in the bush. Given all these constraints, it is a major
decision of financial management.

Dividend policy of a firm is a residual decision. In true sense, it means that a firm with sufficient
investment opportunities will retain the entire earnings to fund its growth avenues. Conversely, if no
such avenues are forthcoming, the firm will payout its entire earnings. So there exists a relationship
between return on investments r and the cost of capital k. So long as r exceeds k, a firm shall have
good investment opportunities. That is, if the firm can earn a return r higher than its cost of capital k,
it will retain its entire earnings and if this source is not sufficient, it will go in for additional sources in
the form of additional financing like equity issue, debenture issue or term loans. Thus, the dividend
decision is a tradeoff between retained earnings and financing decisions.

Different theories have been given by various people on dividend policy. We have the traditional
theory and new sets of theories based on the relationship between dividend policy and firm value.
The modern theories can be grouped as – (a) theories that consider dividend decision as an active
variable in determining the value of the firm and (b) theories that do not consider dividend decision as
an active variable in determining the value of the firm.

Learning Objectives:

After studying this unit, you should be able to understand the following.
1. Explain the importance of dividends to investors.
2. Discuss the effect of declaring dividends on share prices.
3. Mention the advantages of a stable dividend policy.
4. List out the various forms of dividend.
5. Give reasons for stock split.

15.2 Traditional Approach
This approach is given by B. Graham and D. L. Dodd. They clearly emphasize the relationship
between the dividends and the stock market. According to them, the stock value responds positively



to high dividends and negatively to low dividends, that is, the share values of those companies rises
considerably which pay high dividends and the prices fall in the event of low dividends paid.
Symbolically, P = [m (D+E/3)]
Where P is the market price,
M is the multiplier,
D is dividend per share,
E is Earnings per share.

Drawbacks of the Traditional Approach: As per this approach, there is a direct relationship
between P/E ratios and dividend payout ratio. High dividend payout ratio will increase the P/E ratio
and low dividend payout ratio will decrease the P/E ratio. This may not always be true. A company’s
share prices may rise in spite of low dividends due to other factors.

15.3 Dividend Relevance Model
Under this section we examine two theories – Walter Model and Gordon Model.

15.3.1 Walter Model
Prof. James E. Walter considers dividend payouts are relevant and have a bearing on the share
prices of the firm. He further states, investment policies of a firm cannot be separated from its
dividend policy and both are interlinked. The choice of an appropriate dividend policy affects the
value of the firm. His model clearly establishes a relationship between the firm’s rate of return r, its
cost of capital k, to give a dividend policy that maximizes shareholders’ wealth. The firm would have
the optimum dividend policy that will enhance the value of the firm. This can be studied with the
relationship between r and k. If r>k, the firm’s earnings can be retained as the firm has better and
profitable investment opportunities and the firm can earn more than what the shareholders could by
reinvesting, if earnings are distributed. Firms which have r>k are called ‘growth firms’ and such firms
should have a zero payout ratio.

If return on investment r is less than cost of capital k, the firm should have a 100% payout ratio as
the investors have better investment opportunities than the firm. Such a policy will maximize the firm
value.



If a firm has a ROI r equal to its cost of capital k, the firm’s dividend policy will have no impact on the
firm’s value. The dividend payouts can range between zero and 100% and the firm value will remain
constant in all cases. Such firms are called ‘normal firms’.

Walter’s Model is based on certain assumptions:
· Financing: All financing is done through retained earnings.Retained earnings is the only source
of finance available and the firm does not use any external source of funds like debt or new
equity.
· Constant rate of return and cost of capital: The firm’s r and k remain constant and it follows
that any additional investment made by the firm will not change the risk and return profile.
· 100% payout or retention: All earnings are either completely distributed or reinvested entirely
immediately.
· Constant EPS and DPS: The earnings and dividends do not change and are assumed to be
constant forever.
· Life: The firm has a perpetual life.
Walter’s formula to determine the market price is as follows:
D [ ( - D / Ke
r E ) ]
P = +
Ke Ke
Where P is the market price per share,
D is the dividend per share,
Ke is the cost of capital,
g is the growth rate of earnings,
E is Earnings per share,
r is IRR.
Example:
The following information relates to Alpha Ltd. Show the effect of the dividend policy on the market
price of its shares using the Walter’s Model
Equity capitalization rate Ke 11%
Earnings per share Rs. 10
ROI (r) may be assumed as follows: 15%, 11% and 8%
Show the effect of the dividend policies on the share value of the firm for three different levels of r,
taking the DP ratios as zero, 25%, 50%, 75% and 100%



Solution
Ke 11%, EPS 10, r 15%, DPS=0
D [ / Ke ( - D
r E )]
P = +
Ke Ke
Case I r>k (r=15%, K=11%)

0 + [ . / 0 11 10 - 0
0 15 . ( )]
a. DP = 0 =  13.64/0.11 = Rs. 123.97
0 11
.
2. + [ . / 0 11 10 - 2 5
5 0 15 . ( . )]
b. DP = 25% = 12.73/0.11 = Rs. 115.73
0 11
.
5 + [ . / 0 11 10 - 5
0 15 . ( )]
c. DP = 50% =  11.82/0.11 = Rs. 107.44
0 11
.
7. + [ . / 0 11 10 - 7 5
5 0 15 . ( . )]
d. DP = 75% =  10.91/0.11 = Rs. 99.17
0 11
.
10 + [ . / 0 11 10 - 10
0 15 . ( )]
e. DP = 100% =  10/0.11 = Rs. 90.91
0 11
.
Case II r = k (r = 11%, K = 11%)
0 + [ . / 0 11 10 - 0
0 11 . ( )]
a. DP = 0 =  10/0.11 = Rs. 90.91
0 11
.
2. + [ . / 0 11 10 - 2 5
5 0 11 . ( . )]
b. DP = 25% =  10/0.11 = Rs. 90.91
0 11
.
5 + [ . / 0 11 10 - 5
0 11 . ( )]
c. DP = 50% =  10/0.11 = Rs. 90.91
0 11
.
7. + [ . / 0 11 10 - 7 5
5 0 11 . ( . )]
d. DP = 75% =  10/0.11 = Rs. 90.91
0 11
.
10 + [ . / 0 11 10 - 10
0 11 . ( )]
e. DP = 100% =  10/0.11 = Rs. 90.91
0 11
.

Case III r<k (r=11%, K=8%)
0 + [ . / 0 08 ( - 0
0 11 . 10 )]
f. DP = 0 =  13.75/0.08 = Rs. 171.88
0 08
.
2. + [ . / 0 08 ( - 2 5
5 0 11 . 10 . )]
g. DP = 25% =  12.81/0.08 = Rs. 160.13
0 08
.



5 + [ . / 0 08 ( - 5
0 11 . 10 )]
h. DP = 50% =  11.88/0.08 = Rs. 107.95
0 08
.
7. + [ . / 0 08 ( - 7 5
5 0 11 . 10 . )]
i. DP = 75% =  10.94/0.08 = Rs. 99.43
0 08
.

10 + [ . / 0 08 ( - 10
0 11 . 10 )]
j. DP= 100% =  10/0.08 = Rs. 90.91
0 08
.
Interpretation: The above workings can be summarized as follows:
1. When r>k, that is, in growth firms, the value of shares is inversely related to DP ratio, as the DP
increases, market value of shares decline. Market value of share is highest when DP is zero and
least when DP is 100%.
2. When r=k, the market value of share is constant irrespective of the DP ratio. It is not affected
whether the firm retains the profits or distributes them.
3. In the third situation, when r<k, in declining firms, the market price of a share increases as the DP
increases. There is a positive correlation between the two.

Limitations
Walter has assumed that investments are exclusively financed by retained earnings and no external
financing is used. This model is applicable only to allequity firms. Secondly r is assumed to be
constant which again is not a realistic assumption. Finally, Ke is also assumed to be constant and
this ignores the business risk of the firm which has a direct impact on the firm value.

15.3.2 Gordon’s Dividend Capitalization Model
Gordon also contends that dividends are relevant to the share prices of a firm. Myron Gordon uses
the Dividend Capitalization Model to study the effect of the firm’s dividend policy on the stock price.

Assumptions
· All equity firm: The firm is an all equity firm with no debt.
· No external financing is used and only retained earnings are used to finance any expansion
schemes.
· Constant return r
· Constant cost of capital Ke
· The life of the firm is indefinite.
· Constant retention ratio: The retention ratio g=br is constant forever.



· Cost of capital greater than br, that is Ke>br

Gordon’s model assumes investors are rational and riskaverse. They prefer certain returns to
uncertain returns and therefore give a premium to the constant returns and discount uncertain
returns. The shareholders therefore prefer current dividends to avoid risk. In other words, they
discount future dividends. Retained earnings are evaluated by the shareholders as risky and
therefore the market price of the shares would be adversely affected. Gordon explains his theory with
preference for current income. Investors prefer to pay higher price for stocks which fetch them
current dividend income. Gordon’s model can be symbolically expressed as:
E 1 - b
( )
P=
Ke - br
Where P is the price of the share,
E is Earnings Per Share,
b is Retention raio,
(1 – b) is dividend payout ratio,
Ke is cost of equity capital,
br is growth rate in the rate of return on investment.

Example:
Given Ke as 11%, E is Rs. 10, calculate the stock value of Mahindra Tech. for (a) r=12%, (b) r=11%
and (c) r=10% for various levels of DP ratios given under:
DP ratio (1 – b) Retention ratio
A 10% 90%
B 20% 80%
C 30% 70%
D 40% 60%
E 50% 50%

Solution
Case I r>k ( r=12%, K=11%)
P = E(1—b)
Ke—br



a. DP 10%, b 90%
10(1—0.9) equals 1/.002 = Rs. 500
0.11(0.9*0.12)
b. DP 20%, b 80%
10(1—0.8) equals 2/.014 = Rs. 142.86
0.11(0.8*0.12)
c. DP 30%, b 70%
10(1—0.7) equals 3/.026 = Rs. 115.38
0.11(0.7*0.12)
d. DP 40%, b 60%
10(1—0.6) equals 4/.038 = Rs. 105.26
0.11(0.6*0.12)
e. DP 50%, b 50%
10(1—0.5) equals 5/.05 = Rs. 100
0.11(0.5*0.12)

Case II r=k ( r=11%, K=11%)
P = E(1—b)
Ke—br
a. DP 10%, b 90%
10(1—0.9) equals 1/.011 = Rs. 90.91
0.11(0.9*0.11)
b. DP 20%, b 80%
10(1—0.8) equals 2/.022 = Rs. 90.91
0.11(0.8*0.11)
c. DP 30%, b 70%
10(1—0.7) equals 3/.033 = Rs. 90.91
0.11(0.7*0.11)
d. DP 40%, b 60%
10(1—0.6) equals 4/.044 = Rs. 90.91
0.11(0.6*0.11)



e. DP 50%, b 50%
10(1—0.5) equals 5/.55 = Rs. 90.91
0.11(0.5*0.11)

Case III r<k ( r=10%, K=11%)
P = E(1—b)
Ke—br
a. DP 10%, b 90%
10(1—0.9) equals 1/.02 = Rs. 50
0.11(0.9*0.1)
b. DP 20%, b 80%
10(1—0.8) equals 2/.03 = Rs. 66.67
0.11(0.8*0.1)
c. DP 30%, b 70%
10(1—0.7) equals 3/.04 = Rs. 75
0.11(0.7*0.1)
d. DP 40%, b 60%
10(1—0.6) equals 4/.05 = Rs. 80
0.11(0.6*0.1)
e. DP 50%, b 50%
10(1—0.5) equals 5/.06 = Rs. 83.33
0.11(0.5*0.1)

Interpretation: Gordon is of the opinion that dividend decision does have a bearing on the market
price of the share.
1. When r>k, the firm’s value decreases with an increase in payout ratio. Market value of share is
highest when DP is least and retention highest.
2. When r=k, the market value of share is constant irrespective of the DP ratio. It is not affected
whether the firm retains the profits or distributes them.
3. When r<k, market value of share increases with an increase in DP ratio.



15.4 Miller and Modigliani Model
The MM hypothesis seeks to explain that a firm’s dividend policy is irrelevant and has no effect on
the share prices of the firm. This model advocates that it is the investment policy through which the
firm can increase its share value and hence this should be given more importance.

Assumptions
· Existence of perfect capital markets: All investors are rational and have access to all
information free of cost. There are no floatation or transaction costs, securities are infinitely
divisible and no single investor is large enough to influence the share value.
· No taxes: There are no taxes, implying there is no difference between capital gains and
dividends.
· Constant investment policy: The investment policy of the company does not change. The
implication is that there is no change in the business risk position and the rate of return.
· No Risk – Certainty about future investments, dividends and profits of the firm. This
assumption was, however, dropped at a later stage.

Based on the above assumptions, Miller and Modigliani have explained the irrelevance of dividend as
the crux of the arbitrage argument. The arbitrage process refers to setting off or balancing two
transactions which are entered into simultaneously. The two transactions are paying out dividends
and raising external funds to finance additional investment programs. If the firm pays out dividend, it
will have to raise capital by selling new shares for financing activities. The arbitrage process will
neutralize the increase in share value (due to dividends) with the issue of new shares. This makes
the investor indifferent to dividend earnings and capital gains as the share value is more dependent
on the future earnings of the firm than on its current dividend policy.
Symbolically, the model is given as:
Step I: The market price of a share in the beginning is equal to the PV of dividends paid and market
price at the end of the period.
P0 = 1 * (D1 + P1)
(1+Ke)
Where P0 is the current market price,
P1 is market price at the end of period 1,
D1 is dividends to be paid at the end of period 1,
Ke is the cost of equity capital.



Step II: Assuming there is no external financing, the value of the firm is:
nP0 = = 1 * (nD1 + nP1)
(1+Ke)
Where n is number of shares outstanding.
Step III: If the firm’s internal sources of financing its investment opportunities fall short of funds
required, new shares are issued at the end of year 1 at price P1. The capitalized value of the
dividends to be received during the period plus the value of the number of shares outstanding is less
than the value of new shares.
nP0 = = 1 * (nD1 + (n + n1)P1 – n1p1)
(1+Ke)
Firms will have to raise additional capital to fund their investment requirements after utilizing their
retained earnings, that is,
n1P1 = I—(E—nD1) which can be written as n1P1 = I—E + nD1
Where I is total investment required,
nD1 is total dividends paid,
E is earnings during the period,
(E—nD1) is retained earnings.
Step IV: The value of share is thus:
nP0 = = 1 * (nD1 + (n + n1)P1 –I + E—nD1)
(1+Ke)
Example:
A company has a capitalization rate of 10%. It currently has outstanding shares worth 25000 shares
selling currently at Rs. 100 each. The firm expects to have a net income of Rs. 400000 for the current
financial year and it is contemplating to pay a dividend of Rs. 4 per share. The company also
requires Rs. 600000 to fund its investment requirement. Show that under MM model, the dividend
payment does not affect the value of the firm.

Solution
Case I: When dividends are paid:
Step I: P0 = 1 * (D1 + P1)
(1+Ke)



100 = 1/(1+0.1) * (4 + P1)
P1 = Rs. 106
Step II: n1P1 = I—(E—nD1), nD1 is 25000*4
n1P1 = 600000—(400000—100000)=Rs. 300000
Step III: Number of additional shares to be issued
300000/106 = 2831 shares
Step IV: The firm value
nP0 = = (n + n1)P1 –I + E
(1+Ke)
(25000 + 2831)*106—600000 + 400000 equals Rs. 2500000
(1+0.1)

Case II: When dividends are not paid:
Step I: P0 = 1 * (D1 + P1)
(1+Ke)
100 = 1/(1+0.1) * (0 + P1)
P1 = Rs. 110
Step II: n1P1 = I—(E—nD1), nD1 is 25000*4
n1P1 = 600000—(400000—0)=Rs. 200000
Step III: Number of additional shares to be issued
200000/110 = 1819 shares
Step IV: The firm value
nP0 = = (n + n1)P1 –I + E
(1+Ke)
(25000 + 1819)*110—600000 + 400000 equals Rs. 2500000
(1+0.1)
Thus, the value of the firm remains the same in both the cases whether or not dividends are
declared.

Critical Analysis of MM Hypothesis:
Floatation costs: Miller and Modigliani have assumed the absence of floatation costs. Floatation
costs refer to the cost involved in raising capital from the market, that is, the costs incurred towards
underwriting commission, brokerage and other costs. These costs ordinarily account to around 10%



15% of the total issue and they cannot be ignored given the enormity of these costs. The presence of
these costs affects the balancing nature of retained earnings and external financing. External
financing is definitely costlier than retained earnings. For instance, if a share is issued worth Rs. 100
and floatation costs are 12%, the net proceeds are only Rs. 88.

Transaction costs: This is another assumption made by MM that there are no transaction costs like
brokerage involved in capital market. These are the costs associated with sale of securities by
investors. This theory implies that if the company does not pay dividends, the investors desirous of
current income sell part of their holdings without any cost incurred. This is very unrealistic as the sale
of securities involves cost, investors wishing to get current income should sell higher number of
shares to get the income they are to receive.

Underpricing of shares: If the company has to raise funds from the market, it should sell shares at
a price lesser than the prevailing market price to attract new shareholders. This follows that at lower
prices, the firm should sell more shares to replace the dividend amount.

Market conditions: If the market conditions are bad and the firm has some lucrative opportunities, it
is not worthapproaching new investors at this juncture, given the presence of floatation costs. In
such cases, the firms should depend on retained earnings and low payout ratio to fuel such
opportunities.

15.5 Stability of Dividends
Stability of dividends is the consistency in the stream of dividend payments. It is the payment
of certain amount of minimum dividend to the shareholders. The steadiness is a sign of good health
of the firm and may take any of the following forms – (a) constant dividend per share,
(b) constant DP ratio and (c) constant dividend per share plus extra dividend.

Constant dividend per share: As per this form of dividend policy, a firm pays a fixed amount of
dividend per share year after year. For example, a firm may have a policy of paying 25% dividend per
share on its paidup capital of Rs. 10 per share. It implies that Rs. 2.50 is paid out every year
irrespective of its earnings. Generally, a firm following such a policy will continue payments even if it
incurs losses. In such years when there is a loss, the amount accumulated in the dividend
equalization reserve is utilized. As and when the firm starts earning a higher amount of revenue it will
consider payment of higher dividends and in future it is expected to maintain the higher level.



Constant DP ratio: With this type of DP policy, the firm pays a constant percentage of net earnings
to the shareholders. For example, if the firm fixes its DP ratio as 25% of its earnings, it implies that
shareholders get 25% of earnings as dividend year after year. In such years where profits are high,
they get higher amount.

Constant dividend per share plus extra dividend: Under this policy, a firm usually pays a fixed
dividend ordinarily and in years of good profits, additional or extra dividend is paid over and above
the regular dividend.
The stability of dividends is desirable because of the following advantages:
· Build confidence amongst investors: A stable dividend policy helps to build confidence and
remove uncertainty in the minds of investors. A constant dividend policy will not have any
fluctuations suggesting to the investors that the firm’s future is bright. In contrast, shareholders of
a firm having an unstable DP will not be certain about their future in such a firm.
· Investors’ desire for current income: A firm has different categories of investors – old and
retired persons, pensioners, youngsters, salaried class, housewives, etc. Of these, people like
retired persons prefer current income. Their living expenses are fairly stable from one period to
another. Sharp changes in current income, that is, dividends, may necessitate sale of shares.
Stable dividend policy avoids sale of securities and inconvenience to investors.
· Information about firm’s profitability: Investors use dividend policy as a measure of evaluating
the firm’s profitability. Dividend decision is a sign of firm’s prosperity and hence firm should have
a stable DP.
· Institutional investors’ requirements: Institutional investors like LIC, GIC and MF prefer to
invest in companies which have a record of stable DP. A company having erratic DP is not
preferred by these institutions. Thus to attract these organizations having large quantities of
investible funds, firms follow a stable DP.
· Raise additional finance: Shares of a company with stable and regular dividend payments
appear as quality investment rather than a speculation. Investors of such companies are known
for their loyalty and whenever the firm comes with new issues, they are more responsive and
receptive. Thus raising additional funds becomes easy.
· Stability in market price of shares: The market price of shares varies with the stability in
dividend rates. Such shares will not have wide fluctuations in the market prices which is good for
investors.



Self Assessment Questions I
1. ____________constitute an important source of financing investment requirements of a firm.
2. Dividend policy has a direct influence on the two components of shareholders’ return__________
and ____________.
3. ______________considers dividend payouts are relevant and have a bearing on the share
prices of the firm.
4. If a firm has a ROI r equal to its cost of capital k, it is called a ___________
5. ________ model explains that consumers prefer certain returns to uncertain returns and
therefore give a premium to the constant returns and discount uncertain returns.
6. The __________process refers to setting off or balancing two transactions which are entered into
simultaneously.
7. __________ costs refer to the cost involved in raising capital from the market.
8. ______________are the costs associated with sale of securities by investors.

15.6 Forms of Dividends
Dividends are that potion of earnings available to shareholders. Generally, dividends are distributed
in cash, but sometimes they may also declare dividends in other forms which are discussed below:
· Cash dividends: Most companies pay dividends in cash. The investors also, especially the old
and retired investors depend on this form of payment for want of current income.
· Scrip dividend: In this form of dividends, equity shareholders are issued transferable promissory
notes with shorter maturity periods which may or may not have interest bearing. This form is
adopted if the firm has earned profits and it will take some time to convert its assets into cash
(having more of current sales than cash sales). Payment of dividend in this form is done only if
the firm is suffering from weak liquidity position.
· Bond dividend: Scrip and bond dividend are the same except that they differ in terms of
maturity. Bond dividends carry longer maturity period and bear interest, whereas scrip dividends
carry shorter maturity and may or may not carry interest.
· Stock dividend (Bonus shares): Stock dividend, as known is USA or bonus shares in India, is
the distribution of additional shares to the shareholders at no additional cost. This has the effect
of increasing the number of outstanding shares of the firm. The reserves and surplus (retained
earnings) are capitalized to give effect to bonus issue. This decision has the effect of



recapitalization, that is, transfer from reserves to share capital not changing the total net worth.
The investors are allotted shares in proportion to their present shareholding. Declaration of bonus
shares has a favourable psychological effect on investors. They associate it with prosperity.

15.7 Stock Split
A stock split is a method to increase the number of outstanding shares by proportionately reducing
the face value of a share. A stock split affects only the par value and does not have any effect on the
total amount outstanding in share capital. The reasons for splitting shares are:
· To make shares attractive: The prime reason for effecting a stock split is to reduce the market
price of a share to make it more attractive to investors. Shares of some companies enter into
higher trading zone making it out of reach to small investors. Splitting the shares will place them
in more popular trading range thus providing marketability and motivating small investors to buy
them.
· Indication of higher future profits: Share split is generally considered a method of
management communication to investors that the company is expecting high profits in future.
· Higher dividend to shareholders: When shares are split, the company does not resort to
reducing the cash dividends. If the company follows a system of stable dividend per share, the
investors would surely get higher dividends with stock split.

15.8 Summary
Dividends are the earnings of the company distributed to shareholders. Payment of dividend is not
mandatory, but most companies see to it that dividends are paid on a regular basis to maintain the
image of the company. As payment of dividend is not compulsory, the question which arises in the
minds of policy makers is “Should dividends be paid, if yes, what should be the quantum of
payment?” Various theories have come out with various suggestions on the payment of dividend. B.
Graham and D. L. Dodd are of the view that there is a close relationship between the dividends and
the stock market. The stock value responds positively to high dividends and vice versa.

Prof. James E. Walter considers dividend payouts are necessary but if the firm’s ROI is high,
earnings can be retained as the firm has better and profitable investment opportunities.



Gordon also contends that dividends are significant to determine the share prices of a firm.
Shareholders prefer certain returns (current) to uncertain returns (future) and therefore give a
premium to the constant returns and discount uncertain returns.

Miller and Modigliani explain that a firm’s dividend policy is irrelevant and has no effect on the share
prices of the firm. They are of the view that it is the investment policy through which the firm can
increase its share value and hence this should be given more importance.

Dividends can be paid out in various forms such as cash dividend, scrip dividend, bond dividend and
bonus shares.

Terminal Questions
1. Write a short note on the different types of dividend.
2. What is stock split? What are its advantages?
3. The following information is available in respect of a company.
Equity capitalization 15%
EPS Rs. 25
Dividend payout ratio25%
ROI 12%
What is the price of the share as per Walter Model?

4. Considering the following information, what is the price of the share as per Gordon’s Model?
Net sales Rs. 120 lakhs
Net profit margin 12.5%
Outstanding preference shares Rs. 50 lakhs @ 12% dividend
No. of equity shares 250000
Cost of equity shares 12%
Retention ratio 40%
ROI 16%
5. If the EPS is Rs.5, dividend payout ratio is 50%, cost of equity is 20%, growth rate in the ROI is
15%, what is the value of the stock as per Gordon’s Dividend Equalization Model?
6. Nile Ltd. makes the following information available. What is the value of the stock as per Gordon
Model?



Ke 14%, EPS Rs. 20, D/P ratio 35% Retention ratio 65%, ROI 16%
7. What is the stock price as per Gordon Model if DP ratio is 60% in the above case?

Answers to Self Assessment Questions
Self Assessment Questions 1
1. Retained earnings
2. Dividends and capital gains
3. Prof. James E. Walter
4. Normal firm
5. Gordon
6. Arbitrage
7. Floatation costs
8. Transaction costs

Answers to Terminal Questions:
1. Refer to10.6
2. Refer to10.7
3. Hint: Apply the formulaWalter’s formula to determine the market price
P = D + [r(E—D)/Ke]
Ke Ke
4, 5, 6, 7 : Hint: Apply the Gordon formula of P = E(1—b)
Ke—br


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