The document discusses dividend policy in financial management, detailing the nature of dividends and their importance as returns on equity shares. It explains legal provisions under the Indian Companies Act, dividend theories including irrelevance and relevance theories, and models by Modigliani & Miller, Walter, and Gordon, which analyze how dividend policies affect firm value. Additionally, it outlines factors influencing dividend policy decisions, such as profitability, liquidity, and management objectives.

1. DIVIDEND POLICY
FINANCIAL MANAGEMENT-II
SECOND SEMESTER, 2014
Prof. Ajit Kumar Ray

2. What is dividend?
•Dividend is the return on the investment made in the
shares (equity or preference) and is paid out of the profits
of the company.
•The shareholders being the owners of the company are
entitled to get their share of profit and the part of profit
which is distributed among the shareholders is known as
dividend.
•While the rate of dividend in case of preference shares is
fixed, the dividend on equity shares varies from year to
year depending upon the profit for the year and few other
determinants.
•Dividend rate is used for valuation of share and is an
indicator of performance of the company.

3. Legal Provisions Regarding Dividend
Under Indian Acts
Section 205 of the Indian Companies Act, 1956
regulates the declaration and distribution of
dividend.
All the companies which have share capital other
than section 25 companies and make profit are
bound by law to declare and distribute dividends.
As per the Section 205, a dividend (including
interim dividend) can be paid out of current profits
or profits accumulated of earlier years out of the
profits of the company for that year arrived at after
providing for depreciation .

4. Before declaring the dividend, the some part of the profit has to
be compulsorily transferred to the Reserves of the Company.
This amount is based on the proposed rate of dividend.
However voluntary transfer of higher percentage to reserves is
permitted subject to the conditions stipulated in the Act.
TAX PROVISION:
In addition to the income tax chargeable in respect of the total
income of a company for any assessment year, any amount
declared, distributed or paid by such company by way of
dividends (whether interim or otherwise) and also whether paid
out of current or accumulated profits is charged with additional
tax at the rate of 15 %.
Legal Provisions Regarding Dividend
Under Indian Acts

5. What implies Dividend Policy :
Dividend Policies thus involve the following decisions,
1. Whether to retain earnings for capital investment
and other purposes;
or
2. To distribute earnings in the form of dividend among
shareholders;
or
3. To retain some earning and to distribute remaining
earnings to shareholders.

6. Dividend Policy thus resolves two questions:
• Question 1:
– Does dividend policy affect firm value?
• Question 2:
– If so
• What is the optimal level of distribution ratio i.e., %
Net Income to be distributed as dividend (Payout
ratio)
• What is the optimal form of dividend i.e., cash
dividend or stock dividend or both.
What is Dividend Policy :

7. Dividend Theories
Two Groups of Theories:
A. Irrelevance Theories
which consider dividend decision to be irrelevant as it
does not affects the value of the firm.
Modigliani and Miller’s Model
B. Relevance Theories
which consider dividend decision to be relevant as it
affects the value of the firm
a) Traditional View b) Walter’s Model c) Gordon’s
Model

8. Irrelevance Theory: Modigliani & Miller (1961)
Assumptions of the Model:
1. Capital Market is
perfect
2. Investors are rational
3. There is no
discrimination of tax
between dividend
income and income from
capital gains.
4. There is no
transaction cost
Under such conditions
M-M model believes
that the price of equity
shares of a firm in the
market depends solely
on competency &
capability of its earning
ability and not
influenced by the split
of earnings between
dividends and retained
earnings

9. M-M Model
Let,
P0 = Market Price of share in the beginning of the year
= PV of sum of [dividend (D1) + Market Price of the
share(P1)] at the beginning of the next period
I = Amount to be invested in the beginning of the next
period
n = Number of shares at the initial period
E = Earnings of the period
I + D1 – E = Amount to be raised from the market by issuing m
shares at the price P1

10. M-M Model
Then,
1 1
0
e
D +P
P =
1+k
ekWhere = cost of equity shares
M-M showed that value of n shares at the beginning of the year
1
0
(n+m)P I+E
V= nP =
1 + Ke
−

11. Example 1
A company belongs to a risk class of which appropriate
capitalization rate is 10 percent. It currently has 1000
shares of Rs. 10 each. The firm is contemplating the
declaration of a dividend of Rs. 0.6 per share at the
beginning of the next fiscal year, which has just begun. On
the basis of M-M model, answer the following:
(1)What will be the price of the share at the beginning of the
next year if dividend is not declared?
(2) Assuming that the firm pays dividend, has net income of
Rs. 10,000 and makes new investment of Rs. 20,000, how
many new shares must be issued?

12. Example 2
A company has 5000 outstanding shares. The
current market price per share is Rs. 10 each.
Estimated net income at the end of the current
year is Rs. 5000.Board is considering a
dividend of Re. 0.5 per share at the end of the
current financial year. The firm needs Rs.
10,000 for an approved investment
expenditure. Capitalization rate is 10 percent.
Show how does the M-M approach affect the
market value of the firm if dividends are (a)
paid and (b) not paid.

13. Relevance Theory
a) Traditional View
b) Walter’s Model
c) Gordon’s Model

14. Relevance Theory
Traditional View:
• Bird in hand view: A bird in hand is better than two in the
bushes
• Graham & Dodd observed: “ The stock market is
overwhelmingly in favour of liberal dividend.”
• Accordingly, traditional theorists believe that value of
share is directly proportional to the size of the dividend
and earning per share with lesser weightage.
Accordingly, Graham & Dodd proposed that the market price (P) of a share is to
be obtained by
P = m(D + E/3)
= m(D + (D+R)/3)
= m(4D+R)/3)
Where, Dividend per share = D and Earnings per Share = E
Retained earnings = R and ‘m’ is a constant proportional (called multiplier)
The weight given by Graham and Dodd is completely subjective consideration of them
and is not based on any empirical or theoretical analysis.

15. Walter’s Valuation Model:
Prof. James E Walter argued that in the long-run the share
prices reflect only the present value of expected dividends.
Retentions influence stock price only through their effect on
future dividends.
Assumptions of Walter’s Model
1. External sources of funds like debt or new equity capital are not used.
2. Retained earnings represents the only source of funds.
3. All investment is done through retained earnings.
4. With additional investment undertaken, the firm’s business risk does not
change. (It implies that firm’s IRR and cost of capital are constant.)
5. The return on investment remains constant.
6. The firm has an infinite life and is a going concern.
7. All earnings are either distributed as dividends or invested internally
immediately.
8. There is no change in the key variables such as EPS .

16. Walter’s Model
Walter identified two factors
that influence the market
price of a share:
i)Dividend pay-out ratio (P/O
ratio)
ii) The relationship between
Internal Return on retained
earnings (r) and cost of equity
capital (ke).
Walter classified all firms into
three categories:
a)Growth firm
b)Constant or Normal firm
and
c)Declining firm
Given r and ke,
(i) Growth firm, if r > ke
(ii) Constant or Normal firm,
if r = ke
(iii) Declining firm, if r < ke

17. Walter concluded the following:
(i) The optimum pay-out ratio is nil in case of growth firm
(ii) the payout ratio of a constant firm is irrelevant or
every pay-out ratio is optimum
(iii) the optimum pay-out ratio for a declining firm is 100
per cent
Walter’s Model

18. Category of
firm
relation
between
r and ke
Correlation
between
dividend and
market price of
the share
Optimum P/O
ratio
Growth r > ke Negative nil
Constant r = ke No correlation Any P/O ratio
is optimum
Declining r < ke Positive 100%
Walter’s Model

19. Walter’s Valuation Model:
e
e
r
D+(E-D)
k
p
k
=
Walter proposed the following to compute the valuation of firm:
E = Earning per share, r = rate of return on retained earnings
D = Dividend per share ke = cost of equity capital
P = Market price per share

20. Problems
Walter’s Model
1
EPS is given as Rs. 16.00. The market rate of discount applicable to the
company is 12.5 percent. Retained earnings can be employed to yeild a
return of 10 percent. The company is considering a pay-out of 25
percent, 50 percent and 75 percent. Which of these would maximize the
wealth of shareholders?
2
Cost of equity is 20 percent and EPS is Rs 5. dividend per share Rs. 4.
rate of return on investment 20 percent. Find market price of the share
after dividend announcement using Walter model.
3
A company earns Rs 6 per share having capitalization rate of 10
percent and has a return on investment at the rate of 20 percent.
According to Walter’s model, what should be the price per share at 30
percent dividend pay-out ratio? Is this the optimum pay-out ratio as
per Walter?
4
Consider the following information of a company:
Net Profit 3.0 million
Outstanding 12 percent preference share 10.0 million
No of equity shares 0.3 million
Return on investment 20 percent
Cost of equity 16 percent
What should be the appropriate P/O ratio so as to keep the price at Rs 40
per share by using Walter’s model?

21. GORDON’S MODEL OF DIVIDEND POLICY

22. GORDON’S MODEL OF DIVIDEND POLICY
Gordon’s Model which is termed as ‘Growth Valuation Model’
based on the following assumptions:
1. The firm is an all equity firm and external financing is not used and
thus has no debt.
2. Retained earnings represent the only source of financing.
3. The internal rate of return is the firm’s cost of capital ’k’ which remains
constant and is taken as the appropriate discount rate.
4. Future annual growth rate of dividend is expected to be constant.
5. Growth rate of the firm is the product of retention ratio and its rate of
return.
6. Cost of Capital is always greater than the growth rate.
7. The company has perpetual life and the stream of earnings are
perpetual.
8. Corporate taxes does not exist.
9. The retention ratio ‘b’ once decided upon, remain constant. Therefore,
the growth rate g=br, is also constant forever.

23. •According to Prof. Gordon, Dividend Policy almost always affects
the value of the firm.
•He showed how dividend policy can be used to maximize the
wealth of the shareholders.
•The main proposition of the model is that the value of a share
reflects the value of the future dividends accruing to that share.
Hence, the dividend payment and its growth are relevant in
valuation of shares.
•The model holds that the share’s present market price (P0) is
equal to the sum of share’s discounted future dividend payment.
GORDON’S MODEL OF DIVIDEND POLICY

24. GORDON’S MODEL OF DIVIDEND POLICY
The growth of dividend of a normal firm is expected to continue in the foreseeable
future at a constant rate ‘g’.
Thus if such a company’s dividend which has already been paid at time t=0 is d0
, its dividend in the next period t=1 would be d1=d0(1+g)
Similarly, at time t=2 dividend would be d2=d1(1+g) = d0(1+g)^2
Thus, present market price P0 is sum of PV of stream of dividends for infinte
times
∑= +
+
=
+
+
+
+
+
+
=
α
1t
t
e
t
0
3
e
3
2
e
2
e
1
0
)k(1
g)(1d
.......
)k(1
d
)k(1
d
)k(1
d
P

25. GORDON’S MODEL OF DIVIDEND POLICY
Since ‘g’ is assumed to be constant, the above expression may be simplified to
.
k
d
P
e
1
0
g−
=
Where,
P0 = Price of shares
b = Retention Ratio
ke = Cost of equity capital
g = growth rate of dividend= br ; r =rate of return on investment of an all-
equity firm
d1 = Dividend per share at the end of first year

26. The implications of Gordon’s basic valuation model is identical to Walter’s
model and may be summarized as follows:
1.When the rate of return of firm’s investment is greater than the required rate
of return, i.e. when r > k, the price per share increases as the dividend payout
ratio decreases. Thus, growth firm should distribute smaller dividends and
should retain maximum earnings.
2.When the rate of return is equal to the required rate of return, when r = k,
the price per share remains unchanged and is not affected by dividend policy.
Thus, for a normal firm there is no optimum dividend payout.
3.When the rate of return is less than the required rate of return, i.e., when
r<k, the price per share increases as the dividend payout ratio increases.
Thus, the shareholders of declining firm stand to gain if the firm distributes its
earnings. For such firms, the optimum pay out would be 100%.
GORDON’S MODEL OF DIVIDEND POLICY

27. A Ltd Co’s registered earnings is Rs. 800,000 for the year ended 31st March. They
finance all investments from out of retained earnings. The opportunities for
investments are many. If such opportunities are not availed their earnings will stay
perpetually at Rs. 800,000. Following figures are relevant.
The returns to shareholders are expected to rise if the earnings are retained
because of the risk attached to new investments. As for the current year, dividend
payments will be made with or without retained earnings. What according to you,
should be retained ?
GORDON’S MODEL OF DIVIDEND POLICY
An Example
Policy Retention (%) Growth (%) Cost of equity on all
investments
A 0 0 14
B 25 5 15
C 40 7 16

28. Determinants or Factors affecting Dividend Policy :
1. Availability of Distributable Profits
2. Availability of Profitable Reinvestment Opportunities
3. Availability of Liquidity
4. Inflation Effect on Market Prices
5. Composition of Shareholding
6. Company’s own policy regarding stability of dividend
7. Extent of access to external sources
8. Attitude and Objectives of Management

29. Thank You