DIVIDEND DECISIONS

Dividend decision refers to the policy that the management formulates in regard
to earnings for distribution as dividends among shareholders. Dividend decision
determines the division of earnings between payments to shareholders and
retained earnings.

The Dividend Decision, in corporate finance, is a decision made by the directors

of a company about the amount and timing of any cash payments made to the
company’s stockholders. The Dividend Decision is an important part of the
present day corporate world.

The Dividend decision is an important one for the firm as it may influence
its capital structure and stock price. In addition, the Dividend decision may
determine the amount of taxation that stockholders pay.

Significance of dividend decision

 The firm has to balance between the growth of the company and the
distribution to the shareholders
 It has a critical influence on the value of the firm
 It also has to strike a balance between the long term financing decision(
company distributing dividend in the absence of any investment
opportunity) and the wealth maximization.
 The market price gets affected if dividends paid are less.
 Retained earnings help the firm to concentrate on the growth, expansion
and modernization of the firm.
 To sum up, it to a large extent affects the financial structure, flow of
funds, corporate liquidity, stock prices, and growth of the company and
investor’s satisfaction.
Theories of Dividend:

On the relationship between dividend and the value of the firm different
theories have been advanced. Some of the major different theories of
dividend in financial management are as follows:
 Walter’s model

 Gordon’s model

 Modigliani and Miller’s hypothesis

Walter’s model:

Professor James E. Walter argues that the choice of dividend policies almost
always affects the value of the enterprise. His model shows clearly the
importance of the relationship between the firm’s internal rate of return (r) and
its cost of capital (k) in determining the dividend policy that will maximise the
wealth of shareholders.

Walter’s model is based on the following assumptions:

1. The firm finances all investment through retained earnings; that is debt or
new equity is not issued;

2. The firm’s internal rate of return (r), and its cost of capital (k) are constant.

3. All earnings are either distributed as dividend or reinvested internally

immediately.

4. Beginning earnings and dividends never change. The values of the earnings
per share (E), and the divided per share (D) may be changed in the model to
determine results, but any given values of E and D are assumed to remain
constant forever in determining a given value.
5. The firm has a very long or infinite life.

Walter’s formula to determine the market price per share (P) is

as follows:
P = D/K +r (E-D)/K/K

The above equation clearly reveals that the market price per
share is the sum of the present value of two sources of income:
i) The present value of an infinite stream of constant dividends, (D/K) and

ii) The present value of the infinite stream of stream gains.

[r (E-D)/K/K].

Criticism:
Walter’s model is quite useful to show the effects of dividend policy on an all
equity firm under different assumptions about the rate of return. However, the
simplified nature of the model can lead to conclusions which are net true in
general, though true for Walter’s model.

The criticisms on the model are as follows:

1. Walter’s model of share valuation mixes dividend policy with investment

policy of the firm. The model assumes that the investment opportunities of the
firm are financed by retained earnings only and no external financing debt or
equity is used for the purpose when such a situation exists either the firm’s
investment or its dividend policy or both will be sub-optimum. The wealth of
the owners will maximise only when this optimum investment in made.

2. Walter’s model is based on the assumption that r is constant. In fact decreases

as more investment occurs. This reflects the assumption that the most profitable
investments are made first and then the poorer investments are made.
The firm should step at a point where r = k. This is clearly an erroneous policy
and fall to optimise the wealth of the owners.

3. A firm’s cost of capital or discount rate, K, does not remain constant; it

changes directly with the firm’s risk. Thus, the present value of the firm’s
income moves inversely with the cost of capital. By assuming that the discount
rate, K is constant, Walter’s model abstracts from the effect of risk on the value
of the firm.

Gordon’s Model:
One very popular model explicitly relating the market value of the firm to
dividend policy is developed by Myron Gordon.

Assumptions:
Gordon’s model is based on the following assumptions.

1. The firm is an all Equity firm

2. No external financing is available

3. The internal rate of return (r) of the firm is constant.

4. The appropriate discount rate (K) of the firm remains constant.

5. The firm and its stream of earnings are perpetual

6. The corporate taxes do not exist.

7. The retention ratio (b), once decided upon, is constant. Thus, the growth rate
(g) = br is constant forever.
8. K > br = g if this condition is not fulfilled, we cannot get a meaningful value
for the share.

According to Gordon’s dividend capitalisation model, the market value of a

share (Pq) is equal to the present value of an infinite stream of dividends to be
received by the share. Thus:

The above equation explicitly shows the relationship of current earnings (E,),
dividend policy, (b), internal profitability (r) and the all-equity firm’s cost of
capital (k), in the determination of the value of the share (P0).

Modigliani and Miller’s hypothesis:

According to Modigliani and Miller (M-M), dividend policy of a firm is

irrelevant as it does not affect the wealth of the shareholders. They argue that
the value of the firm depends on the firm’s earnings which result from its
investment policy.

Thus, when investment decision of the firm is given, dividend decision the split
of earnings between dividends and retained earnings is of no significance in
determining the value of the firm.

M – M’s hypothesis of irrelevance is based on the following

assumptions.

1. The firm operates in perfect capital market

2. Taxes do not exist

3. The firm has a fixed investment policy

4. Risk of uncertainty does not exist. That is, investors are able to forecast
future prices and dividends with certainty and one discount rate is appropriate
for all securities and all time periods. Thus, r = K = Kt for all t.
Under M – M assumptions, r will be equal to the discount rate and identical for
all shares. As a result, the price of each share must adjust so that the rate of
return, which is composed of the rate of dividends and capital gains, on every
share will be equal to the discount rate and be identical for all shares.

Thus, the rate of return for a share held for one year may be calculated as
follows:

Where P^ is the market or purchase price per share at time 0, P, is the market
price per share at time 1 and D is dividend per share at time 1. As hypothesised
by M – M, r should be equal for all shares. If it is not so, the low-return yielding
shares will be sold by investors who will purchase the high-return yielding
shares.

This process will tend to reduce the price of the low-return shares and to
increase the prices of the high-return shares. This switching will continue until
the differentials in rates of return are eliminated. This discount rate will also be
equal for all firms under the M-M assumption since there are no risk
differences.

From the above M-M fundamental principle we can derive their valuation
model as follows:
Multiplying both sides of equation by the number of shares outstanding (n), we
obtain the value of the firm if no new financing exists.

If the firm sells m number of new shares at time 1 at a price of P^, the value of
the firm at time 0 will be

The above equation of M – M valuation allows for the issuance of new shares,
unlike Walter’s and Gordon’s models. Consequently, a firm can pay dividends
and raise funds to undertake the optimum investment policy. Thus, dividend and
investment policies are not confounded in M – M model, like waiter’s and
Gordon’s models.

Criticism:
Because of the unrealistic nature of the assumption, M-M’s hypothesis lacks
practical relevance in the real world situation. Thus, it is being criticised on the
following grounds.

1. The assumption that taxes do not exist is far from reality.

2. M-M argue that the internal and external financing are equivalent. This
cannot be true if the costs of floating new issues exist.

3. According to M-M’s hypothesis the wealth of a shareholder will be same

whether the firm pays dividends or not. But, because of the transactions costs
and inconvenience associated with the sale of shares to realise capital gains,
shareholders prefer dividends to capital gains.
4. Even under the condition of certainty it is not correct to assume that the
discount rate (k) should be same whether firm uses the external or internal
financing.

If investors have desire to diversify their port folios, the discount rate for
external and internal financing will be different.

5. M-M argues that, even if the assumption of perfect certainty is dropped and
uncertainty is considered, dividend policy continues to be irrelevant. But
according to number of writers, dividends are relevant under conditions of
uncertainty.

Determinants of Dividend:
The main determinants of dividend policy of a firm can be classified into:

 Dividend pay-out ratio

 Stability of dividends
 Legal, contractual and internal constraints and restrictions
 Owner's considerations
 Capital market considerations and
 Inflation.

Dividend pay-out ratio:

Dividend pay-out ratio refers to the percentage share of the net earnings
distributed to the shareholders as dividends. Dividend policy involves the
decision to pay out earnings or to retain them for reinvestment in the firm. The
retained earnings constitute a source of finance. The optimum dividend policy
should strike a balance between current dividends and future growth which
maximizes the price of the firm's shares. The dividend pay-out ratio of a firm
should be determined with reference to two basic objectives maximizing the
wealth of the firm’s owners and providing sufficient funds to finance growth.
These objectives are interrelated.
Stability of dividends:

Dividend stability refers to the payment of a certain minimum amount of

dividend regularly. The stability of dividends can take any of the following
three forms:

a. constant dividend per share

b. constant dividend pay-out ratio or
c. constant dividend per share plus extra dividend

Legal, contractual and internal constraints and restrictions:

Legal stipulations do not require a dividend declaration but they specify

the conditions under which dividends must be paid. Such conditions pertain to
capital impairment, net profits and insolvency. Important contractual restrictions
may be accepted by the company regarding payment of dividends when the
company obtains external funds. These restrictions may cause the firm to
restrict the payment of cash dividends until a certain level of earnings has been
achieved or limit the amount of dividends paid to a certain amount or
percentage of earnings. Internal constraints are unique to a firm and include
liquid assets, growth prospects, financial requirements, availability of funds,
earnings stability and control.

Owner's considerations:

The dividend policy is also likely to be affected by the owner's

considerations of the tax status of the shareholders, their opportunities of
investment and the dilution of ownership.

Capital market considerations:

The extent to which the firm has access to the capital markets, also affects
the dividend policy. In case the firm has easy access to the capital market, it can
follow a liberal dividend policy. If the firm has only limited access to capital
markets, it is likely to adopt a low dividend pay-out ratio. Such companies rely
on retained earnings as a major source of financing for future growth.
Inflation:

With rising prices due to inflation, the funds generated from depreciation
may not be sufficient to replace obsolete equipment and machinery. So, they
may have to rely upon retained earnings as a source of fund to replace those
assets. Thus, inflation affects dividend pay-out ratio in the negative side.

Dividend Policy
A dividend policy is the parameters used by a board of directors as the basis
for its decisions to issue dividends to investors. A well-defined policy
addresses the timing and size of dividend issuances, which can be a major
part of a company's outgoing cash flows.

Dividend policy is concerned with financial policies regarding paying cash

dividend in the present or paying an increased dividend at a later stage. Whether
to issue dividends and what amount, is determined mainly on the basis of the
company's unappropriated profit (excess cash) and influenced by the company's
long-term earning power. When cash surplus exists and is not needed by the
firm, then management is expected to pay out some or all of those surplus
earnings in the form of cash dividends or to repurchase the company's stock
through a share buyback program.

Types of dividend policy

There are basically 4 types of dividend policy:

 Regular dividend policy

 Stable dividend policy

 Irregular dividend
  No dividend

Regular dividend policy:

In this type of dividend policy the investors get dividend at usual rate. Here
the investors are generally retired persons or weaker section of the society who
want to get regular income. This type of dividend payment can be maintained
only if the company has regular earning.

Merits of Regular dividend policy:

 It helps in creating confidence among the shareholders.

 It stabilizes the market value of shares.
 It helps in marinating the goodwill of the company.
 It helps in giving regular income to the shareholders.

Stable dividend policy:

here the payment of certain sum of money is regularly paid to the

shareholders. It is of three types:

a) Constant dividend per share: here reserve fund is created to pay fixed
amount of dividend in the year when the earning of the company is not enough.
It is suitable for the firms having stable earning.

b) Constant pay-out ratio: it means the payment of fixed percentage of

earning as dividend every year.

c) Stable rupee dividend + extra dividend: it means the payment of low

dividend per share constantly + extra dividend in the year when the company
earns high profit.

Merits of stable dividend policy:

  It helps in creating confidence among the shareholders.
 It stabilizes the market value of shares.
 It helps in marinating the goodwill of the company.
 It helps in giving regular income to the shareholders.

Irregular dividend:

As the name suggests here the company does not pay regular dividend
to the shareholders. The company uses this practice due to following reasons:

 Due to uncertain earning of the company.

 Due to lack of liquid resources.
 The company sometime afraid of giving regular dividend.
 Due to not so much successful business.

No dividend:

The company may use this type of dividend policy due to requirement
of funds for the growth of the company or for the working capital requirement.

Bonus Shares

Sometimes a company cannot pay dividend in cash due to shortage of

liquid funds—viz. cash—in spite of earning a large amount of profit for a
particular period. Under the circumstances, the company issues new shares to
the existing shareholders in lieu of paying dividend in cash.

These shares are known as ‘Bonus Shares’. Such bonus shares are to be offered
to the existing shareholders in proportion to the shareholdings and dividend
rights.

Bonus shares are additional shares given to the current shareholders without
any additional cost, based upon the number of shares that a shareholder owns.
These are company's accumulated earnings which are not given out in the form
of dividends, but are converted into free shares.

Effect of Bonus Issue:

(a) Issue of bonus share does not invite liquidity crisis like payment of cash
dividends. As no cash payment is made, liquidity position remains unaffected.

(b) Since total numbers of shares are increased as a result of bonus issue,
dividend per share may be less.

(c) Issue of bonus shares earns confidence of the public.

Advantages of Issuing Bonus Shares:

A. From the company’s viewpoint:
(a) By issuing bonus shares, shareholders are to be satisfied when the company
cannot pay dividend in cash due to shortage of liquid funds, i.e., profit can be
distributed without distributing the liquid resources, viz. cash.

(b) By issuing bonus shares, shareholders are to be satisfied, particularly when

the company does not prefer to pay dividend in cash for the purpose of either its
expansion or its working capital or any other specific purpose, such as any
particular programme of diversification or modernisation.

(c) Sometimes a company is bound to reduce its reserve for the interest of its
own. It may so happen that the amount of earning profits exceeds the amount of
total paid-up capital of the company which, in other words, encourages the
competitors and creates unhealthy relationship between workers and the
company.

B. From the shareholder’s viewpoint:

(a) Shareholders need not pay tax on the bonus shares but they are to pay them
on the dividend so received in cash.
(b) Shareholders, if they so desire, can convert the shares into cash by disposing
off the same at a higher price.

(c) If partly paid shares are converted into fully paid by issuing bonus, the
shareholders need not pay a further sum for the purpose. On the other hand,
their shares become fully paid-up.

Disadvantages of issuing Bonus Shares:

From the company’s viewpoint:
(a) More dividends would be paid as the numbers of shares are increased.

(b) Over-capitalisation may appear due to the issues.

(c) If the rate of dividend cannot be maintained market value of shares may go
down.

From the shareholder’s point of view:

(a) If the rate of dividend fluctuates, i.e., cannot be maintained, the market value
of shares may go down.

(b) If the rate of profit is not increased, the rate of dividend may be decreased.

(c) It encourages speculation which is not desirable.

Stock Split
A stock split is a procedure that increases or decreases a corporation's total
number of shares outstanding without altering the firm's market value or the
proportionate ownership interest of existing shareholders. This action, which
requires advance approval from the company's board of directors, usually
involves the issuance of additional shares to existing stockholders.
For example, a company which has 100 issued shares priced at $50 per share
has a market capitalization of $5000 = 100 × $50. If the company splits its stock
2-for-1, there are now 200 shares of stock and each shareholder holds twice as
many shares. The price of each share is adjusted to $25 = $5000 / 200. The
market capitalization is 200 × $25 = $5000, the same as before the split.

Advantages of Stock Split for Investors:

• A stock split is a good buying indicator, signalling that the prices of

shares of the company are increasing.
• A stock split helps the small investors to acquire shares, particularly when
the prices of shares are very high.
• If bonus shares are issued by a company, investors (being shareholders)
get more shares as a result of stock split.
• Investors get higher price at the time of selling shares.
• No additional amount is required by the investor to acquire shares as a
result of stock split.

Reverse Split

Reverse stock split or reverse split is a process by which shares of

corporate stock are effectively merged to form a smaller number of
proportionally more valuable shares. A reverse stock split is also called a stock
merge. New shares are typically issued in a simple ratio, e.g. 1 new share for 2
old shares, 3 for 4, etc. A reverse split is the opposite of a stock split.

Reasons for a Reverse Stock Split:

• The desire to increase the share price, especially if the shares are penny
stocks. Low prices tend to elicit negative emotions in investors
• Major stock exchanges have minimum dollar amounts for the price of the
stocks they list. So, to stay listed, a low-priced stock may reverse split in
order to push its price to those minimums.

• Companies looking to create spinoffs at attractive prices may use reverse

splits.