DIVIDEND DECISION

Prof. Prapti Paul

CONCEPT AND SIGNIFICANCE:
 The dividend decision is one of the 3 basic decisions which a financial manager
maybe required to take, the other two being the investment decisions and the
financing decisions. In each period any earnings that remain after satisfying
obligations to the creditors, the government and the preference sh.hol can either be
retained or paid out as dividends or bifurcated between retained earnings and
dividends. The retained earnings can be invested in assets which will help the firm
increase or at least maintain its present rate of growth. The dividend decision
requires a financial manager to decide about the distribution of profits as dividends.
Profits may be distributed as cash dividends to sh.hol or in the form of stock
dividends ( also known as bonus sh.) .
DIVIDEND POLICY AND VALUE OF THE FIRM
 Dividend policy is basically concerned with deciding whether to pay dividend in cash
now or to pay increased dividends at a later stage or distribution of profits in the form
of bonus shares. The current dividend provides liquidity to the investors but the
bonus share will bring capital gains to the sh.hol. The investors preferences between
current cash dividend and future capital gain have been viewed differently.

 The basic question to be resolved while framing the dividend policy : ‘Given the firm’s
investments and financing decisions, what is the effect of firm’s dividend policies on
the share prices?’. Does a high dividend payment decrease, increase or does not
affect at all the share prices.

 Various models have been proposed to evaluate the dividend policy decision in
relation to the value of the firm
 RELEVANCE OF DIVIDEND POLICY
 Generally , the firms pay dividends and view such dividend payments positively. The
investors also expect and like to receive dividend income on their investments. The
firms not paying dividends maybe adversely rated by the investors thereby affecting
the market value of share. The basic argument of those supporting the dividend
relevance is that because current cash dividends reduce investors uncertainty, the
investors will discount the firm’s earnings at a lower rate, ke, thereby placing higher
value on the shares. If dividends are not paid then the uncertainty of
sh.holders/investors will increase, raising the required rate of return, ke, resulting in
relatively lower market price of the share. So it maybe argued that the dividend policy
has an effect on the market value of the share and the value of the firm. The market
price of the share will increase if the firm pays dividends otherwise it may decrease.
 Two models representing the relevance of the dividend policy are:
1. Walter’s Model
2. Gordon’s Model
 WALTER’S MODEL
 Walter J.E. supports the view that dividend policy has a bearing on the market price of
the share & has presented a model to explain of dividend policy based on the
following assumptions:
i. All investment proposals of the firm are to be financed through retained earnings only
and no external finance is available to the firm.
ii. The business risk complexion of the firm remains the same even after fresh
investment decisions are taken. In other words, rate of return on investment ‘r’ and
the cost of capital of the firm i.e. ke are constant.
iii. The firm has an infinite life.

This model considers that the investment decision and dividend decision of a firm are
inter related. A firm should or should not pay dividends depends upon whether it has
got the suitable investment opportunities to invest the retained earnings or not.
 The model: if a firm pays dividends to its sh.hol., they in turn will invest this income to
get further returns. This expected return to the sh.hol is the opportunity cost of the
firm and hence the cost of capital, ke , to the firm. On the other hand if the firm does
not pay dividends and instead retains, then these retained earnings will be reinvested
by the firm to get return on these investments. This rate of return on the investment, r,
of the firm must be at least equal to the cost of capital, ke. If r=ke the firm is earning a
return just equal to what the sh.hol could have earned had the dividends been paid to
them.
 If the rate of return, r, is more than the cost of capital, ke, the firm can earn more by
retaining the profits than the sh.hol can earn by investing their dividend income.
 The Walter’s model thus says that if r>ke, the firm should refrain from dividends and
should re-invest the retained earnings and thereby increase the wealth of the sh.hol..
And if r<ke i.e. if the investment opportunities before the firm to re-invest the retained
earnings are expected to give a rate of return which is less than the opportunity cost
of sh.hol of the firm, then the firm should better distribute the entire profits. This will
give opportunity to the sh.hol to re-invest this dividend income and get higher returns.
 Thus a firm can maximize the market value of its share and the value of the firm by
adopting a dividend policy as follows:
i. If r> ke, the payout ratio should be zero (i.e. retention of 100% profits).
ii. If r<ke, the payout ratio should be 100% and the firm should not retain any profit, and
iii. If r=ke, the dividend is irrelevant and the dividend policy is not expected to affect the
market value of the share.

In order to testify the above, Walter has suggested a mathematical valuation model:
P= D + (r/ke) (E-D)
ke ke
where P= market value of equity share
D= dividend per share paid by the firm
r= rate of return on investment of the firm
ke= cost of equity share capital
E= earnings per share of the firm
As per the above formula, the market price of share is the sum of 2 components:
1) The present value of infinite stream of dividends, and
2) Present value of infinite stream of return from retained earnings.

Thus, the Walter’s formula shows the market value of a share is the present value of the
expected stream of dividends and capital gains.
 GORDON’S MODEL
 Myron Gordon has proposed a model suggesting that the dividend policy is relevant
and can affect the value of the share and that of the firm. This model is also based
on assumptions similar to that of Walter’s model. In addition are the foll assumptions:
1. The growth rate of the firm ‘g’, is the product of its retention ratio, b and its rate of
return, r, i.e. g=br, and
2. The cost of capital besides being constant is more than the growth rate, i.e. ke>g,

Gordon argues that investors have a preference for current dividends and there is a
direct relationship between dividend policy and the market value of share. He has
built the model on the basic premise that the investors are basically risk averse and
they evaluate the future dividends/ capital gains as a risky and uncertain proposition.
Dividends are more predictable than capital gains; management can control
dividends but it cannot dictate the market price of the share. Investors are certain
about receiving income from dividends than from future capital gains. The
incremental risk associated with capital gain implies a higher required rate of return
for discounting the capital gains than for discounting the current dividends. In other
words, an investor values current dividends more highly than the expected future
capital gain.
 Thus, Gordon’s model is a share valuation model like that of Walter’s. under this the
market price of the share can be calculated as:
P=E(1-b)
ke-br
Where P= market price of equity share
E= earnings per share of the firm
b= retention ratio (1-payout ratio)
r = rate of return on investment of the firm
ke= cost of equity share capital
br= g i.e. growth rate of the firm

 This model shows that there is a relationship between payout ratio, cost of capital,
rate of return and the market value of share.
 ILLUSTRATION 1:
 The foll info is available in respect of ABC Ltd.
EPS or E= Rs.10 (constant)
ke = .10( constant)
Find out the market price of share under different rate of return, r, of 8%,10% and 15%
for different payout ratios of 0%, 40%, 80% and 100% using Walter’s model.
Solution: if r= 15% and Dividend payout ratio is 40%, then
P= D+ (r/ke) (E-D)
ke ke
P= 4 + (.15/.10) (10 - 4)
.10 .10
= 40+90 =130
Similarly, if r =8% and dividend payout ratio =80%, then
P= 8 + (.08/.10) (10-8)
.10 .10
= 80+16 =96
 The expected market price of the share under different market combinations of ‘r’ and
‘ke’ have been calculated and presented as foll:

r= 15% r= 10% r= 8%
D/P ratio 0% 150 100 80
40% 130 100 88
80% 110 100 96
100% 100 100 100

It may be seen from the table that for a growth firm (r=15% and r>ke) the market
price is highest at Rs.150 when the firm adopts a zero payout and retains the entire
earnings. As the payout increases gradually from 0% to 100% the market price
tends to decrease from Rs.150 to Rs.100. For a firm having r< ke (i.e. r= 8%), the
market price is highest when the payout ratio is 100% and the firm retains no profit.
However, if r=ke= 10%, then the price is constant at Rs. 100 for different payout
ratios. Such a firm does not have an optimum payout ratio and every payout ratio is
as good as any other.
 ILLUSTRATION 2:
 The foll info is available in respect of XYZ Ltd.
EPS or E= Rs.10 (constant)
ke = .10 (constant)
Find out the market price of share under different rate of return, r, of 8%, 10% and 15%
for different payout ratios of 0%, 40%, 80% and 100% using Gordon’s Model.
Solution: if r = 15% and payout ratio is 40%, then the retention ratio, b, is .6 (i.e.,1-.4) and
the growth rate, g= br=.09 (i.e. .6*.15) and the market price of the share is:
P= E(1-b)
ke-br
= 10(1-.6)
.10- .09
=Rs.400
If r= 8% and payout ratio is 80%, then the retention ratio, b, is .2( i.e. 1-.8) and the growth
rate, g= br = .16( i.e. .2*.08) and the market price of the share is:
P= 10(1-.2)
.10- .016
=Rs.95
 Similarly the expected market price under different combinations of ‘r’ and the
dividend payout ratio have been calculated in the table below:

r= 15% r =10% r= 8%
D/P ratio 0% 0 0 0
40% 400 100 77
80% 114.3 100 95
100% 100 100 100

On the basis of the figures given in table above, if the firm adopts a zero payout
then the investor may not be willing to offer any price. For a growth firm (i.e. r>ke)
the market price decreases when the payout ratio is increased. For a firm having
r<ke, the market price increases when the payout is increased.
If r=ke , the dividend policy is irrelevant and the market price remains constant at
Rs.100 only. However, in his revised model, Gordon has argued that even if r= ke,
the dividend payout ratio matters and the investors being risk averse prefer current
dividends which are certain to future capital gains which are uncertain. The
investors will apply a higher capitalization rate i.e., ke to discount the future capital
gains. This will compensate them for the future uncertain capital gain, and thus the
market price of the share of a firm which retains profit will be adversely affected.
 IRRELEVANCE OF DIVIDEND POLICY
 The advocates of this school of thought argue that the dividend policy has no effect on
the market price of the share. The sh.hol. do not differentiate between the present
dividend or future capital gains. They are basically interested in higher returns earned
by the firm by re-investing profits in profitable investment opportunities or earned by
themselves by making investment of dividend income.
 The underlying intuition for dividend irrelevance is : firms that pay more dividend offer
less price appreciation but provide the same total return to the sh.hol, given the risk
characteristics of the firm. The investor should be indifferent of receiving their returns
in the form of current dividends or in the form of price increases in the market.
 The conclusion that dividends are not relevant is based on two pre-conditions: (1) that
investment and financing decisions have already been made and that these decisions
will not be altered by the amount of dividends payment, and (2) that the perfect
capital market is there in which an investor can buy and sell shares without any
transaction cost and that the companies can issue shares without any floatation cost.
 2 theories are discussed:
1) Residual theory of dividends
2) Modigliani and Miller Approach
RESIDUALS THEORY OF DIVIDENDS
 This theory is based on assumption that either the external financing is not available
to the firm or if available , cannot be used due to its excessive costs of financing the
profitable investment opportunities of the firm. Therefore the firm finances its
investment decisions by retaining profits. The quantum of profits to be distributed is
the balancing figure and thus depends on what portions of profits is to be retained. If
a firm has sufficient profitable investment opportunities then the wealth of the
sh.hol will be maximized by retaining profits and re-investing them in the financing of
the investment opportunities either by reducing dividends or even by paying no
dividend to the sh.hol. If the firm has no such investment opportunity, then the
profits maybe distributed among the sh.hol.
 Thus a firm does not decide as to how much dividends be paid rather it decides as
to how much profits should be retained. The profits not required to be retained
maybe distributed as dividends. Therefore, dividend decision is a passive decision.
The dividends are a distribution of residual profits after retaining sufficient profit for
financing the available opportunities.
 MODIGLIANI AND MILLER APPROACH
 They have argued that the market price of a share is affected by the earnings of the
firm and is not influenced by the pattern of income distribution. The dividend policy is
immaterial and is of no consequence to the value of the firm. What matters on the
other hand, is the investment decisions which determine the earnings of the firm and
thus affect the value of the firm.
 Assumptions of the MM Approach:
1. The capital markets are perfect and investors behave rationally.
2. All information are freely available to all investors.
3. There is no transaction cost and no time lag.
4. Securities are divisible and can be spilt into any fraction. No investor can affect the
market price.
5. There are no taxes and no floatation costs.
6. The firm has a defined investment policy and the future profits are known with
certainty. The implication is that the investment decisions are unaffected by the
dividend decision and operating cash flows are same no matter which dividend policy
is adopted.
 The model: MM argue that neither the firm paying dividends nor the shareholders
receiving the dividends will be adversely affected by the firms paying either too little or
too much dividends. They have used the arbitrage process to show that the division of
profits between dividends and retained earnings is irrelevant from the point of view of
shareholders. They have shown that given the investment opportunities, a firm will
finance these either by ploughing back profits or if pay dividends, then will raise an
equal amount of new share capital externally by selling new shares. The amount of
dividends paid to existing share holders will be replaced by new share capital raised
externally.
 Valuation model: P0 = 1 (D1+P1) ……………….equation (1)
(1+ke)
where P0 = present market price of share
ke = cost of equity share capital
D1 = expected dividend at the end of year 1
P1 = expected market price of share at the end of year 1
If the company has ‘n’ number of equity shares outstanding, then the value of the firm is
n times P0, or
 nP0 = 1 (nD1+nP1) ………………………..eqn (2)
(1+ke)
 Now the co. can finance its investment proposal either by retained earnings or by sale
of new shares. Say, the co. plans to issue ‘m’ no. of eq. sh. at a price P1 and raising
funds equal to mP1, to finance the investment opportunities at the end of year 1. the
value of the firm therefore maybe defined as:
nP0 = 1 (nD1+nP1 + mP1-mP1)
(1+ke)
nP0 = 1 [nD1+(n+ m)P1 -mP1) ………………….eqn (3)
(1+ke)

mP1 is equal to the funds raised by the firm by the issue of new shares at year1. This is
also equal to the total investment at the end of the year 1 less the amount of retained
earnings, or
mP1 = I-( E-nD1)
= I –E +nD1 …………………………………………………………..eqn (4)
where I = Total investment to be made at year 1
E= Total earnings of the firm.
Eqn (4) simply states that the firm must issue fresh capital of an amount equal to total
requirement for investment as reduced by the profit retained. And, the profits retained
depends upon the amount of dividends paid i.e. nD1 . So whatever of capital funds
needs is not financed by the retained earnings (i.e., E-nD1) must be financed by the
issue of fresh share capital.
 Substituting eqn (4) into (3):
nP0 = 1 [nD1+(n+ m)P1 - (I-E+nD1)]
(1+ke)

= 1 [nD1+(n+ m)P1 - I+E-nD1)]

(1+ke)
= 1 [(n+ m)P1 - I+E] ………………………..eqn (5)
(1+ke)
Since D1 is not found in eqn (5) and other variables i.e.(n+ m)P1, I,E and ke are all
independent of D1,MM have concluded that the value of the firm, nP0, does not
depend on the dividend decision and hence the dividend policy is irrelevant.
 The success of MM Model depends upon the arbitrage process , i.e. replacement of
amount paid as dividend by the issue of fresh capital. The arbitrage process involves
two simultaneous actions. With reference to dividend policy are:
1. Payment of dividend by the firm
2. Raising of fresh capital
With the help of arbitrage process, MM have shown that the dividend payment will not
have any effect on the value of the firm. Even if the firm pays dividends, resulting in a
increase in the market value of the share, the effect on the value of the firm will be
neutralized by a decrease in terminal value of the share.
 Say a firm has 1,00,000 shares outstanding and is planning to declare a dividend of
Rs.5 at the end of the financial year. The present market price of the share is Rs.100.
the cost of equity share capital, ke maybe taken at 10%. The expected market price at
the end of year 1 maybe found under 2 options: 1) if dividend of Rs.5 is paid and 2) if
dividend is not paid, as follows:
1) If dividend of Rs. 5 is paid ( the value of D1 is 5):
P0 = 1 (D1+P1)
(1+ke)
P0 (1+ke) = D1+P1
P1 = P0 (1+ke) –D1
=100(1.10) -5
= 105
So the market price of the share is expected to be Rs.105 if the firm pays dividend of
Rs.5.
2) If dividend of Rs.5 is not paid (the value of D1 is 0) :
P1 = P0 (1+ke) –D1
= 100(1.10)
=110
The market price of the share is expected to be Rs.110, if the firm does not pay
dividend of Rs.5
 However, in both cases the position of the shareholders would be the same. A sh.hol
having say 1 share will be having same worth of his holding whether the firm pays
dividend or not. In case the dividend of Rs.5 is paid, he will receive Rs.5 from the firm
as dividend and the market price of the share would be Rs. 105, giving a total worth of
Rs. 110. incase the dividend is not paid then the market price of the share or the
worth of the shareholder would still be Rs.110. So the shareholder will be indifferent
whether dividend is paid or not to him.
 The same example can be extend further to analyze the effect of arbitrage process
employed by the firm:
 Say the firm has total profits of Rs.10,00,000 during the year 1 and is planning to
make an investment of Rs.20,00,000 at the end of year1. The arbitrage process and
value of the firm may be explained as follows:
1) If dividend of Rs.5 is paid by the firm at the end of the year1:
total earnings Rs.10,00,000
dividends paid( 1,00,000* Rs.5) 5,00,000
retained earnings 5,00,000
total funds required for investment 20,00,000
therefore fresh capital to be issued 15,00,000
market price at the end of year 1 105
no. of shares to be issued ( 15,00,000/105) 14,285.71
total no. of shares (1,00,000+ 14285.71) 1,14,285.71
 Applying eqn (5), the value of the firm, nP0 is:
nP0 = 1 [(n+ m)P1 - I+E]
(1+ke)
= 1 [(1,14,285.71)105-20,00,000+ 10,00,000]
1.10
=Rs.100,00,000

2) If dividend of Rs.5 is not paid by the firm at the end of year 1:

total earnings Rs.10,00,000
dividend paid -----------
retained earnings 10,00,000
total funds required for investment 20,00,000
therefore, fresh capital to be issued 10,00,000
market price of share at end of year1 110
no. of shares to be issued (10,00,000/110) 9090.9
total no. of shares (1,00,000 +9090.9) 1,09,090.9
 Applying eqn (5), the value of the firm, nP0 is:
nP0 = 1 [(n+ m)P1 - I+E]
(1+ke)
= 1 [(1,09,090.9)110-20,00,000+ 10,00,000] = Rs.100,00,000
1.10
 So the value of the firm remains the same at Rs.100,00,000 whether the dividend is
paid or not.
 The eqn(5) used on the previous slides gives the current market value of the firm i.e.
nP0. The MM Model shows whether the dividend is paid or not at the end of the
current year, the present market value of the firm remains same at Rs. 100,00,000.
the same example can be expanded to find out the expected market value of the firm
at the end of the current year as follows:
 If dividend of Rs.5 is paid:
Total no. of shares 1,14,285.71
Market price Rs.105
Total market value( 1,14,285.71*105) Rs.120,00,000
 If dividend of Rs. 5 is not paid:
Total shares 1,09,090.90
Market price Rs.110
Total market value ( 1,09,090.90*110) Rs.120,00,000
 The MM Model thus shows that the current market value or the expected market
value of the firm both are unaffected by the dividend decision of the firm.
 RATIONAL EXPECTATIONS HYPOTHESIS
 This hypothesis says that what matters in economics is not what actually happens but
the difference between what actually happens and what was supposed or expected
to happen. Hence, only the surprises in policy would have the effects the policy maker
is striving to achieve.
 Implications of rational expectations hypothesis for the dividend policy of the firm. If
the dividend announced is equal to what the market expected, there would no
change in the market price of the share, even if the dividend were higher or lower
than the previous dividend. The market, expecting the dividend to be higher had
discounted it. Higher expectation was reflected in the market price already. Hence the
announcement of the higher dividend would not have any impact on the market price.
 What happens when the dividend announced is higher than what was expected by
the market?? In such a case the market begins to revise its assesement of future
earnings. This reappraisal would lead to an upward price movement in the share.
Likewise, when the dividend announced is lower than expected, the market may
revise unfavorably its appraisal of future earnings and this would mean a downward
price movement in the share.
 To sum it up, in a world of rational expectations, unexpected dividend announcement
would transmit messages about changes in earnings potential which were not
incorporated in the market price earlier. The reappraisal that occurs as a result of
these signals leads to price movements which look like responses to the dividends
themselves, though they are caused by an underlying revision of the estimate future
earnings potential.