# dividend policies

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By ANUP K SUCHAK

What is Dividend PolicyDividend Policies involve the decisions,

whetherTo 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.

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 Companys 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)

Walters Model

Gordons Model

Modigliani and Millers Model

GORDONS 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 shares market price is equal to the sum of shares 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 firms 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.

Walters 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 Walters ModelD + r (E-D) k P= kWhere, 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 firms investment or Internal Rate of Return k = Cost of Equity Capital

Assumptions of Walters 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 firms business risk does not change. It implies that firms 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 1. In case of Growing firm i.e. where r > k If Dividend Payout ratio Increases If Dividend Payout Ration decreases Market Value of Share Market Value of a share decreases increases

2. In case of Declining Market Value of Share Market Value of share firm i.e. where r < k increases 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 Walters ModelNo External Financing Firms internal rate of return does not always

remain constant. In fact, r decreases as more and more investment in made. Firms cost of capital does not always remain constant. In fact, k changes directly with the firms 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 Walters 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.

10. The Equity Capitalization rate is 10%. Internal Rate of return on retained earnings is 10%. Using Walters 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 3 (In case of Declining Firm)The earnings per share of a company are Rs. 10.

The Equity Capitalization rate is 20%. Internal Rate of return on retained earnings is 10%. Using Walters 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 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 Walters formula, compute the market value of the companys 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 & Millers 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 firms earnings and firms earnings are influenced by its investment policy and not by the dividend policy

Modigliani & Millers 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 Taxes Fixed Investment Policy No 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 P =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 capital0

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) NP1 =Where, N I E n D1 P1 = = = = = = Change in the number of shares outstanding during the period. Total Investment amount required for capital budget Earning of net income of the firm during the period Number of shares outstanding at the beginning of the period Dividend to be received at the end of period one Market price of a share at the end of period one

Criticism of M-M ModelNo perfect Capital Market Existence of Transaction Cost Existence of Floatation Cost Lack of Relevant Information Taxes Exist No fixed investment Policy Investors desire to obtain current income

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