DIVIDEND POLICY

By :HINA R. ANTALA
What is Dividend Policy

“ Dividend policy determines the division of

earnings between payments to shareholders and
retained earnings”.
- Weston and Bringham

Dividend decisions depends on what portion of the

earnings is to be retained by the firm and what
portion is to be paid off
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.
Factors Affecting Dividend Policy
1. Profitable Position of the Firm
2. Uncertainty of Future Income
3. Legal Constrains
4. Liquidity Position
5. Sources of Finance
6. Growth Rate of the Firm
7. Tax Policy
8. Capital Market Conditions
 Types of Dividend Policy
Dividend policy depends upon the nature of the firm, type of
shareholder and profitable position.
On the basis of the dividend declaration by the firm, the
dividend policy may be classified under the following types:
 Regular Dividend Policy

 Stable Dividend Policy

Constant dividend per share

Constant pay out ratio
Constant dividend per share + extra dividend
 Irregular Dividend Policy
 No Dividend
 • Dividend payable at the usual rate is called as regular dividend policy. This type of
Regular
policy is suitable to the small investors, retired persons and others.
Dividend Policy

• Stable dividend policy means payment of certain minimum amount of dividend

regularly.This dividend policy consists of the following three important forms:
Stable Dividend
Constant dividend per shareConstant payout ratioStable rupee dividend plus extra
Policy dividend.

• When the companies are facing constraints of earnings and unsuccessful business
operation,they may follow irregular dividend policy. It is one of the temporary
Irregular
arrangements to meet the financial problems. These types are having adequate
Dividend Policy profit. For others no dividend is distributed.

• Sometimes the company may follow no dividend policy because of its unfavourable
No Dividend
working capital position of the amount required for future growth of the concerns
Policy
Stability
 Stable Dividend Policy
 Constant dividend payout Ratio
 Constant Dividend per share
 Constant dividend per share + extra
Dividends
• Stability of dividend is desirable due to
following advantages
 Building confidence among the investors
 Investors desire for current income
 Information about firms profitability
 Institutional investors’ requirements
 Raise additional finance
 Stability in market
 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 Gordon’s
Model Model

Modigliani and Traditional

Miller’s Model Approach
Walter’s Model
 Prof. James E Walter argued that the dividend
payouts are relevant and have a bearing on
the share price of the firm. He further states
that investment policy of the firm cannot be
separated from the dividend policy as both are
inter-linked. The choice of the appropriate
dividend policy affects the firm.
Assumption of the Walter’s Model:
 Internal Financing
 constant Return-r and Cost of Capital-ke

 100% payout or Retention

 Constant EPS and DPS

 Infinite time(Life)
Formula of walter model
D + [r/K (E-D)]
P = K

Where,
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 firm’s investment or Internal Rate of
Return
Ke = Cost of Equity Capital
Illustration:
 Growth Firm (r > k):
r = 20% k = 15% E = Rs. 4
If D = Rs. 4
P = 4+(0) 0.20 /0 .15 = Rs. 26.67
0.15
If D = Rs. 2
P = 2+(2) 0.20 / 0.15 = Rs. 31.11
0.15
Illustration:
 Normal Firm (r = k):
r = 15% k = 15% E = Rs. 4
If D = Rs. 4
P = 4+(0) 0.15 / 0.15 = Rs. 26.67
0.15
If D = Rs. 2
P = 2+(2) 0.15 / 0.15 = Rs. 26.67
0.15
Illustration:
 Declining Firm (r < k):
r = 10% k = 15% E = Rs. 4
If D = Rs. 4
P = 4+(0) 0.10 / 0.15 = Rs. 26.67
0.15
If D = Rs. 2
P = 2+(2) 0.10 / 0.15 = Rs. 22.22
0.15
Effect of Dividend Policy on Value of
Share
Case If Dividend Payout If Dividend Payout
ratio Increases Ration decreases

1. In case of Growing Market Value of Share Market Value of a share

firm i.e. where r > k 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 No change in value of No change in value of

i.e. where r = k Share Share
Criticisms of Walter’s Model
 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.
 Firm’s cost of capital does not always remain
constant. In fact, k changes directly with the
firm’s risk.
 Gordon’s Model
 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:
All equity firm i.e no debt
No external Financing
Constant Returns r
Constant Cost of Capital k
Perpetual Earnings
No taxes
Retention ratio “g = br” constant forever
Cost of Capital “ke” is greater than growth
rate (k>br=g)
Formula of Gordon’s Model
E (1 – b)
P =
K - br

 Where,
P = Price
E = Earning per Share
b = Retention Ratio
k = Cost of Capital
br = g = Growth Rate
 Illustration:
 Growth Firm (r > k):
r = 20% k = 15% E = Rs. 4
If b = 0.25
P0 = (0.75)4
0.15- (0.25)(0.20) = Rs. 30
 If b = 0.50
P0 = (0.50)4
0.15- (0.5)(0.20)
= Rs. 40
 Illustration:
 Normal Firm (r = k):
r = 15% k = 15%
E = Rs. 4
If b = 0.25
P0 = (0.75)4
0.15- (0.25)(0.15)
= Rs. 26.67
 If b = 0.50
P0 = (0.50) 4
0.15- (0.5)(0.15) = Rs. 26.67
 Illustration
 Declining Firm (r < k):
r = 10% k = 15% E = Rs. 4 If b = 0.25

P0 = (0.75)4 = Rs. 24
0.15- (0.25)(0.10)
 If b = 0.50
P0 = (0.50)4 = Rs. 20
0.15- (0.5)(0.10)
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.
Modigliani & Miller’s Irrelevance
Model

Value of Firm (i.e. Wealth of Shareholders)

Depends on

Firm’s Earnings

Depends on

Firm’s Investment Policy and not on dividend policy

Modigliani and Miller’s
Approach
 Assumption
Capital Markets are Perfect and people are
Rational
No taxes
Floating Costs are nil
Investment opportunities and future profits of
firms are known with certainty (This assumption
was dropped later)
Constant Investment policy
M-M’s Argument
Based on above assumptions Miller and
Modiglian have explained the irrelevance of
dividend as crux of arbitrage argument
Two transaction which the arbitrate process refers
to are:
1. Paying out dividend
2. Raising external funds to finance additional
external projects
The arbitrage process will neutralise the increase
in share value
 Hence,
the division of earnings between dividends and
retained earnings is IRRELEVANT from the point
of view of shareholders.
Formula of M-M’s Approach
1 ( D1+P1 )
P0 =
(1 + k)

Where,
Po = Market price per share at time 0,
D1 = Dividend per share at time 1,
P1 = Market price of share at time 1
 1 (nD1+nP1)
nPo =
(1 + k)

mP1 = I – (X – nD1)

The expression of the outstanding equity

shares of the firm at time 0 is obtained as:

nPo = 1 (nD1+(n + n1)P1- n1P1)

(1 + k)
Value of the share is thus...
nPo = 1 nD1+ (n + n1)P1– I +E – nD1)
(1 + k)

Po
= 1 ((n + n1)P1– I +E
(1 + k)
Criticism of M-
M Model
 No perfect Capital Market
 Existence of Transaction Cost
 Existence of Floatation Cost
 Under pricing of shar
 Market conditions

current
Traditional
Approach
 Traditional approach clearly emphasise the
relationship between the dividend and stock market.
According to them, Stock value responds positively to
high dividend and negatively to low dividends. So,
The earnings available may be retained in the
business for re-investment
Or if the funds are not required in the business
they may be distributed as dividends.
 Thus the decision to pay the dividends or retain the
earnings may be taken as a residual decision
 This theory assumes that the investors do
not differentiate between dividends and
retentions by the firm
 Thus, a firm should retain the earnings if it
has profitable investment opportunities
otherwise it should pay than as dividends.
Thank You