Financial Management

Theory
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UNIT 6: DIVIDEND DECISIONS:

• Dividend Policy:

Dividend is the part of Company’s profit which is given by Company to its shareholders. As the
shareholders invest their valuable money in the Company, they expect maximum returns out of it. If the
Company pays more dividends from it available profits, then they are unable to retain the earned profits
for future investment. Hence, it is necessary for the Company to decide upon how much should be
retained and how much to distribute as dividend. This decision is called the Dividend Policy.

The Dividend distributed can be in the form of cash dividend, Scrip/Bond Dividend (promise to pay in
future), Stock Dividend (Bonus Shares), and Property Dividend.

• Types of Dividend Policy:

1. Stable Dividend policy:

Stable dividend policy is the easiest and most commonly used. The goal of the policy is steady and
predictable dividend payouts each year, which is what most investors seek. Whether earnings are up or
down, investors receive a dividend. The goal is to align the dividend policy with the long-term growth of
the company rather than with quarterly earnings volatility. This approach gives the shareholder more
certainty concerning the amount and timing of the dividend.

2. Constant Dividend Policy:

The primary drawback of the stable dividend policy is that investors may not see a dividend increase in
boom years. Under the constant dividend policy, a company pays a percentage of its earnings as dividends
every year. In this way, investors experience the full volatility of company earnings. If earnings are up,
investors get a larger dividend; if earnings are down, investors may not receive a dividend. The primary
drawback to the method is the volatility of earnings and dividends. It is difficult to plan financially when
dividend income is highly volatile.

3. Residual Dividend Policy:

Residual dividend policy is also highly volatile, but some investors see it as the only acceptable dividend
policy. With a residual dividend policy, the company pays out what dividends remain after the company
has paid for capital expenditures and working capital. This approach is volatile, but it makes the most
sense in terms of business operations. Investors do not want to invest in a company that justifies its
increased debt with the need to pay dividends.

4. No Dividend:
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This policy maybe implemented by the Company, if it requires funds for further expansion or to meet
working capital requirements.

Factors Affecting Dividend policy of Company:

The following are the various factors/determinants that impact the dividend policy of a company:

(1) Type of Industry

The nature of the industry to which the company belongs has an important effect on the dividend policy.
Industries, where earnings are stable, may adopt a consistent dividend policy as opposed to the industries
where earnings are uncertain and uneven. They are better off in having a conservative approach to
dividend payout.

(2) Ownership Structure

The ownership structure of a company also impacts the policy. A company with a higher promoter'
holdings will prefer a low dividend payout as paying out dividends may cause a decline in the value of the
stock. Whereas, a high institutional ownership will favor a high dividend payout as it helps them to
increase the control over the management.

(3) Age of corporation

Newly formed companies will have to retain major part of their earnings for further growth and
expansion. Thus, they have to follow a conservative policy unlike established companies, which can pay
higher dividends from their reserves.

(4) The extent of Share Distribution

A company with a large number of shareholders will have a difficult time in getting them to agree to a
conservative policy. On the other hand, a closely held company .has more chances of succeeding to
finalize conservative dividend payouts.

(5) Different Shareholders' Expectations

Another factor that impacts the policy is the diversity in the type of shareholders a company has. A
different group of shareholders will have different expectations. A retired shareholder will have a
different requirement vis-a-vis a wealthy investor. The company needs to clearly understand the different
expectations and formulate a successful dividend policy.

(6) Leverage
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A company having more leverage in their financial structure and consequently, frequent interest payments
will have to decide for a low dividend payout. Whereas a company utilizing their retained earnings will
prefer high dividends.

(7) Future Financial Requirements

Dividend payout will also depend on the future requirements for the additional capital. A company having
profitable investment opportunities Is justified in retaining the earnings. However, a company with no
internal or extemal capital requirements should opt for a higher dividend.

(8) Business Cycles

When the company experiences a boom, it is prudent to save up and make reserves for dips. Such reserves
will help a company declare high dividends even in depressing markets to retain and attract more
shareholders.

Growth Companies with a higher rate of growths, as reflected in their annual sales growth, a ratio of
retained earnings to equity and return on net worth, prefer high dividend payouts to keep their investors
happy.

Changes in Government Policies There could be the change in the dividend policy of a company due to
the imposed changes by the government. The Indian government had put temporary restrictions on
companies to pay dividends during 1974-75.

(9) Profitability

The profitability of a firm is reflected in net profit ratio, current ratio, and ratio of profit to total assets. A
highly profitable company generally pays higher dividends and a company with less or no profits will
adopt a conservative dividend policy.

(10) Taxation Policy

The corporate taxes will affect dividend policy, either directly or indirectly. The taxes directly reduce the
residual earnings after tax available for the shareholders. Indirectly, the dividend distribution is taxable
after a certain limit.

(11) Trends of Profits

Even if the company has been profitable over the years, the trend should be properly analyzed to find the
average earnings of the company. This average number should be then studied in relation to the general
economic conditions. This will help in opting for a conservative policy if a depression is approaching.

(12) Liquidity
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Liquidity has a direct relation with the dividend policy. If a firm has a strong liquidity and enough cash
for its working capital, it can afford to pay higher dividends. However, a firm with less liquidity will
choose a conservative dividend policy.

(13) Legal Rules

There are certain legal restrictions on the companies for dividend payments. It is legal to pay a dividend
only if the capital is not reduced post payment. These rules are in place to protect creditors' interest.

Inflation Inflationary environments compel companies to retain major part of their earnings and indulge in
lower dividends. As the prices rise, the companies need to increase their capital reserves for their
purchases and other expenses.

(14) Control Objectives

The firms aiming for more control in the hands of current shareholders prefer a conservative divid.o.C1
payout policy. It is imperative to pay fewer dividends to retain more control and the earnings in the
company. In a nutshell, the management of a company is completely free to frame the requiredweigh
dividend polbove-There are no obligations to be adhered to. So, the company needs to judiciously all the
a mentioned factors and formulate a balanced dividend policy. A dividend policy can also be revised in
the wake of changes in any of the factors.

• Definition of Dividend as per Income Tax Act:

As per S. 2(22) of the Income Tax Act, 1961, unless the context otherwise requires, the term “dividend”
includes-

(a) any distribution by a company of accumulated profits, whether capitalised or not, if such distribution
entails the release by the company to its shareholders of all or any part of the assets of the company;

(b) any distribution to its shareholders by a company of debentures, debenture-stock, or deposit certificates
in any form, whether with or without interest, and any distribution to its preference shareholders of shares
by way of bonus, to the extent to which the company possesses accumulated profits, whether capitalised or
not;

(c) any distribution made to the shareholders of a company on its liquidation, to the extent to which the
distribution is attributable to the accumulated profits of the company immediately before its liquidation,
whether capitalised or not;
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(d) any distribution to its shareholders by a company on the reduction of its capital, to the extent to which
the company possesses accumulated profits which arose after the end of the previous year ending next
before the 1st day of April, 1933, whether such accumulated profits have been capitalised or not;

(e) any payment by a company, not being a company in which the public are substantially interested, of any
sum (whether as representing a part of the assets of the company or otherwise) made after the 31st day of
May, 1987, by way of advance or loan to a shareholder, being a person who is the beneficial owner of
shares (not being shares entitled to a fixed rate of dividend whether with or without a right to participate in
profits) holding not less than ten per cent of the voting power, or to any concern in which such shareholder
is a member or a partner and in which he has a substantial interest (hereafter in this clause referred to as the
said concern) or any payment by any such company on behalf, or for the individual benefit, of any such
shareholder, to the extent to which the company in either case possesses accumulated profits; (**)

but “dividend” does not include-

(i) a distribution made in accordance with sub-clause (c) or sub-clause (d) in respect of any share issued
for full cash consideration, where the holder of the share is not entitled in the event of liquidation to
participate in the surplus assets;

(ia) a distribution made in accordance with sub-clause (c) or sub-clause (d) in so far as such distribution is
attributable to the capitalised profits of the company representing bonus shares allotted to its equity
shareholders after the 31st day of March, 1964, and before the 1st day of April, 1965;

(ii) any advance or loan made to a shareholder or the said concern by a company in the ordinary course of
its business, where the lending of money is a substantial part of the business of the company;

(iii) any dividend paid by a company which is set off by the company against the whole or any part of any
sum previously paid by it and treated as a dividend within the meaning of sub-clause (e), to the extent to
which it is so set off;

(iv) any payment made by a company on purchase of its own shares from a shareholder in accordance with
the provisions of (section 77A of the Companies Act, 1956) sec 68 of Companies Act 2013;

(v) any distribution of shares pursuant to a demerger by the resulting company to the shareholders of the
demerged company (whether or not there is a reduction of capital in the demerged company).

Explanations:
1. The expression “accumulated profits”, wherever it occurs in this clause, shall not include capital gains
arising before the 1st day of April, 1946, or after the 31st day of March, 1948, and before the 1st day of
April, 1956.

2. The expression “accumulated profits” in sub-clauses (a), (b), (d) and (e), shall include all profits of the
company up to the date of distribution or payment referred to in those sub-clauses, and in sub-clause (c)
shall include all profits of the company up to the date of liquidation, but shall not, where the liquidation is
consequent on the compulsory acquisition of its undertaking by the Government or a corporation owned or
controlled by the Government under any law for the time being in force, include any profits of the company
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prior to three successive previous years immediately preceding the previous year in which such acquisition
took place.

3. For the purposes of this clause,

(a) “concern” means a Hindu undivided family, or a firm or an association of persons or a body of
individuals or a company;

(b) a person shall be deemed to have a substantial interest in a concern, other than a company, if he is, at
any time during the previous year, beneficially entitled to not less than twenty per cent of the income of
such concern.

• Meaning and Provisions of Dividend under Companies Act 2013.

o Section 2(35) of Companies Act

Dividend includes any interim dividend.

This definition is inclusive and not exhaustive. Dividend means the profits of the company,
which is not retained in the business and is distributed among the shareholders.

The companies having license under section 8 (formation of companies with charitable
objectives) of the Act are prohibited by their constitution from paying any dividend to its
members. They apply the profits in promoting the objects of the company.

o Types of dividends:

There are following types of dividend:—

a. Interim dividend; and

b. Final dividend
c. Preference share Dividend

o Interim Dividend:

(As per Clause 81 of Model Articles of Company Limited by shares as Contained in Table-F of
Schedule-I of the 2013 Act)

i. Interim dividend can only be declared by board of Directors.

ii. Generally paid in the middle of the year.
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iii. Board of Directors can declare dividend out of surplus in profit and loss account at the
beginning of the year or profit during the year.
In case of Company incurred losses in current financial

If the company has incurred loss during the current financial year upto the end of the quarter
immediately preceding the date of declaration of interim dividend such interim dividend shall not
be declared at a rate higher than the average dividends by the company during the immediately
preceding three financial years Section 123(3).

Note:

i. Interim dividend is really a mode of keeping shareholder happy and keeping good image
of Company in stock market.
ii. All legal provisions applicable on final dividend equally apply on interim dividend.

o Final Dividend:

Dividend is said to be a final dividend if it is declared at the annual general meeting of the
company. Final dividend once declared becomes a debt enforceable against the company.

o Condition common for Both Final Dividend and Interim Dividend:

i. Deposit of Amount of declared dividend in separate Bank Account.
ii. Payment of dividend within 30 days of declaration.
iii. Transfer of unpaid dividend in special account.
iv. Interest for late payment.
v. Transfer of Investor protection Fund after Seven year.
vi. Penalty for non-payment etc.

o HOW TO DECIDE THE SHAREHOLDERS TO WHOM DIVIDEND WILL BE

GIVEN:

Unlisted Companies (Include unlisted Public and Private Limited Company:

In case of the annual dividend, the persons who are members as on the date of the annual
general meeting will be eligible to receive the dividend as the dividend is approved by the
members on the day when annual general meeting is held.

Listed companies are required to inform the Stock Exchange [atleast 7 working days] in
advance of closing the Register of members for payment of dividend declared at the Annual
General Meeting.

o Declaration of dividend - BASIC UNDERSTANDING

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a) Sec 51 permits companies to pay proportionate dividend i.e. in proportion to amount paid on
each shares. If there are different classes of equity shares based on paid up value of shares, then
dividend will be paid on pro-rata basis. However, in case of preference shares, dividend is always
paid at a fixed rate.

b) Section 134(3)(k) - BOD must state in their Director's report the amount of dividend which it
recommends to be paid and the same must be declared in AGM. (this does not apply to interim
dividend

c) Declaration of final dividend - declared at AGM [section 102(2)] by members if and only if the
same has been recommended by BOD.

d) Declaration of interim dividend - declared by BOD at any time before the closure of financial
year.

e) Sources for payment of dividend - Section 123(2)

i. Profit of the current year after providing of the depreciation; or

ii. Profit of the previous financial year or years after providing for depreciation for previous
years; or

iii. Out of the money provided by Central or State Government for payment of dividend in
pursuance of guarantee given by that, if any.

o Important points to be noted as under –

1. Whether is it compulsory requirement of making provision for depreciation before payment

of dividend?

In terms of the provisions of section 123 of the Act, no company can pay dividend in any year without
charging depreciation in the profit and loss account for the current year and that there is no balance of un
provided depreciation of any earlier year or years.

Depreciation shall be provided in accordance with the provisions of Schedule II to the Companies Act,
2013.

2. Whether the term "Profit of the current year" used in 123(1)(a) refers to profits after tax or
before tax?

It refers to profits after tax. Term 'Profit, Profit can be either revenue profit or Capital profits or both.
Thus, dividend can't be paid by revaluation of assets, as the surplus has not been actually realized.
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For the purpose of prohibition of payment of dividend out of capital, capital means capital according to
the Act and not the goods or things on which capital is laid out. [Lubbock v British Bank of South
America (18921 2 Ch. 198 (CAI)

Sec 123: Declaration of dividend.—(1) No dividend shall be declared or paid by a company for any
financial year except—
(a) out of the profits of the company for that year arrived at after providing for depreciation in
accordance with the provisions of sub-section (2), or out of the profits of the company for any previous
financial year or years arrived at after providing for depreciation in accordance with the provisions of
that sub-section and remaining undistributed, or out of both; or
(b) out of money provided by the Central Government or a State Government for the payment of dividend
by the company in pursuance of a guarantee given by that Government:
Provided that a company may, before the declaration of any dividend in any financial year, transfer such
percentage of its profits for that financial year as it may consider appropriate to the reserves of the
company:
Provided further that where, owing to inadequacy or absence of profits in any financial year, any
company proposes to declare dividend out of the accumulated profits earned by it in previous years and
transferred by the company to the reserves, such declaration of dividend shall not be made except in
accordance with such rules as may be prescribed in this behalf:
Provided also that no dividend shall be declared or paid by a company from its reserves other than free
reserves:
1[Provided also that no company shall declare dividend unless carried over previous losses and
depreciation not provided in previous year or years are set off against profit of the company for the
current year.]
1. Ins. by Act 21 of 2015, s. 10 (w.e.f. 29-5-2015).
(2) For the purposes of clause (a) of sub-section (1), depreciation shall be provided in accordance with
the provisions of Schedule II.
(3) The Board of Directors of a company may declare interim dividend during any financial year out of
the surplus in the profit and loss account and out of profits of the financial year in which such interim
dividend is sought to be declared:
Provided that in case the company has incurred loss during the current financial year up to the end of the
quarter immediately preceding the date of declaration of interim dividend, such interim dividend shall not
be declared at a rate higher than the average dividends declared by the company during the immediately
preceding three financial years.
(4) The amount of the dividend, including interim dividend, shall be deposited in a scheduled bank in a
separate account within five days from the date of declaration of such dividend.
(5) No dividend shall be paid by a company in respect of any share therein except to the registered
shareholder of such share or to his order or to his banker and shall not be payable except in cash:
Provided that nothing in this sub-section shall be deemed to prohibit the capitalization of profits or
reserves of a company for the purpose of issuing fully paid-up bonus shares or paying up any amount for
the time being unpaid on any shares held by the members of the company:
Provided further that any dividend payable in cash may be paid by cheque or warrant or in any
electronic mode to the shareholder entitled to the payment of the dividend.
(6) A company which fails to comply with the provisions of sections 73 and 74 shall not, so long as such
failure continues, declare any dividend on its equity shares.
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3. Whether it is mandatory for the Company to transfer some amount in reserve before
declaration of dividend?

No, it's not mandatory to transfer the amount. Earlier in Companies Act, 1956 it was Compulsory to
transfer the amount in reserve while declaration of dividend. But the same is on the discretion of the
Company in Companies Act, 2013. A company may before the declaration of any dividend in any
financial year transfer such % of its profits for financial year as it may consider appropriate.

The reserve shall, at the discretion of the Board, be applicable for any purpose to which the profits of the
company may be properly applied, including provision for meeting contingencies.

4. Inadequacy or absence of profits in any year

If company proposes to declare dividend in such case, company has to follow Companies (Declaration
and payment of dividend) Rules, 2014 for declaration of dividends out of accumulated profits earned +
transfer to reserves in any previous financial year/s.

Declaration of dividend out of reserves:

In the event of inadequacy or absence of profits in any year, a company may declare dividend out of free
reserves subject to the fulfillment of the following conditions:

(1) The rate of dividend declared shall not exceed the average of the rates at which dividend was
declared by it in the 3 years immediately preceding that year,
Provided that this sub rule shall not apply to a company, which has not declared dividend in each
of the 3 preceding financial years.
(2) The total amount to be drawn from such accumulated profits shall not exceed one-tenth of the
sum of its paid- up share capital and free reserves as appearing in the latest audited financial
statements.
(3) The amount so drawn shall first be utilised to set off the losses incurred in the financial year in
which dividend is declared before any dividend in respect of equity shares is declared.
(4) The balance of reserves after such withdrawal shall not fall below fifteen per cent of its paid up
share capital as appearing in the latest audited financial statement.
(5) No company shall declare dividend unless carried over previous losses and depreciation not
provided in previous year are set off against profit of the company of the current year the loss or
depreciation, whichever is less, in previous years is set off against the profit of the company for
the year for which dividend is declared or paid.

5. Whether it is mandatory to Recommendation of dividend by the Board is compulsory

In the matter of payment of dividend or not in any financial year irrespective of the profit earned by a
company in the financial year is left to the discretion of the Board to recommend or not to recommend
dividend for any year. If the Board does not recommend any dividend, the company in general meeting
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cannot consider and approve any dividend for payment. The company in general meeting cannot also
increase the rate of dividend recommended by the Board.

Following steps are required to be taken by a company i.r.o. declaration of dividend.

1. Issue notice in accordance with section 173 for holding meeting of BOD to consider the matter.

2. In case of listed companies, stock exchanges are required to be notified at least 2 working days in
advance of the date of BOD meeting at which recommendation of final dividend is to be considered.

3. Holding of BOO meeting for passing resolution stating quantum of final dividend to be declared at next
AGM, sources of funds etc)

4. Fixation of date, time and venue of AGM.

5. Ensure that the required of profits as decided by the board is transferred to company's reserves.

6. Close the register of members and the share transfer register.

7. Hold AGM and pass ordinary resolution declaring payment of dividend to the shareholders as per
recommendation by BOD.

Following steps are required to be taken by a company i.r.o. payment of dividend.

1. Ensure that the dividend tax is paid to the tax authorities within the prescribed time.

2. Open a separate bank account for making dividend payment and credit the said bank account within 5
days from the date of declaration.

3. In case of listed company, mode of payment is strictly through ECS or NEFT.

4. Dividend is to be paid within 30 days from the declaration.

5. Unpaid or unclaimed dividend is to be transferred to special a/c within 7 days named "unpaid dividend
A/c" after expiry of 30 days of declaration of final dividend.

6. Transfer above mentioned unpaid amount to Investor Education and Protection Fund after the expiry of
7 years from the date of transfer to unpaid a/c.

6. Whether it is mandatory for the Board of Directors to recommend dividend?

In the matter of payment of dividend or not in any financial year irrespective of the profit earned by a
company in the financial year is left to the discretion of the Board to recommend or not to recommend
dividend for any year. If the Board does not recommend any dividend, the company in general meeting
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cannot consider and approve any dividend for payment. The company in general meeting cannot also
increase the rate of dividend recommended by the Board.

7. Whether Board's recommendation can be withdrawn before communication to others?

Since the director's recommendation of dividend is only a proposal, it can be withdrawn by the Board
before it is included in the notice for the annual general meeting.

8. Whether Dividend becomes unsecured debt against the company after approval in the
general meeting?

Where a dividend is approved by the shareholders at the annual general meeting, it becomes a debt
against the company and it is deemed to be receivable by the members only in the year at which the
members declared the dividend and not at the time when the dividend was recommended by the Board.

9. Prohibition on Dividend:

A company which has default under Section 73 and 74 related to deposit and repayment of deposit or
interest thereon may not declare dividend.

A company cannot declare dividend if the company fails to comply with acceptance of deposits and
repayment of deposits accepted prior to the commencement of this Act. (Section 73 Et 74 of Companies
Act 2013.

10. Free Reserve:

No dividend shall be paid from its reserves other than free reserves. The term "Free Reserves" is defined
under Section 2 (43) of the Company Act 2013. Free reserve means such reserve which, as per the latest
audited balance sheet of a Company, are available for distribution of profit.

11. Punishment for Failure to Distribute Dividend (SECTION 127):

Where a dividend has been declared by a company but has not been paid or the warrant in respect thereof
has not been posted within thirty days from the date of declaration to any shareholder entitled to the
payment of the dividend, every director of the company shall, if he is knowingly a party to the
default, be punishable with imprisonment which may extend to two years and with fine which shall
not be less than one thousand rupees for every day during which such default continues and the
company shall be liable to pay simple interest at the rate of eighteen percent per annum during the
period for which such default continues.

No offence under this section shall be deemed to have been committed:—

(a) Where the dividend could not be paid by reason of the operation of any law;

(b) Where a shareholder has given directions to the company regarding the payment of the dividend and
those directions cannot be complied with and the same has been communicated to him;
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(c) Where there is a dispute regarding the right to receive the dividend; (d) Where the dividend has been
lawfully adjusted by the company against any sum due to it from the shareholder; or

(e) Where, for any other reason, the failure to pay the dividend or to post the warrant within the period
under this section was not due to any default on the part of the company.

• Relationship Between Dividend and Market Value of Shares (Share Prices)

It is generally said that the value of the firm is maximized if the shareholders get maximum wealth which
means if they get maximum dividend. But some believe that the dividend decision does not affect the
value of the firm. In this regard there are two theories given.

o Theory of Irrelevance
o Theory of Relevance

➢ Theory of Irrelevance:

This theory believes that the value of the firm and the wealth of the shareholders are not affected by the
Dividend Policy of the Company. This can be further explained with the help of the following two
approaches.

i. Residual Approach:

As per this approach, dividend decisions does not affect the shareholders wealth or the value of
the firm as the investors are not interested only in dividend but they are interested in earning high
returns on their investment. This means if the firm is in a position to gain high profits by making
further investment, then the shareholders would like to keep their money with the firm. However,
if the firm has no profitable opportunity, than the shareholders would like to receive dividend.

ii. Modigliani and Miller Approach:

As per this approach, the value of a firm is solely dependent on the earning capacity of the firm.
How a firm is distributing its earnings is not the deciding factor in the valuation. The MM
argument says that a firm may retain its earnings or it may distribute them. If the earnings are
retained, it will lead to capital appreciation. On the other hand, if dividends are distributed, the
shareholders will enjoy dividend income which is equal to the amount by which his capital would
have appreciated if the Company would have retained its earnings. The shareholders, therefore,
do not make any differentiation between present dividend and retained earnings.

This theory assumes:

a. There are no taxes

b. There is a perfect market
c. Investors act rationally
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d. No transaction cost
e. All earnings go to the shareholders
f. Rigid investment policy of the firm

Po = D1 + P1/1+Ke

The above formula means that the market price of the shares at the beginning of the period
(Po) is equal to the present value of dividend paid at the end of the period (D1) plus market
price of the shares at the end of the period (P1) divided by the 1+ cost of capital (Ke).

Criticisms:

a. Prefect capital market does not really exist

b. The firm has to incur floating cost
c. Taxes really exist
a. There is no rigid investment policy
d. The company information is available to all

➢ Theory of Relevance:

This theory believes that the dividend policy of the Company affect the shareholder wealth as well as
value of the firm. This can be further explained with the help of the following approaches.

1) Walter’s Approach:

As per this approach dividend decision affect the shareholders wealth as well as value of the firm.
The relationship between the internal rate of return and cost of capital is helpful in determining
the dividend policy, as this approach is based upon return on investment ‘(r) and cost of capital
(k).

James E Walter has given three types of the firm

a. Growth firm:

In this case the r > k, it means that the optimum dividend policy will be 100% retention of profits
and 0% payout. The market price of shares will go on increasing when dividend payout ratio
starts decreasing and vice versa.

b. Declining firm:

In this case the r < k, it means that the optimum dividend policy will be 100% payout of profit
and no retention. The market price will increase as the dividend payout increases.

c. Normal firm:

In this case the r = k, it means that there is no fixed dividend policy and it makes no difference.
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The reasons for these types of changes in the market prices of the shares are that in case of a
growth firm, there are a number of profitable opportunities outside and hence instead of declaring
dividend, if the amount of profit is retained, the market price of shares will rise. In case of
declining firms, exactly opposite things take place. As no opportunities are available outside,
instead of retaining profits, it is better to distribute the profits as dividends. In case of Normal
Firm, whether dividends are given or not will make no difference.

This theory assumes

a) Earnings per share, dividend per share do not change

b) External sources are not used by the firm
c) The company has long life
d) IRR and cost of capital are constant

P = { D + (r/Ke)(E-D)}/Ke

P = Market price per share

D = Dividend per share

R = Rate of Return

E = Earnings per share

Ke = Cost of Capital (Equity)

2) Gordon’s Approach:

Gordon’s Approach is similar to Walter’s approach. He also divided the firms in the same way and on the
same basis. The only difference was in the manner of calculation of the Market Price of shares.

P = E(1-b)/k-br

P = Market Price

b = Retention Ratio

(1-b) = Dividend payout ratio

K = Rate of Discount

br = growth rate of earnings and dividends

r= rate of return

E = Earnings per share

Financial Management
Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation
Assumptions:

a) Retained earnings are the only source of financing

b) Rate of Return and Cost of Capital of the firm are constant
c) Growth rate of the firm is the product of its retention ratio and its rate of return.
d) The firm has an indefinite life
e) Taxes do not exists.

3) Traditional Approach (Graham and Dodd)

They believed that the shareholders preferred dividends to retained earnings. Hence, market price will
increase with increase in dividend payout.

4) Radical Approach (Michael J Brennan)

He advocates a low payout position as a low dividend promotes welfare of shareholders. The reason for
this is, for taxation purposes capital gains are taxed for favorably than the income from dividends. Hence,
investors prefer those shares which provide more capital appreciation and less dividend income.

To conclude, both the above theories on dividend and market price relation are contradictory to each
other. Which one holds true is difficult to determine. As per a recent school of thought, if a dividend is
declared as expected, then it will not affect the share price irrespective of the amount of dividend paid. If
the dividend declared in more than the market expectation, then the market prices of the shares will rise
because higher dividends would indicate high profitability and vice versa.
Financial Management
Theory
New Law College, BBA LLB 3rd yr
Notes for Limited Circulation