Professional Documents
Culture Documents
UNIT – V: (Part- A)
Dividend decisions, influencing factors, forms and special dividends. Walter, Gordon and MM
models (Numerical Problems) Linter’s model dividend practices in India. Buy back of shares,
taxation of dividends and capital gains.
Dividend Policy
Meaning of Dividend
Dividend refers to the business concerns net profits distributed among the shareholders. It may
also be termed as the part of the profit of a business concern, which is distributed among its
shareholders.
Definition: A dividend policy can be defined as the dividend distribution guidelines provided by
the board of directors of a company. It sets the parameter for delivering returns to the equity
shareholders, on the capital invested by them in the business.
While taking such decisions, the company has to maintain a proper balance between its debt and
equity composition
What is a Dividend?
A dividend is nothing but the return declared to the equity shareholders through the distribution
of a portion of profits earned by the organization.
FORMs OF DIVIDEND
Dividend may be distributed among the shareholders in the form of cash or stock. Hence,
Dividends are classified into:
Cash dividend
Stock dividend
Bond dividend
Property dividend
Cash Dividend
*Associate Professor, Wings Business School, Tirupati, A.P. Contact: 96422 12727 1
Dr Ravikumar Gunakala* Financial Management
If the dividend is paid in the form of cash to the shareholders, it is called cash dividend. It is paid
periodically out the business concerns EAIT (Earnings after interest and tax). Cash dividends are
common and popular types followed by majority of the business concerns.
Stock Dividend
Stock dividend is paid in the form of the company stock due to raising of more finance. Under
this type, cash is retained by the business concern. Stock dividend may be bonus issue. This issue
is given only to the existing shareholders of the business concern.
Bond Dividend
Bond dividend is also known as script dividend. If the company does not have sufficient funds to
pay cash dividend, the company promises to pay the shareholder at a future specific date with the
help of issue of bond or notes.
Property Dividend
Property dividends are paid in the form of some assets other than cash. It will distributed under
the exceptional circumstance. This type of dividend is not published in India.
These dividend decisions of an organization are dependent upon the following determinants:
*Associate Professor, Wings Business School, Tirupati, A.P. Contact: 96422 12727 2
Dr Ravikumar Gunakala* Financial Management
Funds Liquidity: It should be framed in consideration of retaining adequate working capital and
surplus funds for the uninterrupted business functioning.
Past Dividend Rates: There should be a steady rate of return on dividends to maintain stability;
therefore previous year’s allowed return is given due consideration.
Earnings Stability: When the earnings of the company are stable and show profitability, the
company should provide dividends accordingly.
Debt Obligations: The organization which has leveraged funds through debts need to pay
interest on borrowed funds. Therefore, such companies cannot pay a fair dividend to its
shareholders.
Investment Opportunities: One of the significant factors of dividend policy decision making is
determining the future investment needs and maintaining sufficient surplus funds for any further
project.
Control Policy: When the company does not want to increase the shareholders’ control over the
organization, it tries to portray the investment to be unattractive, by giving out fewer dividends.
Nature and Size of Organization: Huge entities have a high capital requirement for expansion,
diversification or other projects. Also, some business may require enormous funds for working
capital and other entities require the same for fixed assets. All this impacts the dividend policy of
the company.
Company’s Financial Policy: If the company’s financial policy is to raise funds through equity,
it will pay higher dividends. On the contrary, if it functions more on leveraged funds, the
dividend payouts will always be minimal.
*Associate Professor, Wings Business School, Tirupati, A.P. Contact: 96422 12727 3
Dr Ravikumar Gunakala* Financial Management
Impact of Trade Cycle: During inflation or when the organization lacks adequate funds for
business expansion, the company is unable to provide handsome dividends.
Borrowings Ability: The company’s with high goodwill has excellent credibility in the capital
as well as financial markets. With a better borrowing capability, the organization can give decent
dividends to the shareholders.
Legal Restrictions: In India, the Companies Act 1956 legally abide the organizations to pay
dividends to the shareholders; thus, resulting in higher goodwill.
Corporate Taxation Policy: If the organization has to pay substantial corporate tax or dividend
tax, it would be left with little profit to pay out as dividends.
Government Policy: If the government intervenes a particular industry and restricts the issue of
shares or debentures, the company’s growth and dividend policy also gets affected.
Divisible Profit: The last but a crucial factor is the company’s profitability itself. If the
organization fails to generate enough profit, it won’t be able to give out decent dividends to the
shareholders.
Types of Dividend Policy:
The following categories of dividend policies provide the answer to the above question:
*Associate Professor, Wings Business School, Tirupati, A.P. Contact: 96422 12727 4
Dr Ravikumar Gunakala* Financial Management
Let us see the three essential steps to take flawless dividend decisions:
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Dr Ravikumar Gunakala* Financial Management
1. Lower Dividends in Initial Stage: When the company is at the beginning stage and
earns little profit, it should still provide dividends to the shareholders, though less.
2. Gradual Increase in Dividends: As the company prosper and grow, the dividend should
be kept on increasing proportionately, to build shareholders’ confidence.
3. Stability: It is one of the crucial features of a superior dividend policy. When the
company can survive in the market, it should ensure a stable rate of return in the form of
dividends to its shareholders. This leads to retention of shareholders and gains investors
interest, all resulting in the enhancement of shares market value.
Dividend policy provides as a base for all capital budgeting activities and in designing a
company’s capital structure.
Following are some of the reasons for which dividend policy is essential in every business
organization:
Develop Shareholders’ Trust: When the company has a constant net earnings
percentage, it secures a stable market value and pays suitable dividends. The shareholders
also feel confident about their investment decision, in such an organization.
*Associate Professor, Wings Business School, Tirupati, A.P. Contact: 96422 12727 6
Dr Ravikumar Gunakala* Financial Management
Example:
A well known Indian company, ‘Tata Chemicals Ltd.’, listed on Bombay Stock Exchange, have
a dividend policy to pay an annual return to its shareholders in the form of dividends.
The company also shares its intention of paying out special dividends on earning extraordinary
profits or other events.
It has also listed all the factors which it considers while dividend decision-making process. These
include past dividend payouts, investment opportunities, debt obligations, earnings, maintaining
reserves for adverse situations, government policy, etc.
*Associate Professor, Wings Business School, Tirupati, A.P. Contact: 96422 12727 7
Dr Ravikumar Gunakala* Financial Management
DIVIDEND DECISION
Dividend decision of the business concern is one of the crucial parts of the financial manager,
because it determines the amount of profit to be distributed among shareholders and amount of
profit to be treated as retained earnings for financing its long term growth. Hence, dividend
decision plays very important part in the financial management.
Dividend decision consists of two important concepts which are based on the relationship
between dividend decision and value of the firm.
Walter’s Model
Definition: According to the Walter’s Model, given by prof. James E. Walter, the dividends are
relevant and have a bearing on the firm’s share prices. Also, the investment policy cannot be
separated from the dividend policy since both are interlinked.
Walter’s Model shows the clear relationship between the return on investments or internal
rate of return (r) and the cost of capital (K). The choice of an appropriate dividend policy
affects the overall value of the firm. The efficiency of dividend policy can be shown through a
relationship between returns and the cost.
If r>K, the firm should retain the earnings because it possesses better investment
opportunities and can gain more than what the shareholder can by re-investing. The firms
with more returns than a cost are called the “Growth firms” and have a zero payout ratio.
*Associate Professor, Wings Business School, Tirupati, A.P. Contact: 96422 12727 8
Dr Ravikumar Gunakala* Financial Management
If r<K, the firm should pay all its earnings to the shareholders in the form of dividends,
because they have better investment opportunities than a firm. Here the payout ratio is
100%.
If r=K, the firm’s dividend policy has no effect on the firm’s value. Here the firm is
indifferent towards how much is to be retained and how much is to be distributed among
the shareholders. The payout ratio can vary from zero to 100%.
All the financing is done through the retained earnings; no external financing is used.
The rate of return (r) and the cost of capital (K) remain constant irrespective of any
changes in the investments.
All the earnings are either retained or distributed completely among the shareholders.
The earnings per share (EPS) and Dividend per share (DPS) remain constant.
The firm has a perpetual life.
It is assumed that the investment opportunities of the firm are financed through the
retained earnings and no external financing such as debt, or equity is used. In such a case
either the investment policy or the dividend policy or both will be below the standards.
The Walter’s Model is only applicable to all equity firms. Also, it is assumed that the rate
of return (r) is constant, but, however, it decreases with more investments.
It is assumed that the cost of capital (K) remains constant, but, however, it is not realistic
since it ignores the business risk of the firm, that has a direct impact on the firm’s value.
Note: Here, the cost of capital (K) = Cost of equity (Ke), because no external source of
financing is used.
*Associate Professor, Wings Business School, Tirupati, A.P. Contact: 96422 12727 9
Dr Ravikumar Gunakala* Financial Management
Illustration-1: Santosh Limited earns Rs.5 per share is capitalized at a rate of 10% and has
a rate of return on investments of 18%. According the Walter's Formula:
(i) What should be the price per share at 25% dividend pay-out ratio?
Solution:
(ii) As per above calculation at 25% dividend pay-out, the value of share is Rs.80. But, according
to Walter's model, it is not an optimum dividend pay-out because, in such case where internal
rate of return is more than the cost of capital (r > Ke), he has suggested zero dividend pay-out.
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Dr Ravikumar Gunakala* Financial Management
Compute the value of an equity share of each of these companies applying Walter's
formula when dividend pay-out ratio is (a) 0%, (b) 20%, (c) 40%, (d) 80%, and (e) 100%.
Comment on the conclusions drawn.
Solution:
Value per share as per Walter formula
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Dr Ravikumar Gunakala* Financial Management
The investors are satisfied with the firm’s retained earnings as long as the returns are more than
the equity capitalization rate “Ke”. What is an equity capitalization rate? The rate at which the
earnings, dividends or cash flows are converted into equity or value of the firm. If the returns are
less than “Ke” then, the shareholders would like to receive the earnings in the form of dividends.
Miller and Modigliani have given the proof of their argument, that dividends have no effect on
the firm’s share price, in the form of a set of equations, which are explained in the content below:
There is a perfect capital market, i.e. investors are rational and have access to all the
information free of cost. There are no floatation or transaction costs, no investor is large
enough to influence the market price, and the securities are infinitely divisible.
There are no taxes. Both the dividends and the capital gains are taxed at the similar rate.
It is assumed that a company follows a constant investment policy. This implies that there
is no change in the business risk position and the rate of return on the investments in new
projects.
There is no uncertainty about the future profits, all the investors are certain about the
future investments, dividends and the profits of the firm, as there is no risk involved.
It is assumed that a perfect capital market exists, which implies no taxes, no flotation, and
the transaction costs are there, but, however, these are untenable in the real life situations.
The Floatation cost is incurred when the capital is raised from the market and thus cannot
be ignored since the underwriting commission, brokerage and other costs have to be paid.
The transaction cost is incurred when the investors sell their securities. It is believed that
in case no dividends are paid; the investors can sell their securities to realize cash. But
however, there is a cost involved in making the sale of securities, i.e. the investors in the
desire of current income has to sell a higher number of shares.
There are taxes imposed on the dividend and the capital gains. However, the tax paid on
the dividend is high as compared to the tax paid on capital gains. The tax on capital gains
is a deferred tax, paid only when the shares are sold.
The assumption of certain future profits is uncertain. The future is full of uncertainties,
and the dividend policy does get affected by the economic conditions.
Thus, the MM Approach posits that the shareholders are indifferent between the dividends
and the capital gains, i.e., the increased value of capital assets.
*Associate Professor, Wings Business School, Tirupati, A.P. Contact: 96422 12727 12
Dr Ravikumar Gunakala* Financial Management
Gordon’s Model
Definition: The Gordon’s Model, given by Myron Gordon, also supports the doctrine that
dividends are relevant to the share prices of a firm. Here the Dividend Capitalization Model is
used to study the effects of dividend policy on a stock price of the firm.
Gordon’s Model assumes that the investors are risk averse i.e. not willing to take risks and
prefers certain returns to uncertain returns. Therefore, they put a premium on a certain return
and a discount on the uncertain returns. The investors prefer current dividends to avoid risk;
here the risk is the possibility of not getting the returns from the investments.
But in case, the company retains the earnings; then the investors can expect a dividend in future.
But the future dividends are uncertain with respect to the amount as well as the time, i.e. how
much and when the dividends will be received. Thus, an investor would discount the future
According to the Gordon’s Model, the market value of the share is equal to the present value of
P = [E (1-b)] / Ke-br
b = retention ratio
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Dr Ravikumar Gunakala* Financial Management
Ke = capitalization rate
Br = growth rate
The firm is an all-equity firm; only the retained earnings are used to finance the
The rate of return (r) and cost of capital (K) are constant.
It is assumed that firm’s investment opportunities are financed only through the retained
earnings and no external financing viz. Debt or equity is raised. Thus, the investment
The Gordon’s Model is only applicable to all equity firms. It is assumed that the rate of
returns is constant, but, however, it decreases with more and more investments.
It is assumed that the cost of capital (K) remains constant but, however, it is not realistic
in the real life situations, as it ignores the business risk, which has a direct impact on the
firm’s value.
Thus, Gordon model posits that the dividend plays an important role in determining the share
*Associate Professor, Wings Business School, Tirupati, A.P. Contact: 96422 12727 14
Dr Ravikumar Gunakala* Financial Management
In 1956, John Lintner developed this dividend model through inductive research with 28 large,
public manufacturing firms.2 Although Lintner passed away years ago, his model remains the
accepted starting point for understanding how companies’ dividends behave over time.
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Dr Ravikumar Gunakala* Financial Management
2. Earnings increases are not always sustainable. As a result, dividend policy will not
materially change until managers can see that new earnings levels are sustainable.
While all companies wish to sustain a constant dividend payout to maximize shareholder
wealth, natural business fluctuations force companies to project the dividends in the long run,
based on their target payout ratio.
From Lintner’s formula, a company’s board of directors thus bases its decisions about dividends
on the firm’s current net income, yet adjusts them for certain systemic shocks, gradually
adapting them to shifts in income over time.
A company’s board of directors sets the dividend policy, including the rate of payout and the
date(s) of distribution. This is one case in which shareholders are not able to vote on a corporate
measure—unlike a merger or acquisition, and additional critical issues such as executive
compensation.
1. The residual approach, in which dividend payments come out of the residual or leftover
equity only after specific project capital requirements are met. Companies using the
residual dividend approach usually attempt to maintain balance in their debt-to-equity
(D/E) ratios before making any distributions.
2. The stability approach, in which the board often sets quarterly dividends at a fraction of
yearly earnings. This reduces uncertainty for investors and provides them with a steady
source of income.
3. A hybrid of both the residual approach and stability approach, in which a company’s
board views the D/E ratio as a longer-term goal. In these cases, companies usually
decide on one set dividend that is a relatively small portion of yearly income and can be
easily maintained, as well as an extra dividend payment to distribute only when income
exceeds general levels.
*Associate Professor, Wings Business School, Tirupati, A.P. Contact: 96422 12727 16
Dr Ravikumar Gunakala* Financial Management
Buy-back is the process by which Company buy-back it’s Shares from the existing
Shareholders usually at a price higher than the market price. When the Company buy-back the
Shares, the number of Shares outstanding in the market reduces/fall. It is the option
available to Shareholder to exit from the Company business. It is governed by section 68 of the
Companies Act, 2013.
Reasons of Buy-back:
Modes of Buy-back:
A Company may buy-back its Shares or other specified Securities by any of the following
method-
*Associate Professor, Wings Business School, Tirupati, A.P. Contact: 96422 12727 17
Dr Ravikumar Gunakala* Financial Management
Sources of Buy-back:
A Company can purchase its own shares and other specified securities out of –
However, Buy-back of any kind of shares or other specified securities cannot be made out
of the proceeds of the earlier issue of same kind of shares or same kind of other specified
securities.
Conditions of Buy-back:-
As per Section 68 of the Companies Act, 2013 the conditions for Buy-back of shares are-
Articles must authorize otherwise Amend the Article by passing Special Resolution in
General Meeting.
For buy-back we need to pass Special Resolution in General Meeting, but if the buy-
back is up to 10%, then a Resolution at Board Meeting need to be passed .
Maximum number of Shares that can be brought back in a financial year is twenty-five
percent of it’s paid up share capital.
Maximum amount of Shares that can be brought back in a financial year is twenty-five
percent of paid up share capital and free reserves (where paid up share capital includes
equity share capital and preference share capital; & free reserves includes securities
premium).
Post buy-back debt-equity ratio cannot exceed 2:1.
Only fully paid up shares can be brought back in a financial year.
Company must declare its insolvency in Form SH-9 to Register of Companies,
signed by At least 2 Directors out of which one must be a Managing Director, if any.
The notice of the meeting for which the Special Resolution is proposed to be passed
*Associate Professor, Wings Business School, Tirupati, A.P. Contact: 96422 12727 18
Dr Ravikumar Gunakala* Financial Management
According to section 69 of the Companies Act, 2013, where a Company brought back
shares out of free reserves or out of the securities premium account, then an amount equal to
the nominal value of the shares need to be transferred to the Capital Redemption Reserve
Account. Such transfer detailed to be disclosed in the Balance sheet.
The Capital Redemption Reserve account may be utilized for paying unissued shares of the
company to the members as fully paid bonus shares.
According to section 70 of the Companies Act, 2013, A Company should not buy-back its
*Associate Professor, Wings Business School, Tirupati, A.P. Contact: 96422 12727 19
Dr Ravikumar Gunakala* Financial Management
Conclusion
It prevents takeovers and mergers thus preventing monopolization and aiding the survival of
consumer sovereignty. On the other hand Buy back can help in manipulating the records in
flatting share prices Price- Earnings Ratio, Earning per share, thus misleading shareholders.
Thus, knowledge of the impacts of Buy-back becomes vital and every shareholder must
reconsider all his views before purchasing the shares of companies involved in the process
of Buy- back.
*Associate Professor, Wings Business School, Tirupati, A.P. Contact: 96422 12727 20