Dividend Policy

Meaning of dividend
The part of earning that is distributed among
shareholder is called dividend. It is the reward
for investment made by them in the shares of
the company.
 Meaning of dividend policy
To determine the amount of earnings to be
distributed to shareholders and the amount to
be retained in the firm.
(i) To retain 100% of the earnings in the business
& deploy them for business
(ii) To distribute 100% of the earnings among
shareholders
(iii) To retain a part and distribute the remainder
to shareholders
 Dividend Decision
There are two schools of thought regarding
dividend policy. One set of people believes that
dividend policy affects the value of firm, while
the other set of people as irrelevant to the value
of firm.

(i) The irrelevance concept of dividend

(ii) The relevance concept of dividend
 Theory of Relevance

According to them dividends communicate

information to the investors about the firms
profitability and hence dividend decision
becomes relevant. The firms which pay higher
dividends will have greater value as compared
to those which do not pay dividends or have a
lower dividend pay out ratio.
 Walters Approach
According to this the relationship between the
internal rate of return earned by the firm and the
cost of capital is very significant in determining
dividend policy to maximize the goal of wealth of
shareholders. The following observations have
been made:
(a) If the firm earns a higher rate of return on its
investment that the required rate of return, then
firm should retain earnings. Such firms are growing
firms & optimum pay out is zero so it will maximize
the value of shares.
(b) For a declining firm the shareholders can earn
more on distributed earnings than the firm can
provide from retained earnings.
(c) For a normal firm investors are indifferent to
the dividend policy because retained earnings
will yield the same return as distributed
earnings. Thus share price is constant .
 Assumptions
• Internal financing:
• Constant return and cost of capital:
• 100% pay out or retention:
• Infinite time or very long life of firm:
• Earnings or dividends do not change while
determining the value:
 Criticism

• No external financing
• Constant rate of return:
• Constant cost of capital: it changes directly
with the firms risk.
 Gordon’s Approach
1. When the rate of return of firm on its
investment is greater than the required rate of
return ,the price per share increases as the
dividend pay out ratio decreases.
2. When the rate or return is equal to the required
rate of return the price per share remains
unchanged & not affected by dividend policy
3. When rate of return is less than required rate of
return price per share increases due to increase
in dividend pay out ratio
 Assumptions
• All equity firm and has no debts
• No external financing
• Constant return
• Constant cost of capital
• No corporate taxes
• Constant retention
• Cost of capital greater than growth rate
Irrelevance Theory of Dividend
According to this there is no relation between
dividend policy and market value of shares and
the value of firm is determined by the earning
capacity of the firm or its investment policy.

For shareholders wealth, it is immaterial how

the earnings are distributed or retained.
Dividend is relevant to shareholders wealth
not the dividend policy
 Assumptions
• Uniform/homogeneous expectations:
• Perfect capital market: no transaction cost, all
investors are equally well informed and
interpret information in same way, buying and
selling actions of investors do not influence the
price.
• No uniform taxes:
• Investors are indifferent to dividend income and
capital gains
 Explanation
The increase in the value of the firm results
from the payment of dividend, will be exactly off
set by the decline in the market price of shares
because of external financing and there will be
no change in the total wealth of the
shareholders.
P0 = D1 + P1 P0= mkt price per share in begning
1 + Ke D1 = dividend at end
Ke = cost of equity capital
P1 = mkt price per share at end
 Criticism
• Investment and dividend policy are linked and
not independent of each other
• Existence of taxes
• Firms has to incur transaction cost
• Perfect capital market does not exist in reality
• Information is not available to all the persons
 Considerations in Dividend Policy
• Legal restrictions
• Magnitude and trend of earnings
• Desire and type of shareholders
• Nature of industry
• Age of company
• Future financial requirements
• Governments economic policy
• Taxation policy
• Inflation
• Control objectives
• Requirements of institutional investors
• Stability of dividends
• Liquid resources
 Types of dividend policy
• Regular dividend policy: usual rate
• Stable dividend policy: consistency or
lack of variability
• Irregular dividend policy: uncertainty
• No dividend policy: due to
unfavorable conditions or
requirement of funds