week 6 dividend policy

FINANCIAL MANAGEMENT

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Prepared by Tishta Bachoo

Overview:

What is Dividend? What is dividend policy? Theories of Dividend Policy

Relevant Theory Walter’s Model Gordon’s Model

Irrelevant Theory M-M’s Approach


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Once a company makes a profit, management must decide on what to do with those profits. They could continue to retain the profits within the company, or they could pay out the profits to the owners of the firm in the form of dividends.

Once the company decides on whether to pay dividends they may establish a somewhat permanent dividend policy, which may in turn impact on investors and perceptions of the company in the financial markets. What they decide depends on the situation of the company now and in the future. It also depends on the preferences of investors and potential investors.


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Dividend Dividends are payments made to stockholders from a

firm's earnings, whether those earnings were generated in the current period or in previous periods. Dividends are paid from the company’s earnings taking into account the Payout Ratio.


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Payout ratio is the proportion of earnings paid out as dividends to shareholders, typically expressed as a percentage.

Dividend Policy

Dividend policy is the set of guidelines a company

uses to decide how much of its earnings it will pay

out to shareholders.

Some evidence suggests that investors are not

concerned with a company's dividend policy since

they can sell a portion of their portfolio of equities if

they want cash.


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Dividend Policies involve the decisions, whether:

To 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.


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There is no obligation for firms to pay dividends to common shareholders.

Shareholders cannot force a Board of Directors to declare a dividend, and courts will not interfere with the BOD’s right to make the dividend decision because: Board members are jointly and severally liable for any damages

they may cause Board members are constrained by legal rules affecting

dividends including: Not paying dividends out of capital Not paying dividends when that decision could cause the

firm to become insolvent


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Forms of Dividend

Dividend basically is a distribution of profits earned

by a joint stock company among its shareholders.

Mostly dividends are paid in cash, but there are also

other forms such as script dividends, stock dividends,

and in an unusual circumstances, property dividends.

These are briefly described below:


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Scrip Dividend: means of payment when the company

cannot pay in cash. This system simply means

shareholders are paid with commodities, vouchers, tokens

or some other indication of credit instead of cash.

Bond Dividend: Referred to as fixed-income investment

instruments because they promise the holder a fixed

payment as returns on investment.


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10Property Dividend: refers to the formal distribution of

an asset other than cash to holders of preferred or

common shares of stock.Cash Dividend: money paid to stockholders, normally

out of the corporation's current earnings or accumulated

profits.Bonus share or Stock dividends: do not come with an

explicit payment promise. The amount of dividends paid

to stockholders varies depending on the profits of the

issuing company

Factors Affecting Dividend Policy Legal Restrictions: Company laws

Trend of earnings: High profit or low

Desire and type of Shareholders Nature of Industry: capital intensive, asset intensive, share

intensive

Age of the company: old or new in market

Taxes on Retained Earnings Future Financial Requirements: will a loan be needed, will

there be expansion, will the firm go international

Stage of Business cycle: Recession, boom, depression, recovery


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Dividend Models

Dividend Relevance Model Walter Model Gordon Model

Dividend Irrelevance Model Miller & Modigliani Model


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Relevant TheoryIf the choice of the dividend policy affects the value of a firm, it is considered as relevant. In that case a change in the dividend payout ratio will be followed by a change in the market value of the firm.

If the dividend is relevant, there must be an optimum payout ratio. Optimum payout ratio is that ratio which gives highest market value per share.


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The dividend policy given by James Walter considers that dividends are relevant and they do affect the share price.

The model is simple and easy to compute.

Two factors which influence the market price of the share are the EPS and DPS.

Walter’s Model


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Walter’s Model

In this model , he studied the relationship between the internal rate of return (r) and the cost of capital of the firm(K), to give a dividend policy that maximizes the shareholders’ wealth.

When r > Ke the firm has to adopt Zero% payout policy.

r < ke the firm has to adopt 100% payout policy.

r = ke any policy between 0 to 100% payout.

Walter model also look at profitable opportunities whether to retain their earning instead of getting dividends. The cost of retention is important here.


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Formula of Walter’s Model

Where,

P = Current Market Price of equity share

E= Earnings per share

D = Dividend per share (use payout ratio to calculate)

(E-D)= Retained earnings per share (EPS- DPS)

r = Rate of Return on firm’s investment or % of retained earnings

k = Cost of Equity Capital or Cost of capitalization

P D + r (E-D)

k k

=


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Assumptions of Walter’s Model:

The firm finances all investment through retained earnings. 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. The firm has a very long or infinite life.


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Criticisms of Walter’s Model The model does not consider all the factors affecting

dividend policy and share prices. The model assumes that the investment opportunities

of the firm are financed by retained earnings only and no external financing.

Firm’s internal rate of return does not always remain constant. In fact, r decreases as more and more investment in made. (income from investment)

Walter model on dividend policy ignored the business risk of the firm, which has a direct impact on the value of the firm. Thus, k cannot be assumed to be constant.


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Impact of Dividend Policy on Market Price

EPS =$ 8Dividend Payout

r > ke r < ke r = ke15% > 12% 10% < 12% 12% = 12%

Market Price (P) Market Price (P) Market Price (P)0% 83 56 67

25% 79 58 6750% 75 61 6775% 71 64 67

100% 67 67 67 Dividend

Policy Zero Payout 100% Payout Payout 0% to 100%

FormulaP = D + r/ke (E-D)

Ke Prepared by Tishta Bachoo

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Illustration Exercise


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Solution (i)


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EPS ( E ) = earnings/ no. of shares= $ 500 000/ 100 000= $5 DPS (D)= dividend payout ratio * EPS = 60% x $ 5= $3 E-D = $5 - $3 = $2 K= 12 % R= 15%

P= 3 + 0.15(2)

0.12

0.12

P = $ 229 .17

Solution (ii)


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Gordon’s Model

• Gordon uses the dividend capitalization approach to study the effect of the firms dividend policy on the stock price.

• According to him, what is presently available is more preferred that what may be available in the future.


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Gordon’s Model

Gordon model assumes that the investors are rational, they want to avoid risk.

They would prefer to pay a higher price for the shares now which earn them current dividends income .

In the same way, they would retain their earnings if the company postpones dividends.

Again, the share price and the dividend depend on the retention rate.


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Formula of Gordon’s Model

Where,

P = Market Price

E = Earnings per Share

b = Retention Ratio (100 % - % dividend payout ratio)

K = Rate of return required by shareholders

r = Rate of return on investment

br = g = Growth Rate

P = E (1 – b) K - br


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According to Gordon; The firms with rate of return greater than the cost

of capital should have a higher retention ratio. Firms which have rate of return less than the cost

of capital, should have a lower retention ratio. The firms which have a rate of return equal to the

cost of capital will however not have any impact on its share value, it can adopt any retention policy.

Assumptions: The firm is an all equity firm Only financed by retained earnings The internal rate of return (r) and the cost of

capital (k)of the firm is constant. Constant Cost of Capital The retention ratio (b), once decided upon, is

constant


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Criticisms of Gordon’s model

As the assumptions of Walter’s Model and Gordon’s Model are same so the Gordon’s model suffers from the same limitations as the Walter’s Model.


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Illustration 2

The following data are available for Rogers Group.

Earnings per share: $ 40.00

Rate of Return on Investment: 20%

Rate of Return required by shareholders: 30%

If the Gordon valuation model holds, what will be the price per share when the dividend payout ratio is 25%?


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Solution


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P = 40 (1- 0.75) 0.30 – (0.2 x 0.75) = 10 0.15 = $ 66.67


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Irrelevant Theory

According to this concept, investors do not pay any importance to the dividend history of a company and thus, dividends are irrelevant and have no impact on the value of a firm.


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Modigliani & Miller’s Irrelevance Model

Depends on

Depends on


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Modigliani & Miller’s

According to M & M, the value of the firm remains the same whether or not the company pays dividend.

The value of a firm depends solely on its earnings power resulting from the investment policy and not influenced by the manner in which its earnings are split between dividends and retained earnings.


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Formula of M-M’s Approach

Po = ( D1+P1 ) (1 + p)

Where,

Po = Market price per share at time 0,

D1 = Dividend per share at time 1,

P1 = Market price of share at time 1

p = Capitalization Rate


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Modigliani and Miller’s Approach Assumption

Capital markets are perfect:- Investors are rational, information is freely available, transaction cost are nil, and no investor can influence the market price of the share.

Taxes do not exist The firm has a fixed investment policy


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Criticism of M-M Model

No perfect Capital Market Lack of Relevant Information The assumption that taxes do not exist

is far from reality. No fixed investment Policy


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Summary

Dividend is the part of profit paid to Shareholders.

Firm decide, depending on the profit, the percentage of paying dividend.

Walter and Gordon says that a Dividend Decision affects the valuation of the firm.

While the Traditional Approach and MM’s Approach says that Value of the Firm is irrelevant to Dividend we pay.


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Workshop Questions & Answers


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Question 1

Expanda Ltd. had 50,000 equity shares of $ 10 each outstanding on January 1. The shares are currently being quoted at market price. In the wake of the removal of dividend restraint, the company now intends to pay a dividend of $ 2 per share for the current calendar year. It belongs to a risk-class whose appropriate capitalization rate is 15%. Using MM model and assuming no taxes, ascertain the price of the company's share as it is likely to prevail at the end of the year (i) when dividend is declared, and (ii) when no dividend is declared.


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Answer to Q1(i) Price as per share when dividends are paid P1 = P0 (1+ke) – D1

= 10 (1+.15)-2

= 11.5-2

= Rs. 9.5.

(ii) Price per share when dividends are not paid: P1 = P0 (1+ke)-D1

= 10 (1+. 15)-0

= Rs. 11.5


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Question 2

The following data are available for Phoenix International.


Rate of Return on Investment: 20%

Rate of Return required by shareholders: 16%

If the Gordon valuation model holds, what will be the price per share when the dividend payout ratio is (i) 25%? (ii) 50%?


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Answer to Q2


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Question 3

The following information is available about Benny Musicals.


Rate of return required by shareholders: 16 %

Assuming that the Gordon valuation model holds, what rate of return should be earned on investments to ensure that the market price is $ 50 when the dividend payout is 40%?


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Answer to Q3


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Question 4

The earnings per share of company are $ 8 and the rate of capitalization applicable to the company is 10%. The company has before it an option of adopting a payout ratio of 25% or 50% or 75%. Using Walter's formula of dividend payout, compute the market value of the company's share if the productivity of retained earnings is (i) 15% (ii) 10% and (iii) 5%


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Question 5The following information is available for Avanti Corporation.


Rate of return on investments: 18%

Rate of return required by shareholders: 15%

What will be the price per share as per the Walter model if the payout ratio is (i) 40%? (ii) 50%? (iii) 60%?


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Question 6

ABC Ltd. had 100,000 equity shares of $ 20 each outstanding on January 1. The shares are currently being quoted at market price. In the wake of the removal of dividend restraint, the company now intends to pay a dividend of $ 5 per share for the current calendar year. It belongs to a risk-class whose appropriate capitalization rate is 20%. Using MM model and assuming no taxes, ascertain the price of the company's share as it is likely to prevail at the end of the year (i) when dividend is declared, and (ii) when no dividend is declared.


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END OF SESSIONIt was a pleasure to work with you all

ENJOY YOUR TUITION FREE WEEKS


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Tishta BachooLecturer in AccountingCharles Telfair Institute

Tel: 401-6511 | Fax: 433-3005 Email:

[email protected]

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mailto:[email protected]

week 6 dividend policy

Economy & Finance