MB0045-Financial Management Unit-15 Dividend Decisions

Program Semester Subject Code Subject Name Unit number

: MBA : II : MB0045 : Financial Management : 15 55

Unit Title
Lecture Number Lecture Title

: Dividend Decisions
: 15 : Dividend Decisions

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MB0045-Financial Management Unit-15 Dividend Decisions

Financial Management

Objectives:
After studying this unit, you should be able to: Explain the importance of dividends to investors Analyse the effect of declaring dividends on share prices Describe the advantages of a stable dividend policy List out the various forms of dividend Elucidate reasons for stock split

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MB0045-Financial Management Unit-15 Dividend Decisions

Lecture Outline
Introduction Traditional Approach Dividend Relevance Model

Walter Model
Gordons Model Miller and Modigliani (MM) Model Critical Analysis of MM Hypothesis

Stability of Dividends
Forms of Dividends Stock Split Summary

Check Your Learning

Activity

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MB0045-Financial Management Unit-15 Dividend Decisions

Introduction
Dividends are that portion of a firms net earnings which are paid to the shareholders. Preference shareholders are entitled to a fixed rate of dividend irrespective of the firms earnings.

Dividend decisions depend on what portion of earnings is to be retained by the firm and what portion is to be paid off.
As dividends are distributed out of net profits, the firms decisions on retained earnings have a bearing on the amount to be distributed. Retained earnings constitute an important source of financing investment requirements of a firm. Dividend policy has a direct influence on the two components of shareholders return dividends and capital gains. A low payout and high retention may have the effect of accelerating the earnings growth.

In this session, you will learn the importance of dividends to investors, the effect of declaring dividends on share prices, advantages of stable dividend policy and the various forms of dividend and reasons for stock split.
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MB0045-Financial Management Unit-15 Dividend Decisions

Traditional Approach
According to traditional approach stock value responds positively to high dividends and negatively to low dividends, that is, the share values of those companies which pay high dividends, rises considerably and the

prices fall in the event of low dividends paid.

Symbolically, P = [m (D+E/3)] Where P is the market price m is the multiplier

D is dividend per share

E is earnings per share As per this approach, there is a direct relationship between P/E ratios and

dividend pay-out ratio . High dividend pay-out ratio will increase the P/E
ratio and low dividend pay-out ratio will decrease the P/E ratio.
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MB0045-Financial Management Unit-15 Dividend Decisions

Dividend Relevance Model

Dividend relevance models support the view that the dividend policy of the firm has a bearing on share valuation. The two theories of dividend relevance model are:

Two theories

Walter Model

Gordon Model

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MB0045-Financial Management Unit-15 Dividend Decisions

Walter Model
The following are the assumptions on which the Walters model is based:

Financing

Life
Assumptions

Constant rate of return and cost of capital

Constant EPS and DPS

100% pay-out or retention 7

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MB0045-Financial Management Unit-15 Dividend Decisions

Gordons Model
Some assumptions regarding Gordons dividend capitalisation model are as follows:
The firm is an all-equity firm with no debt No external financing is used Constant return r Constant cost of capital Ke The life of the firm is indefinite The retention ratio g = br is constant forever Cost of capital is greater than br,

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MB0045-Financial Management Unit-15 Dividend Decisions

Miller and Modigliani Model

The Miller and Modigliani (MM) hypothesis seeks to explain that a firms dividend policy is irrelevant and has no effect on the share prices of the firm. Certain assumptions regarding Miller and Modigliani model are as follows:
Existence of perfect capital markets

Certainty about future investments

Assumptions

No taxes

Constant investment policy

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MB0045-Financial Management Unit-15 Dividend Decisions

Critical Analysis of MM Hypothesis

The analysis of MM hypothesis considers the following costs transaction cost, floatation cost, under-pricing of shares.

Floatation costs

Market conditions

Analysis of MM hypothesis

Transaction costs

Underpricing of shares

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MB0045-Financial Management Unit-15 Dividend Decisions

Stability of Dividends
Stability of dividends is the consistency in the stream of dividend payments. This method relates to the payment of certain amount of minimum dividend to the shareholders.

The steadiness is a sign of good health of the firm and may take any of the following forms:

Constant dividend per share

Constant dividend policy ratio

Constant dividend per share plus extra dividend

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MB0045-Financial Management Unit-15 Dividend Decisions

Forms of Dividends
Dividends are portions of earnings available to the shareholders. The different forms of dividends are:

Cash dividend

Stock dividend

Forms of dividends

Scrip dividend

Bond dividend

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MB0045-Financial Management Unit-15 Dividend Decisions

Stock Split
A stock split is a method to increase the number of outstanding shares by proportionately reducing the face value of a share. The reason for splitting shares are as follows:
To make shares attractive

Reasons Indication of higher future profits

Higher dividend to shareholders

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MB0045-Financial Management Unit-15 Dividend Decisions

Summary
Dividends are that portion of a firms net earnings which are paid to the shareholders. As per traditional approach, there is a direct relationship between P/E ratios and dividend pay-out ratio. Dividend relevance models support the view that the dividend policy of the firm has a bearing on share valuation. The Miller and Modigliani (MM) hypothesis seeks to explain that a firms dividend policy is irrelevant and has no effect on the share prices of the firm. The analysis of MM hypothesis considers the transaction cost, floatation cost, under-pricing of shares and market conditions. Stability of dividends is the consistency in the stream of dividend payments. This method relates to the payment of certain amount of minimum dividend to the shareholders. A stock split is a method to increase the number of outstanding shares by proportionately reducing the face value of a share.

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MB0045-Financial Management Unit-15 Dividend Decisions

Check Your Learning

1. Name two theories of dividend relevance model. Ans: The two theories of dividend relevance model are: a. Walter model

b. Gordon model
2. List the different forms of dividends. Ans: The different forms of dividends are:

a. Cash dividend
b. Scrip dividend c. Bond dividend d. Stock dividend

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MB0045-Financial Management Unit-15 Dividend Decisions

Activity Assume that for a firm XYZ Ltd., the dividend pay-outs are relevant and have a bearing on the share prices of the firm. The investment policies of a firm cannot be separated from its dividend policy and both are interlinked. What dividend model is the firm following? Explain the assumptions based on that model.

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