dividend policies

By ANUP K SUCHAK

What is Dividend PolicyDividend Policies involve the decisions,

whether-To retain earnings for capital investment and

other purposes; orTo distribute earnings in the form of dividend

among shareholders; orTo retain some earning and to distribute

remaining earnings to shareholders.

Determinant or Factors affecting Dividend Policy• Availability of Divisible Profits• Availability of Profitable Reinvestment

Opportunities• Availability of Liquidity• Inflation• Effect on Market Prices• Composition of Shareholding• Company’s own policy regarding stability of

dividend• Contractual restrictions by Financial Institutions• Extent of access to external sources• Attitude and Objectives of Management

Dividend Theories

Relevance Theories

(i.e. which consider dividend decision to be relevant as it affects the value of the firm)

Irrelevance Theories

(i.e. which consider dividend decision to be irrelevant as it does not affects the value of the firm)

Walter’s Model

Gordon’s Model

Modigliani and Miller’s

Model

GORDON’S MODEL OF DIVIDEND POLICY• 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.

Assumptions of Gordon Growth Valuation Model.• The firm is an all equity firm and has no debt• External financing is not used in the firm. Retained

earnings represent the only source of financing.• The internal rate of return is the firm’s cost of capital ’k’. It

remains constant and is taken as the appropriate discount rate.

• Future annual growth rate dividend is expected to be constant.

• Growth rate of the firm is the product of retention ratio and its rate of return.

• Cost of Capital is always greater than the growth rate.• The company has perpetual life and the stream of earnings

are perpetual.• Corporate taxes does not exist.• The retention ratio ‘b’ once decided upon, remain constant.

Therefore, the growth rate g=br, is also constant forever.

Walter’s Valuation ModelProf. 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.

Formula of Walter’s Model D + r (E-D)

kP = kWhere,

P = Current Market Price of equity shareE = Earning per shareD = 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

Assumptions of Walter’s ModelAll financing is done through retained earnings

and external sources of funds like debt or new equity capital are not used. Retained earnings represents the only source of funds.

With additional investment undertaken, the firm’s business risk does not change. It implies that firm’s IRR and its cost of capital are constant.

The return on investment remains constant.The firm has an infinite life and is a going

concern.All earnings are either distributed as dividends or

invested internally immediately.There is no change in the key variables such as

EPS or DPS.

Effect of Dividend Policy on Value of ShareCase If Dividend Payout

ratio IncreasesIf 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

Criticisms of Walter’s ModelNo External FinancingFirm’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.

Illustration 1 (In case of Growing Firm)The earnings per share of a company are Rs.

10. The Equity Capitalization rate is 10%. Internal Rate of return on retained earnings is 20%. Using Walter’s formula:What should be the optimum payout ratio of

the company?What should be the price of share at optimum

payout ratio?How shall this price be affected if different

payout (say 80%) were employed?

Illustration 2 (In case of Normal Firm)The earnings per share of a company are Rs.





Illustration 3 (In case of Declining Firm)The earnings per share of a company are Rs.





Illustration 4The earning per share of a company are Rs.

10 and the rate of capitalization applicable to it is 10%. The company has before it the option of adopting a payout of 20% or 40% or 80%. Using Walter’s formula, compute the market value of the company’s share if the productivity of retained earning is (a) 20% (b) 10% and (c) 8%. What inference can be drawn from the above exercise?

Modigliani & Miller’s Irrelevance ModelAccording to M-M, under a perfect market

situation, the dividend policy of a firm is irrelevant as it does not affect the value of the firm. They argue that the value of the firm depends on the firm’s earnings and firm’s earnings are influenced by its investment policy and not by the dividend policy

Modigliani & Miller’s Irrelevance Model

Depends on

Depends on

Assumption of M-M ModelPerfect Capital Market: This means that:

The investors are free to buy and sell securities.The investors behave rationally.There are no transaction cost/ flotation cost.They are well informed about the risk-return on all

types of securities.No investor is large enough to affect the market

price of a share.No TaxesFixed Investment PolicyNo Risk

Formulae of M-M ModelAccording to M-M model the market price of a

share, after dividend declared, is calculated by applying the following formula:

P1 + D1 1 + Ke

Where,

P0 = Prevailing market price of a share

P1 = Market Price of a share at the end of the period one

D1 = Dividend to be received at the end of period one

Ke = Cost of equity capital

P0 =

Formulae of M-M ModelThe number of shares to be issued to implement

the new projects is ascertained with the help of the following:

I – (E-nD1) P1

Where, ΔN = Change in the number of shares outstanding during the period.I = Total Investment amount required for capital budgetE = Earning of net income of the firm during the periodn = Number of shares outstanding at the beginning of the periodD1 = Dividend to be received at the end of period oneP1 = Market price of a share at the end of period one

ΔN =

Criticism of M-M ModelNo perfect Capital MarketExistence of Transaction CostExistence of Floatation CostLack of Relevant InformationTaxes ExistNo fixed investment PolicyInvestor’s desire to obtain current income

dividend policies

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