The document discusses various topics related to dividends, including: - Defining dividends as profits distributed to shareholders. Companies determine dividend amounts and frequencies based on earnings, finances, and policies. - Theories of investor preference for dividends, including the irrelevance model, traditional model, Walter model, Gordon model, and bird-in-hand theory. These theories make different predictions about whether investors prefer high or low dividend payouts. - The residual distribution model, which aims to maintain a company's target capital structure by distributing residual earnings as dividends after accounting for required equity financing. - Other dividend-related topics like stock repurchases, stock dividends vs splits, and dividend

1. Professor Raju Indukoori

2. Dividend
Professor Raju Indukoori
It is the distribution of profits to the
share holders who are owners of the
company. The period or frequency of
distribution varies from company to
company based on its earnings,
financial health and policy.
Though earned profits, some
companies don’t pay dividends and
retain the earnings.
2

3. Dividend Types
Professor Raju Indukoori
Based on the Form
 Cash Dividend
 Stock Dividend
Base on the timing
 Annual Dividend
 Interim Dividend
Base on the size of pay out
(DPS/EPS)
 High dividend payout
 Low dividend payout
3

4. Dividend Policy
Professor Raju Indukoori
It gives the direction for the company towards
its profits distributions. It is need for the
following reasons.
1. Level of cash distributions to shareholders
2. Sock vs Cash
3. Stability of the distribution
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5. Framing Dividend Distribution Policy
 Forecast capital needs.
 Set a target capital structure.
 Estimate annual equity needs.
 Set target payout based on the residual model.
 Generally, some dividend growth rate emerges.
 maintain target growth rate if possible.
 varying capital structure somewhat if necessary.
5
Professor Raju Indukoori

6. Do investors prefer
High payouts
or
low payouts?
6
Professor Raju Indukoori

7. Theories of Investor’s
Preference
Professor Raju Indukoori
Irrelevant Models
1. MM Theory
2. Rationale Expectation
Model
7
Relevant Models
1. Traditional Model
2. Walter Model
3. Gordon’s Model
4. Bird-in-hand
5. Tax preference
6. Residual
Distribution

8. Irrelevant Models

9. Propositions
1. Investors don’t care about payout.
2. Investors are indifferent between dividends and retention-generated
capital gains.
3. If they want cash, they can sell stock. If they don’t want cash, they
can use dividends to buy stock.
Professor Raju Indukoori 9
1 MM Model

10. Critics
1. Based on unrealistic assumptions
• no taxes
• brokerage costs
2. hence may not be true. Need empirical test.
Professor Raju Indukoori 10
1 MM Model

11. 2. Rational Expectations Model
As long as the dividend rate is up to the expectations
there is no impact of dividend declaration on market
price.
1. If dividends are above the expectations, price goes up.
2. If dividends are below the expectations, price goes
down.
Professor Raju Indukoori 11

12. Relevant Models

13. 1. Traditional Model
• P/E ratios are directly related to D/P ratios.
• High D/P increases P/E ratio.
Professor Raju Indukoori

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
3
E
DmP
13
Where
P = Market Price
m = multiplier
D = DPS
E = EPS

14. Problem 1a
• A firm has Rs 150 crores of EAT and is indifferent to
fix the Dividend rate as it may influence the MPS
according to traditional model. Assuming retention
ratio of thirty and fifty percent with a mulitple of 9
what would be the impact of dividend rate on MPS
with outstanding shares of 100 crores
Professor Raju Indukoori 14

15. Professor Raju Indukoori
Solution 1a
• Retention ratio 30% means D/P ratio 70%
• Retention ratio 50% means D/P ratio 50%
95.13
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15

16. 2. Walter Model : James E Walter
It gives the relationship between IRR (r) and Cost of capital
of the firm which gives a dividend policy to maximize
wealth.
Assumptions
o Retained earnings only source of finance.
o r and k constant.
o Infinite companies firms life.
o DPS and EPS remain constant.
Professor Raju Indukoori 16

17. Walter Model : James E Walter
Propositions
1. r > ke : Market value decreases as the DP ratio increases.
2. r < ke : Market value increases as the DP ratio increases.
3. r = ke : Market value remains same at any DP ratio.
Professor Raju Indukoori
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17

18. 3. Gordon Model : Myron Gordon
Similar to Walter model but considers current
dividends.
Assumptions
1. 100% equity firm.
2. Retention ratio and growth rates are constant.
3. Investors are rational and risk averse.
4. Investors prefer certain to uncertain returns.
5. Ke > br (Cost of equity is greater than growth.
Professor Raju Indukoori 18

19. Gordon Model : Myron Gordon
Propositions
1. r > ke
Market value decreases as the DP ratio increases.
2. r < ke
Market value increases as the DP ratio increases.
3. r = ke
Market value remains same at any DP ratio.
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Professor Raju Indukoori 19

20. Problem 2
A firm had an earnings after tax of Rs 10,12,25,374 with an
expansion plan of Rs 60 Crs. The expected return on the new
investment is 25% where as ROE is 32%. If the company has
a retention ratio of sixty two percent with 8,74, 68,259 shares
what would be the value of the firm.
Professor Raju Indukoori 20

21. Solution 2
• Walter Model Rs 2.47
Professor Raju Indukoori
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32.0
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32.0
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OP
47.2752.172.0 OP

22. Solution 2
• Walter Model Rs 8.38
• Gordon Model Rs 2.67
Professor Raju Indukoori
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23. 4. Bird-in-the-Hand Theory
1. Investors prefer high dividends
2. Investors think dividends are less risky than potential
future capital gains, hence they like dividends.
3. Investors would value high payout firms result in a
high P0.
Professor Raju Indukoori 23

24. 5. Tax Preference Theory
1. Investors prefer a low payout, hence growth.
2. Low payouts mean higher capital gains. Capital
gains taxes are deferred.
3. This could cause investors to prefer firms with low
payouts, i.e., a high payout results in a low P0.
Professor Raju Indukoori 24

25. 6. Residual Distribution Model
1. Objective is to maintain the existing capital
structure ratio.
2. The earnings are adjusted to equity part as a ratio
to total capital.
3. What ever is left after adjustment is distributed as
dividend.
Professor Raju Indukoori 25

26. Professor Raju Indukoori
Problem 6a
The Adarsh Company expects next year’s net income to be Rs
1,50,00,000. The firm’s debt ratio is currently 40%. Adarsh has Rs
1,20,00,000 of profitable investment opportunities, and it wishes to
maintain its existing debt ratio. According to the residual distribution
model, how large should Adarsh’s dividend payout ratio be next
year?
26

27. Professor Raju Indukoori
Solution 6a
Equity financing = Rs1,20,00,000(0.60)
= Rs72,00,000.
Dividends = Net income - Equity financing
= Rs1,50,00,000 - Rs72,00,000
= Rs78,00,000.
Dividend payout ratio = Dividends/Net income
= Rs78,00,000/Rs1,50,00,000
= 52%.
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28. Professor Raju Indukoori
Problem 6b
Axel Telecommunications has a target capital structure that consists
of 70 % debt and 30% equity. The company anticipates that its
capital budget for the upcoming year will be Rs 3 Cr. If Axel reports
net income of Rs 2 Cr and it follows a residual distribution model
with all distributions as dividends, what will be its dividend payout
ratio?
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29. Professor Raju Indukoori
Solution 6b
Debt = 70%
Equity = 30%
Capital Budget = Rs3,00,00,000
NI = Rs2,00,00,000
DP = ?
Equity retained = 0.3(Rs3,00,00,000) = Rs90,00,000.
NI Rs2,00,00,000
-Additions 90,00,000
Earnings Remaining Rs1,10,00,000
Payout = (Rs 1,10,00,000 / Rs 2,00,00,000) = 55%.
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30. Implications of Theories for Managers
Professor Raju Indukoori
Theory Implication
- Any payout OK
- Set high Payout
- Depends on r and k
- Depends on r and k
- Set high payout
- Set low payout
MMs Irrelevance
Traditional Model
Walter Model
Gordon Model
Bird-in-the-hand
Tax preference
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31. * Empirical testing has not been able to
determine which theory, if any, is correct.
* Thus, managers use judgment when setting
policy.
* Analysis is used, but it must be applied with
judgment.
31Professor Raju Indukoori

32. Professor Raju Indukoori
Stock Repurchases
It is a process of a company buying its own stock
Reasons :
 Alternative to distributing cash as dividends.
 To dispose of one-time cash from an asset
sale.
 To make a large capital structure change.
32

33. Professor Raju Indukoori
Stock Repurchases
Advantages
 Optional to Stockholders
 Helps avoid setting a high dividend that cannot be
maintained.
 Repurchased stock can be used in takeovers or resold to raise
cash as needed.
 Income received is capital gains rather than higher-taxed
dividends.
 Stockholders may take as a positive signal-management
thinks stock is undervalued.
33

34. Professor Raju Indukoori
Stock Repurchases
Disadvantages
 May be viewed as a negative signal (firm has poor
investment opportunities).
 Selling stockholders may not be well informed, hence
be treated unfairly.
 Firm may have to bid up price to complete purchase,
thus paying too much for its own stock.
34

35. Professor Raju Indukoori
Stock Dividends vs. Stock Splits
Stock dividend
Firm issues new shares in lieu of paying a
cash dividend. If 10%, get 10 shares for
each 100 shares owned.
Stock split
Firm increases the number of shares
outstanding, say 2:1. Sends shareholders
more shares. 35

36. Professor Raju Indukoori
DRIP
 Dividend Re-Investment Plan (DRIP)
 Shareholders can automatically reinvest
their dividends in shares of the company’s
common stock. Get more stock than cash.
 There are two types of plans:
– Open market
– New stock
36

37. Professor Raju Indukoori
DRIP
 Dividend Re-Investment Plan (DRIP)
 Shareholders can automatically reinvest
their dividends in shares of the company’s
common stock. Get more stock than cash.
 There are two types of plans:
– Open market
– New stock
37

38. Professor Raju Indukoori
Stock Split
 It is dividing one unit of share into more
than 1.
 Due to this face value of share decreases.
 Number of shares holding increases.
 Market value per share decreases.
 Market capitalization remains same.
 Capital Structure is not disturbed.
38

39. Professor Raju Indukoori
Problem 3
Gamma Medical’s stock trades at Rs 90 a share.
The company is contemplating a 3 for 2 stock split.
Assuming that the stock split will have no effect on
the total market value of its equity, what will be the
company’s stock price following the stock split?
39

40. Professor Raju Indukoori
Solution 3
P0 = Rs 90
Split = 3 for 2
New P0 = ?
P0New = = Rs 60.
2/3
90Rs
40

41. Professor Raju Indukoori
Dividend Yields for Selected
Industries
Industry Div. Yield %
Airline 0.2
Software & Programming 0.3
Biotechnology & Drugs 0.3
Restaurants 1.0
Chemical Manufacturing 2.2
Paper & Paper Products 2.7
Electric Utilities 4.4
Tobacco 5.6
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42. Professor Raju Indukoori
Thank You
Any Questions???
42