Dividend Policy and Dividend Decision Theories

1. DIVIDEND AND RETENTION
POLICY

2. Introduction
:
 What is Dividend?
 What is dividend policy?
 Theories of Dividend Policy
 Relevant Theory
 Walter’s Model
 Gordon’s Model
 Irrelevant Theory
 M-M’s Approach
 Traditional Approach

3. What is Dividend?
“A dividend is a distribution to shareholders out of
profit or reserve available for this purpose”.
- Institute of Chartered Accountants of India

4. Forms/Types of
Dividend
 On the basis of Types of Share
 Equity Dividend
 Preference Dividend
 On the basis of Mode of Payment
 Cash Dividend
 Stock Dividend
 Bond Dividend
 Property Dividend
 Composite Dividend

5.  On the basis of Time of
Payment
 Interim Dividend
 Regular Dividend
 Special Dividend
Cont
d.

6. What is Dividend
Policy :
 “ Dividend policy determines the division of
earnings between payments to shareholders
and retained earnings”.
- Weston and Bringham

7. Dividend Policies involve the decisions, whether-
 To retain earnings for capital investment and
other purposes; or
 To distribute earnings in the form of dividend
among shareholders; or
 To retain some earning and to distribute
remaining earnings to shareholders.
Cont
d.

8. Factors Affecting Dividend
Policy
 Legal Restrictions
 Magnitude and trend of earnings
 Desire and type of Shareholders
 Nature of Industry
 Age of the company
 Future Financial Requirements
 Taxation Policy
 Stage of Business cycle

9.  Regularity
 Requirements of Institutional Investors
Cont
d.

10. Dimensions of Dividend
Policy
 Pay-out Ratio
 Funds requirement
 Liquidity
 Access to external sources of financing
 Shareholder preference
 Difference in the cost of External Equity and
Retained Earnings
 Control
 Taxes

11.  Stability
 Stable dividend payout Ratio
 Stable Dividends or Steadily changing
Dividends
Cont
d.

12. Types of Dividend
Policy
 Regular Dividend Policy
 Stable Dividend Policy
 Constant dividend per share
 Constant pay out ratio
 Stable rupee dividend + extra
dividend
 Irregular Dividend Policy

14. Dividend Theories
Relevance Theories
(i.e. which consider dividend
decision to be relevant as it
affects the value of the firm)
Walter’s
Model
Gordon’s
Model
Irrelevance Theories
(i.e. which consider dividend
decision to be irrelevant as it
does not affects the value of the
firm)
Modigliani and
Miller’s Model
Traditional
Approach

16.  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. Walter has formulated this
and used the dividend to optimize the wealth
of the equity shareholders.
Walter’s Model

17.  Assumptions of Walter’s
Model:
 Internal Financing
 constant Return in Cost of
Capital
 100% payout or Retention
 Constant EPS and DPS
 Infinite time

18. Formula of Walter’s Model
Where,
P = Current Market Price of equity share
E = Earning per share
D = Dividend per share
(E-D)= Retained earning per share
r = Rate of Return on firm’s investment or Internal Rate of
Return
k = Cost of Equity Capital
P
D + r (E-D)
k
k
=

19.  Growth Firm (r > k):
r = 20% k = 15% E = Rs. 4
If D = Rs. 4
P = 4+(0) 0.20 /0 .15 = Rs. 26.67
0.15
If D = Rs. 2
P = 2+(2) 0.20 / 0.15 = Rs. 31.11
0.15
Illustration
:

20.  Normal Firm (r = k):
r = 15% k = 15% E = Rs. 4
If D = Rs. 4
P = 4+(0) 0.15 / 0.15 = Rs. 26.67
0.15
If D = Rs. 2
P = 2+(2) 0.15 / 0.15 = Rs. 26.67
0.15
Illustration
:

21.  Declining Firm (r < k):
r = 10% k = 15% E = Rs. 4
If D = Rs. 4
P = 4+(0) 0.10 / 0.15 = Rs. 26.67
0.15
If D = Rs. 2
P = 2+(2) 0.10 / 0.15 = Rs. 22.22
0.15
Illustration
:

22. Effect of Dividend Policy on Value of
Share
Case If Dividend Payout
ratio Increases
If Dividend Payout
Ration decreases
1. In case of Growing
firm i.e. where r > k
Market Value of Share
decreases
Market Value of a share
increases
2. In case of Declining
firm i.e. where r < k
Market Value of Share
increases
Market Value of share
decreases
3. In case of normal firm
i.e. where r = k
No change in value of
Share
No change in value of
Share

23. Criticisms of Walter’s
Model
 No External Financing
 Firm’s internal rate of return does not always
remain constant. In fact, r decreases as more
and more investment in made.
 Firm’s cost of capital does not always remain
constant. In fact, k changes directly with the
firm’s risk.

24. Gordon’s
Model
 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 market price is
equal to the sum of share’s discounted future
dividend payment.

25.  Assumptions:
 All equity firm
 No external Financing
 Constant Returns
 Constant Cost of Capital
 Perpetual Earnings
 No taxes
 Constant Retention
 Cost of Capital is greater then growth rate
(k>br=g)

26. Formula of Gordon’s
Model
 Where,
P = Price
E = Earning per Share
b = Retention Ratio
k = Cost of Capital
br = g = Growth Rate
P =
E (1 – b)
K - br

27.  Growth Firm (r > k):
r = 20% k = 15% E = Rs. 4
If b = 0.25
P0 = (0.75) 4 = Rs. 30
0.15- (0.25)(0.20)
If b = 0.50
P0 = (0.50) 4 = Rs. 40
0.15- (0.5)(0.20)
Illustration
:

28.  Normal Firm (r = k):
r = 15% k = 15% E = Rs. 4
If b = 0.25
P0 = (0.75) 4 = Rs. 26.67
0.15- (0.25)(0.15)
If b = 0.50
P0 = (0.50) 4 = Rs. 26.67
0.15- (0.5)(0.15)
Illustration
:

29.  Declining Firm (r < k):
r = 10% k = 15% E = Rs. 4
If b = 0.25
P0 = (0.75) 4 = Rs. 24
0.15- (0.25)(0.10)
If b = 0.50
P0 = (0.50) 4 = Rs. 20
0.15- (0.5)(0.10)
Illustration
:

30. Criticisms of Gordon’s
model
 As the assumptions of Walter’s Model
and Gordon’s Model are same so the
Gordon’s model suffers from the same
limitations as the Walter’s Model.

32. Modigliani & Miller’s Irrelevance
Model
Value of Firm (i.e. Wealth of Shareholders)
Firm’s Earnings
Firm’s Investment Policy and not on dividend policy
Depends on
Depends on

33. Modigliani and Miller’s
Approach
 Assumption
 Capital Markets are Perfect and people are
Rational
 No taxes
 Floating Costs are nil
 Investment opportunities and future profits of
firms are known with certainty (This assumption
was dropped later)
 Investment and Dividend Decisions are
independent

34. M-M’s Argument
 If a company retains earnings instead of giving
it out as dividends, the shareholder enjoy
capital appreciation equal to the amount of
earnings retained.
 If it distributes earnings by the way of
dividends instead of retaining it, shareholder
enjoys dividends equal in value to the amount
by which his capital would have appreciated
had the company chosen to retain its earning.

35.  Hence,
the division of earnings between dividends and
retained earnings is IRRELEVANT from the point
of view of shareholders.

36. Formula of M-M’s
Approach
P
o
=
1 ( D1+P1 )
(1 + p)
Where,
Po = Market price per share at time 0,
D1 = Dividend per share at time 1,
P1 = Market price of share at time 1

37.  The expression of the outstanding equity
shares of the firm at time 0 is obtained as:
nPo =
1 {nD1+(n + m)P1- mP1}
(1 + p)
nPo =
1 (nD1+nP1)
(1 + p)

38. nPo =
1 [nD1+ (n + m)P1– {I – (X –
nD1)}]
(1 + p)
mP1 = I – (X – nD1)
Where,
X = Total net profit of the firm for year
1
nPo =
1 nD1+ (n + m)P1– I +X – nD1
(1 + p)

39. nPo =
1 (n + m)P1– I +X
(1 + p)

40. Criticism of M-M
Model
 No perfect Capital Market
 Existence of Transaction Cost
 Existence of Floatation Cost
 Lack of Relevant Information
 Differential rates of Taxes
 No fixed investment Policy
 Investor’s desire to obtain current
income

41. Traditional Approach
 This theory regards dividend decision merely
as a part of financing decision because
 The earnings available may be retained in the
business for re-investment
 Or if the funds are not required in the business
they may be distributed as dividends.
 Thus the decision to pay the dividends or
retain the earnings may be taken as a residual
decision

42.  This theory assumes that the investors do
not differentiate between dividends and
retentions by the firm
 Thus, a firm should retain the earnings if it
has profitable investment opportunities
otherwise it should pay than as dividends.

43. Summary
 Dividend is the part of profit paid to
Shareholders.
 Firm decide, depending on the profit, the
percentage of paying dividend.
 Walter and Gordon says that a Dividend
Decision affects the valuation of the firm.
 While the Traditional Approach and MM’s
Approach says that Value of the Firm is
irrelevant to Dividend we pay.