Chapter –10-

Dividend Policy and Value of Firm

After studying this chapter you should be able to:

1. Understand the relationship between dividend and value of

firm.
2. Possible methods of rewarding the shareholder and there
implications.
3. Understand and apply theories on dividend.
4. Factors affecting dividend policy of a company and constrains
in deciding on dividend distribution.

Chapter –10 Page - 1 -

10.1 INTRODUCTION
Dividend as we all understand is a residual income for the shareholders after meeting all
the obligations. Investors who have invested in shares of the company have different
intentions and expectations and so the dividend distribution has a varying affect on
shareholders. Theoretically, there are various views on distribution of dividend and value
of firm. On one hand, we have research, which proves that dividend policy has an impact
on valuation of firms and on the other hand we have theory, which prove just the
opposite.

10.2 ASPECTS RELATING TO DIVIDEND POLICY

1. When dividend decision is treated as a financing decision then the net earning of
the firm, which can be distributed as dividend is treated as a source of financing
the future expansion. With this approach dividend can be paid only if an
opportunity cost of retaining the dividend is much higher than the cost of sacrifice
made by the industry.
2. Investor’s need for income is also a concern when deciding upon a dividend
policy. If the shareholders pattern shows that the investor is primarily a small
investor than a company may be forced to think as to what the shareholder is
looking for. Whether it is a regular income or capital appreciation. If the
shareholder has invested with an intention to earn regular flow of dividend and if
in some year he does not receive the dividend it sends a wrong signal. The
investor may think that perhaps the company is not cash rich or perhaps the
profits are mere book profits. (We will look into the dividend holding pattern of
few firms later in this chapter ) .
a) Stability of dividend refers to the consistency in the stream of dividend, in
more precise term it means that a certain minimum amount of dividend is paid
regularly. The stability can take three forms: a) Constant dividend per share
b) Constant dividend payout ratio c) Constant dividend per share plus extra
dividend in boom period
b) Constant dividend per share: In this form of dividend policy a company
follows a policy of paying a fixed amount per share without regards to earning
per share.
c) Constant payout ratio: In this form of dividend policy a company follows a
policy of paying a constant proportion of earnings as dividend per share which
primarily means that if the earnings vary the dividend vary. If the company
has a policy to 50% of earning as dividend that means with the change in EPS,
DPS will also change in the same proportion.
d) Constant dividend per share plus extra dividend in boom period: This method
follows a system where constant dividends are paid to the shareholders and an
extra amount is paid only when the earnings are substantially high.

Chapter –10 Page - 2 -

10.3 HOW DIVIDENDS ARE PAID
Usual practice in India is to pay dividend in cash, which is primarily decided by the
Directors and approved in the Annual General Meeting of the shareholders. The
announcement of dividend states that payment would be made to all those shareholders
who are registered on a particular record date and dividend warrants are issued with 30
day of declaring dividend. Shares when purchased before the record date are referred to
as “cum dividend” after the record date is over the shares are referred as “ex dividend” (If
you look at the financial column in economic times you will find the names of the
companies which have declared a record date before the names of these companies you
will also find the word CD, After the RD is over the word CD will be replaced by XD).
Other forms of payment of dividend can be bonus shares or stock split (although stock
split is not a form of payment of dividend but it affects are similar to the affect of bonus
shares).
There are also other forms of passing benefits to shareholders like sending coupons of
discount to purchase a product or to send samples of new product launch by the company.
Companies abroad also use a policy known as dividend reinvestment plan (DRIPs). Drip
plans offer investors the option of reinvesting their cash dividends by purchasing
additional shares or fractional shares. Companies offering DRIPs include companies like
Bank of America, Coca Cola, Nokia, Phillip Morris, and Yahoo. A company may also go
in for issuing right shares to the existing shareholders at a considerable discount and
thereby transferring a dividend income indirectly to the shareholders and also saving on
floatation cost. Let us discuss the two most common ways of paying dividend.

10.3.1 Cash dividend

For paying dividend in cash the first thing a company requires is liquidity. If it does not
have enough bank balance, arrangement needs to be made. When a company follows a
stable dividend policy it can plan for the payment of dividend by preparing a cash budget
in advance. But it is difficult to make cash planning if the dividend needs are unstable.
The accounting treatment is that, the cash balance on the asset side will be reduced and
the reserve balance on the liability side will also go down by the same amount. Normally
it is seen that if the share is traded at Rs. 10 cum dividend and if the company declares a
dividend of Rs. 2 the share price of the company will fall to Rs. 8 after the record date.
(We will discuss this point in detail, later).

10.3.2 Bonus Issues

Bonus shares are issued to the existing shareholders without payment of any
consideration. Bonus shares are issued by conversion of the reserves and surplus of the
company into shares. Obviously, bonus shares can be issued only by companies which
have accumulated large free reserves i.e. reserves not set apart for any specific purpose
and which can be distributed as dividend. However, bonus shares can be issued out of
the balance in the share premium account.

Chapter –10 Page - 3 -

The main advantage of issuing bonus shares is that the company does not have to arrange
for cash for the payment of dividend. It also reduces the share price in the market thereby
increasing the marketability and availability of the share. The reserves of the company
will go down in the same manner as with distribution of cash dividend but in bonus issue
since cash is not involved the amount which was earlier lying in reserve will be
transferred to the share capital account.

Lets assume that shareholder fund of a company comprise of the following.

Paid up share capital @ Rs.10 each 1,000

Share premium account 200
Reserve and surplus 1,500

If the company declares a bonus of 1:2 a shareholder of two shares will get one more
share. In our case there are 100 shareholders and 50 new shares are to be issued, if the
market price of the share is Rs. 20 each which means 10 for the face value and Rs.10 for
the premium then the reserve and surplus account will go down by 50*20 = Rs.1,000
from this Rs.1,000, Rs. 500 will be transferred to share capital and Rs. 500 will the
transferred to share premium account, the position after the issue will be.

Paid up share capital @ Rs.10 each 1,500

Share premium account 700
Reserve and surplus 500

10.3.3 Points to remember while declaring Bonus Issue

 Bonus shares can be issued out of retained earnings or other reserves permitted by
company law. The credit balances in the following accounts can be capitalized.

1. Profit and Loss account

2. Profit and Loss Appropriation account
3. General Reserve
4. Share Premium
5. Capital Redemption Reserve

 Bonus shares cannot be issued if the company has come out with any public/rights
issue in the past 12 months.
 Bonus shares cannot be issued in lieu of dividend.
 Bonus shares can be issued only out of free reserves (which means that bonus shares
cannot be issued from reserves set apart for any specific purpose) built out of the
genuine profits or share premium collected in cash only.
 Bonus shares cannot be issued out of the reserves created by revaluation of fixed
assets.
 If the existing shares are partly paid up, the company cannot issue Bonus Shares. It
will be appropriate to first make the shares fully paid up before issuing Bonus Shares.

Chapter –10 Page - 4 -

 It should be ensured that the company has not defaulted in payment of interest or
principal in respect of fixed deposit and interest on existing debentures or principal.
 It should be checked whether Articles of Association contains the provision of
capitalization of reserves. If no such provisions are contained steps should be taken
by altering the Articles of Association by the consent of the members of the company
 It should be checked whether the post bonus capital is within the limits of authorized
share capital. If it is not so, steps should be taken to increase the authorized share
capital by amending memorandum and articles of association.
 All the shares so issued by way of bonus will rank pari-passu with the existing shares.
The company cannot create any other rights for the bonus shares.

10.3.4 Bonus Issue and Stock Split

Bonus Issue Stock Split

The par value of the share is unchanged.
A part of reserved is capitalized.
The shareholders’ proportional ownership
remains unchanged.
The book value per share, the earnings per
share, and the market price per share
decline.
The market price per share is brought
within a popular trading range.
A par value of the share is reduced.
There is no capitalization of reserves.
The shareholders’ proportional ownership
remains unchanged.
The book value per share, the earnings per
share, and the market price per share
decline.
The market price per share is brought
within a more popular trading range.

10.4 HOW DOES COMPANY DECIDE ON DIVIDEND

PAYMENT
In mid 1950 John Lintner conducted a survey and interviewed managers and asked them
questions with regard to dividend policy of the company1. His description on how
dividends are determine can be summarized as

1. Managers are reluctant to make dividend changes that might have to be reversed and
so even in situations of higher earnings they do not increase the dividend per share
substantially they will do so only if they are very sure that a higher earnings can be
maintained in future. For adjusting a current earnings they use a adjustment factor.
2. Mature companies with stable earnings have a tendency to pay high proportion of
earnings and young companies which have future investment proposals at end do not
pay dividends but prefer to retain and reinvest into the business.
3. Managers do not focus on dividend amounts but they focus more on percentage
change in dividend because if in the previous year Rs. 5 was paid as a dividend and in
this year Rs. 10 are paid which is an increase of 100 percentage this change will give
a signal to the market that the company is cash rich and in the next year also same

1
J. Lintner, “Distribution of Income of Corporations among Dividends, Retained Earnings, and Taxes,”
American Economic Review 46 (May 1956), pp. 97 – 113 and Terry A. Marsh Robert C. Merton,
“Dividend Behavior for the Aggregate Stock Market”, Journal of Business 60 (January 1987), pp. 1-40

Chapter –10 Page - 5 -

 kind of increase may be there which may or may not hold true. So managers try to
smooth dividends and do not allow transitory earnings to affect the dividend. Lintner
developed a model based on these facts and explained dividend payment as

D1 = Dividend at the end of year one

D0 = Dividend paid in the current year
D1= Target dividend =Target ratio * EPS1

Dividend change = D1-D0 = Target change = (Target ratio*EPS1)-D0

Since the managers do not pass on transitory earnings affect on the dividend they will
like to control the EPS1 in the above formula so that target change is not affected by
change in EPS1 and so they will use an adjustment factor (A1).

D1-D0 = Target change

D1-D0 = Target change*Adjustment factor
D1-D0 = Adjustment factor* (Target ratio*EPS1)-D0

Lintner model suggests that dividend depend in part on firms current earnings and firms
dividend in the previous year, which in turn depends upon earnings in that year and
dividend of the previous year. Therefore, Lintner described dividend in terms of
weighted average of current and past earnings. We will test the model on few companies
in the later part of the chapter.

10.5 THEORIES ON DIVIDEND AND VALUE OF FIRM

1. Modigliani and Miller (MM) Hypothesis
2. Walter’s Model
3. Gordon’s Model

10.5.1 Modigliani and Miller (MM) Hypothesis

Modigliani and Miller gave argument in support of irrelevance of dividend based on few
assumption they proved that dividend policy do not affect share price. According to them
it is the investment policy through which the firm can increase its earnings and value of
firm2

10.5.1.1 Assumptions

-Perfect Capital Market in which all investors are rational, information is freely available,
no transaction cost, securities are divisible, no investor is large enough to influence the
market.
-Absence of Tax
-No discrimination between dividend Income and Capital Appreciation
2
Miller, MH and Modigiliani, ‘Dividend Policy, growth and the valuation of shares’, Journal of Business,
October 1961, pp. 441-33

Chapter –10 Page - 6 -

-Required Rate of Return is measurable and constant

When dividend is paid Market Price of the share falls by the amount equivalent to
dividend. This happens because investor do not discriminate between capital
appreciation and dividend income.
Arbitrage process: It implies that the total market value plus current dividends of two
firms which are alike in all respects except D/P ratio will be identical. The individual
shareholder can retain and invest his own earnings as well as the firm would.

10.5.1.2 Proof of Arbitrage

Price of the share now is a function of dividend and price at the end of year one. This is
what we learnt in the chapter of cost of capital. Symbolically, it can be represented as

P0 = D1 +P1 (1)
(1+Ke)

P0 = 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 a share at the end of period 1

Now if we want to find the value of firm we need to multiply number of shares to the
price of share. The equation generate will look like

nP0 = nD1+nP1 (2)

(1+Ke)

Now the firm requires more funds and so it needs to issue new shares, which will be
denoted by (n). The above equation can also be re-written as

nP0 = (nD1 +(n+n)P1 -nP1) (3)

(1 + Ke)
If we solve the above equation nP1 will be cancelled and the equation will be equivalent
to the second equation.

If the firm wants to finance its investment proposals the total amount to be raised through
new shares can be calculated as:

nP1 = I – (E-nD1)
nP1 = I – E+nD1

I= Investment Required
E= Earnings of the year
nP1= is the Amount to be raised for financing some future project
nP1 = Investment – Retained earning

Chapter –10 Page - 7 -

 nP1 = I – (Earning – nD1)
nP1 = I – E + nD1

Now if we substitute nP1 in equation no. 3 we get:

nP0 = (nD1 +(n+n)P1 – (I – E + nD1)) (4)

(1 + Ke)

Solving the above equation we get:

nP0 = nD1 +(n+n)P1 – I + E - nD1 (5)

(1 + Ke)

nP0 = (n+n)P1 – I + E (6)

(1 + Ke)

In equation 6, what we see is that the value of the firm is the function of future price,
amount required for investment and earnings; nowhere we see dividend as a component
in determination of the value of company and so MM proves that dividend does not affect
value of firm.

Illustration 1

Lets take an example of a company known as XYZ Ltd. which has a capitalization rate
of 10%. It currently has outstanding 50,000 shares of 100 each. The management wants
to declare a dividend of 5 per share at the end of financial year. It expects to have an
income of 3.5 lakh and has a proposal for investing Rs. 7 lakh in a new project. Calculate
the value of firm according to the MM approach if the company pays dividend and do not
pay any dividend.

Solution

Value of firm when company pays dividend

P0 = D1 +P1
(1+Ke)

100 = (5+P1)/1.1
110 = 5+P1
P1=105

Amount required to be raised = nP1 = I – (E-nD1)

=700,000- (350,000-(50,000*5)
= 600,000

Chapter –10 Page - 8 -

Number of shares to be issued = 600,000/105 = 5,714.28

So, value of firm = nP0 = (n+n)P1 – I + E

(1 + Ke)

(50,000 + 5,714.28)105 – 700,000 + 350,000

1.1
= 5,000,000

Lets look at the value of firm if the company does not pay dividend

P0 = D1 +P1
(1+Ke)

100 = (0+P1)/1.1
110 = P1

Amount required to be raised = nP1 = I – (E-nD1)

=700,000-(350,000-0)
= 350,000

Number of shares to be issued = 350,000/110 = 3,181.81

So, value of firm = nP0 = (n+n)P1 – I + E

(1 + Ke)

(50,000 + 3,181.81)110 – 700,000 + 350,000

1.1
= 5,000,000

This concludes that the value of firm remains unchanged whether the company declares
dividend or not.

10.5.1.3 Critique

Under the assumptions the conclusion derived from the theory are justified but if we look
towards the assumption we find that none of the assumptions holds true in practice.

1. Floatation Cost

MM argues that internal financing and external financing are equal. It does not hold true
because whenever a company has to raise money from the market there is a cost involved
with regards to printing the prospectus, legal fees, agency cost, etc. Whereas, if we do not
pay dividends and retain the amount for future investments this cost is not incurred. So,
internal and external financing cannot be equal.

Chapter –10 Page - 9 -

2. Transaction Cost

If the shareholder is not paid any dividend, according to MM the new share price will be
equivalent to P0 + D which means that the shareholder can sell the share and get his
principal and dividend back. In practice this does not hold true because when a person
sell a share there will be dematerialization and brokerage charges so his assumption that
transaction cost does not exist is not valid.

3. Dividend Tax System

MM assumes that there are no taxes and if there are dividend and capital gain taxes are
equal and so the final result will not be affected. If we look at the system of taxing
dividend and capital gains in India, this assumption does not hold true. In India, dividend
is free in the hands of shareholders but the company is liable to pay dividend tax before
issuing dividend warrants. Rate of capital gain taxes in India is only applicable when an
investor sells the share. The method of Indexation is also applicable if the holding period
is more than 3 years and the rate of capital gain tax is also different from the income tax
rate. Does the taxation system create a conflict between shareholders and company? In
the financial year 2002-03, the system of taxing dividend was entirely different. During
that period, companies did not prefer distributing dividends because the companies were
also supposed to pay 10% as dividend tax and if the investor is in the higher tax bracket
he was supposed to pay the differential.

System of taxing shareholders is different in different countries and so the assumption of

Modigliani and Miller does not stand.

10.5.2 Walter’s Model

Professor James E. Walter theory is known as the theory of relevance because according
to him dividend policy always affect the value of firm3.

10.5.2.1 Assumptions

1. Internal financing: Where a firm is assumed to finance all its requirements

through retained earnings
2. The firm’s rate of return (r) and cost of capital (Ko) remains constant and the
business risk do not change.
3. Firm has perpetual life.

According to Walter model price is a function of Present Value of flow of dividend

stream with infinite life, so he starts with the share valuation model and defines
Price/Value as.

3
Walter, James E., Dividend Policy: Its Influence on the Value of the Enterprise, Journal of Finance, 18
May, 1963.

Chapter –10 Page - 10 -

 D1
P0  (1)
Ke  g

P0 = Price of the share today

D1 = Dividend
Ke = Cost of equity capital
g = Expected growth rate where, growth rate can also be defined as
Retention Rate * Return on Investment
r = ROI
P = Change in price

D1
Ke  g (2)
P0

Growth can also be measured as P / P. Now after substituting growth we get

D1 P
Ke   (3)
P0 P

Since Retention = Earnings – Dividends, P can also be defined as

P 
r
E  D 
ke

After substituting the value of P in equation 3 we get

r
D ( E  D)
K e Ke (4)
P

r
D ( E  D)
P Ke (5)
Ke

10.5.2.2 Criticism

Walter model is useful in determining value of firm with regards to its dividend policy
but assumptions of Walter model do not hold true.

1. Internal financing: Walter mixes dividend policy with investment policy and so he
assumes that investment opportunities are only financed by retained earnings
which automatically leads us to conclude that we cannot take any project in which
investment is more than the retained earnings.

Chapter –10 Page - 11 -

 2. He also assumes the return on investment and cost of capital to remain constant,
which does not, holds true because if the company undertakes a project with a
higher profitability the ROI of the firm will definitely increase.

Illustration 2
Let us work out the value of share of a company who’s EPS is Rs. 20 and has a Return on
investment of 20%. Ke of the XYZ Ltd. is 15%.

If the return on investment is expected to be 8% in future what is the value of share and
what should be the firm’s dividend policy, if the return on investment is equal to the cost
of equity ?

Solution
We have built a model based on the formula given by Walter, in cell no. B7
=((B6+($B$3/$B$4)*($B$2-B6))/$B$4), now we can experiment with various values of
Ke to calculate the value of share.
If ROI is 20% then the value of share, is as shown in the exhibit below.

Exhibit 10.1

When ROI is 8% then the value of share works out to.

Exhibit 10.1

10.5.2.3 Analysis

When the ROI is greater than the Ke it is in the interest of the shareholder that the
company retains the money as they can earn a better rate, and so we find the value of
share is maximum when the company retain the full amount as is shown in the first
exhibit.

Chapter –10 Page - 12 -

The reverse also holds true if the company cannot earn the value of the shareholder will
be maximum if the company pays them the full amount as dividend.
If the ROI and Ke are same the value of the share will not be affected.

10.5.3 GORDEN MODEL

Professor Gorden theory is also known as the theory of relevance because according to
him dividend policies always affect the value of firm4.

10.5.3.1 Assumptions

1. Firm is an all equity firm and it employees no debt.

2. ROI & Ko are measurable and will remain constant throughout the life.
3. Firm has perpetual life.
4. Taxes do not exist.
5. Discount rate is always greater than the growth rate in order for the suggested model
to work.
6. Formula will cease to work if 100% Retention is done by the company, it means that
dividend has to be paid.

E (1  RR )
P
ke  g

Where,

P = Price of a share
E = Earnings per share
RR = Retention ratio
Ke = Capitalization rate
g = Expected growth rate of earnings, growth rate can also be defined as
Retention Rate Return on Investment

Illustration 3

The following information is available in respect of the rate of Return on Investment

(ROI), the capitalization rate (Ke) and earnings per share (EPS) of Hypothetical Ltd.
EPS is Rs. 20 and has a Return on investment of 16%. Ke of the Hypothetical Ltd. is
15%.
Calculate the value of share if the dividend payout ratio is 10%, 25% 50% and 75%,
What should be the policy of the company and value of share?

4
Gordon, Myron J., The Investment, Financing and Valuation of Corporation, Richard D. Irwin, 1962.

Chapter –10 Page - 13 -

Solution
In order to find the value of share given the level of retention and ROI we have inserted
the formula given by Gordon in cell no. B9 =($B$2*(1-B6))/($B$4-B8).

Exhibit 10. 2

As we can see value of the share is maximum Rs.333 when the company dividend payout
ratio is least, because company ROI is greater than the expectation of the shareholders

10.5.3.2 Critique

Gorden model holds true when all his assumptions are true. Lets look at the assumption
that discounting rate is always greater than the growth rate. It means that model will not
work for those companies with high growth rate. Practically there are many companies
who command a higher share price simply because of higher growth rate they possesses.

The second assumption that taxes do not exist is also not a valid proposition. His model
will also fail to work on companies, which have debt in their capital structure. Gorden
model conclusions are very similar to Walter model. Their assumptions are also more or
less similar and both suffer from same limitations.

10.5.3.3 Dividend communicate

As a classic argument in the financial theory on dividend MM concludes that how can a
investor benefit from a dividend when he is paid a Rupee out of the value of share. It is
logical that if a Rupee is paid from the company earnings the share price would go by the
similar amount but that do not happen because of the existence of taxes. Taxes change
the income preference of companies and investors. If the company’s dividend payout is
seemed to have exceeded market expectation the act causes the share price to rise
abnormally. This primarily happens because it leads the investor to anticipate higher
future dividend. So as a result some of the benefit of subsequent increase in dividend is
already transferred into the existing share price. The basic idea behind this market signal
is that the firm is able to generate cash surplus instead of the book surplus and the higher
payment will motivate the management to perform well to maintain its dividend and
avoid a dividend cut. The Lintner model also supports this point. Dividend also has the
advantage of simplicity and visibility. It really takes time and efforts to interpret about
the health of the company through its financial report but investors never fail to

Chapter –10 Page - 14 -

understand a dividend warrant. On the other hand there are companies like Microsoft the
world’s biggest company as measured by market capitalization, which pays no dividend
nor does the Berkshire Hathaway, the biggest investment company. Nor do hundreds of
the high-tech stars of NASDAQ, these companies have a growth potential and they look
down on dividends as Hallmark of old economy. These companies have a policy of not
paying out of the earnings and they resort to method of purchasing their own shares
(Buy-back). This results into pushing up the market price because there are lesser
number of shareholders. It is also used as an instrument of financial planning and fixing
a market price if the share is undervalued. This leads to a greater reward to shareholders
than dividend because Indian system, do not tax buy-back.
Few companies in India have also resorted to a new method where they issue bonus
debentures like Hindustan Lever Limited issue bonus debenture, carrying 9.7% interest
redeemable after 3 years in order to get rid of their cash reserves that could not be easily
deployed in business reported by, (Economic Times, “Why Pay Dividends, 6 march
2002).

Let us look at the dividend and earnings trend of top 10 companies in India based on
market Capitalization.

Graph 10.3
 EPS
DPS

ONGC

8000
PAT/Div.

6000
4000
2000
0
1997 1998 1999 2000 2001 2002
Years

Graph 10.4

Chapter –10 Page - 15 -

 HLL

2000
PAT/Div.
1500
1000
500
0
1996 1997 1998 1999 2000 2001
Years

Graph 10.5
Reliance

4000
PAT/Div.

3000
2000
1000
0
1997 1998 1999 2000 2001 2002
Years

Graph 10.6
Wipro

1000
PAT/Div.

500

0
1997 1998 1999 2000 2001 2002
Years

Graph 10.7

Chapter –10 Page - 16 -

 Infosys

1000
PAT/Div.

500

0
1997 1998 1999 2000 2001 2002
Years

Graph 10.8
IOC

4000
PAT/Div.

3000
2000
1000
0
1997 1998 1999 2000 2001 2002
Years

Graph 10.9
ITC

1500
PAT/Div.

1000
500
0
1997 1998 1999 2000 2001 2002
Years

Graph 10.10

Chapter –10 Page - 17 -

 SBI

3000
PAT/Div.

2000
1000
0
1997 1998 1999 2000 2001 2002
Years

Graph 10.11

Ranbaxy

300
PAT/Div.

200
100
0
7 97 98 98 99 99 00 00 01 01
-9 - - - - p- - - - -
ar ep ar ep ar ar ep ar ep
M S M S M Se M S M S
Years

Graph 10.12
ICICI

1500
PAT/Div.

1000
500
0
1996 1997 1998 1999 2000 2001
Years

Source: CMIE database Prowess.

Data of the graphs is available on the CD.

Well let us analyze the graphs of these 10 companies.

1. Earnings of all the companies are fluctuating.

2. Dividends flow of all the company’s is smooth and is not changing with the
change in earnings.

Chapter –10 Page - 18 -

 3. No company follows a policy of fixed dividend payout ratio. Although from the
graph of HLL we can say that the company has a constant payout ratio policy.

4. Gap between earnings and dividend payout is more, for Wipro, Infosys, ONGC,
Reliance, IOC and ITC if we compare it with other companies the reason is
evident that these companies have greater opportunities to invest and there
earning power is greater that other firms, so they are retaining more and investing
in the business.

5. Earnings for ICICI and Ranbaxy have fallen in the year 2002 yet they have
maintained the dividend flow perhaps they do not want to decrease dividend and
communicate to the market that they are not doing well, other reason can be that
the management feels that the earning of 2002 are effected by some abnormal
event and the company will recover soon.

10.6 EQUITY HOLDING PATTERN

Wipro
Company Name HLL ICICI I T C Ltd. IOC Infosys ONGC SBI Ltd
Holding Date 2003.03.31 2002.03.31 2003.03.31 2003.03.31 2003.03.31 2002.12.31 2003.03.31 2003.03.31
Promoters Share 51.56 0 0 82.03 28.42 84.11 0 83.9
Indian Promoters Share 0 0 0 82.03 28.42 84.11 0 83.9
Private Holdings Share 0 0 0 0 28.42 0 0 83.9
Govt. Holdings Share 0 0 0 82.03 0 84.11 0 0
Central Government Share 0 0 0 82.03 0 84.11 0 0
State Government Share 0 0 0 0 0 0 0 0
Govt. Others Share 0 0 0 0 0 0 0 0
Foreign Promoters /
Collaborator's share 51.56 0 0 0 0 0 0 0
Non-Promoters Share 48.45 100 100 17.97 71.58 15.89 100 16.1

All figures are in Percentage. Source CMIE Database.

Equity holding pattern is also a criterion while deciding on the payment of dividend as
the investor expectation is attached to the dividend payment, larger the number of
individual investor in the shareholding pattern larger will be the influence on share prices,
if there is a change in dividend flow.

Exhibit 10.13

Abstract of Chairman (Director) report when company report dividend.

Hindustan Lever Ltd.

Date: 2001.12.31. Chairman's Speech
Chairman speech for the year ended 31st December 2001.

Chapter –10 Page - 19 -

Net Profits have grown by over 25% to Rs. 1641 crores in 2001 with a corresponding
increase in earnings per share to Rs. 7.46 in 2001. Profits before depreciation, interest and
taxes (PBDIT) have risen by 16% to Rs. 2096 crores in 2001. Return on net worth has
increased to 53.9% in 2001.

Even by very conservative calculations, your Company's economic value added (EVA)
has risen by over 25% from Rs. 858 crores in 2000 to Rs. 1,080 crores in 2001. This
performance has been reflected in the increase in total dividend from Rs. 3.50 per share
in 2000 to Rs. 5.00 in 2001.
Signed on: 20th May 2002.

Infosys Technologies Ltd.

Date: 2002.03.31. Director's Report
Directors' report for the year ended 31st March 2002

Dividend:
An interim dividend of Rs. 7.50 per share (150% on par value of Rs. 5) was paid in
November 2001. Your directors now recommend a final dividend of Rs. 12.50 per share
(250% on par value of Rs. 5) aggregating Rs. 20.00 per share (400% on par value of Rs.
5), for the current year. The total amount of dividend is Rs. 132.36 crore, as against Rs.
66.15 crore for the previous year. Dividend (including dividend tax), as a percentage of
profit after tax from ordinary activities, is 17.01%, as compared to 12.01% in the
previous year.

Until March 31, 2002, the receipt of dividend was tax-free in the hands of the
shareholders, under the Indian Income Tax Act, 1961. Effective April 1, 2002, the
dividend income is proposed to be taxed in the hands of the shareholders and,
accordingly, is subject to deduction of tax, if any The tax on distributed profits, paid by
the company on the interim dividend was Rs. 5.06 crore. As per the proposed tax
regulations, there is no distribution tax on the profits distributed after March 31, 2002.

Increase in share capital:

Your company issued 28,013 shares on the exercise of stock options, issued under the
1998 and 1999 employee stock option plans. Due to this, the outstanding issued,
subscribed and paid-up equity share capital increased from 66,158,117 shares, during the
previous year, to 6,61,86,130 shares in the year under review.

Reliance Enterprises Ltd.

Date: 2002.03.31. Director's Report
11th directors' report for the year ended 31st March 2002.

During the year, the Company earned a profit of Rs. 6.17 crores (Previous Year Rs. 4.84
crores) mainly through Dividend income. Your Directors have not recommended any
dividend for the financial year under review.

Chapter –10 Page - 20 -

Oil & Natural Gas Corp. Ltd.
Date: 2002.03.31. Director's Report

DIVIDEND
Your Directors are happy to recommend a dividend of Rs. 14 per share for the year ended
31st March, 2002, absorbing Rs. 19,963.08 million.

10.7 CONSTRAINTS IN PAYMENT OF DIVIDEND

10.7.1 Liquidity

The payment of dividend means cash outflow. Although the firm may have adequate
earnings yet it may not have adequate cash to issue dividend warrants. Mature
companies are generally more liquid and they are able to pay a larger amount but young
companies need more amount for expansion and so they are reluctant to pay dividends.

10.7.2 Financial condition of the company

Financial condition refers to the structure of debt and equity employed by the company
and the potential of the company to raise funds. If a company is highly debt financed it
should try to retain the dividend and increase its equity base and on the other hand if the
company is not at all levered than it can pay dividends by raising money through
borrowings. If the company is not in a good position to borrow money because it already
has a huge amount of debt outstanding than it should retain and strengthen the equity
structure.

10.7.3 Legal restrictions

Dividend manner and time of payment is regulated according to the companies act 1956
section 205, 205 A, 205 B, 205 C, 206, 206 A and 207 and so the dividends have to be
paid without violating any of the above sections.

10.7.4 Control

When a company pays large amount as dividends it may have to raise funds by issuing
fresh equity or debt, which primarily means changing the capital structure and the
control. When the company is a closely held company the body of the shareholders is
small and the expectation of the shareholders is usually known, management can easily
adopt a policy and satisfy the shareholders. But when the structure is widely held it
becomes difficult to satisfy all the shareholders because their needs may differ depending
upon their earning level, purpose of investment, etc.

Chapter –10 Page - 21 -

10.7.5 Investment opportunity

If the company is a growing company then its financial needs are larger and investment
opportunities occur frequently and so they relate the dividend policy with the financial
policy. Under this situation as long as the company is able to earn a higher return than
the shareholder the company should retain the earnings.

Practice Question in Finance

Illustration 1

XYZ products have its shares quoted in Bombay stock exchange. The face value of the
share is Rs. 10 and the total paid up capital is Rs. 5,000,000. This year company paid a
dividend of 21% and the company is growing at the rate of 3%. If the expected return by
shareholders is 16%, calculate the share price investors are willing to pay.

Solution

21
Dividend distributed during the year = 5,000,000 *  1,050,000
100

1,050,000(1  0.03) 
 
 0.16  0.03

1,050,000(1.03) 
 
 0.13

1,081,500 
 =8,319,231 rounded up to 8,320,000
 0.13 

Number of shares = 5 lakh

 8,320,000
Value per share     16.64
 500,000 

Illustration 2

Details of ABC Company are as follows

Earning per share Rs. 4

Dividend per share Rs. 2.5
Internal rate of return 18%
Cost of capital 16%

Chapter –10 Page - 22 -

Calculate the share price using the Walter formula.

Solution

r
D ( E  D)
P Ke
Ke

0.18
2.50  (4  2.50)
 0.16   26.17
0.16

Illustration 3

The earning per share of the company is Rs. 8 and the cost of capital is 10% and the
company earns at the rate of 15%, it has two options, either to pay 50% dividend or 75%
dividend. Using Walter model determine the share price in both the cases.

Solution

r
D ( E  D)
P Ke
Ke

Share price when dividend paid out is 50%

r = Rate of return = 15%

d = Dividend = Rs. 8 * 0.5 = Rs. 4
ke = Cost of capital = 10%

P=(4+(0.15/0.10)*(8-4))/0.1
P=Rs.100
Share price when dividend paid out is 75%

r = Rate of return = 15%

d = Dividend = Rs. 8 * 0.75 = Rs. 6
ke = Cost of capital = 10%

P=(6+(0.15/0.10)*(6-4))/0.1
P= Rs.90

Chapter –10 Page - 23 -

Illustration 4

The beta of ABC Ltd. is 1.4, the company is growing at the rate of 8%, the dividend paid
this year is Rs. 4 per share and the return on gilt-edge securities is 10%. Return from the
share market is 15%. If the current market price of ABC is Rs. 36 should the share be
purchased?

Solution

Cost of equity using CAPM model is

=10% +1.4(15% -10%)
=17%

Using the dividend growth rate model, share price can be calculated as follows:

Ke = (D1/P0) + g

= 0.17 = ((4*1.08)/P0) + 0.08

4(1.08)
= P0 =  Rs.48
0.09

The ABC equity share is valued at an equilibrium price is Rs. 48 and its present market
value is at Rs. 36. Hence it is recommended to purchase at market price.

SUMMARY

Chapter –10 Page - 24 -

We have discussed theory of relevance and theories of irrelevance. We have also
discussed the Lintner Model, which is based on a survey of managers, and after looking
at the dividend and the earning pattern we can conclude that Lintner model is applicable,
but if the situations in the economy do not change the perception of the investor remains
same towards the dividend and the tax structure also remains same them a slightest
change in any of the following may result into a policy where a management may be
forced to cut down on dividend; a point where investors simply do not go by the
information content in the dividend and the moment managers are able to convince and
convey that reinvesting dividends is more profitable to the shareholders we may see the
pattern decrease in dividend will increase the share price.

We have also discussed the various ways in which a company can reward its
shareholders. We also know what issues affect the dividend policy of a company. In
practice we have discussed, the earnings and the dividend pattern of few companies from
which we could summarize that managers are reluctant to decrease the dividend per share
because of the concept of dividend signaling hypothesis. Managers are also reluctant to a
change in dividend with a change in earnings. We are also very clear that as long as the
company rate of earnings is more than the equity shareholders expectations there is no
point in passing the earnings to the shareholders. If a company earns Rs. 10 per share
and the PE Multiple in the industry is 10 then the Market Price of the share will go up by
Rs. 100 if the companies do not pay dividend. Now, if the investor is in the higher tax
bracket he would certainly prefer capital gains than dividend tax and would certainly like
the company to retain the money. So to sum up, what primarily determines the dividend
policy of the company is the form of organization, shareholding pattern, economic
condition, growth potential of the company, product life cycle and history of dividend
policy.

Web Based Exercise

Access the web sight www.hdfcsec.com and check out the details of any company you
wish to analyze, generate share price chart of that company and try to relate the share
price movement when the company declared dividend.

Problem Set

Chapter –10 Page - 25 -

Q1) In how many ways can a company pass on the benefits to there shareholders?

Q2) What are the theories of relevance and irrelevance do they make any sence, how
does company decide dividend in practice?

Q3) Can stock split be considered as a mechanism of passing dividend to shareholder

if not then why? When there are stock splits how does the market react to it?

Q4) Does the Lintner’s model apply to companies in India?

Q5) What does dividend communicate? What is dividend-signaling hypothesis?

Q6) “Right issues can be a mechanism to consolidate holding by the promoter” discuss
this statement in the light of right issues offered by more than 1100 companies
since 1991?

The list of companies is given on the compact disk attached with the book (source
CMIE Database)

Q7) Does the equity holding pattern have something to do with the dividend policy of
the company?

Q8) How are rights valued and why are they primarily offered?

Q9) A company offers a right issue of 1 share of Rs 100 at a premium of 20% for
every three shares held by the shareholder. The current market price is Rs 150.
What is the value of right.

Q10) “If a company is not paying dividend it means it is of no good” critically evaluate

Q11) When is it beneficial to issue bonus shares then to distribute cash dividend,
analyze this statement with reference to the data on bonus share provided on the
compact disk? (Source CMIE database)

Chapter –10 Page - 26 -