UNIT – IV

The financial manager must take careful decisions on

how the profit should be distributed among
shareholders. It is very important and crucial part of
the business concern, because these decisions are
directly related with the value of the business concern
and shareholder’s wealth. Like financing decision and
investment decision, dividend decision is also a major
part of the financial manager.
Meaning of Dividend
According to the Institute of Chartered Accountant
of India, dividend is defined as “a distribution to
shareholders out of profits or reserves available for this
purpose”.
FACTORS DETERMINING DIVIDEND
POLICY
 Profitable Position of the Firm
 Uncertainty of Future Income
 Legal Constrains
 Liquidity Position
 Sources of Finance
 Growth Rate of the Firm
 Tax Policy
 Capital Market Conditions
 DIVIDEND THEORIES
 The most important point in dividend theories is to
determine the amount of profits to be distributed as
dividend to the shareholders and the amount of profit to
be retained in the business.
 There are two conflicting schools in this regard. One
school is of opinion that dividend decisions has relevance
to the value of the firm. Which include:-
Walter’s Model & Gordon’s Model
 The other school is of the view that dividend are
irrelevant to the value of the firm:-
Modigliani & Miller Model and Residual Theory of
Dividend.
Walter’s Model
Prof. James E. Walter argues that the dividend
policy almost always affects the value of the firm.
According to this model investment policy of a firm
cannot be isolated from its dividend policy both are
interrelated.
Walter model is based in the relationship between the
following important factors:
• Rate of return (Internal Rate of Return)(r)
• Cost of capital (Required rate of return)(k)
Assumptions
Walters model is based on the following important
assumptions:
1. The firm uses only internal finance.
2. The firm does not use debt or equity finance.
3. The firm has constant return and cost of capital.
4. The firm has 100 recent payout.
5. The firm has constant EPS and dividend.
6. The firm has a very long life.
Criticism of Walter’s Model
1. Walter model assumes that there is no extracted
finance used by the firm. It is not practically
applicable.
2. There is no possibility of constant return. Return
may increase or decrease, depending upon the
business situation. Hence, it is applicable.
3. According to Walter model, it is based on constant
cost of capital. But it is not applicable in the real life
of the business.
 P = [D + r/Ke (E-D)]
Ke

Where,

 P = Market price of an equity share

 D = Dividend per share
 r = Internal rate of return
 E = Earning per share
 Ke = Cost of equity capital
 According to the Walter’s model, if r > k, the firm
is able to earn more than what the shareholders could
by reinvesting, if the earnings are paid to them. In this
case dividend payout ratio is zero. Price will be
maximum when Dividend is zero. This is the case of
growth firm.
 The implication of r < k is this case dividend
payout is 100%. Price will be maximum when dividend
is 100%. This is case of declining firm.
 If the firm has r = k, it is a matter of indifferent
whether earnings are retained or distributed. This is a
case of normal firm.
Numerical Walter Model
 R = 8% D= 50% of 10 = 5
 = 5 + .08/0.12(10-5)
 0.12
 = 69.44

 R = 8% D = 75% of 10 = 7.5
 = 7.5 + 0.8/0.12 (10 -7.5)
 0.12
= 76.38
Gordon’s Model
Myron Gorden suggest one of the popular model
which assume that dividend policy of a firm affects its
value, and it is based on the following important
assumptions:
1. The firm is an all equity firm.
2. The firm has no external finance.
3. Cost of capital and return are constant.
4. The firm has perpectual life.
5. There are no taxes.
6. Constant relation ratio (g=br).
7. Cost of capital is greater than growth rate (Ke>br).
Criticism of Gordon’s Model
1. Gordon model assumes that there is no debt and
equity finance used by the firm. It is not applicable
to present day business.
2. Ke and r cannot be constant in the real practice.
3. According to Gordon’s model, there are no tax paid
by the firm. It is not practically applicable.
 Gordon’s model can be calculated with the help of the
following formula:
P = E (1-b) / Ke – br
Where,
 P = Price of a share
 E = Earnings per share
 b = percentage of earning retained or retention ratio
 1 – b = percentage of earnings distributed as dividends
 Ke = Capitalization rate
 br = Growth rate = rate of return on investment of an
all equity firm or (% of earning distributed X r )
 According to Gordon’s model, dividend policy of the
firm is relevant and that investors put a positive
premium on current dividend. He is of the view that
dividend policy affects the value of shares even in a
situation when return on investment is equal to cost of
capital
 P = E (1-b)/Ke – br
 E = 45
 b = % of earning retained 45 – 30 = 15 , 15/45*100 =
33.33%
 Ke = 15%
 br = % of earning distributed X r
 = 30/45*100 = 66.67 %
 r = EPS/ Market price per share *100
 r = 45/225*100 = 20%
 br = 66.67 * 20 = 0.1334
Modigliani and Miller’s Approach
According to MM, under a perfect market condition,
the dividend policy of the company is irrelevant and it
does not affect the value of the firm.
“Under conditions of perfect market, rational
investors, absence of tax discrimination between
dividend income and capital appreciation, given the
firm’s investment policy, its dividend policy may have
no influence on the market price of shares”.
Assumptions of M-M Approach
 1. Perfect capital market.
 2. Investors are rational.
 3. There are no tax.
 4. The firm has fixed investment policy.
 5. No risk or uncertainty.
Proof for MM approach
MM approach can be proved with the help of the
following Steps:
Step 1:- Po = D1 + P1 / (1 + Ke)
Where,
 Po = Prevailing market price of a share.
 Ke = Cost of equity capital.
 D1 = Dividend to be received at the end of period one.
 P1 = Market price of the share at the end of period one
 Step 2 :- Suppose there is no external financing, the
value of the firm (V) would be simply the number of
shares (n) times the price of each share(Po)
 V = nPo
 = n {D1 + P1 / (1 + Ke)}

 Step 3 :- New shares (m) are issued to meet the

requirement of funds at price (P1), the value of
firm (V) will be
 V = nPo
 mP1 + V = nP0 + mP1
 nP0 = V + mP1 – mP1
 nP0 = n (D1 + P1) + mP1 – mP1 / (1 + Ke)
 nP0 = nD1 +nP1 +mP1 – mP1 / (1 + Ke)
 nP0 = nD1 + P1(n + m) – mP1 / (1 + Ke)

 Step 4 :- The total value of new shares issued is:

 mP1 = I – (E – nD1)
m × P1 = I – (E – nD1)
Where,
m = Number of new share to be issued.
P1 = Price at which new issue is to be made.
I = Amount of investment required.
E = Total net profit of the firm during the period.
nD1= Total dividend paid during the period.
 Step 5 :- If we substitute equation 4 into equation 3
We drive equation 5 as follows:
nP0 = nD1 + P1(n +m) – {I – (E – nD1)} / (1 + Ke)

nP0 = nD1 + P1(n +m) – {I – E + nD1} / (1 + Ke)

nP0 = nD1 + P1(n +m) – I + E - nD1 / (1 + Ke)

nP0 = P1(n +m) – I + E / (1 + Ke)

V = P1(n +m) – I + E / (1 + Ke)

 Criticism of MM approach
1. MM approach assumes that tax does not exist. It is not
applicable in the practical life of the firm.
2. MM approach assumes that, there is no risk and
uncertain of the investment. It is also not applicable in
present day business life.
3. MM approach does not consider floatation cost and
transaction cost. It leads to affect the value of the firm.
4. MM approach considers only single decrement rate, it
does not exist in real practice.
5. MM approach assumes that, investor behaves rationally.
But we cannot give assurance that all the investors will
behave rationally.
 Residual Theory of Dividend
 According to this theory of dividend , if earnings of a firm
can be profitably utilized in investment opportunities, no
funds will be left and no dividend will be paid to
shareholders. On the other hand if a firm has earnings
left over after financing all profitable investment
opportunities available to it, these left over earnings
would be distributed to shareholders in the form of cash
dividend.
 There will be fluctuations in the dividend payout ratio
from zero to one from period to period because payment
of dividend will depend upon profitable investment
opportunities available to the firm.
Thank You