7.

RETAINED EARNINGS AND DIVIDEND DECISION

7.1. Dividend Policy

Dividend policy is the guiding principle of the company regarding the division of earnings
between dividends and retained earnings. It is an integral part of firm financing decision.
This is because retained earnings are one of the most significant sources of funds for
financing the corporate growth. The amount of earnings that can be distributed to the
shareholders is determined by dividend payout ratio. The dividend payout ratio is determined
by Dividend Policy of the firm. The amount of earnings that can be retained in the firm for
reinvestment purpose is determined by retention ratio.

Retention Ratio = 1 – Dividend Payout Ratio

7.2. Types of Dividend Policies

We may distinguish between the following types of dividend policies:

i. Stable Monetary amount per share: Also known as stable dividend policy. A
constant dividend amount is paid per share.

ii. Constant Payout Ratio Policy: A constant percentage of earnings is paid as

dividend. As earning usually fluctuates, following this policy means that the
monetary amount of dividend will fluctuate.

iii. Regular and Extra Dividend Policy: The company following this policy would set a
regular dividend at a level that can be maintained by the company. In addition in
periods of prosperity the company may declare an extra dividend. This policy gives
company flexibility but it leaves investors somewhat uncertain about what their
dividend income will be.

7.3. Factors Influencing Dividend Policy

In establishing a dividend policy, number of factors may be taken into consideration. The
factors may include:

i. Funding Needs of the Firm: A firm having different projects to undertake may
refrain from paying more dividends to finance the proposed projects from retained
earnings. So the greater the funding needs of the firm, the lesser dividends the
firm is likely to pay.

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7. RETAINED EARNINGS AND DIVIDEND DECISION

ii. Liquidity Considerations: Dividend presents a cash outflow, the greater the cash
position and overall liquidity of the company, the greater is its ability to pay
dividends.

iii. Ability to Borrow: If the firm has ability to borrow from money or capital
market, then it may be relatively financially flexible, thus, the greater the ability
of the firm to borrow the greater its financial flexibility and greater its ability to
pay cash dividend.

iv. Rate of Firm Expansion: The more rapid the rate at which the firm is growing,
the greater will be its needs for financing assets expansion. The greater the future
needs for funds the more likely the firm to retain earnings rather than pay them
out.

7.4. Dividend Stability

This is the maintenance of the position of the firm dividend payment in relation to a trend
line, preferably one that is upward sloping.

Advantages of Stable Dividend:

1. Lead to higher stock price. Fluctuating dividends are riskier than stable dividend; this
means a firm with stable dividend will have a lower cost of equity than one whose
dividends fluctuate.

2. Stability of dividend payment is an attractive feature to many investors. Many

investors will buy share in expectation of dividends

3. Dividends are sources of income, because many shareholders leave on income

received in the form of dividend.

7.5. Stock Dividends and Stock Split

A stock dividend is simply the payment of additional shares of common stocks to

shareholders. It represents bookkeeping shift within the shareholders equity account on the
firm balance sheet.

A stock dividend involve a bookkeeping transfer from retained earnings to the capital stock
account:

Entry: Dr. Retained Earnings xx

Cr. OSC xx

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7. RETAINED EARNINGS AND DIVIDEND DECISION

Stock Split represents an increase in the number of shares by reducing the par value of the
stock. e.g in a 2 for 1 stock split,

Each shareholder will receive 2 shares for one previously held

Passive and Active Dividend Policy

Under passive dividend policy, the payment of cash dividend is a passive variable i.e the
dividend policy is treated as strictly a financing decision. Dividends are only to be paid out if
the company can not make better use of the fund for the benefit of the shareholders thus the
active decision variable is retained earnings, i.e we decide how much to retain and the
residue is paid out as dividend.

With active dividend policy, dividend become an active decision variable, while earning
retention is a passive variable i.e we decide how much to pay as dividend and the residue is
retained.

7.6 Dividend Theories

The objective of the Dividend Policy should be to maximize the shareholders returns or
wealth. The return to shareholders consist of two components:

i. Dividend, and
ii. Capital gains

Dividend Policy has a direct influence on these two components. On the relationship between
dividend and the value of the firm, different theories have been advised. These theories can
be grouped into two classes:-

i. Theories which consider dividend decision to be relevant, and

ii. Theories which consider dividend decision to be irrelevant.

i) Dividend Relevancy (Walter’s & Gordon’s Models)

a) Walter’s Model
Maintain that the choice of dividend policy almost always affect the value of the firm i.e. the
dividend policy is very relevant to the determination of the value of the firm and the wealth
of shareholders.

Assumptions:

 The firm finances all investments through retained earnings i.e. debt or new equity
not issued
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7. RETAINED EARNINGS AND DIVIDEND DECISION

 The firm’s IRR and the cost of capital are constant

 All earnings are distributed as dividend or reinvested internally immediately
 The firm has a very long or infinite life

The Walter’s formula to determine the market price per share is given as

P = D + [ r (EPS – D)/ Ke]

Ke Ke
= D + (EPS – D)r/Ke
Ke
Where: P = Market price per share
D = Dividend per share
EPS = Earnings per share
r = Internal rate of return
Ke = Cost of capital or capitalization rate (cost of
equity)

According to Walter the market price per share is the sum of the PV of two sources of
income

i. A present value of infinite stream of constant dividend

ii. A present value of infinite stream of capital gain

b) Gordon’s Model
Is very popular maintain that dividend play a significant role in the determination of the
value of the firm and the wealth of the shareholder, so dividend policy affect the value of the
firm, the value of the share and the wealth of the shareholders

Assumptions:

 The firm is an all equity firm

 No external financing is available
 IRR of the firm is constant
 The appropriate discount of the firm remain constant
 The firm and its stream of earnings are perpetual
 Corporate taxes do not exist
 The retention ratio and growth in dividend are constant forever
 The cost of equity i.e. the discount rate is greater than the growth rate

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7. RETAINED EARNINGS AND DIVIDEND DECISION

The Gordon’s Model calculate the value of the share as follows

Po = D1 + D2 + ………… + D∞
(1 + ke)1 (1 + Ke)2 1 + Ke)∞

Introducing the growth rate in dividends (g)

Po = D0 (1+g)1 + D0 (1+g)2 + ………… + D0 (1+g)∞

(1 + ke)1 (1 + Ke)2 (1 + Ke)∞

Po = Do (1 + g) Po = D1
Ke – g Ke – g Ke > g

rb model (g=rb):

If retention ratio = b,
Then, dividend payout ratio = 1 – b
Thus, Do = EPSo (1 – b)
D1 = EPS1 (1 – b)
D1= EPSo(1 – b)(1 + g)

g = rb
where: r = return on investment
= internal rate of return
= Return on equity
= Return on capital employed

Ke – g = Ke - rb
r = Net Income
Total Assets
EPS = Total Assets x r
No of shares in issue

Assets per share = A = Total assets

No. of shares in issue
Ar = EPS

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7. RETAINED EARNINGS AND DIVIDEND DECISION

ii) Dividend Irrelevance - Modigliani & Miller Hypothesis

According to M&M dividend policy of a firm is irrelevant because it does not affect the
wealth of the shareholders. M&M ague that the value of the firm depend on the firm earning
which result from its investment policy thus the split of earnings between dividend and
retained earnings is of no significance in determining the value of the firm.

M&M hypothesis is based on the following assumptions

 The firm operate in perfect capital market

 Taxes do not exist
 The firm has fixed investment policy
 Risk of uncertainty do not exist

M&M started their Model by defining the rate of return for a share held for one year.
According to the hypothesis that rate of return (r) is defined as

r = Dividends + Capital Gains (Loss)

Sales Price

r = D1 + (P1 – Po)
Po D1 = Dividend per share at period 1
Po = Market price per share at period 0
P1 = Market price per share at period 1

According to M&M the required rate of return (r) will be equal to the cost of equity ke

r = Ke

The M&M valuation model is derived by expressing the Po in terms of the other valuables,
thus

Po = D1 + P1 = D1 + P1
1+r 1 + Ke

The total value of the firm if no new financing exist is obtained by simply multiplying Po by
number of shares outstanding (n), thus

Value of the firm, V = nPo

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7. RETAINED EARNINGS AND DIVIDEND DECISION

If the firm sales m number of new shares at time 1 at a price of P1 the value of the firm at
time 0 is calculated as follows:

V = nPo = nD1 + (n+m)P1 – mP1

(1 + Ke)

Investment program of the firm in a given period of time can be financed either by retained
earnings or by the issuance of shares or both, the number of shares issued to finance an
investment program can be deduced from the following relation:

mP1 = C1 – (X1 – nD1) or mP1 = C1 – X1 + nD1

Where: Co = Total amount of investment during period 1

X1 = Net profit of the firm during period 1

Example:

The market value of a company is Tsh. 100 per share. Normally the company pays a dividend
of Tsh. 5 per share. The return required by ordinary shareholders is 10%.

a) Calculate the price of the share at the end of the year if dividend is not declared;

b) Calculate the price if the company declared dividends;

c) Comment on above results (a) and (b).