Dividend Policy

The dividend policy of a company determines what

proportion of earnings is distributed to the shareholders by way of dividends, and what proportion is ploughed back for reinvestment purposes.

Since the main objective of financial management

is to maximise the market value of equity shares, one key area of study is the relationship between the dividend policy and market price of equity shares.

Dividend Policy Models

Walter Model Gordon Model Modiliani-Miller Model

Rational Expectation Model

Walter Model
According to this model founded by James Walter, the

dividend policy of a company has an impact on the share valuation. Assumptions Retained earnings is only available source of finance for the firm r & k assumed to be constant-additional investment made by the firm will not change its risk & return profile Firm has infinite life For a given value of the firm ,the dividend per share & EPS remain constant

 As per this model,the market price of the share is the sum

of the present value of the future cash dividends & capital gains Quantitatively P = D + r(E D)/k k Where: r = internal rate of return on the investments k = cost of capital. Interpretation: When r>k, the price per share increases as the payout ratio decreases (optimal payout ratio is nil) When r=k, the price per share does not vary with the changes in the payout ratio (optimal payout ratio does not exist) When r<k, the price per share increases as the payout ratio increases (optimal payout ratio is 100%)

Example
The EPS of a company is Rs.20 and the capitalisation rate applicable is 15 %.It is considering the dividend payout ratios of 50 %, 80 % and 100 %. What would be the market price of the companys shares as per Walters model ,if it can earn a return of a)12 % (b) 15 % (c) 20%

Limitations
Unrealistic assumption of exclusive financing by

retained earnings makes the model suitable for all equity firms Return on investment is assumed to be constant Ignores the impact of business risk on value of the firm (k can not be assumed to be constant)

Gordon Model
Myron Gordon used the dividend capitalization approach

to study the effects of the firms dividend policy on the stock price.

Assumptions: All equity firms with new investments being financed

solely by the retained earnings r & k remain constant Firm has an infinite life The retention ratio & hence the growth rate is constant K i.e. cost of capital is greater than the growth rate Investors are rational & risk-averse they put a premium on certain returns & discount the uncertain returns

Gordon Model
Quantitatively Po= E1 (1-b)/(k-br) Where: P is the price per share E is the earnings per share b is the retention ratio 1-b is the payout ratio br is the growth rate r is the return on investment k is the rate of return required by shareholders On comparing r and k, the relationship between

market price and the payout ratio is exactly the same as compared to the Walter model.

Example
The following data is available for a particular company following Gordons model: EPS : Rs.80 Rate of return on investment : 16 % Equity capitalisation rate : 12 % At present the dividend payout ratio is 80 %. The company is considering reducing the D/P ratio to 50 %. What would be your advice to the company? Would your advice change if the rate of return on investment is expected to be 10 %?

MM model
The market price of the share does not depend on the

dividend payout, i.e. the dividend policy is irrelevant. Assumptions: Perfect market conditions & the floatation & transaction costs do not exist No differential tax rates for dividends & capital gains Constant investment policy w.r.t. risk & rate of return Investors are able to forecast the future dividends & the share value with certainty

MM model
This model explains the irrelevance of the dividend policy

based on the assumptions & the process of arbitrage as follows: When profits are used to declare dividends, the market price increases. But at the same time there is a fall in the reserves for reinvestment. Hence for expansion, the company raises additional capital by issuing new shares. Increase in the overall number of shares, will lead to a fall in the market price per share. Hence the shareholders would be indifferent towards the dividend policy.

Rational Expectation Model

This model states that there would be no impact of

dividend policy on the market price of the share as long as it is at the expected rate. However it may show adjustments in case the dividends declared are higher or lower than the expected level

Dividend policy stability

Stability of dividends depends on the payout policy followed by the companies. Stable dividend Payout ratio : The percentage of earnings paid out as dividends remain constant irrespective

of the level of earnings. Thus, as earnings of a company fluctuates, dividends paid by it also fluctuates accordingly. Stable Dividends / Steadily changing dividends Dividends in rupee terms mostly remain constant irrespective of the level of earnings. Most of the times, it is gradually increased over a period. Rationale for stability of dividend: Investors prefer a predictable pattern of dividends rather fluctuating pattern. Stable dividends are signs of stable earnings of the company. Certain investors mainly institutional consider the stability of dividends as an important criteria before they decide on the investment in that particular firm.

Practical aspects of Dividend Policy

While deciding on the dividend policy, firms face two questions What should be the average pay ratio? How stable should the dividends be over time?

Firms consider the following factors to determine the payout ratio Funds requirement Liquidity Availability of external sources of financing Shareholder preference Difference in the cost of external equity and retained earnings Control Taxes