Finance Management

Swapnil S Karvir

Finance Management – Swapnil S Karvir 1

 Module 6 ( 3 hours)
• Dividend Policy
– Meaning and Importance of Dividend Policy
– Factors Affecting an Entity’s Dividend Decision
– Overview of Dividend Policy Theories and Approaches
• Gordon’s Approach
• Walters Approach
• Modigliani-Miller Approach

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 Dividend
Company’s Earnings
(After paying Interest,
Depreciation and Tax )

Payout Retention

Distribute Dividends to Re-invest the earnings in

Shareholders (Preference and business
Equity) (Future or Ongoing Needs)

Payout Ratio = % earnings distributed as dividends

Retention Ratio (b) = % earnings retained by the firm for reinvesting in business

Total Earnings = Payout + Retention

Therefore, Retention Ratio (b) = 1- Payout Ratio

Growth = ROE * b , where ROE is Return on Equity

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Finance Management – Swapnil S Karvir
 Dividend
• Dividend
– Distribution of a portion of profits by a company to its shareholders
– Dividend on equity shares can be distributed only after dividend on preference shares is
declared
– Rate of dividend in case of preference shares is fixed. Dividend on equity shares varies from
year to year
– Paid out as:
• Cash: For e.g. Rs. 1.5 per share
• Shares: For e.g. 1 new Share for every 100 existing shares owned
– Many investors view a steady dividend history as an important indicator of a good
investment

• How much dividend should the company pay?

– All Earnings to be paid as dividends: Nothing is left to reinvest and grow the business.
Company will have to borrow from outside.
– No Dividend: Shareholders may get unhappy

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 Dividend: Important Dates
• Declaration Date:
– Date on which Dividends are announced by company. Shareholders approval is must before
dividends can be paid.
– Dividend to be paid within 30 days of declaration

• Ex-dividend Date:
– If you buy a share before the ex-dividend date, then you will receive the next
dividend payment. If you buy the share on or after the ex-dividend date, you will not receive
the dividend.
– E.g. if a share has an ex-date of Monday, Feb 17, then shareholders who buy the stock on or
after that day will NOT qualify to get the dividend. Shareholders who own the stock one
business day prior to the ex-date - that is on Friday, Feb 14, or earlier - will receive the
dividend.

• Record Date: Cut-off date, decided by the company in order to determine which shareholders are
eligible to receive dividends. Generally 2 days after Ex-Dividend Date.

• Payment Date: The date when dividend amount gets credited to investors' accounts (online
transfer) / When dividend cheques get printed

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 Factors Affecting Dividend Decision
• Legal:
– Dividend can be paid only out of current/past profits after providing for depreciation (there
are certain exceptions when the central government permits dividends without providing for
depreciation)
– A company providing more than ten per cent dividend is required to transfer certain
percentage of the current year's profits to reserves
– The dividends cannot be paid out of capital, because it will amount to reduction of capital,
adversely affecting the security of its creditors.
• Earnings:
– The magnitude of earnings decide the upper limit on dividends that can be paid
– Companies also consider past earnings trends while deciding dividends
• Shareholders:
– Some shareholders want dividends as a source of income to meet their living expenses e.g.
Senior Citizens
– Shareholders who are in the high tax paying category, do not prefer dividends since they will
have to pay more taxes

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 Factors Affecting Dividend Decision
• Industry Type:
– Industries that have stable earnings can have a consistent dividend policy
– Industries where the earnings are inconsistent/uncertain are cautious when giving dividends
• Age of the company:
– New companies would like to retain maximum earnings to finance future growth
– Older companies generally have built up sufficient reserves over the years and can hence
afford to pay regular dividends
• Future Requirements:
– If the company sees opportunity for business expansion, it will want to retain the earnings
instead of distributing it as dividends
• Economic Policy of the country:
– A company has to adjust its dividend policies to the economic policies of the country it is
operating in
• Taxation:
– If the company has to pay more tax on profits, it will have less earnings to distribute as
dividends and vice versa
– If the shareholders will have to pay tax on dividends received, they will not prefer cash
dividends

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 Factors Affecting Dividend Decision
• Inflation:
– When prices rise, funds generated by depreciation would not be adequate to replace fixed
assets, since the same assets would now cost more. During such times the company will try to
retain maximum earnings
• Control:
– When dividend pay out is very high, the retained earnings are insignificant. Therefore the
company will have to issue new shares to raise money for its future requirements
– When new shares are issued, the control of existing shareholders may be diluted
• Institutional Investors:
– Institutional investors like banks, insurance companies etc usually favor regular dividends.
They may stipulate such a condition when they are buying shares of the company

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 Types of Dividend Policies
• Dividend Policy: Strategy followed by a company to decide the amount and timing
of dividends

Types of Dividend
Policy

Regular Stable Dividend Irregular

No Dividend
Dividend Policy Policy Dividend Policy

Constant Constant Dividend

Constant Payout
Dividend per per Share + Extra
Ratio
Share Dividend

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 Types of Dividend Policies
• Regular Dividend Policy:
– Company regularly pays certain dividend to its shareholders. Shareholders can treat these dividends
as their regular income i.e. retired people, senior citizen etc.
– Only companies with stable earnings can opt for such a policy
– Merits: Shareholder Confidence, stable market price, company goodwill, regular income for
shareholder
• Stable Dividend Policy: Three types
– Constant Dividend per share:
• Company pays constant dividend per share irrespective of the fluctuations in earnings. If the
company reaches new level of earnings, it can increase the dividend per share
• Earnings fluctuate, therefore in years of above average earnings, the company builds up reserves
(dividend equalization reserve) so that it can pay same dividends in years when earnings are low
– Constant Payout Ratio:
• Fixed percentage of earnings will be distributed as dividends. For e.g. If the company decides a
payout ratio of 40%, it will distribute 40% of earnings as dividends. If the earning per share is Rs.
10 in a particular year, Rs. 4 will be paid as dividend per share. In the subsequent year if the
earning per share is Rs. 5, Rs. 2 will be paid as dividend per share
• No dividend will be paid in years where company incurs loses
– Constant Dividend per Share + Extra Dividend:
• Fixed minimum dividend per share to ensure that company never misses dividend payment
• Investors get fixed cash flow plus occasional extra income

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 Types of Dividend Policies
• Irregular Dividend Policy:
– Company doesn’t pay regular dividends due to reasons like earnings fluctuation, retention of earnings
for future growth etc

• No Dividend:
– Company retains all earnings and uses them for future growth. This may be true in case of
newer companies in high growth sectors
– If the company’s earnings grow due to such a policy, investors will benefit from increase in
share prices

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 Dividend Policy Theories
Dividend Policy Theories: Theories on the relationship between dividend policy
and the value of the firm

Dividend Theory

Dividend policy is irrelevant Dividend policy is relevant

to the value of the firm to the value of the firm

Miller-Modigliani Walter’s Gordon’s

(MM) Hypothesis Model Model

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 Dividend Theory : Walter’s Model
• What does Walter’s Model say:
– Choice of dividend policies almost always affect the value of the firm
– As per this model, the relationship between the firms rate of return (r) and its cost of capital
(k) is important in determining a dividend policy that will maximize wealth of shareholders

• Walter’s Model is based on the following assumptions:

– Internal Financing: The firm only uses retained earnings to finance all investments i.e. debt or
new equity is not issued
– Constant Return: The firms rate of return (r) is constant
– Constant Cost of Capital: The firms cost of capital (k) is constant
– 100 % payout or retention: All earnings are either distributed as dividends or reinvested
internally immediately
– Constant EPS and DIV: Beginning earnings and dividends never change. Though different
values of EPS and DIV may be used in the model, but they are assumed to remain constant
while determining a value.
– Infinite Time: The firms life is infinite

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 Dividend Theory : Walter’s Model
• According to Walter’s Model :
• According to the model, Market Price per share (P) is the sum of present value of two sources of income
i.e. dividends and capital gains

P = DIV + (r/k)(EPS – DIV)

k k

Where:
– P = Market price per share
– DIV = dividend per share
– EPS = Earnings per share
– r = Firms rate of return
– k = firms cost of capital or capitalization rate
– DIV/k = Present Value of infinite stream of constant dividends
– {(r/k)(EPS-DIV)}/k = Present Value of infinite stream of capital gains

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 Dividend Theory : Walter’s Model
• Effect of dividend policy on different types of firm
Sr. Relationship Type of When dividend When dividend
Dividend Policy
No. between r and k Firm payout is increased payout is decreased
Value of the firm Value of the firm
1 r >k Growth
decreases increases
Retain all earnings

No change in value No change in value of

2 r=k Normal
of the firm the firm
No effect on policy

Value of the firm Value of the firm Distribute all

3 r<k Decline
increases decreases earnings

P = DIV + (r/k)(EPS – DIV)

• Illustration:
Growth Firm (r > k)
r=0.15, k=0.10, EPS= Rs.10
1. Payout = 0% means DIV=0
• P= Rs. 150
k k
Normal Firm (r = k) Declining Firm (r < k)
r=0.10, k=0.10, EPS= Rs.10 r=0.08, k=0.10, EPS= Rs.10
1. Payout = 0% means DIV=0 1. Payout = 0% means DIV=0
• P= Rs. 100 • P= Rs. 80

2. Payout=40%, means DIV=4 2. Payout=40%, means DIV=4 2. Payout=40%, means DIV=4

• P = Rs. 130 • P = Rs. 100 • P = Rs. 88

3. Payout = 100%, means DIV=10 3. Payout = 100%, means DIV=10 3. Payout = 100%, means DIV=10
• P=Rs. 100 • P=Rs. 100 • P=Rs. 100

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Finance Management – Swapnil S Karvir
 Walter’s Model: Criticism

• No external financing: Walter’s model assumes complete internal financing by the firm through
retained earnings. However in the real world, firms do require external financing for new
investments
• Constant return (r): Rate of return decreases as more investment is made. Therefore this
assumption is wrong
• Constant cost of capital(k): As the firms risk increases, the cost of capital also increases.
Therefore this assumption is wrong.

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 Dividend Theory : Gordon’s Model
• Gordon’s Model:
– Also known as dividend-capitalization model
– Gordon’s model explicitly relates the market value of the company to its dividend policy
– Market value of the share is determined by the following:
• Perpetual stream of future dividends
• Cost of capital
• Expected annual growth rate of the company
• Gordon’s Model is based on the following assumptions:
– All-equity firm: The firm has no debt
– No external financing: Retained earnings will be used to finance expansion
– Constant return: The internal rate of return (r) of the firm is constant
– Constant cost of capital: Cost of capital (k) remains constant
– Perpetual earnings: The firm and its stream of earnings are perpetual
– No Taxes: Corporate Taxes do not exist
– Constant retention: Retention ratio (b), once fixed, is constant. Thus the growth rate g=br is
constant forever
– Cost of capital greater than growth rate: k>g

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 Dividend Theory : Gordon’s Model
• According to Gordon’s Model :

P = EPS*(1 - b)
k - br

Where:
– P = Market price per share
– DIV = dividend per share = EPS*(1-b)
– b = retention ratio
– EPS = Earnings per share
– r = Firms rate of return
– k = firms cost of capital or capitalization rate
– g=br = growth rate of the firm

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 Dividend Theory : Gordon’s Model
• Effect of dividend policy on different types of firm
Sr. Relationship Type of When dividend When dividend
Dividend Policy
No. between r and k Firm payout is increased payout is decreased
Value of the firm Value of the firm
1 r >k Growth
decreases increases
Retain earnings

No change in value No change in value of

2 r=k Normal
of the firm the firm
No effect on policy

Value of the firm Value of the firm

3 r<k Decline
increases decreases
Distribute earnings

• Illustration: P = EPS*(1 - b)
k - br

Growth Firm (r > k) Normal Firm (r = k) Declining Firm (r < k)

r=0.15, k=0.10, EPS= Rs.10 r=0.10, k=0.10, EPS= Rs.10 r=0.08, k=0.10, EPS= Rs.10
1. Payout = 40% means b=0.6 1. Payout = 40% means b=0.6 1. Payout = 40% means b=0.6
• P= Rs. 400 • P= Rs. 100 • P= Rs. 77

2. Payout=60%, means b=0.4 2. Payout=60%, means b=0.4 2. Payout=60%, means b=0.4

• P = Rs. 150 • P = Rs. 100 • P = Rs. 88

3. Payout = 90%, means b=0.1 3. Payout = 90%, means b=0.1 3. Payout = 90%, means b=0.1
• P=Rs. 106 • P=Rs. 100 • P=Rs. 98

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Finance Management – Swapnil S Karvir
 Gordon’s Model: Limitations

• No external financing: Walter’s model assumes complete internal financing by the firm through
retained earnings. However in the real world, firms do require external financing for new
investments
• Constant return (r): Rate of return decreases as more investment is made. Therefore this
assumption is wrong
• Constant cost of capital(k): As the firms risk increases, the cost of capital also increases.
Therefore this assumption is wrong.

Similar to Walter’s Model

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Dividend Theory : Miller Modigliani(MM) Hypothesis
• What does MM Hypothesis say:
– Under a perfect market situation, the dividend policy of a firm is irrelevant, as it does not affect the value
of the firm
– According to MM, value of the firm depends on its earnings that result from its investment policy

• Assumptions:
– Perfect Capital Markets: Firm operates in a perfect capital market i.e. investors behave rationally,
information is freely available to all, transaction costs do not exist and no investor is large enough to affect
the price of the share
– No Taxes: There is no difference between tax rates applicable to dividends and capital gains i.e. from an
investors point of view, a rupee of dividend is same as a rupee in capital gain
– Investment Policy: The firm has a fixed investment policy
– No Risk: Risk of uncertainty does not exist. Forecasting future prices and dividends in possible. r=k for all t

• A firm operating under perfect market conditions may face any of the three situations given below:
– Firm has sufficient cash to pay dividends
– Firm does not have sufficient cash to pay dividends, so it issues new shares to raise money and pay
dividends
– The firm does not pay dividends, but shareholders need cash

Lets examine each of these three situations to see the impact of firms action on the value of the
firm

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Dividend Theory : Miller Modigliani(MM) Hypothesis
• Case1: Firm has sufficient cash to pay dividends

Firm pays dividends using

its cash reserves

Shareholders get cash in Firms Assets (cash balance)

hand decline

Shareholders claim on
Shareholders cash increases residual assets (cash)
decreases
Net Effect: What shareholders gain in cash, they lose by way of claim on residual assets. Therefore
there is no net gain or loss for the shareholder

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Dividend Theory : Miller Modigliani(MM) Hypothesis
• Case2: Firm does not have sufficient cash to pay dividends, so it issues new shares to raise money
and pay dividends
Firm issues new shares
to raise money

New shareholders pay cash to

Existing shareholders get cash buy shares at fair price
in form of dividends (=existing price – dividends)

For existing shareholders, value New shareholders get claim on

of their claim on assets residual assets
decreases

Net Effect: Wealth of shareholders does not change

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Dividend Theory : Miller Modigliani(MM) Hypothesis
• Case3: The firm does not pay dividends, but shareholders need cash

Shareholder sells some of

the shares owned by him
to obtain cash

No. of Shares with the

New Shareholder gets
shareholder reduces.
ownership in the company to
Effectively his ownership in
the extent of shares purchased
the company reduces

Net Effect: Value of the firm remains unchanged

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Dividend Theory : Miller Modigliani(MM) Hypothesis
• MM Hypothesis: Valuation Formula

P0 = (P1 + DIV1) / (1+k)

OR
P1 = P0 * ( 1+k) – DIV1

Where:

P0 = Market Price of the share at time T0 ( for e.g. purchase price)

P1 = Market Price of the share at time T1
DIV1 = Dividend per share at time T1
k= cost of capital ( In case of MM Hypothesis k=r, where r is the rate of return of the firm)

If the firm has “n” outstanding shares, the total value of the firm (V), when no new financing
exists, can be calculated as
V= n*P0

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Dividend Theory : Miller Modigliani(MM) Hypothesis
• MM Hypothesis: Valuation Formula
In a scenario where the firm decides to pay dividends, but it also requires funds to invest in
further growth etc, it can raise such funds by issue of new shares. In such cases, the
number of new shares to be issued can be calculated using the following formula

m*P1 = I1 - (X1 - n*DIV1)

Where:

m = number of new shares to be issued at time t1

P1 = Price at which new shares are sold
I1 = Total amount of Investment during period t1
X1 = Total net profit of the firm during period t1
n = Total outstanding shares
DIV1 = Dividend to be given

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 Criticism of Miller Modigliani(MM) Hypothesis

• Perfect Capital Markets do not exist in reality

• Information symmetry is not always possible
• Floatation and transaction costs do exist
• Taxes do exist. Therefore you cannot treat income from dividends in the same way as
income from capital gains
• The firms do not follow a rigid dividend policy at all times
• Shareholders may prefer current income ( dividends) over future income ( capital gains)

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 MM Hypothesis - Illustration
ABC Ltd currently has 1 lakh outstanding shares selling at Rs. 100 each. The firm has net profits of Rs.
10 Lakhs and wants to make new investments of Rs. 20 lakhs during the period. The firm is also
thinking of declaring a dividend of Rs. 5 per share at the end of the current fiscal year. The firms
opportunity cost of capital is 10%. What will be the price of the share at the end of the year if:
1. Dividend is not declared
2. Dividend is declared
3. How many new shares must be issued to finance the investment if dividend is paid
Given Data:
No of shares outstanding = n = 1,00,000
P0= Price of 1 share at the beginning of the year = Rs. 100
Net Profits = Earnings = X1 = Rs. 10 ,00,000
Proposed Dividend per share= DIV = Rs. 5
Intended Investment = I = Rs. 20,00,000
Cost of Capital = k = 0.1

Let P1 be the price at the end of the year. Then, Using the formula, P1 = P0 * ( 1+k) – DIV1

Case 1: When dividend is not declared, i.e. DIV= 0

P1= 100*(1+0.1) - 0 = Rs. 110

Case 2 : When dividend is declared, i.e. DIV= 5

P1= 100*(1+0.1) – 5 = Rs. 105

Case3: Let m be the number of new shares to be issued. Then, using the formula, mP1 = I – (X1 – n*DIV)

m*105 = 20,00,000 – ( 10,00,000 – 1,00,000*5)

m = 15,00,000/105
m = 14,286 shares Finance Management – Swapnil S Karvir 28
End of Module

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