Dividend Policy II - Dividend theories .pptx

MEANING OF
DIVIDEND
 The term dividend refers to
that portion of profit which is
distributed among the
owners/shareholders of the
firm.

INTRODUCTION TO DIVIDEND POLICY
 The dividend policy of a firm determines what proportion of earnings is
paid to shareholders by way of dividends and what proportion is ploughed
back in the firm for reinvestment purposes. If a firm’s capital budgeting
decision is independent of its dividend policy, a higher dividend payment
will call for a greater dependence on external financing. Thus, the dividend
policy has a bearing on the choice of financing. On the other hand, firm’s
capital budgeting decision is dependent on its dividend decision; a higher
dividend payment will cause shrinkage of its capital budget and vice versa.
In such case, the dividend policy has a bearing on the capital budgeting
decision.

MEANING OF DIVIDEND POLICY
 Dividend policy refers to the policy that the
management formulates in regard to earnings for
distribution as dividend among shareholders. It is not
merely concerned with dividends to be paid in one year,
but is concerned with the continuous course of action to
be followed over a period of several years.

FACTORS AFFECTING DIVIDEND
POLICY
 1 Stability of Earnings
 2. Financing Policy of the Company
 3. Liquidity of Funds
 4. Dividend
 5. Policy of Competitive Concerns
 6. Past Dividend Rates
 7. Debt Obligations
 8. Ability to Borrow
 9. Growth Needs of the Company;

 1 Stability of earnings is one of the important factors influencing
the dividend policy. If earnings are relatively stable, a firm is in a better
position to predict what its future earnings will be and such companies
are more likely to pay out a higher percentage of its earnings in
dividends than a concern which has a fluctuating earnings.
 2. Financing Policy of the Company:
Dividend policy may be affected and influenced by financing policy of the
company. If the company decides to meet its expenses from its earnings,
then it will have to pay less dividend to shareholders. On the other hand, if
the company feels, that outside borrowing is cheaper than internal
financing, then it may decide to pay higher rate of dividend to its
shareholder. Thus, the internal financing policy of the company influences
the dividend policy of the business firm

 3. Liquidity of Funds:
 The liquidity of funds is an important consideration in dividend decisions.
According to Guthmann and Dougall, although it is customary to speak of paying
dividends ‘out of profits’, a cash dividend only be paid from money in the bank.
The presence of profit is an accounting phenomenon and a common legal
requirement, with the -cash and working capital position is also necessary in order
to judge the ability of the corporation to pay a cash dividend.
Payment of dividend means, a cash outflow, and hence, the greater the cash position
and liquidity of the firm is determined by the firm’s investment and financing
decisions. While the investment decisions determine the rate of asset expansion and
the firm’s needs for funds, the financing decisions determine the manner of financing
 4. Dividend, Policy of Competitive Concerns:
Another factor which influences, is the dividend policy of other competitive concerns
in the market. If the other competing concerns, are paying higher rate of dividend
than this concern, the shareholders may prefer to invest their money in those
concerns rather than in this concern. Hence, every company will have to decide its
dividend policy, by keeping in view the dividend policy of other competitive concerns
in the market.

 5. Past Dividend Rates:
If the firm is already existing, the dividend rate may be decided on the basis of
dividends declared in the previous years. It is better for the concern to maintain
stability in the rate of dividend and hence, generally the directors will have to keep
in mind the rate of dividend declared in the past.
 6. Debt Obligations:
A firm which has incurred heavy indebtedness, is not in a position to pay higher
dividends to shareholders. Earning retention is very important for such concerns
which are following a programme of substantial debt reduction. On the other hand,
if the company has no debt obligations, it can afford to pay higher rate of dividend.
 7. Ability to Borrow:
Every company requires finance both for expansion programmes as well as for
meeting unanticipated expenses. Hence, the companies have to borrow from the
market, well established and large firms have better access to the capital market
than new and small, firms and hence, they can pay higher rate of dividend. The
new companies generally find it difficult to borrow from the market and hence they
cannot afford to pay higher rate of dividend.

 8. Growth Needs of the Company:
 Another factor which influences the rate of dividend is the growth needs of the
company. In case the company has already expanded considerably, it does not
require funds for further expansions. On the other hand, if the company has
expansion programmes, it would need more money for growth and development.
Thus when money for expansion is not, needed, then it is easy for the company to
declare higher rate of dividend.
 9. Profit Rate:
 Another important consideration for deciding the dividend is the profit rate of the
firm. The internal profitability rate of the firm provides a basis for comparing the
productivity of retained earnings to the alternative return which could be earned
elsewhere. Thus, alternative investment opportunities also play an important role
in dividend decisions.
 10. Legal Requirements:
 While declaring dividend, the board of directors will have to consider the legal
restriction. The Indian Companies Act, 1956, prescribes certain guidelines in
respect of declaration and payment of dividends and they are to be strictly
observed by the company for declaring dividends.

 11. Policy of Control:
 Policy of control is another important factor which influences dividend policy. If
the company feels that no new shareholders should be added, then it will have to
pay less dividends. Generally, it is felt, that new shareholders, can dilute the
existing control of the management over the concern. Hence, if maintenance of
existing control is an important consideration, the rate of dividend may be lower so
that the company can meet its financial requirements from its retained earnings
without issuing additional shares to the public.
 12. Corporate Taxation Policy:
 Corporate taxes affect the rate of dividends of the concern. High rates of taxation
reduce the residual profits available for distribution to shareholders. Hence, the
rate of dividend is affected. Further, in some circumstances, government puts
dividend tax on distribution of dividends beyond a certain limit. This may also
affect rate of dividend of the concern.
 Effect of Trade Cycle:
 Trade cycle also influences the dividend policy of the concern. For example, during
the period of inflation, funds generated from depreciation may not be adequate to
replace the assets. Consequently there is a need for retained earnings in order to
preserve the earning power of the firm.

Dividend Types
Regular dividend policy
Stable Dividend Policy
Irregular Dividend Policy
No Dividend Policy

Types of dividend
• CASH
DIVIDEND
• STOCK
DIVIDEND
• BOND
DIVIDEND
• PROPERTY
DIVIDEND

 Cash dividend: If the dividend is paid in the form of cash to the
shareholders, it is called cash dividend. It is paid periodically out of
the business concerns EAIT (Earnings after interest and tax). • Cash
dividends are common and popular types followed by majority of
the business concerns. • Many companies pay dividends in cash.
Sometimes cash dividend may be supplemented by a bonus issue
(stock dividend). • Company should have enough cash when cash
dividend are declared else arrangement should be made to borrow
funds. • If company follows stable dividend policy , it should
prepare a cash budget for coming period , it is relatively difficult to
make cash planning in anticipation of dividend needed.
 Bond dividend is also known as script dividend. If the company
does not have sufficient funds to pay cash dividend, the company
promises to pay the shareholder at a future specific date with the
help of issue of bond or notes

 . Stock dividend • Stock dividend is paid in the form of the
company stock due to raising of more finance. • Under this type,
cash is retained by the business concern. Represented as
distribution of shares in addition to cash dividend to existing
shareholders • The shares are distributed proportionately . Thus, a
shareholder retains his proportionate ownership of the company.
 Property dividend • Property dividends are paid in the form of
some assets other than cash. It will distributed under the
exceptional circumstance. This type of dividend is not published in
India. • A company may issue a non-monetary dividend to
investors, rather than making a cash or stock payment. • Record
this distribution at the fair market value of the assets distributed. •
Since the fair market value is likely to vary somewhat from the book
value of the assets, the company will likely record the variance as a
gain or loss.

Dividend theories
1 Walter’s
model
2. Gordon’s
model
3.
Modigliani
and Miller’s
hypothesis

Walter’s model:
 Professor James E. Walterargues that the choice of
dividend policies almost always affects the value of the
enterprise. According to him the dividend policy
of a firm is based on the relationship between
the internal rate of return (r) earned by it and
the cost of capital or required rate of return
(Ke).

Walter’s model is based on the following
assumptions:
 1. The firm finances all investment through retained earnings; that is debt or
new equity is not issued;
 2. The firm’s internal rate of return (r), and its cost of capital (k) are constant;
 All earnings are either distributed as dividend or reinvested internally
immediately.
 4. Beginning earnings and dividends never change. The values of the earnings
pershare (E), and the divided per share (D) may be changed in the model to
determine results, but any given values of E and D are assumed to remain
constant forever in determining a given value.
 5. The firm has a very long or infinite life.

 As per this model, the investment decisions and dividend decisions
of a firm are inter related. A firm should retain its earnings if the
return on investment exceeds the cost of capital. Such firms are
called Growth Firms (r > Ke). Such firms should have zero pay-out
and should re-invest their entire earnings. On the other hand, a
firm should distribute its earnings to the shareholder if the internal
rate of return is less than the cost of capital (r < Ke). Such firms are
called declining firms.
 Such firms should distribute the entire profits i.e. 100 per cent pay-
out ratio. Firms with internal rate of return equal to the cost of
capital (r = Ke) are called Normal Firms. In such firms, the
shareholders will be indifferent whether the firm pays dividends or
retain the profits.

The formula to determine the market value of
share as suggested by Prof. Walter is as under

Illustration: Santosh Limited earns Rs.5 per share is capitalized at a rate of 10% and has a rate of return on
investments of 18%. According the Walter's Formula:
(i) What should be the price per share at 25% dividend pay-out ratio?
(ii) Is this optimum pay-out ratio?

 As per above calculation at 25% dividend pay-
out, the value of share is Rs.80. But, according
to Walter's model, it is not an optimum dividend
pay-out because, in such case where internal
rate of return is more than the cost of capital (r
> Ke), he has suggested zero dividend pay-out

llustration:2 The details regarding three companies are given
below :Compute the value of an equity share of each of these companies
applying Walter's formula when dividend pay-out ratio is (a) 0%, (b) 20%, (c) 40%,
(d) 80%, and (e) 100%. Comment on the conclusions drawn

 Effect of Dividend Policy on Market Price of Shares

Criticisms of Walter Model
 1) Absence of External Financing: Prof. Walter's main assumption
that financing of investment proposals only by retained earnings
and no external financing is seldom found in real life. Most of the
firms meet their financial requirements by loans or issuing new
shares.
 (2) Stable Internal Rate of Return: The rate of return earned by
the firm is never stable. Actually, the rate of return changes with
the increase in investments.
 (3) Stable Cost of Capital: The assumption of constant cost of
capital is also unrealistic, because the risk complexion of the firm is
not always uniform. Therefore, cost of capital also changes.

Gordon model
 The Gordon’s Model, given by Myron Gordon, also supports the
doctrine that dividends are relevant to the share prices of a firm.
Here the Dividend Capitalization Model is used to study the
effects of dividend policy on a stock price of the firm.
 Gordon’s Model assumes that the investors are risk averse i.e. not
willing to take risks and prefers certain returns to uncertain
returns. Therefore, they put a premium on a certain return and a
discount on the uncertain returns. The investors prefer current
dividends to avoid risk; here the risk is the possibility of not getting
the returns from the investments.
 According to the Gordon’s Model, the market value of the share is
equal to the present value of future dividends. It is represented as

Formula
 P = [E (1-b)] / Ke-br
Where, P = price of a share
E = Earnings per share
b = retention ratio
1-b = proportion of earnings distributed as
dividends
Ke = capitalization rate
Br = growth rate

Assumptions of Gordon’s Model
1. The firm is an all-equity firm; only the retained earnings
are used to finance the investments, no external source
of financing is used.
2. The rate of return (r) and cost of capital (K) are constant.
3. The life of a firm is indefinite.
4. Retention ratio once decided remains constant.
5. Growth rate is constant (g = br)
6. Cost of Capital is greater than br

Criticism of Gordon’s Model
1. It is assumed that firm’s investment opportunities are financed only
through the retained earnings and no external financing viz. Debt
or equity is raised. Thus, the investment policy or the dividend
policy or both can be sub-optimal.
2. The Gordon’s Model is only applicable to all equity firms. It is
assumed that the rate of returns is constant, but, however, it
decreases with more and more investments.
3. It is assumed that the cost of capital (K) remains constant but,
however, it is not realistic in the real life situations, as it ignores the
business risk, which has a direct impact on the firm’s value.

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