dividend decision

DIVIDEND DECISION

& DIVIDEND POLICY

INTRODUCTIONDefinitions DividendDividend refers to the corporate net profits distributed among shareholders. Dividends can be both preference dividends and equity dividends. Preference dividends are fixed dividends paid as a percentage every year to the preference shareholders if net earnings are positive. After the payment of preference dividends, the remaining net profits are paid or retained or both depending upon the decision taken by the management.Dividend DecisionIt’s a decision made by the directors of a company. It relates to the amount and timing of any cash payments made to the company stockholders. The decision is an important one for the firm as it may influence its capital structure and stock price. In addition, it may determine the amount of taxation that stockholders should pay.

DETERMINANTS OF DIVIDEND POLICY.

The main determinants of dividend policy of a firm can be classified into:

Dividend payout ratio Stability of dividends Legal, contractual and internal

constraints and restrictions Owner's considerations Capital market considerations and Inflation.

TYPES OF DIVIDEND POLICY REGULAR DIVIDEND POLICY STABLE DIVIDEND POLICYa. constant dividend per shareb. constant pay out ratioc. stable rupee dividend plus extra

dividend IRREGULAR DIVIDEND POLICY NO DIVIDEND POLICY

TYPES OF DIVIDENDS

1. Interim Dividend

2. Proposed Dividend

3. Final Dividend

4. Unclaimed Dividend

5. Liquid Dividend

6. Stock Dividend

7. Dividend in Asset Form

In order to better understand the relationship between dividend policy and the value of the firm, different theories have been advanced. These theories can be grouped into two categories:

a. Theories that consider dividend decisions to be irrelevant and

b. Theories that consider dividend decisions to be an active variable influencing the value of the firm.

In the latter, there are 2 extreme views that is:i. Dividends are good as they increase the shareholder

valueii. Dividends are bad since they reduce shareholder value.

The following are some of the models that have critical evaluation on these points

1. Walter’s model on the Relevance of Dividends2. Gordon’s model on the Relevance of Dividends and3. The Miller-Modigliani(MM) Hypothesis about Dividend

Irrelevance.These models shall be explained in the subsequent

paragraphs.

DETERMINANTS OF DIVIDEND POLICY.1. STABILITY OF EARNINGS.2. LIQUIDITY OF FUNDS.3. PAST DIVIDEND RATES.4. RATE OF ASSET EXPANSION.5. PROFIT RATE.6. ABILITY TO BORROW.7. CONTROL.8. NEED TO REPAY DEBT.9. MAINTENANCE OF A TARGET DIVIDEND.10.NATURE OF OWNERSHIP.

DETERMINANTS OF DIVIDEND POLICY…

11. TIMING OF INVESTMENT OPPORTUNITIES. 12. EFFECT OF TRADE CYCLES. 13. LEGEAL REQUIREMENTS. 14. GOVERNMENT POLICY. 15. CORPORATION TAXATION POLICY.

TYPES OF DIVIDEND Regular dividend Interim dividend Stock dividend Script dividend Bond dividend Property dividend Proposed dividend Unclaimed dividend Liquid dividend Cash dividend

WALTER’S MODELIntroduction: Professor James E Walter argues that the choice of dividend policy almost always affect the value of the firm. His model, one of the earlier theoretical works, shows the importance of relationship between the firm’s rate of return(r) and its cost of capital(k) in determining the dividend policy that will maximize the shareholders wealth.

ASSUMPTIONWalters model based on the following assumption:- Internal financing Constant return and cost of capital 100% payout or retention Constant EPS and DIV Infinite time

P = DIV + (EPS-DIV)r/k k kHere P = Market price per share DIV= Dividend per share EPS= Earning per share r = Firm’s average rate of return k = Firms cost of capital

Walter’s Formula to determine the market price per shareis as follows:

CASES OF WALTER’S MODEL. Growth firm: Internal rate more than the

opportunity cost of capitalFor example: r = 20% P=DIV + (EPS – DIV)r/kK = 15% k k EPS = Rs 4 = 4+(0)0.20/015DIV = Rs 4 0.15 = Rs 26.67

Normal firm : Internal rate equals opportunity cost of capital

For exampler = 15% P=DIV+ (EPS-DIV)r/kk = 15% k k EPS=Rs 4 =4+(0)0.15/0.15DIV=Rs 4 0.15 = Rs26.67

Declining firm : internal rate less than opportunity cost of capital

For exampler = 10% P=DIV+(EPS-DIV)r/kk = 15% k kEPS=Rs 4 =4+(0)0.15/0.15DIV =Rs 4 0.15 =Rs26.67

Here you can see that all price is similar for all the three firms, now if we compute the new price for all the firms. Take dividend is Rs 2 instead of Rs4 other things remain same The res result also change in growth firm Rs 31.11 normal firm Rs 26.67 declining firm Rs 22.22

CRITISISMS OF WALTER’S MODEL No external financing Constant return Constant opportunity cost of capital

GORDON’S MODEL Gordon's theory contends that dividends

are relevant. This model is of the view that dividend policy of a firm affects its value.

He relates the market value of the firm to the dividends of the firm.

ASSUMPTIONS OF GORDON’S MODEL

All re equity firms There is no external financing There is constant return The cost of capital is constant There is perpetual earnings No taxes Constant retention Cost of capital will be greater than

growth rate.

FORMULA BY GORDANPo=EPS(1-b) k-brWhere EPS is earnings per share b is retention ratio(100-payout%) k is cost of capital br is rate of return*retention rate

A ILLUSTRATION ON GORDON’S MODEL Taking a growth firm where r>kr=0.15 k=0.10

EPS(1)=Rs10When pay out ratio is 40%g=br=o.6*0.15=0.09p=10(1-0.6) 0.10-0.09 = 4 =Rs400 0.01

When payout ratio is 60%g=br=0.4*0.15=0.06p=10(1-0.4) 0.10-0.06 = 6 =Rs150 0.04

IN A DECLINING FIRM r<k When payout ratio is 40%

r=0.08g=br=o.6*0.08=0.048 k=0.10p=10(1-0.6)

eps(1)=Rs10 0.10-0.048 = 4 =Rs77 0.052

IN A NORMAL FIRM WHERE r=k Payout ratio is 40% r=0.10 g=br=0.60*0.10=0.06 k=0.10 p=10(1-0.6)

eps(1)=Rs10 0.10-0.06 = 4 =Rs100 0.04

Payout ratio is 60% g=br=0.40*0.10=0.04 p=10(1-0.4) 0.10-0.04 = 6 =Rs100 0.06

Payout ratio is 90% g=br=0.10*0.10=0.01 p=10(1-0.1) 0.10-0.01 = 9 =Rs100 0.09

MILLER-MODIGLIANI MODELAccording to him, under a perfect market situation the

dividend policy of a firm is irrelevant, as it does not affect the value of the firm.

A firm operate in perfect capital market condition may face one of the following three situation regarding the payment of dividends:

1.The firm has sufficient cash to pay dividends2. 1.The firm does not have sufficient cash to pay

dividends & therefore issue new share to finance dividends

3.The firm does not pay dividend, but shareholder need cash

In first situation, shareholder get cash but the firm’s assets reduce(its cash balance)

In second situation, two transaction take place: first existing shareholder get dividends but they lose value of their claim on assets reduces. Second new shareholders part their cash in exchange for new shares at “FAIR PRICE PRE SHARE.”

In third situation, shareholder can create a “HOME MADE DIVIDEND” by selling their share at market price

PROBLEM AND SOLUTIONHimgiri company issues 2crore shares at

100 per share.Firm made new investment & yield 20crore

positive return.Firm wants to pay dividend of Rs15.Firm issues new share it pay dividends.How the firm value be affected if it does

not pay dividend & if it pays dividend

If firm does not pay dividend:Firm’s current value is 2*100=200croreAfter the capex the value will increase to

200+20=220crore.If the firm does not pay dividend the value

per share will be 220/2=110Rs

If the firm pays dividends of Rs15: Firm need 30crore(15*2) To raise 30crore it has to issue new shares. Value of firm after paying dividend will be- 110-15=95 Shareholder get dividend but incur loss of 15Rs in the

firm of reduced share value. Firm issues(30crore/95) 31.6lakh share to raise 30crore. Firm has 2.316crore share at 95 per share. Thus value of firm is 2.316*95=220crore That means no net gain/loss for shareholder & firm

value remain unaltered

ASSUMPTIONS Perfect capital market No taxes Investment policy No risk

CALCULATION OF MM MODEL THROUGH FORMULA

P0 = 1/(1 + ke) x (D1 + P1) Where: P0 =Prevailing market price of a share ke = cost of equity capital D1 = Dividend to be received at the end

of period 1 and P1 = Market price of a share at the end

of period 1.

Market price of share at end of the period

P1=P0(1+Ke)-D1 Where: P1=Market price of

share at end of the period

P0=Market price of share at beginning of the period

Ke= cost of equity D1= dividend at the

end of the period

Value of the firm

Value of the firm, nP0 = (n + ∆ n) P1 – I + E /(1 + ke)

Where: n = number of shares

outstanding at the beginning of the period

∆ n = change in the number of shares outstanding during the period/ additional shares issued.

I = Total amount required for investment

E = Earnings of the firm during the period.

A company whose capitalization rate is 10% has outstanding shares of 25,000 selling at Rs100 each. The firm is expecting to pay a dividend of Rs5 per share at the end of the current financial year. The company's expected net earnings are Rs250,000 and the new proposed investment requires Rs500,000. Prove that using MM model, the payment of dividend does not affect the value of the firm.

LIMITATION OF MM MODEL Assumption of perfect capital market is

unrealistic Investors cannot be indifferent between

dividend & retained earnings

THANK YOUPresented by: mahadeva prasad.M 1st M.F.M Manasa gangotri mysore

dividend decision

Economy & Finance