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Structure 15.1 Introduction 15.2 TraditionalApproach 15.3 DividendRelevanceModel 15.3.1 15.3.2 WalterModel GordonsDividendCapitalizationModel

DividendDecision

15.4 DividendIrrelevanceTheory: MillerandModiglianiModel 15.5 StabilityofDividends 15.6 FormsofDividends 15.7 StockSplit 15.8 Summary TerminalQuestions AnswerstoSAQsandTQs 15.1Introduction Dividendsarethatportionofafirmsnetearningspaidtotheshareholders.Preferenceshareholders are entitled toafixed rateof dividend irrespective of thefirms earnings. Equity holders dividends fluctuateyearafteryear.Itdependsonwhatportionofearningsistoberetainedbythefirmandwhat portionistobepaidoff.Asdividendsaredistributedoutofnetprofits,thefirmsdecisionsonretained earningshaveabearingontheamounttobedistributed.Retainedearningsconstituteanimportant source of financing investment requirements of a firm. However, such opportunities should have enough growth potential and sufficient profitability. There is an inverse relationship between these two larger retentions, lesser dividends and vice versa. Thus two constituents of net profits are alwayscompetitiveandconflicting. Dividendpolicyhasadirectinfluenceonthetwocomponentsofshareholdersreturndividendsand capitalgains.Alowpayoutandhighretentionmayhavetheeffectofacceleratingearningsgrowth. Investorsofgrowthcompaniesrealizetheirmoneyintheformofcapitalgains. Dividend yield will belowforsuchcompanies.Theinfluenceofdividendpolicyonfuturecapitalgainsistohappenin
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distant future and therefore by all means uncertain. Share prices are a reflection of many factors including dividends. Some investors prefer current dividends to future gains as prophesied by an English saying A bird inhand is worth two in the bush. Given all these constraints, it is a major decisionoffinancialmanagement. Dividend policy of a firm is a residual decision. In true sense, it means that a firm with sufficient investmentopportunitieswillretaintheentireearningstofunditsgrowthavenues.Conversely,ifno suchavenuesareforthcoming,thefirmwillpayoutitsentireearnings.Sothereexistsarelationship betweenreturnoninvestmentsrandthecostofcapitalk.Solongasrexceedsk,afirmshallhave goodinvestmentopportunities.Thatis,ifthefirmcanearnareturnrhigherthanitscostofcapitalk, itwillretainitsentireearningsandifthissourceisnotsufficient,itwillgoinforadditionalsourcesin theformofadditionalfinancinglikeequityissue,debentureissueortermloans.Thus,thedividend decisionisatradeoffbetweenretainedearningsandfinancingdecisions. Different theories have been given by various people on dividend policy. We have the traditional theory andnewsetsoftheoriesbased on the relationshipbetweendividend policy andfirm value. Themoderntheoriescanbegroupedas(a)theoriesthatconsiderdividenddecisionasanactive variableindeterminingthevalueofthefirmand(b)theoriesthatdonotconsiderdividenddecisionas anactivevariableindeterminingthevalueofthefirm.

LearningObjectives: Afterstudyingthisunit,youshouldbeabletounderstandthefollowing.

1. Explaintheimportanceofdividendstoinvestors. 2. Discusstheeffectofdeclaringdividendsonshareprices. 3. Mentiontheadvantagesofastabledividendpolicy. 4. Listoutthevariousformsofdividend. 5. Givereasonsforstocksplit.

15.2TraditionalApproach This approach is given by B. Graham and D. L. Dodd. They clearly emphasize the relationship betweenthedividendsandthestockmarket.Accordingtothem,thestockvaluerespondspositively

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tohighdividendsandnegativelytolowdividends,thatis,thesharevaluesofthosecompaniesrises considerablywhichpayhighdividendsandthepricesfallintheeventoflowdividendspaid. Symbolically,P=[m(D+E/3)] WherePisthemarketprice, Misthemultiplier, Disdividendpershare, EisEarningspershare. Drawbacks of the Traditional Approach: As per this approach, there is a direct relationship betweenP/Eratiosanddividendpayoutratio.HighdividendpayoutratiowillincreasetheP/Eratio andlowdividendpayoutratiowilldecreasetheP/Eratio.Thismaynotalwaysbetrue.Acompanys sharepricesmayriseinspiteoflowdividendsduetootherfactors. 15.3DividendRelevanceModel Underthissectionweexaminetwotheories WalterModelandGordonModel. 15.3.1WalterModel Prof. James E.Walter considers dividend payouts are relevant and have a bearing on the share prices of the firm. He further states, investment policies of a firm cannot be separated from its dividend policy and both are interlinked. The choice of an appropriate dividend policy affects the valueofthefirm.Hismodelclearlyestablishesarelationshipbetweenthefirmsrateofreturnr,its costofcapitalk,togiveadividendpolicythatmaximizesshareholderswealth.Thefirmwouldhave the optimum dividend policy that will enhance the value of the firm. This can be studied with the relationship between rand k. If r>k, thefirms earnings can be retainedas thefirm has betterand profitableinvestmentopportunitiesandthefirmcanearnmorethanwhattheshareholderscouldby reinvesting,ifearningsaredistributed.Firmswhichhaver>karecalledgrowthfirmsandsuchfirms shouldhaveazeropayoutratio. Ifreturnoninvestmentrislessthancostofcapitalk,thefirmshouldhavea100%payoutratioas theinvestorshavebetterinvestmentopportunitiesthanthefirm.Suchapolicywillmaximizethefirm value.

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IfafirmhasaROIrequaltoitscostofcapitalk,thefirmsdividendpolicywillhavenoimpactonthe firmsvalue.Thedividendpayoutscanrangebetweenzeroand100%andthefirmvaluewillremain constantinallcases.Suchfirmsarecallednormalfirms. WaltersModelisbasedoncertainassumptions: Financing:Allfinancingisdonethroughretainedearnings.Retainedearningsistheonlysource of finance available and the firm does not use any external source of funds like debt or new equity. Constantrateofreturnandcostofcapital:Thefirmsrandkremainconstantanditfollows thatanyadditionalinvestmentmadebythefirmwillnotchangetheriskandreturnprofile. 100%payoutorretention:Allearningsareeithercompletelydistributedorreinvestedentirely immediately. Constant EPS and DPS: The earnings and dividends do not change and are assumed to be constantforever. Life:Thefirmhasaperpetuallife.

Waltersformulatodeterminethemarketpriceisasfollows: P=
D [ ( - D /Ke r E ) ] + Ke Ke

WherePisthemarketpricepershare, Disthedividendpershare, Keisthecostofcapital, gisthegrowthrateofearnings, EisEarningspershare, risIRR. Example: ThefollowinginformationrelatestoAlphaLtd.Showtheeffectofthedividendpolicyonthemarket priceofitssharesusingtheWaltersModel EquitycapitalizationrateKe11% Earningspershare Rs.10 ROI(r)maybeassumedasfollows:15%,11%and8% Showtheeffectofthedividendpoliciesonthesharevalueofthefirmforthreedifferentlevelsofr, takingtheDPratiosaszero,25%,50%,75%and100%

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Solution Ke11%,EPS10,r15%,DPS=0 P=
D [ /Ke( - D r E )] + Ke Ke

CaseIr>k(r=15%,K=11%)

a. DP=0

0 + [ . /0 1110- 0 015 . ( )] =13.64/0.11=Rs.123.97 011 . 2. + [ . /01110- 2 5 5 0 15 . ( . )] = 12.73/0.11=Rs.115.73 0 11 . 5 + [ . /0 1110- 5 015 . ( )] =11.82/0.11=Rs.107.44 011 . 7. + [ . /0 1110- 7 5 5 0 15 . ( . )] =10.91/0.11=Rs.99.17 0 11 . 10 + [ . /0 1110- 10 015 . ( )] =10/0.11=Rs.90.91 0 11 .

b. DP=25% c. DP=50% d. DP=75%

e. DP=100%

CaseIIr=k(r=11%,K=11%) a. DP=0
0 + [ . /0 1110- 0 0 11 . ( )] =10/0.11=Rs.90.91 0 11 . 2. + [ . /0 1110- 2 5 5 0 11 . ( . )] =10/0.11=Rs.90.91 011 . 5 + [ . /0 1110- 5 0 11 . ( )] =10/0.11=Rs.90.91 0 11 . 7. + [ . /01110- 7 5 5 011 . ( . )] =10/0.11=Rs.90.91 0 11 . 10 + [ . /0 1110- 10 0 11 . ( )] =10/0.11=Rs.90.91 0 11 .

b. DP=25% c. DP=50% d. DP=75% e. DP=100%

CaseIIIr<k(r=11%,K=8%) f. DP=0
0 + [ . /0 08( - 0 011 . 10 )] =13.75/0.08=Rs.171.88 0 08 . 2. + [ . /008( - 2 5 5 0 11 . 10 . )] =12.81/0.08=Rs.160.13 0 08 .

g. DP=25%

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h. DP=50% i. DP=75%

5 + [ . /0 08( - 5 011 . 10 )] =11.88/0.08=Rs.107.95 0 08 . 7. + [ . /008( - 7 5 5 0 11 . 10 . )] =10.94/0.08=Rs.99.43 0 08 .

j. DP=100%

10 + [ . /0 08( - 10 011 . 10 )] =10/0.08=Rs.90.91 0 08 .

Interpretation:Theaboveworkingscanbesummarizedasfollows: 1. Whenr>k,thatis,ingrowthfirms,thevalueofsharesisinverselyrelatedtoDPratio,astheDP increases,marketvalueofsharesdecline.MarketvalueofshareishighestwhenDPiszeroand leastwhenDPis100%. 2. When r=k, the market value of share is constant irrespective of the DP ratio. It is not affected whetherthefirmretainstheprofitsordistributesthem. 3. Inthethirdsituation,whenr<k,indecliningfirms,themarketpriceofashareincreasesastheDP increases.Thereisapositivecorrelationbetweenthetwo. Limitations Walterhasassumedthatinvestmentsareexclusivelyfinancedbyretainedearningsandnoexternal financing is used. This model is applicable only to allequity firms. Secondly r is assumed to be constant whichagain isnot a realistic assumption. Finally,Ke isalsoassumed tobe constant and thisignoresthebusinessriskofthefirmwhichhasadirectimpactonthefirmvalue. 15.3.2GordonsDividendCapitalizationModel Gordonalsocontendsthatdividendsarerelevanttothesharepricesofafirm.MyronGordonuses theDividendCapitalizationModeltostudytheeffectofthefirmsdividendpolicyonthestockprice. Assumptions Allequityfirm:Thefirmisanallequityfirmwithnodebt. No external financing is used and only retained earnings are used to finance any expansion schemes. Constantreturnr ConstantcostofcapitalKe Thelifeofthefirmisindefinite. Constantretentionratio:Theretentionratiog=brisconstantforever. 236

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Costofcapitalgreaterthanbr,thatisKe>br

Gordons model assumes investors are rational and riskaverse. They prefer certain returns to uncertain returns and therefore give a premium to the constant returns and discount uncertain returns. The shareholders therefore prefer current dividends to avoid risk. In other words, they discount future dividends. Retained earnings are evaluated by the shareholders as risky and thereforethemarketpriceoftheshareswouldbeadverselyaffected.Gordonexplainshistheorywith preference for current income. Investors prefer to pay higher price for stocks which fetch them currentdividendincome.Gordonsmodelcanbesymbolicallyexpressedas:
P= E1- b ( ) Ke- br

WherePisthepriceoftheshare, EisEarningsPerShare, bisRetentionraio, (1b)isdividendpayoutratio, Keiscostofequitycapital, brisgrowthrateintherateofreturnoninvestment. Example: GivenKeas11%,EisRs.10,calculatethestockvalueofMahindraTech.for(a)r=12%,(b)r=11% and(c)r=10%forvariouslevelsofDPratiosgivenunder: DPratio(1b) Retentionratio A B C D E 10% 20% 30% 40% 50% 90% 80% 70% 60% 50%

Solution CaseIr>k(r=12%,K=11%) P=E(1b) Kebr

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a. DP10%,b90% 10(10.9) 0.11(0.9*0.12) b. DP20%,b80% 10(10.8) 0.11(0.8*0.12) c. DP30%,b70% 10(10.7) 0.11(0.7*0.12) d. DP40%,b60% 10(10.6) 0.11(0.6*0.12) e. DP50%,b50% 10(10.5) 0.11(0.5*0.12) CaseIIr=k(r=11%,K=11%) P=E(1b) Kebr a. DP10%,b90% 10(10.9) 0.11(0.9*0.11) b. DP20%,b80% 10(10.8) 0.11(0.8*0.11) c. DP30%,b70% 10(10.7) 0.11(0.7*0.11) d. DP40%,b60% 10(10.6) 0.11(0.6*0.11) equals4/.044=Rs.90.91 equals3/.033=Rs.90.91 equals2/.022=Rs.90.91 equals1/.011=Rs.90.91 equals5/.05=Rs.100 equals4/.038=Rs.105.26 equals3/.026=Rs.115.38 equals2/.014=Rs.142.86 equals1/.002=Rs.500

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e. DP50%,b50% 10(10.5) 0.11(0.5*0.11) CaseIIIr<k(r=10%,K=11%) P=E(1b) Kebr a. DP10%,b90% 10(10.9) 0.11(0.9*0.1) b. DP20%,b80% 10(10.8) 0.11(0.8*0.1) c. DP30%,b70% 10(10.7) 0.11(0.7*0.1) d. DP40%,b60% 10(10.6) 0.11(0.6*0.1) e. DP50%,b50% 10(10.5) 0.11(0.5*0.1) Interpretation:Gordonisoftheopinionthatdividenddecisiondoeshaveabearingonthemarket priceoftheshare. 1. Whenr>k,thefirmsvaluedecreaseswithanincreaseinpayoutratio.Marketvalueofshareis highestwhenDPisleastandretentionhighest. 2. When r=k, the market value of share is constant irrespective of the DP ratio. It is not affected whetherthefirmretainstheprofitsordistributesthem. 3. Whenr<k,marketvalueofshareincreaseswithanincreaseinDPratio. equals5/.06=Rs.83.33 equals4/.05=Rs.80 equals3/.04=Rs.75 equals2/.03=Rs.66.67 equals1/.02=Rs.50 equals5/.55=Rs.90.91

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15.4MillerandModiglianiModel TheMMhypothesisseekstoexplainthatafirmsdividendpolicyisirrelevantandhasnoeffecton thesharepricesofthefirm.Thismodeladvocatesthatitistheinvestmentpolicythroughwhichthe firmcanincreaseitssharevalueandhencethisshouldbegivenmoreimportance. Assumptions Existence of perfect capital markets: All investors are rational and have access to all information free of cost. There are no floatation or transaction costs, securities are infinitely divisibleandnosingleinvestorislargeenoughtoinfluencethesharevalue. No taxes: There are no taxes, implying there is no difference between capital gains and dividends. Constant investment policy: The investment policy of the company does not change. The implicationisthatthereisnochangeinthebusinessriskpositionandtherateofreturn. No Risk Certainty about future investments, dividends and profits of the firm. This assumptionwas,however,droppedatalaterstage. Basedontheaboveassumptions,MillerandModiglianihaveexplainedtheirrelevanceofdividendas the crux of the arbitrage argument. The arbitrage process refers to setting off or balancing two transactions whichare entered into simultaneously. The two transactions are paying out dividends andraisingexternalfundstofinanceadditionalinvestmentprograms.Ifthefirmpaysoutdividend,it will have to raise capital by selling new shares for financing activities. The arbitrage process will neutralizetheincreaseinsharevalue(duetodividends)withtheissueofnewshares.Thismakes theinvestorindifferenttodividendearningsandcapitalgainsasthesharevalueismoredependent onthefutureearningsofthefirmthanonitscurrentdividendpolicy. Symbolically,themodelisgivenas: StepI:ThemarketpriceofashareinthebeginningisequaltothePVofdividendspaidandmarket priceattheendoftheperiod. P0= 1 (1+Ke) WhereP0isthecurrentmarketprice, P1ismarketpriceattheendofperiod1, D1isdividendstobepaidattheendofperiod1, Keisthecostofequitycapital.
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StepII:Assumingthereisnoexternalfinancing,thevalueofthefirmis: nP0== 1 (1+Ke) Wherenisnumberofsharesoutstanding. StepIII:Ifthefirmsinternalsourcesoffinancingitsinvestmentopportunitiesfallshortoffunds required,newsharesareissuedattheendofyear1atpriceP1.Thecapitalizedvalueofthe dividendstobereceivedduringtheperiodplusthevalueofthenumberofsharesoutstandingisless thanthevalueofnewshares. nP0== 1 (1+Ke) Firmswillhavetoraiseadditionalcapitaltofundtheirinvestmentrequirementsafterutilizingtheir retainedearnings,thatis, n1P1=I(EnD1)whichcanbewrittenasn1P1=IE+nD1 WhereIistotalinvestmentrequired, nD1istotaldividendspaid, Eisearningsduringtheperiod, (EnD1)isretainedearnings. StepIV:Thevalueofshareisthus: nP0== Example: Acompanyhasacapitalizationrateof10%.Itcurrentlyhasoutstandingsharesworth25000shares sellingcurrentlyatRs.100each.ThefirmexpectstohaveanetincomeofRs.400000forthecurrent financial year and it is contemplating to pay a dividend of Rs. 4 per share. The company also requires Rs.600000 tofund its investment requirement. Show that under MM model, the dividend paymentdoesnotaffectthevalueofthefirm. Solution CaseI:Whendividendsarepaid: StepI:P0= 1 (1+Ke) *(D1+P1) 1 *(nD1+(n+n1)P1I+EnD1) (1+Ke) *(nD1+(n+n1)P1n1p1) *(nD1+nP1)

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100=1/(1+0.1)*(4+P1) P1=Rs.106 StepII:n1P1=I(EnD1),nD1is25000*4 n1P1=600000(400000100000)=Rs.300000 StepIII:Numberofadditionalsharestobeissued 300000/106=2831shares StepIV:Thefirmvalue nP0== (n+n1)P1I+E (1+Ke) (25000+2831)*106600000+400000 equalsRs.2500000 (1+0.1) CaseII:Whendividendsarenotpaid: StepI:P0= 1 (1+Ke) 100=1/(1+0.1)*(0+P1) P1=Rs.110 StepII:n1P1=I(EnD1),nD1is25000*4 n1P1=600000(4000000)=Rs.200000 StepIII:Numberofadditionalsharestobeissued 200000/110=1819shares StepIV:Thefirmvalue nP0== (n+n1)P1I+E (1+Ke) (25000+1819)*110600000+400000 equalsRs.2500000 (1+0.1) Thus,thevalueofthefirmremainsthesameinboththecaseswhetherornotdividendsare declared. CriticalAnalysisofMMHypothesis: Floatation costs: Miller and Modigliani have assumed the absence of floatation costs. Floatation costsrefertothecostinvolvedinraisingcapitalfromthemarket,thatis,thecostsincurredtowards underwritingcommission,brokerageandothercosts.Thesecostsordinarilyaccounttoaround10%
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15%ofthetotalissueandtheycannotbeignoredgiventheenormityofthesecosts.Thepresenceof these costs affects the balancing nature of retained earnings and external financing. External financingisdefinitelycostlierthanretainedearnings.Forinstance,ifashareisissuedworthRs.100 andfloatationcostsare12%,thenetproceedsareonlyRs.88. Transactioncosts:ThisisanotherassumptionmadebyMMthattherearenotransactioncostslike brokerage involved in capital market. These are the costs associated with sale of securities by investors.Thistheoryimpliesthatifthecompanydoesnotpaydividends,theinvestorsdesirousof currentincomesellpartoftheirholdingswithoutanycostincurred.Thisisveryunrealisticasthesale of securities involves cost, investors wishing to get current income should sell higher number of sharestogettheincometheyaretoreceive. Underpricingofshares:Ifthecompanyhastoraisefundsfromthemarket,itshouldsellsharesat apricelesserthantheprevailingmarketpricetoattractnewshareholders.Thisfollowsthatatlower prices,thefirmshouldsellmoresharestoreplacethedividendamount. Marketconditions:Ifthemarketconditionsarebadandthefirmhassomelucrativeopportunities,it is not worthapproaching new investors at this juncture, given the presence of floatation costs. In such cases, the firms should depend on retained earnings and low payout ratio to fuel such opportunities. 15.5 StabilityofDividends Stabilityofdividendsistheconsistencyinthestreamofdividendpayments.Itisthepayment ofcertainamountofminimumdividendtotheshareholders.Thesteadinessisasignofgoodhealth of the firm and may take any of the following forms (a) constant dividend per share, (b)constantDPratioand(c)constantdividendpershareplusextradividend. Constant dividend per share: As per this form of dividend policy, a firm pays a fixed amount of dividendpershareyearafteryear.Forexample,afirmmayhaveapolicyofpaying25%dividendper share on its paidup capital of Rs. 10 per share. It implies that Rs. 2.50 is paid out every year irrespectiveofitsearnings.Generally,afirmfollowingsuchapolicywillcontinuepaymentsevenifit incurs losses. In such years when there is a loss, the amount accumulated in the dividend equalizationreserveisutilized.Asandwhenthefirmstartsearningahigheramountofrevenueitwill considerpaymentofhigherdividendsandinfutureitisexpectedtomaintainthehigherlevel.

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ConstantDPratio:WiththistypeofDPpolicy,thefirmpaysaconstantpercentageofnetearnings totheshareholders.Forexample,ifthefirmfixesitsDPratioas25%ofitsearnings,itimpliesthat shareholdersget25%ofearningsasdividendyearafteryear.Insuchyearswhereprofitsarehigh, theygethigheramount. Constant dividend per share plus extra dividend: Under this policy,a firm usually pays afixed dividendordinarilyandinyearsofgoodprofits,additionalorextradividendispaidoverandabove theregulardividend. Thestabilityofdividendsisdesirablebecauseofthefollowingadvantages: Build confidence amongst investors: A stable dividend policy helps to build confidence and remove uncertainty in the minds of investors. A constant dividend policy will not have any fluctuationssuggestingtotheinvestorsthatthefirmsfutureisbright.Incontrast,shareholdersof afirmhavinganunstableDPwillnotbecertainabouttheirfutureinsuchafirm. Investors desire for current income: A firm has different categories of investors old and retired persons, pensioners, youngsters, salaried class, housewives, etc. Of these, people like retiredpersonsprefercurrentincome.Theirlivingexpensesarefairlystablefromoneperiodto another. Sharp changes in current income, that is, dividends, may necessitate sale of shares. Stabledividendpolicyavoidssaleofsecuritiesandinconveniencetoinvestors. Informationaboutfirmsprofitability:Investorsusedividendpolicyasameasureofevaluating thefirmsprofitability.Dividenddecisionisasignoffirmsprosperityandhencefirmshouldhave astableDP. Institutional investors requirements: Institutional investors like LIC, GIC and MF prefer to invest in companies which have a record of stable DP. A company having erratic DP is not preferred by these institutions. Thus to attract these organizations having large quantities of investiblefunds,firmsfollowastableDP. Raise additional finance: Shares of a company with stable and regular dividend payments appearasqualityinvestmentratherthanaspeculation.Investorsofsuchcompaniesareknown for their loyalty and whenever the firm comes with new issues, they are more responsive and receptive.Thusraisingadditionalfundsbecomeseasy. Stability in market price of shares: The market price of shares varies with the stability in dividendrates.Suchshareswillnothavewidefluctuationsinthemarketpriceswhichisgoodfor investors.
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SelfAssessmentQuestionsI 1. ____________constituteanimportantsourceoffinancinginvestmentrequirementsofafirm. 2. Dividendpolicyhasadirectinfluenceonthetwocomponentsofshareholdersreturn__________ and____________. 3. ______________considers dividend payouts are relevant and have a bearing on the share pricesofthefirm. 4. IfafirmhasaROIrequaltoitscostofcapitalk,itiscalleda___________ 5. ________ model explains that consumers prefer certain returns to uncertain returns and thereforegiveapremiumtotheconstantreturnsanddiscountuncertainreturns. 6. The__________processreferstosettingofforbalancingtwotransactionswhichareenteredinto simultaneously. 7. __________costsrefertothecostinvolvedinraisingcapitalfromthemarket. 8. ______________arethecostsassociatedwithsaleofsecuritiesbyinvestors. 15.6 FormsofDividends Dividendsarethatpotionofearningsavailabletoshareholders.Generally,dividendsaredistributed incash,butsometimestheymayalsodeclaredividendsinotherformswhicharediscussedbelow: Cashdividends: Mostcompaniespaydividendsincash.Theinvestorsalso,especiallytheold andretiredinvestorsdependonthisformofpaymentforwantofcurrentincome. Scripdividend:Inthisformofdividends,equityshareholdersareissuedtransferablepromissory notes with shorter maturity periods which may or may not have interest bearing. This form is adopted if thefirmhasearned profitsand it willtake some timeto convert itsassets into cash (havingmoreofcurrentsalesthancashsales).Paymentofdividendinthisformisdoneonlyif thefirmissufferingfromweakliquidityposition. Bond dividend: Scrip and bond dividend are the same except that they differ in terms of maturity.Bonddividendscarrylongermaturityperiodandbearinterest,whereasscripdividends carryshortermaturityandmayormaynotcarryinterest. Stockdividend(Bonusshares):Stockdividend,asknownisUSAorbonussharesinIndia,is thedistributionofadditionalsharestotheshareholdersatnoadditionalcost.Thishastheeffect of increasing thenumberofoutstanding sharesof thefirm. The reservesand surplus (retained earnings) are capitalized to give effect to bonus issue. This decision has the effect of

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recapitalization,thatis,transferfromreservestosharecapitalnotchangingthetotalnetworth. Theinvestorsareallottedsharesinproportiontotheirpresentshareholding.Declarationofbonus shareshasafavourablepsychologicaleffectoninvestors.Theyassociateitwithprosperity. 15.7StockSplit Astocksplitisamethodtoincreasethenumberofoutstandingsharesbyproportionatelyreducing thefacevalueofashare.Astocksplitaffectsonlytheparvalueanddoesnothaveanyeffectonthe totalamountoutstandinginsharecapital.Thereasonsforsplittingsharesare: Tomakesharesattractive:Theprimereasonforeffectingastocksplitistoreducethemarket price of a share to make it more attractive to investors. Shares of some companies enter into highertradingzonemakingitoutofreachtosmallinvestors.Splittingtheshareswillplacethem inmorepopulartradingrangethusprovidingmarketabilityandmotivatingsmallinvestorstobuy them. Indication of higher future profits: Share split is generally considered a method of managementcommunicationtoinvestorsthatthecompanyisexpectinghighprofitsinfuture. Higher dividend to shareholders: When shares are split, the company does not resort to reducingthecashdividends.Ifthecompanyfollowsasystemofstabledividendpershare,the investorswouldsurelygethigherdividendswithstocksplit. 15.8Summary Dividendsaretheearningsofthecompanydistributedtoshareholders.Paymentofdividendisnot mandatory,butmostcompaniesseetoitthatdividendsarepaidonaregularbasistomaintainthe imageofthecompany.Aspaymentofdividendisnotcompulsory,thequestionwhicharisesinthe minds of policy makers is Should dividends be paid, if yes, what should be the quantum of payment?Varioustheorieshavecomeoutwithvarioussuggestionsonthepaymentofdividend.B. GrahamandD.L.Doddareoftheviewthatthereisacloserelationshipbetweenthedividendsand thestockmarket.Thestockvaluerespondspositivelytohighdividendsandviceversa. Prof. James E. Walter considers dividend payouts are necessary but if the firms ROI is high, earningscanberetainedasthefirmhasbetterandprofitableinvestmentopportunities.

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Gordon also contends that dividends are significant to determine the share prices of a firm. Shareholders prefer certain returns (current) to uncertain returns (future) and therefore give a premiumtotheconstantreturnsanddiscountuncertainreturns. MillerandModiglianiexplainthatafirmsdividendpolicyisirrelevantandhasnoeffectontheshare prices of the firm. They are of the view that it is the investment policy through which the firm can increaseitssharevalueandhencethisshouldbegivenmoreimportance. Dividendscanbepaidoutinvariousformssuchascashdividend,scripdividend,bonddividendand bonusshares. TerminalQuestions 1. Writeashortnoteonthedifferenttypesofdividend. 2. Whatisstocksplit?Whatareitsadvantages? 3. Thefollowinginformationisavailableinrespectofacompany. Equitycapitalization15% EPSRs.25 Dividendpayoutratio25% ROI12% WhatisthepriceoftheshareasperWalterModel? 4. Consideringthefollowinginformation,whatisthepriceoftheshareasperGordonsModel? Netsales Netprofitmargin Outstandingpreferenceshares No.ofequityshares Costofequityshares Retentionratio ROI Rs.120lakhs 12.5% Rs.50lakhs@12%dividend 250000 12% 40% 16%

5. IftheEPSisRs.5,dividendpayoutratiois50%,costofequityis20%,growthrateintheROIis 15%,whatisthevalueofthestockasperGordonsDividendEqualizationModel? 6. NileLtd.makesthefollowinginformationavailable.WhatisthevalueofthestockasperGordon Model?

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Ke14%,EPSRs.20,D/Pratio35%Retentionratio65%,ROI16% 7. WhatisthestockpriceasperGordonModelifDPratiois60%intheabovecase? AnswerstoSelfAssessmentQuestions SelfAssessmentQuestions1 1. Retainedearnings 2. Dividendsandcapitalgains 3. Prof.JamesE.Walter 4. Normalfirm 5. Gordon 6. Arbitrage 7. Floatationcosts 8. Transactioncosts AnswerstoTerminalQuestions: 1. Referto10.6 2. Referto10.7 3.Hint:ApplytheformulaWaltersformulatodeterminethemarketprice P= D + [r(ED)/Ke] KeKe 4,5,6,7:Hint:ApplytheGordonformulaofP=E(1b) Kebr

SikkimManipalUniversity

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