AA Dividend Policy (@) Stable dividend and (b) Residual dividend. The nature of these two types of dividend are discussed below : lal Stable Dividend : When dividend is paid by maintaining cor ency with the payment of dividends in past years, the dividend is called Stable Dividend. The stability of dividend can be maintained in the following three ways (i) (ii) Constant dividend per share : The stability of dividend can be maintained by paying, @ fixed dividend per share in each year. In such a case, whatever may be the earnings of the company, a fixed amount of dividend is paid per share in each year. So, in this case, even if the earnings of the company are fluctuated, the amount of dividend always remains fixed. 40 30 Earnings per share 20 Dividend per share <— Amount (Rs) —— ven ——— Constant percentage of dividend : The stability of dividend can be maintained by paying dividend at a fixed percentage. In such a case, a company pays dividend at a fixed percentage on its profits in each year. Though the percentage of dividend remains fixed in this case but the amount of dividend payment does not remain fixed. Because, incomes generally fluctuate year after year. So, the amount of dividend is proportionately changed with the change in incomes even if same rate of percentage is applied. Suppose, the rate of dividend payment is 80%. Now, let us see, what change takes place in the amount of dividend due to change in earnings— Re Bae eg ae Te of divatond | amount 4 aca 1 15 | 80% 15x f= 12.00 2 18 80% | 1x 8 = 1440 3 12 80% 12x ST = 9.60 4 20 80% 20 x fi = 16.00 It is clear from the above table that though the rate of dividend remains fixed but the amount of dividend is getting changed along with the change in earnings per share.Earnings per share 20 _ Dividend per share | 2 3 4 5 6 > Year > lend plus extra dividend: Sometimes the companies with fluctuating, earnings fix a small amount of dividend per share and pay an extra dividend on cach share with the increase in earnings. Here the payment involves a small constant dividend instead of paying, a maximum constant dividend on each share to its shareholders. If dividend is paid by a company in this way, the company can pay dividend regularly without default in one hand and in the other hand, it can encourage the shareholders by paying an extra dividend with the increase in earnings (ii) Small constant div: ings per sh 1 dividend share b. Residual Dividend + The central idea of residual dividend policy is that a firm will consider its profitable investment project. If the firm has opportunities of profitable investment project, it distributes residual profit as dividend after raissing necessary finance from the profit earned for investment in that project. In such a case, the dividend Which is distributed among the shareholders is called Residual Dividend. Thus, we can say, when a firm pays dividend from the residual profit after raising necessary finance out of the profit earned for investment in a profitable project available with it, the Sividend is called Residual Dividend. It can be mentioned in this context that if there are opportunities of profitable investment projects in the hand of a firm, the dividend payout ratio of the firm may be zero. On the other hand, ifthe firm is unable to find bat any profitable investment opportunities, the dividend payout ratio will be 100%.‘According to residual dividend policy, if there is any residual income after raising necessary finance from the net income of the firm for the new project, dividend is to be distributed from that residual income. Net income st Less: Required capital expenditure for new project a Residual income a Residual Dividend per share = Res Q Example 1 : Tirupati Ltd. expects to generate the following net income and incur following capital expenditure in the next five years : Year Net income (2) Capital expenditure (8) 7 Ist and 3rd 4th 5th + 1,60,000 3,80,000-—3,60,0004,60,000 400,000 + 1,80,000 —2,00,000—4,00,000—3,00,000—_2,00,000 The company has 40,000 outstanding shares currently on which it pays a dividend of € 4 per share. A. You are required to w determine the dividend per share if the company follows a residual dividend policy. (i) determine the amounts of external financing if the company decides to maintain current dividend. (iii) determine the dividend per share and the amount of external financing that will be required if a dividend payout ratio of 50% is maintained. (iv) determine the external financing if the company decides to raise dividends by 10% every tivo years. (v) identify under which of the above four policies the aggregate dividends are maximised and under which policy the amount of external financing is minimised. B. The company decided to finance its capital expenditure with Debt and Equity in the ratio of 1: 1. If the company follows the residual dividend policy, what will be the expected dividend stream under the following approaches ? (i) Pure residual dividend policy, (ii) Fixed dividend payout ratio. © Solution => A. (i) Statement Showing for Dividend per share and Amount of External Financing under Residual Dividend Policy Net Capital] Residual) External Dividend per share Years | income | expenditure | income financing ne (@ @ (0 @ @ Q) @) @ i) Ast 1,60,000 1,80,000 Nil 20,000 2nd 3,80,000 2,00,000 1,80,000 Nil jBefore paying such d ded by the vide ; recommended by ividend, the rate of dividend, which is went ering of the directors, is required to be » ue company. The shareholders tayafomee da ules holder anced by the directors oF May fecuce it but can never recommend higher rate Interim Dividend : When dividend is declared and paid partly to the eed trim De Preparation of final accounts for a financial year, the dividend is ee vidend. Such type of dividend is declared in between two annual general mee of the company. So, it is called interim dividend. Before declaration of such dividen : following considerations should be taken into account by the directors i (ii) (iii) The various assets have been properly valued. It is prudent to think of probable profits for the rest period and possibilit It shouldbe reviewed whether the payment of interim dividend will adversly afect the working capital of the company. - The rate of interim dividend should be in proportion to the expected final dividend. It is to be considered whether adequate amount of cash will be available for payment of interim dividend and after payment of such dividend, working capital may be reduced or nol. The directors, if so empowered by the Articles of Association, declare interim dividend after taking into consideration the above factors. However, the approval of Cental Government is necessary when it is proposed to pay interim dividend. Under the Companies Act, 1956, no company is allowed to declare and pay interim dividend without the approval of the Central Government Cash Dividend : The dividend which is paid in cash is called Cash Dividend. The shareholders have strong preference for cash dividend among different types of divi- dends. Cash generated by earnings is used to pay cash dividends. But poor performing, company often pays cash dividend by procuring required money by issuing new shares or taking loan from Bank. s of loss in future. (iv) () Bonus Dividend : Generally, dividend is paid in cash, But, sometimes new shares are issued to the shareholders as dividend instead of giving it in cash. The shareholders are not required to pay cash for this type of shares. When dividend is paid ch a way through issue of shares, it is called Bonus Dividend. Thus, in short, it can be said that awhen a company issues equity shares to its existing sharcholders in proportion to the number of shares held by them in lien of paying dividend in cash, the dividend is called Bonus Dividend. The payment of such dividend neither affects cash and earning capacity of the firm nor changes the ownership of the shareholders. The number of shares of the Shareholders increases as a result of paying dividend in such a way. So, the earnings per share is reduced. It can be mentioned in this context that the retained earnings and share capital both are the parts of the capital structure of the firm. So, when dividend is paid from the retained earnings through issue of shares, the amount of retained earnings decreases on the one hand and on the other hand, an equal amount of share capital increases, So, no change takes place in the capital structure of the firm, only an adjustment takes place init. As the capital structure remains unchanged, the cost of capital too remains unchanged. Scrip Dividend : The dividend which is paid through scrip or Promissory Notes is called Scrip Dividend. When there is temporary shortage of cash in the hand of a Company, the company pays such dividend through scrip or promissory notes to its Shuteholders, The date of maturity and the amount of dividend are mentioned in the scripFinancial Management or promissory notes. The shareholders collect their dividend at that date of maturity against their own scrip or promissory notes. But sometimes, the date of maturity is not mentioned in the scrip or promissory notes. In such a case, the payment of dividend is left to the discretion of the Board of Directors. But the scrip dividend has to be repaid within six months. It can be mentioned in this context that sometimes interest is paid on scrip or promissory notes due to delay in payment of dividend. Generally, such dividend is paid in the following circumstances— ()Inspite of having a lot of profit of a company but if it finds a temporary shortage of cash balance, still it has to pay such type of dividend. (i) Ifa company desires to maintain a continuity dividend record cvithout paying cash imme- diately, in that case the company may pay such dividend. (ii) When the financial managers consider that it will not be proper to take loan for paying dividend, then only they pay such dividend. Bond Dividend : Bond dividend is similar to the scrip dividend. But there is only one difference between the scrip and bond dividend is that the former carries short-term maturity period while the later carries long-term maturity. When a company pays dividend through long-term bonds instead of paying the same in cash, the dividend is called Bond Dividend, The company has to pay interest on the bonds for that period which remains unpaid. So, as a result of paying bond dividend, the company has to bear a fixed liability for paying annual interest on the bonds on the one hand and on the other hand, it has to bear long-term liability for the redemption of the bonds at the date of maturity. Property Dividend : When a company pays dividend in the form of property insteau of cash to its shareholders to the equivalent amount of dividend receivable by them, the dividend is called Property Dividend. Generally, such dividend is paid through the distribution of surplus assets of the company. Sometimes, a company supplies own product to its shareholders as such dividend. Again, the shares or debentures of the subsidiary company is used for paying such dividend Composite Dividend : When a company pays a part of the dividend receivable by the shareholders in cash and the other part in property, the dividend is called Composite Dividend. That is, the composite dividend is a mix of cash dividend and property dividend. Optional Dividen ‘ometimes, a company gives option to its shareholders to choose either cash or property against their dividend in lieu of paying composite dividend and the shareholders choose it as they like. When a company gives the opportunity of choosing either cash or property as dividend, the dividend is called Optional Dividend. It can be mentioned in this context that according to section 205(3) of the Indian Companies Act, dividend must be paid in cash. But bonus dividend is exception of this section. The Indian companies can pay final dividend and interim dividend but they can never pay scrip dividend, bond dividend or composite dividend.NAAM Dividend Policy Final Dividend ediiet ise Interim Dividend — Cash Dividend ~~ Bonus Dividend TYPES OF DIVIDEND Serip Dividend Bond Dividend Property Dividend Composite Dividend Optional Dividend [I Determinats of Dividend Policies The factors determining the dividend policy can be classified into two categories, such as—a. Financial factors and b. Legal factors. These are discussed below : a. Financial Factors : The factors relating to money which are concerned with the distri- bution of dividend are called Financial Factors of determining the dividend policy. These are discussed below ZA iw Stability of dividend : The stability of dividend refers to maintain consistency among the distribution of dividends in different years. In case of determining the dividend policy, the amount of dividends is required to be fixed in such a way that it is possible G to maintain stability among the distribution of dividends in different years, because the shareholders prefer stable dividend to fluctuating one. In order to maintain stability of dividends, a stable income is needed. But it is not possible for a firm to eam a definite amount of income in each year. So, it is necessary to form a dividend equalisation fund in order to maintain the stability of dividend. (ii) Need for expansion and development : The dividend policy has to be determined in such a way so that future expansion and development of the business argiijpt adversely affected. If a firm considers long-term growth, then it sets aside a pale! the profits without distributing the entire profits as dividend. Cash reserve is absolutely necessary for long-term growth. The more is the outflow of cash through the distribution of dividend, the slower is the speed of expansion of the business. So, every company has to determine the dividend policy in such a way so that its future development and expansion are not hampered. (iii) Repayment of long-term loan : If the rapid expansion of the business is needed, then it is not enough to depend only on the retained earnings only. In such a case, it is necessary to take long-term loan from external sources in order to make quick financing for the required funds. If any of such type onl of long-term loan is reguivea(iv) (v) (vi) (vii) (viii) e (ix) rovision will be made for to be repaid frat or ihe matter of repaying it before declaration of the long-term loan in Contractual Restricti business profits, then necessary P! dividend. So, it is necessary to consider # a .d policy: case of determining the dividend p* Wy ginstutions issued ion : Sometim -term loan prov’ to a company in such a condition tale company could not pay dividend more than a certain rate until the entire amount of loan is repaid. So, if a company ae ek ae a condition, then it must fulfil the conditions of that contract at the time ulating the dividend policy. tnflow and outflow of cash : According to section 205 (3) of the a dade . dividend should be paid only in cash. So, at the time of determining the ¢ Policy, the cash position of the company should be duly considered. If it is found that the outflow of cash is more than the inflow, then conservative dividend policy should be followed. On the other hand, if itis found that the inflow of cash is more than the outflow, then in that case, liberal dividend policy may be adopted. Position of working capital : It is not possible to distribute more amount of dividend for those companies which require a large amount of working capital inorder to meet their day-to-day activities. Because if more amount of dividend is distributed, then the position of the working capital becomes week due to the decrease of cash balance. Again, if the amount of cash which is needed for paying dividend is prcured by the issue of shares or debentures, then it may not be possible to procure additional capital at the time of expansion of the business in future. So, the amount of cash which is needed for paying dividend is to be procured from the working capital. For this, the dividend policy is to be determined by keeping an eye on the necessity and amount of the working, capital. Financial position of the company : If the financial position of a company is solvent and its capital structure is quite sound, then it can adopt liberal dividend policy. On the other hand, if the financial position of a company is not solvent and its capital structure is weak, then it should adopt conservative dividend policy. So, before distribution of dividend, the financial position of the company should be duly considered. Age of the company : A good number of companies have been established in view of their business for long long years. For these companies a liberal dividend policy may be adopted. But those companies which have just started business or started a few years ago, should adopt the conservative policy relating to the payment of dividend until an adequate amount of reserve is created. As such, the age of the company is also a matter of consideration in deciding the policy of dividend. Reaction of the shareholders : Every company has to incur a huge amount of preliminary expenses under different heads at the initial stage of its formation. So, in case of a new company, declaration of dividend for the first few years may not be necessary because the shareholders do not hesitate to sacrifice it spontaneously for the growth and expansion of the business. But they must expect a'fair dividend from the company in the subsequent periods. Again, if the current rate of dividend decreases or if the payment of dividend is postpond, then dissatisfaction is created in the minds of the shareholders which may play a bad reaction in the market. So, no such dividend policy should be adopted so that an adverse reaction is created among the shareholders. For this, the management should have to consider as to the reaction of the shareholders for distribution of dividend.‘ 5 (xi) (xii) (xiii) (xvi) Tax Policy of the Government : The government u: (x) Need for capital collection : Ifan existing company wants to raise additional capital by issuing new shares, then these shares are sold only at that time when the investors find that the company is paying dividend ata satisfactory rate. So, the dividend policy 's to be fixed in such a way so that the company does not have to face any problem in the procurement of capital in future, if it is necessary. Market price of share : The goodwill of the company increases alongwith the increase in market price of the shares. Moreover, when the demand for share increases, only then the market price of share increases. The companies which pay dividend regularly at'@ comparatively high rate, the demand for shares of those companies is very high. This facts lead to rise in market price of share. For this, the dividend policy is required to be fixed in such a way so that the market price of the shares will increase. Profitable investment opportunities : If there is profitable project in the hand of a company, then it should give more importance on the creation of reserves by increasing the amount of retained earnings than the payment of dividend. Because, the additional capital which is needed to implement the project can be financed from ‘such reserves. For this, at the time of distribution of dividend, every company has to consider the availability of profitable investment opportunities. Regular dividend payment : Though the goodwill of a firm can be increased with the increasing the rate of dividend but if it is not possible to maintain such increased rate, then the goodwill of the firm is deteriorated. So, every firm should determine its dividend policy in such a way so that the dividend can be paid regularly without increasing the rate of dividend unnecessarily in order to keep intact the goodwill of the firm. (xiv) Capital Market : Sometimes the dividend policy of a firm depends on the possibility of entrance in the capital market. The financially strong firms can easily take the advantages of this situation. So, they can easily procure the additional capital, if it is necessary. They do not face much problem even if they adopt liberal dividend Policy in the case of distribution of dividend. On the other hand, the possibility of taking the advantages of entrance in the capital market for the financially weak firms is less. So, if they need additional capital, they are to depend on the internal source. For this, these types of firms should transfer a good portion of undistributed profit to the reserve funds by distributing less amount of dividend. (xv) Government Economic Policy : The government of each country generally follows a few economic policies in order to strengthen the economic systems. As for instance, inorder to encourage in the capital formation of the country, the Government may impose certain restrictions in the distribution of dividend. Again, sometimes the Government may fix maximum rate of distribution of dividend. So, the financial managers have to consider the financial policies adopted by the Government in the case of distribution of dividend. sually charges taxes on the incomes of the company. The higher the rate of tax will be, the higher the amount of profit will be required to pay the tax. So, a negligible portion of the profit will be available for transfer to the reserve fund or payment of dividend. On the other hand, if the rate of tax is low, then sufficient amount of profit will be available for the creation of reserve fund. So, the dividend policy of a company depends also on the tax policy of the government. EM.-55en a (xvii) Pete Of the Industry : In case of public utility anda linen Oat e Se me for regular and assured income. So, in this case, the manage! ‘ein and consistent dividend policy. Whereas, the income of those concerns whik oe ' engaged in the production of luxury and fashionable products, is fluctuating. a conservative policy should be adopted regarding the distribution of dividend. Thus, while the distribution of dividend, the nature of the concerned industry should be considered, (xvii) Trade cycle : It is necessary to create sufficient amount of reserve during the growth of business so that it is possible to create a confidence among the shareholders regarding company by giving dividend at a comparatively high rate by using that reserve during the period of depression. So, it is necessary to distribute dividend at a low rate during the growth period and at a comparatively high rate during the Period of depression. So, at the time of determining the dividend policy, every company has to consider the above fact relating to the trade cycle. (xix) Inflation : Inflation increases the replacement cost of assets. As a result, the fund which is created by charging depreciation on assets may be insufficient for the replacement of assets at the end of their life. So, itis necessary to create more amount of reserves by reducing the rate of dividend during the period of inflation. Again, as depreciation is charged on the historical cost of assets, the amount of depreciation so charged on assets is less during the period of inflation. As a result, profit of the firm increases. Again, if dividend is paid out of this increased profit, then there is a possibility of erosion of capital. So, it is necessary to increase the amount of retained earnings and decrease the dividend payout ratio during the period of inflation. Thus, the financial managers should consider the fact of inflation at the time of formulating the dividend policy. (xx) Control by the existing shareholders : If new shares are issued, then the controlling capacity of the existing shareholders in the management system of the company is diluted. So, when the managers of the company want the controlling capacity to retain in the hands of the existing shareholders, they refrain from the issue of new share. For this, the management of a company keep their attention in creating reserve fund by lower down the rate of dividend in which they do not have to depend on the issue of new shares for procuring additional capital. So, while determining dividend policy the controlling capacity factors should be taken into account. : b. Legal Aspects : The affairs of each company is controlled by the Companies Act. There are some rules and regulations regarding the payment of Dividend in the Companies Act. Every company has to determine the dividend policy by considering the rules and regulations of the Companies Act. These rules and regulations are— (i) Source of divisible profit : Dividend is to be paid out of the profits arrived at after providing for depreciation. Money received as a guarantee from the government may be used for the payment of Dividend. [Section 123(1), 2013] (i) Arrear depreciation : If a company has not provided for depreciation for any year ‘or years or has provided less amount, then the company will have to determine the divisible profit after deducting the arrear depreciation from the current year's profit or past profits. [Rule 5, 2015) (iii) Past losses : Dividend can not be distributed from the current profit without writing off the past losses. [Section 123(1), 2015 (Ammended)] (iv) Cash Dividend : Dividend is to be paid only in cash. [Section 123(5), 2013](v) (vi) (vii) (viii) (x) (x) Dividend Policy {f it or Mode of payment : Dividend can be paid in cheque or in dividend warran through Electronic Mode. [Section 123(5), 2013] th Time limit : Dividend is to be paid or the Dividend Warrant is to be sent to the shareholders within 30 days from the data of declaration of Dividend. [Section 127, 2013) : Receiver : Dividend is to be paid either to the registered shareholders or to his order or to his banker. [Section 123(5), 2013] Transfer to Reserve : Before declaration of Dividend, a company will have to transfer appropriate amount of profit to Reserves of the company. [Section 123(i), 2013] Dividend from Reserves : Owing to inadequacy or absence of profits in any financial year, a company can declare Dividend out of the accumulated profits earned by the company in previous years. [Section 123(i), 2013] Paid up value : Dividend is to be paid only on the paid up value of the shares, But it can not be paid on calls-in-advance in any case.Management gain. It has been stated previously that the part of earnings of the a eel : rivitatan among the shareholders is called Dividend. On the other hand, the valle of shail 60 ENraséd as a result of increase in the net worth of the firm in the long-run is a pi 7 ean. the firm retains more amount of retained earnings in the hand by —, eal ee a ane capacity in the long-run, then the net worth of the firm will increase. As a 1080) © Yt Value of shares will increase. Now, dividend is the part of current incomes to the Sinieetrs and they do not have to pay any tax on it, On the other hand, capital gain is @ ong-t°1™ el which depends on uncertain situation of the future market, Moreover, ax is payaple en he capil Bain So, the shareholders, generally, prefer cash dividend to the capital gain. For this, f Han be said from the view point of the shareholders that the rate of dividend should be more and the amount of retained earnings should be less. Now, Iet us see, from the view-point of the firm, how much should be the amount of retained earnings. If a firm has profitable investment opportunities, then it will retain more amount of retained earnings in hand and pay less amount of dividend, On the other hand, if a firm does not have any profitable investment opportunities, then it will pay more amount of dividend and retain less amount of retained earnings in hand. So, at the time of distributing dividend, a firm must consider the availability of profitable investment opportunities. So, in case of determining the dividend policy, the management has to consider the interest both of the shareholders and firm The objective of distribution of dividend is to maximise the value of the firm. Maximisation of value of the firm means rise in the market price of the share. There is a difference of opinion among the experts whether dividend helps to rise the market price of the share or not. Some experts consider that dividend reacts positively on the value of the firm, but other consider that it does not. Walter, Gordon and other management experts have shown through their model that the value of the firm depedns on the amount of dividend. On the other hand, Modigliani and Miller have shown through their model that the value of the firm does not depend on the amount of dividend. These models are discussed below. Walter’s Model According to Prof. James E. Walter, the value of the share of a firm depends on its dividend policy. Prof. Walter explains the relationship between the internal rate of return (r) and cost of capital (k) of the firm through a model by which he shows that how the dividend policy affects the value of the share (i., the wealth of the shareholders or the value of the firm). Assumption of the Model : Prof. Walter's Model is based on the following assumptions Firstly, the firm does not issue any new share or debenture. Secondly, it makes additional financing through the retained earnings. Thirdly, its internal rate of return (r) and cost of capital (k) remain constant Fourthly, the firm either distributes its entire earnings as dividend or re-invests immediately as additional capital into the busine Fifthly, beginning earnings per share (E) and dividend per share (D) remain constant. The value of E and D may change in the model to determine results, but any given value of E and D are assumed to remain constant in determining a given value. Sixthly, the firm has an infinite life § Derivative of the Model : On the basis of the above assumptions, Walter shows that the value of the share of a firm is equivalent to the sum-total of the present values of the infinite stream of constant dividends and returns on retained earnings. That is, Value of each share = [ Present© dividend Policy value of the infii of : 7 infinite stream the retueng nite stream of constant dividends | + [ Present value of the infin i. retained earnings J. - low, the present value of the infinite stream of constant dividend = _2 D D = qa: + G+)" ay Ke G+K) * 1 1 Di qgamt+— TO Oe? Note that, — 1, ct 7 whose Ist term wk Woe SRE a to te summation ofa infinite G.P. Series peas TH M4 common ratio= ——1__,—1 21 ’ G+ 0+ T+ We know that the summation of an infinite G.P. Series = =—2tbeett gad ak i ae K D D K 2) Returns are obtained continuously from the second year on the retained earnings (E - D) of the first year. So, the present value of the returns which will be obtained in the subsequent years on the retained earnings of the first year would be (E=Dyr (B= Dr (E~ Dr | (+k) (+k) (+k) + Present value of the infinite stream of Constant Dividend = 2 — (+k) =(E-D)r (+k)? Nae aha Se + uw iS the summation of an infinite G.P. Series whose a+Kr G+KP +H | . 1st term = —1 and common ratio = Ry: (1 + Ky i hes gees 1 oe a+kr “Q+KP 0+Ke -wH I (+ ky 1 G@+ky_ 1 = geeks sk w+Financial Management assumed in this model, that the firm either distributes its entire earnings a pemreee tt al capital into the business. This assumption dividend or ploughs back it immediately as additic 0 is not correct. Because, according to section 123 of the Indian Companies Act, 2012 a portion P before declaring dividend. So, of the profits is to be transferred to reserve fund compulsorily fen it is not possible for the firm to distribute its entire profit as dividend. Again, if there is no profitable investment opportunities, then reinvestment of profit is not possible. In such a ness as additional capital situation, a firm never invests its entire profit into the bu: Fifthly, in case of determining the value of the share, no other factor is considered in this model except dividend and return on retained earnings. The value of share of a firm depends ‘on some other factors apart from dividend and return on retained earnings. As for instance, if the shareholders expect that the value of their shares will rise in the future, then the tendency of selling the shares will be less among them. In such a situation, the market value of the share increases. Again, if they apprehend that the value of their share will fall in the future, then the of selling the shares will be more among, them. In such a situation, the market value tendens of the share decreases, TEE Gordon’s Model According to Myron J. Gordon, the dividend policy of a firm affects the value of share of that very firm . dividends are relevant in the case of determining the value of share. He explains this fact with a model which is known as Gordon's Model. This model is based on the following assumptions — Firstly, all capital of the firm is comprised of Equity Capital only, i., there is no debt-capital in the capital structure of the firm. Secondly, the firm does not issue any new share. It makes additional finance through reinvestment of retained earnings. Thirdly, tax does not exist Fourthly, the internal rate of return (r) and cost of capital (K) remain constant. Fifthly, the growth rate (g) of the firm is the product of its retention ratio (b) and its internal rate of return (r) ie, g = br. It can be mentioned in this context that the percentage of earnings of the firm, which is retained in hand for ploughing back into the business without distributing as dividend, is called Retention Ratio. So, it can be said that if b is the retention ratio, then (1 — b) will be the dividend payout ratio. Sixthly, the cost of capital for the firm is greater than the growth rate, ie., K > G br). Seventhly, the firm has an infinite life ® Derivation of the Model : On the basis of the above assumptions, Gordon has shown that the market value of the share is equal to the present value of future stream of dividends to be received by the shareholders. How the value of the share is determined according to the Gordon's Model is shown below Suppose, earning per share on initial investment = F «: Dividend per share for the Ist year = E (1 ~ b), and retained earnings per share for the Ast year = Eb. [eas per share = Earning per share x Dividend payout ratio. So, dividend per share for the Ist year < EG ~ by Agsin, retained enmning per share = Earnings per share x Retention ratio. So, retained earnings Per share for the Ist yenr = Eb.”) Dividend Policy Fanings per share for the 2nd year (Earnings per share on initial investment) + (Barings on Ist year’s retained earings) = E+ Bor ~ Dividend per share for the 2nd year = (E + Ebr) (1b) = E (1 + br) (1 ~b), and retained camnings per share for the 2nd year = (E + Ebr) b. Famings per share for the 3rd year ~ (Eamings per share on initial investment) + (Earnings on Ist year's retained earnings) + (Earnings on 2nd year’s retained earnings) = E+ Ebr + (E+ Ebr) br E+ Ebr + Ebr + Eb’? E + 28br + Eb? = E(1 + 2br + br) E(1+ br)? Dividend per share for the 3rd year = E (1 + br)? (1 ~ b). ‘larly, dividend per share for the 4th, 5th ... year will be E (1 + br)? (1 ~ b), E (1 + br)! (1 ~ b) wanna. respectively. Now, if P be the market value of each share, then — P = (Present value of dividend per share for the Ist year) + (Present value of dividend per share for the 2nd year) + ( Present value of dividend per share for the 3rd year) + venue E(l-b) , EG + b-bd) , Ed + by? (-d) , (+k) (+k) or, P = E (1 ~b) 1+ by + isthe summation of an infinite THRs ae Ky Facet aes G.P. Series, whose Ist term = rao) and common ratio = y=Ry Note that, Now, we know that the summation of an infinite G. P. Series = =—2stterm —_— ea 0+ be) + BP “U4 a+ KP a+K?P esd (+R) ae =e by > We K-1 = 1- Gs a +k) 1 Creme a T+) | K- or) ~ K-OH| Financial Management 1 or, P=E(1—b)- K—bry