Dividend and Valuation

Dividends refer to that portion of a firm’s net earnings which are

paid out to shareholders. We will focus on dividends paid to ordinary
shareholders because holders of preference shares are entitled to a
stipulated rate of dividend. Since dividends are paid out of profits,
the alternative to the payment of dividends is the retention of
earnings/profits. The retained earnings constitute to easily accessible
important source of financing in investment requirements of the
firm. Thus retained earnings and cash dividends have got inverse
relationship between them: larger dividends, lesser dividends;
smaller retentions, larger dividends. Thus the alternative uses of
dividends and retained earnings – are competitive and conflicting.

The decision of financial management is that to choose between

distributing the profits to shareholders or to retain it in the business
keeping in view the ultimate goal of maximisation of shareholders
wealth.

There are however conflicting opinions regarding the impact of

dividends on the valuation of a firm. According to one school of
thought, dividends are irrelevant so that the amount of dividend paid
has no effect on the valuation of a firm. On the other hand, certain
theories considered the dividend decision as relevant to the value of
the firm measured in terms of the market price of the shares.

Irrelevance of dividends

General

The crux of the argument supporting the irrelevance of dividend to

valuation is that the dividend policy of a firm is a part of its financing
decision. As a part of the financing decision, the dividend policy of
the firm is a residual decision and dividends are a passive residual.

If dividend policy is strictly a financing decision, division of profits

between retained earnings and dividend will depend upon available
investment opportunities.

If a firm has sufficient investment opportunities it will retain its

earnings to finance them if not earnings would be distributed to
shareholders.

This relationship can be better understand in detail by taking k as a

cost of capital and r as return on investments.

(i) r > k = Retain earnings to finance investment projects.

(ii) r < k = Distribute dividends to shareholders.

The amount of dividend will fluctuate from year to year depending

upon the acceptable investment opportunities. With abundant
opportunities the dividend payout ratio would be zero. When there
are no profitable opportunities the D/P ratio will be 100.

Dividends are irrelevant is based on the assumption that investors

are indifferent between dividends and capital gains. So long as the
firm is earning more than the cost of capital the investors will not
have any problem with the retained earnings but if the return is less
than the cost of capital investors would prefer to receive the
earnings.

Modigliani and Miller (MM) Hypothesis

Modigliani and Miller maintain that dividend policy has no effect on

the share price of the firm and is, therefore of no consequence.
According to them what matters, is the investment policy through
which the firm can increase its earnings and thereby the value of the
firm. ‘Under conditions of perfect capital markets, rational investors,
absence of tax discrimination between dividend income and capital
appreciation, given the firm’s investment policy, its dividend policy
may have no influence on the market price of shares.’

Assumptions

 Perfect capital markets in which all investors are rational.

Information is available to all free of cost, there are no
transaction cost; securities are infinitely indivisible; no investor
is large enough to influence the market price of securities;
there are no floatation costs.
 There are no taxes. Alternatively there are no differences in tax
rates applicable to capital gains and dividends.
 A firm has a given investment policy which does not change.
The operational implication of this assumption is that financing
of new investments out of retained earnings will not change
the business risk complexion of the firm and, therefore there
would be no change in the required rate of return.
 Investors are able to forecast future prices and dividends with
certainty. This assumption is later on dropped by MM.

Crux of the argument

The crux of the MM position on irrelevance of dividend is the

arbitrage argument. The arbitrage process involves entering
simultaneously into two transactions which exactly balance or
completely offset each other. The two transactions here are the acts
of paying out dividends and raising external funds-either through the
sale of new shares or raising additional loans-to finance investment
programme; Assume that a firm has some investment opportunity.
Given its investment decision the firm has two alternatives:
If the firm selects the (ii) alternative, arbitrage process is involved, in
that payment of dividends is associated with raising funds through
other means of financing. The effect of dividend payment on
shareholders wealth will be exactly offset by the effect of raising
additional share capital.

When dividends are paid to the shareholders, the market value of

the shares will decrease. What investors gained as dividend would be
neutralised by the reduction in terminal value of shares. The market
price before and after the dividend would be identical. According to
MM the investors would then be indifferent between dividend and
retention of earning and as they are indifferent the wealth would not
be affected by the current and future dividend decisions of the firm.
It would depend entirely on the expected future earnings of the firm.

That investors are indifferent between dividend and retained

earnings implies that the dividend decision is irrelevant. The
arbitrage process also implies that the total market value plus the
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.

With dividends being irrelevant the firms cost of capital would be

independent of its D/P ratio.

Finally, the arbitrage process will ensure that under conditions of

uncertainty also the dividend policy would be irrelevant. When two
firms are similar in respect of business risk, prospective future
earnings and investment policies, the market price of their shares
must be same. MM argues it is because of the rational behaviour of
investors who are assumed to prefer more wealth then less wealth.
Differences in current and future dividend policies cannot affect the
market value of two firms as the present value of prospective
dividends and terminal value is the same.

Proof: MM provides the proof in support of their argument in the

following manner.

Step 1. The market price of a share in the beginning of the period is

equal to the present value of dividends paid at the end of the year
plus the market price of share at the end of the period.

Po = ( 1/1 + ke) (D1 + P1)

Where,

Po = Prevailing market price of the share.

Ke = Cost of equity capital

D1 = Dividend to be received at the end of period 1.

P1 = Market price of a share at the end of period 1.

Step .2. Assuming no external financing, the total capitalised value

of the firm would be simply the number of shares (n) times the price
of each share (Po). Thus

nPo = ( 1/1 + ke) (nD1 + nP1)

Step .3. If the firm’s internal sources of financing its investment

opportunities fall short of the funds required, and ∆n is the number
of new shares issued at the end of year 1 at price of P1, the above
equation can be written as:

nPo = ( 1/1 + ke)[( nD1 + (n + ∆n) P1 - ∆nP1)]

Where,

n = Number of shares outstanding at the beginning of the period.

∆n = Change in the number of shares outstanding during the
period/Additional shares issued.

Above equation implies that the total value of the firm is the
capitalised value of the dividends to be received during the period
plus the value of the number of shares outstanding at the end of the
period, considering new shares, less the value of new shares.

Step .4. If the firm were to finance all investment proposals, the total
amount raised through new shares will be –

∆nP1 = I – (E – nD1) or,

∆nP1 = I – E + nD1

Where,

ccP1 = Amount obtained from the sale of new shares of finance

capital budget.

I = Total amount requirement of capital budget.

E = Earnings of the firm during the period.

nD1 = Total dividends paid.

( E – nD1) = Retained earnings

According to above equation whatever investment need (I) are not

financed by retained earnings, must be financed by the sale of
additional equity shares.

If we substitute the above equation in the equation before that we

derive a new equation.

nPo = ( 1/1 + ke)[nD1 + (n + ∆n)P1 – (I – E – nD1)]

solving the above equation we get,

nPo = [nD1 + (n + ∆n) P1 – I + E – nD1]/( 1 + ke)

there is a positive nD1 and negative nD1, which gets cancelled. We

then have

nPo = [ (n + ∆n)P1 – I + E]/( 1 + ke)

Step .6. Conclusion: Since dividends are not found in the above
equation, MM conclude that dividends do not count and that
dividend policy has no effect on the share price.

Example:

A company belongs to a risk class of 10%. It currently has 25000

outstanding shares selling at Rs. 100 each. The firm is contemplating
the declaration of a dividend of Rs. 5 per share at the end of a
current financial year. It expects a net income of Rs. 250000 and has
a proposal for making a new investment of Rs. 500000. Show
according to MM approach, the payment of dividend does not affect
the value of the firm.

Solution:

(a) Value of the firm, when dividends are paid:

(i) Price per share at the end of year 1,
Po = (1/1 + ke) (D1 + P1)
Rs.100 = (1/1 + .10)(Rs 5 + P1)
Rs.110 = Rs 5 + P1
P1 = 105
(ii) Amount required to be raised from the issue of new shares,
∆nP1 = I – (E – nD1)
= Rs 500000 – (Rs 250000 – 125000) = Rs 375000
(iii) Number of additional shares to be issued,
∆n= Rs 375000/Rs. 105 = 75000/21 Shares
(iv) Value of the firm,
 nPo = [ (n + ∆n)P1 – I + E]/( 1 + ke)
=[25000/1 + 75000/21] (Rs 105) – Rs 500000 + Rs 250000
=Rs 2750000/1.10 = Rs 2500000

(b) Value of the firm when dividends are not paid:

(i) Price per share at the end of year 1, Rs 100 = P1/1.10

Or P1 = 110
(ii) Amount required to be raised from issue of new shares,
∆nP1 = (Rs 500000 – Rs 250000) = Rs 250000
(iii) Number of additional shares to be issued,
= Rs 250000/Rs 110 = 25000/11 shares
(iv) Value of the firm
= [25000/1 +25000/11] (Rs 110) – Rs 500000 + 250000
= Rs 2750000/1.1 = Rs. 2500000

Thus, whether dividends are paid or not the value of the firm
remains the same.

A Critique MM argue that the dividend decision of the firm is

irrelevant in the sense that the value of the firm is independent of it.

The crux of their argument is that the investors are indifferent

between dividend and retention of earnings. This is mainly because
of the balancing nature of internal financing and external financing.
Assumptions of MM are unrealistic and illogical in practice. As a
result the conclusion that dividend payments and other methods of
financing exactly offset each other and, hence the irrelevance of
dividends, is not a practical proposition; it is merely of theoretical
relevance.

The validity of MM approach can be questioned on two aspects:

 (i) Imperfection of capital market, and
(ii) Resolution of uncertainty.

MM assumes that capital markets are perfect. This implies that there
are no taxes; no flotation cost exists and there is absence of
transaction cost.

Tax Effect

An assumption of MM hypothesis is that there are no taxes. It

implies that retention of earnings and payment of dividends are,
from the viewpoint of tax treatment, on an equal footing. The
investors find both forms of financing equally desirable.

The tax liability of investors is of two types:

(i) Tax on dividend income.

(ii) Capital gains.

While the first type of tax is payable by investors when the firm pays
dividends, the capital gain tax is related to retention of earnings.
From an operational point of view capital gains tax is:

(i) Lower then tax on dividend income and

(ii) It becomes payable only when the shares are sold i.e. it is a
deferred tax till the actual sale of shares.

The types of taxes, corresponding to two forms of financing are

different although the MM position would imply otherwise. The
different tax treatment of dividend and capital gains means that with
the retention of earnings the shareholders tax liability would be
lower or there would be tax saving for the shareholders.

Flotation Costs
The another assumption of MM hypothesis is the absence of
flotation cost, according to MM given the investment decision of the
firm, external funds would have to be raised, equal to the amount of
dividend, through the sale of new shares to finance the investment
programme. The two methods of financing are not the perfect
substitutes because of flotation costs. The introduction of such cost
will imply that the net proceeds from the sale of new shares would
be less than face value of the shares, depending on their size. It
means that to be able to make use of external funds, equivalent to
dividend payments, the firm would have to sell shares for an amount
excess of retained earnings.

Transaction and Inconvenience Costs

Another assumption of MM which is questionable is there is no

transaction cost in the capital market. The no transaction cost
postulate implies that if dividends are not paid, the investors
desirous of current income to meet consumption needs can sell a
part of their holdings without incurring any cost, like brokerage and
so on. This is obviously an unrealistic assumption. Since the sale of
securities involves cost, to get current income equivalent to the
dividend, if paid, the investors would have to sell securities in excess
of the income that they will receive.

Institutional Restrictions

The dividend alternative is also supported by legal restrictions as to

the type of ordinary shares in which certain investors can invest. For
instance, the life insurance companies are permitted in terms of
section 27-A (1) of the insurance act, 1938, to invest in only such
equity shares on which a dividend of no less than 4% including bonus
has been paid for 7 years or for at least 7 out of 8 or 9 years
immediately preceding. To be eligible for institutional investment,
the companies should pay dividends. These legal aspects, therefore,
favour dividends to retained earnings. A variation of the legal
requirement to pay dividends is to be found in the case of mutual
funds. They are required in terms of the stipulations governing their
operations, to distribute at least 90% of its net income to investors.
The point is that the eligible securities for investment by the mutual
funds are assumed to be those that are on the dividend-paying list.

“Therefore, market imperfections imply that investors would like

the company to retain earnings to finance investment programmes.
The dividend policy is not irrelevant”.

Resolution of Uncertainty

Apart from the market imperfection, the validity of MM hypothesis,

insofar as it argues that dividends are irrelevant, is questionable
under conditions of uncertainty. MM hold, that dividend policy is
irrelevant under conditions of uncertainty as it is when perfect
certainty is assumed. The MM hypothesis is, however, not tenable as
investors cannot be indifferent between dividend and retained
earnings under conditions of uncertainty. This can be illustrated with
reference to following four aspects:

Near Vs Distant Dividend

One aspect of the uncertainty situation is the payment of dividend

now or at a later date. If the earnings are used to pay dividends to
the investors, they will get ‘immediate’ or ‘near’ dividend. If,
however , the net earnings are retained, the shareholders would be
entitled to receive a return after some time in the form of an
increase in the price of shares or bonus shares and so on. The
dividends may,then be referred to as ‘distant’ or ‘future’ dividends.
The crux of the problem is: are investors indifferent between
immediate and future dividends? Or they prefer one over the other?

According to Gordon, investors are not indifferent; rather they would

prefer near dividend to distant dividend. The argument that near
dividend implies resolution of uncertainty is referred to as ‘Bird in
hand’ argument. Since current dividends are less risky than
future/distant dividends, shareholders would prefer dividends to
retained earnings.

Informational Content of Dividends

According to this argument the dividend contains some information

vital to the investors. The payment of dividend conveys to the
shareholders information relating to the profitability of the firm. A
firm following a policy of constant dividends if increases its amount
of dividend it signifies that the firm expects its profitability to
improve in future and vice versa.

As said by Ezra Solomon:

In an uncertain world in which verbal statements can be ignored or

misinterpreted, dividend action does provide a clear cut means of
‘making a statement’ that speaks louder than a thousand words.

MM maintain that dividend policy is irrelevant as dividends do not

determine the market price of shares. They contend that value is
determined by the investment decision of the firm. All that the
informational content of dividends implies is that the dividends
reflect the profitability of the firm. They cannot by themselves
determine the market price of shares. The basic factor therefore is
not the dividend but expectation of future profitability.

The informational content argument also finds support as dividends

convey more significant information then what earnings
announcements do. Further the market reacts to dividend changes-
price rise in response to a significant increase in dividends and fall
when there is a significant decrease or omission.

Preference for Current Income

The MM hypothesis of irrelevance of dividends implies that in case

dividends are not paid, investors who prefer current income can sell
a part of their holdings in the firm for the purpose. But under
uncertainty conditions, the two alternatives are not on the same
footing because:

(i) The prices of share fluctuate so that the selling price is

uncertain, and
(ii) Selling a small portion of holdings periodically is
inconvenient.

That selling shares to obtain income, as an alternate of dividends

involves uncertain price and inconvenience, implies that investors
are likely to prefer current dividend. The MM proposition would
therefore, not be valid as investors are not indifferent.

Underpricing

The MM hypothesis would not be valid when conditions are assumed

to be uncertain because of the prices at which the firm can sell
shares to raise funds to finance investment programmes consequent
upon the distribution of earnings to the shareholders. The
irrelevance argument would be valid provided the firm is able to sell
shares to replace dividends at the current price. Since the shares
would have to be offered to new investors, the firm can sell the
shares only at a price below the prevailing price. It is fact that the
equilibrium price of shares will decline as the firm sells additional
stock to replace dividends. The underpricing or sale of shares at
prices lower than the current market price implies that the firm will
have to sell more shares to replace the dividend. The firm would be
better off by retaining the profits as opposed to paying dividends.

Relevance of Dividends

In sharp contrast to the MM proposition, there are some theories

that considered dividend decision to be an active variable in
determining the value of the firm. The dividend decision is therefore
relevant.

Walter’s Model

Walter’s model supports the doctrine that dividends are relevant.

The investment policy of the firm cannot be separated from its
dividends policy and both are, according to Walter interlinked.

The key argument in the favour of Walter proposition is the

relationship between the return on firm’s investment or its internal
rate of return (r) and its cost of capital or the required rate of return
(k).

 If r > k the firm should retain the earnings.

 If r < K the firm should distribute the earnings to shareholders.

Walter’s model, thus, relates the distribution of dividends to

available investment opportunities. If a firm has adequate profitable
investment opportunities, it will be able to earn more than what the
investors expect so that r > k. Such firms may be called growth firms.
For growth firms the optimum dividend policy would be given by a
D/P ratio of zero.

In contrast, if a firm does not have profitable investment

opportunities when r < k, the shareholders will be better off if
earnings are paid out to them so as to enable them to earn a higher
return by using the funds elsewhere. In such a case, the market price
of shares will be maximised by the distribution of the entire earnings
as dividends. A D/P ratio of 100 would be an optimum dividends
policy.

Assumptions of Walter Model

1. All financing is done through retained earnings, external

sources of funds like debt or new equity capital are not used.
2. With additional investments undertaken, the firm’s business
risk does not change. It implies that r and k are constant.
3. There is no change in key variables namely beginning earning
per share E, and dividends per share.
4. The firm has perpetual life.

According to formula:

P = (D + r/ke(E – D)/ke

Where,

P = The prevailing market price of a share

D= Dividend per share

R = The rate of return on firm’s investment.

Lets understand with the help of an example :

The following information is available in respect of a firm:

Capitalisation Rate (ke) = 0.10

Earnings per share (E) = Rs 10

Assumed rate of return on investments (r): (i) 15, (ii) 8 and (iii) 10.
We have to calculate the effect of dividend policy on the market
price of shares, using walter’s model.

Solution:

Dividend Policy and Value of Shares (Walter’s Model) when r = 15%

(a) D/P ratio = 0 (Dividend per share = 0)

P = (D + r/ke(E – D)/ke
P = [0 + (0.15/0.10)(10 – 0)]/0.10 = Rs. 150

(b) D/P ratio = 25 (Dividend per share = Rs 2.5)

P = [2.5 + (0.15/0.10)(10 – 2.5)]/0.10 = Rs. 137.50

(c) D/P ratio = 50 (Dividend per share = Rs 5)

P = [5 + (0.15/0.10)(10 – 5)]/0.10 = Rs. 125

(c)D/P ratio = 75 (Dividend per share = Rs 7.5)

P = [7.5 + (0.15/0.10)(10 – 7.5)]/0.10 = Rs. 112.50

(d) D/P ratio = 100 (Dividend per share = Rs 10)

P = [10 + (0.15/0.10)(10 – 10)]/0.10 = Rs. 100

Dividend (A) r= (B) r = 0.10 (r = ke)

% 0.8
(r<ke)
0 80 100
25 85 100
50 90 100
75 95 100
100 100 100
Interpretation
 1. When the firm is able to earn a return exceeding the required
rate of return that is, r > ke, the value of shares is inversely
related to the D/P ratio: as the payout ratio increases, the
market value of shares declines. Its value is the highest when
the D/P ratio is zero. So the optimum payout ratio is zero.
2. When the firm is able to earn return less than the required rate
of return i.e. r < ke that is, when the firm does not have ample
profitable investment opportunities, the D/P ratio and the
value of shares are positively correlated as the payout ratio
increases, the market prices of shares also increases. The
dividend policy is optimum when when the D/P ratio = 100%.
3. For a situation in which r = ke the market value of shares is
constant irrespective of the D/P ratio; there is no optimum D/P
ratio. This is a hypothetical situation. In actual practice, r and ke
are different and walter concludes that dividend policy does
matter as a variable in maximising share prices.

Limitations

(i) The model would be applicable only to all-equity firms as it

assumes that the firm’s investments are financed exclusively
by retained earnings; no external financing is used.
(ii) The model assumes that r is constant. This is not a realistic
assumption because when increased investments are made
by the firm, r also changes, and
(iii) The model also assumes that ke is constant whereas the risk
complexion of the firm has direct bearing on it. By assuming
the constant ke Walter’s model ignores the effect of risk on
the value of the firm.

Gordon’s Model
Another theory which supports the relevance of dividends is
Gordon’s Model. This theory as Walter’s also support that dividend
policy of a firm affects its value.

Assumptions of Gordon’s Model

1. The firm is an all equity firm. No external financing is used and

investment programmes are financed exclusively by retained
earnings.
2. Both r and ke are constant.
3. The firm has perpetual life.
4. The retention ratio, once decided upon, is constant. Thus, the
growth rate (g = br) is also constant.
5. Ke > br

Arguments

The assumptions of Gordon’s model are same as Walter’s model, the

crux of Gordon’s argument is a two-fold assumption:

1. Investors are risk averse, and

2. They put a premium on certain returns and discount/penalise
uncertain returns.

As investors are rational, they want to avoid risk. The payment of

current dividends completely removes any chance of risk. If firm
retains the earnings the investors can expect to receive a dividend in
future, but future dividend is uncertain in respect to the amount as
well as the timing. The investor being rational will prefer the current
dividend. The retained earnings are evaluated by the investors as a
risky promise, in case the earnings are retained, therefore the
market price of the shares would be adversely affected.

The above argument is also described as bird in hand argument i.e. a

bird in hand is better than two in the bush is based on the logic that
what is available at present is preferable to what may be available in
the future. Based on his model Gordon argues that the future is
uncertain and the more distant the future is the more uncertain it is
likely to be. If therefore, current dividends are withheld to retain
profits, whether the investors would at all receive them later is
uncertain. Investors would naturally like to avoid uncertainty. In fact
they would be inclined to pay a higher price for shares on which
current dividends are paid.

Symbolically the Gordon’s model can be expressed as:

P = E( 1 – b)/(ke – br)

Where,

P = Price of a share

E = Earnings per share

b = Retention ratio or percentage of earnings retained.

1 – b = D/P ratio i.e. percentage of earnings distributed as dividends

ke = Capitalisation rate/ Cost of capital

br = g = Growth firm = rate of return on investment of an all equity

firm.

Example:

The following information is available regarding a company:

Return on investment (r) = 12%

Earnings per share (E) = Rs. 20

Determine the value of its shares, assuming the following:

 D/P ratio (1-b) Retention ratio (b) Ke (%)
(a) 10 90 20 Dividend policy and
(b) 20 80 19 value of shares
(c) 30 70 18 (Gordon’s Model)
(d) 40 60 17
(e) 50 50 16 (a) D/P ratio = 10
(f) 60 40 15 Retention
(g) 70 30 14 ratio = 90
br(g) = 0.9 * 0.12 = 0.108

P = E( 1 – b)/(ke – br)

P = Rs. 20( 1 – 0.9)/(0.20 – 0.108) = Rs 2/0.092 = Rs. 21.74

(b)D/P ratio = 20

Retention ratio = 80 br(g) = 0.8 * 0.12 = 0.096

P = E( 1 – b)/(ke – br)

P = Rs. 20( 1 – 0.8)/(0.19 – 0.096) = Rs. 42.55

(c) 62.50
(d 81.63
)
(e) 100
(f) 117.65
(g) 134.62

Gordon thus, contends that the dividend decision has a bearing on

the market price of the share. The market price of the share is
favourably affected with more dividends.

Determinants of Dividend Policy

We will discuss the determinants of dividend policy of a firm in three
parts:

(i) Factors
(ii) Bonus shares (Stock Dividend) and Stock splits
(iii) Legal, procedural and tax aspects.

Factors

(a)Dividend Payout Ratio

(b)Stability of dividends

(i) Constant dividend per share

(ii) Constant payout ratio

(iii) Stable rupee dividend plus extra dividend

Why investors would prefer a stable dividend policy and pay a higher
price for a firm’s shares which observes stability in dividends
payments?

 Desire for current income.

 Informational contents
 Requirements of institutional investors

(c)Legal, Contractual, and Internal Constraints and Restrictions

Legal Requirements

 Capital impairment
 Net profits and
 Insolvency

Contractual Requirements
Internal Constraints

 Liquid Assets
 Growth Prospects
 Financial Requirements
 Availability of Funds
 Earning Stability
 Control

Owner’s Consideration

 The tax status of the shareholders

 Their opportunities of investment, and
 The dilution of ownership.

Firm’s Access to Capital Markets

Inflation

Bonus Shares (Stock Dividend) and Stock Splits

An integral part of dividend policy of a firm is the use of bonus shares

and stock splits. Both involve issuing new shares on a pro rata basis
to the current shareholders while the firm’s assets, its earnings, the
risk being assumed and the investors percentage ownership in the
company remains unchanged. The only definite result is the increase
in number of shares outstanding.

Effect of Bonus Share and Stock Splits

(i) Equity portion before the share issue:

Equity share capital (30000 @ 100each) Rs 3000000
Share premium (@ Rs 25 per share) Rs 750000
Retained Earnings Rs 6250000
Total Equity Rs 10000000
(ii) Equity portion after the bonus issue (1 : 2)
 Equity share capital (45000 @ 100 each) Rs 4500000
Share premium (45000 shares @ 25 each) Rs 1125000
Retained earnings (Rs 6250000 – 15000 * 125) Rs 4375000
Total Equity Rs 10000000
(iii) Equity portion after the share splits (10 : 1)
Equity share capital (300000 @ 10 each) Rs 3000000
Share premium Rs 750000
Retained Earnings Rs 6250000
Total Equity Rs 10000000

From the above table it is clear that a share split is similar to bonus
issue from the economic point of view though there are some
differences from accounting point of view. In the equity portion of
the firm, a bonus issue reduces the retained earnings and
correspondingly increases paid-up equity and share premium, if any,
whereas stock/share split has no such effect. The economic effect of
both is to increase the number of equity shares outstanding.

Rationale

As we have pointed out earlier that there exists no major benefit

from bonus shares and share split. Yet, certain advantages are
associated with them.

 The issue of bonus shares/share splits would have the effect of

bringing the market price of shares within more popular range
as a result of large number of shares outstanding. The large
number of outstanding shares will also promote more active
trading in the shares due to availability of floating stock.
 Another advantage may relate to the informational content of
bonus/split announcement. The announcement is perceived as
favourable news by the investors in that with growing earnings,
the company has bright prospects and the investors can
reasonably look for increase in future dividends.