Financial

Management
MBA Second Sem.
Unit -4 - Dividend Decisions

 Meaning of Dividend and Its Form

 Theories of Dividend Policy and
 Their Impact on the Value of a Firm
 Determinants of Dividend Policy.
 What is Dividend ?

Dividend is the part of profit of a company

which is distributed by the company among its
shareholders
It is the reward of the shareholders for
investment made by them in the share of the
wealth
“A dividend is a distribution to shareholders out
of profit or reserve available for this purpose”.
- Institute of Chartered Accountants
of India
Forms of Dividend
• Cash Dividend
• Stock Dividend
• Scrip Dividend
• Bond Divined
• Property Dividend
• Composite Dividend
 Cash Dividend - Money paid to stockholders,
normally out of the corporation's current earnings or
accumulated profits.

 Property Dividend- It refers to the formal distribution

of an asset other than cash to holders of preferred or
common shares of stock.

 Scrip Dividend- It 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 - It referred to as fixed-income
investment instruments because they promise the
holder a fixed payment as returns on investment.
 Stock Dividend- Stock dividend is paid in the
form of the company stock due to raising of more
finance. Under this type, cash is retained by the
business concern. Stock dividend may be bonus
issue. This issue is given only to the existing
shareholders of the business concern. 
 Composite Dividend- When a part of dividend is
paid in cash and another part in the form of
property , It is called Composite Dividend
 What is Dividend Policy

“Dividend policy determines the

division of earnings between
payments to shareholders and
retained earnings ”.

Weston and Bringham

Dividend Policies involve the decisions, whether:

1. To retain earnings for capital investment and other

purposes; or
2. To distribute earning in the form of dividend
among shareholders; or
3. To retain some earning and to distribute remaining
earnings to shareholders.
 Types of Dividend Policy

1 Regular Dividend Policy

●

2 Stable Dividend Policy

●

3 Irregular Dividend Policy

●

4 No Dividend Policy
●
1-Regular Dividend Policy

In this policy, Payment of dividend at a usual rate is

termed as regular dividend. The investors such as retired
persons, widows and other economically weaker persons
prefer to get regular dividends
Advantages of regular dividend policy-
1. It stabilizes the market value of shares.
2. It aids in long-term financing and renders
financing easier
3. It creates the confidence amongst the shareholders.
4. It established the profitable record of the company.
2-Stable Dividend Policy
The term ‘stability of dividend ‘ means consistency
or lack of variability in the stream of dividend
payments. It means payment of certain minimum
amount of dividend regularly. A stable dividend
policy may be established in any of the following
three forms:
1. Constant dividend per share
2. constant pay out ratio
3. Stable rupee dividend plus extra dividend
Advantages of Stable dividend policy-
• It is sign of continued normal operations of the
company.
• It stabilizes the market value of shares.
• It creates confidence among the investors.
• It provides a source of livelihood to those investors
who view dividends as a source of funds to meet
day to day expenses.
• It meets the requirements of institutional investors
who prefer companies with stable dividends.
3-Irregular Dividend Policy
 In this policy, the company is under no obligation to pay
its shareholders and the board of directors can decide what
to do with the profits. If they a make an abnormal profit in
a certain year, they can decide to distribute it to the
shareholders or not pay out any dividends at all and
instead keep the profits for business expansion and future
projects.
 The irregular dividend policy is used by companies that do
not enjoy a steady cash flow.
 Investors who invest in a company that follows the policy
face very high risks as there is a possibility of not
receiving any dividends during the financial year.
4-No Dividend Policy
In this policy, the company doesn’t distribute
dividends to shareholders. It is because any profits
earned is retained and reinvested into the business
for future growth. Companies that don’t give out
dividends are constantly growing and expanding,
and shareholders invest in them because the value
of the company stock appreciates. For the investor,
the share price appreciation is more valuable than a
dividend payout.
Sound Dividend Policy
Sound dividend policy is a long term policy that
aims in maximization of shareholders wealth.
While determining such a policy investment
opportunity of the firm, its present economic status
and investor preferences should be given due
weight age. Sound dividend policy remains stable
during the prosperous and lean years. Dividend are
paid in cash and stock dividend is paid only when
the amount of reserves exceed too much
Essentials of a Sound Dividend Policy
1. Stability
:
2. Gradual rise in Dividend Rates
3. Distribution of Cash Dividend
4. Moderate Start – In the beginning years of company’s
incorporation, dividend should be declared at lower rates for some
years so that company ‘s financial position may become
sound.After words with the growth of the company, dividend rates
may be increased gradually .
5. Other Factors- Dividend must be paid out of profit earned.
It should be paid after setting of the past losses. Normally,
dividend is paid only once in a year but interim dividend may
be paid just to boost the zeal and morale of the shareholders
Advantage of a Sound Dividend Policy

• Shareholder’s Satisfaction

• Confidence among the Shareholders

• Relative stability in Market Price of Shares

• Helpful in Long term Planning

• Stability in National Income

Determinants of Dividend Policy
The following Factors affect dividend policy of a firm.
1. Financial Needs of the Company
2. Age of the Company
3. Stability of Dividends
4. Liquidity
5. Investment Opportunity
6. Effects on Earning Per Share
7. Taxation Policy
 Dividend Theories

Relevance Theories Irrelevance Theories

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

Walter’s Gordon’s
Model Model

Modigliani and Traditional

Miller’s Model Approach
Relevant Theory
According to school of thought, dividend policy is
relevant to the valuation of a firm. Two important
theories under this school are Walter’s Model and
Gordon’s Model. They say that dividend of a firm
affects its value
 1-Walter’s Model
• In this approach it shows that dividend decision are relevant
and affect the value of the firm i.e. market price of the
share
• In Walter approach , approach it shows the dividend policy
has to factors which is affected by 2 element .i.e. cost of
capital (k) and rate of return (r)

Assumptions-
1. Retain earnings presents the only source of
financing of new investment
2. Rate of Return and Cost of Capital are remain
constant
3. The firm has an infinite life
 According to Walter’s Model

I. It r > k, the firm earn higher rate of return on its investment than the
required rate of return. So firm should retain earning . Such firm are
termed as growth firm.
II. II. It r < k, the firm earn lower rate of return on its investment than the
required rate of return. So firm should distribute their earning as dividend.
III. It r = k, the firm earn equal rate of return on its investment as expected. In
such firm there is no optimum dividend pay out and the value of the firm
would not change with the change in dividend rate.
 Formula of Walter’s Model

D+ r (E-D)
P= k
k

Where,
P = Current Market Price of equity share
E = Earning per share
D = Dividend per share
(E-D) = Retained earning per share
r = Internal Rate of Return
k = Cost of Capital
 2- Gordon’s Model
•In this approach it shows that dividend decision are relevant and
affect the value of the firm i.e. market price of the share
•It talks only about dividend & nothing about capital appreciation
•Shareholders are interested in more dividend than retention
•Shareholders want growth of dividend every year
•In this, approach it shows the dividend policy has to factors
which is affected by 2 element .i.e. cost of capital (k) and rate of
return (r)
Assumptions of Gordon’s Model

1. Growth and Cost of Capital are remain constant

2. The firm has an infinite life

3. Firm has only equity & no debt

4. Retain earnings presents the only source of
financing of new investment
5. No Taxation
 According to Gordon’s Model

I. It r > k, Market Price will be maximum where Retention is maximum. Such

firm are termed as growth firm.

II. It r < k, Market Price will be maximum when Retention will be minimum
and dividend distribution will be maximum. Such firm are termed as growth
firm.

III. It r = k, the firm earn equal rate of return on its investment as expected. In
such firm there is no optimum dividend pay out and the value of the firm
would not change with the change in dividend rate.
 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
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.
 Modigliani & Miller’s
Irrelevance Model
According to Modigliani and Miller-
Dividend Policy of a firm has no effect on
the value of the firm. Dividend are
Depends on
irrelevant to the shareholder’s wealth.
According to this, the price of shares of a
firm is determined by its power and
investment decision and not by the Depends on
decision of dividend the earnings into
dividend distribution and retained
earnings.
Assumptions of M-M Theory
This hypothesis is based on the following assumptions-
1- The Capital Market are perfect. Perfect Capital Market
imply that-
a) Information is freely available to all
b) Transaction and floatation costs do not exist and.
c) Investors behave rationally.
2- No Tax- Either there are no tax or there is no difference in
the rate of tax applicable to dividend income and capital
gain
3- Fixed Investment Policy –The organization has a fixed
investment policy.
4- No Risk- No Risk exists. In other words, investors are able
to forecast future profits and dividend with certainty
 Criticism of M-M Theory
 M-M Hypothesis of dividend irrelevance is based on
unrealistic assumptions, the most critical which are as
follows-
 Perfect Capital Market -Perfect Capital Market does not
exist in reality .Information about the company is not
available to all persons
 Tax Differential –Taxes do exist and there are two different
rate of tax for capital gains and dividends. Capital gains are
subject to lower tax rate compared to dividend . Hence, cost of
internal financing will be cheaper than external financing .So
the shareholders would favor retention of earnings on account
of tax differential.
 Rigid Investment Policy- The firms do not follow a raised
investment policy
 Continue
• Floatation Cost- The form have to incur floatation cost while
raising funds from outside. Hence , external financing will be
costlier than internal financing.
• Transaction Cost- The shareholders have to pay brokerage
fees on selling their shares. Moreover, it is inconvenient also
to sell share. Hence, share holders would prefer to have
dividend as compared to capital gains
• Uncertainty- There is always uncertainty in the capital
market. Hence shareholders prefer present dividend to future
dividend. Hence the value of shares of that company would
be higher than that of a company which is following the
policy of retention of earnings
• .
 Formula of M-M’s Approach

Where-
Po = ( D1+P1)
Po = Market price per share at beginning or 0
(1 + CR) D1 = Dividend per share at time 1,
P1 = Po(1+CR)-D P1 = Market price at the end of period 1
CR = Capitalization Rate of the firm.
D1 = Dividend Per Share at the period 1
52