DIVIDEND POLICY

BY DR.SAYLEE GHARGE
 Contents
❑ Introduction
❑ Objective of Dividend Policy
❑ Importance of Dividend policy
❑ Types of Dividend Policies
❑ Essentials of a Sound Dividend Policy
❑ Factor’s affecting in entity’s dividend decision
❑ Dividend policies
✓ Modigliani Millar Approach
✓ Gordon’s Approach
✓ Walter’s Approach
 Introduction
Meaning of Dividend Policy: According to Weston and Brigham, “Dividend policy
determines the division of earnings between payments to shareholders and retained
earnings”

A dividend policy can be defined as the dividend distribution guidelines provided by the
board of directors of a company. It sets the parameter for delivering returns to the equity
shareholders, on the capital invested by them in the business.

It is to determine the amount of earnings to be distributed to shareholders and the

amount to be retained in the firm. Retained earnings are the most significant internal
sources of financing the growth of the firm. Dividend policy involves the balancing of the
shareholders’ desire for current dividends and the firms’ needs for funds for growth.
 Objective of dividend policy
➢ A firms’ dividend policy has the effect of dividing its net earnings into two parts:
retained earnings and dividends.

➢ The retained earnings provide funds to finance the firm’s long – term growth. It is
the most significant source of financing a firm’s investment in practice.

➢ Dividends are paid in cash. Thus, the distribution of earnings uses the available
cash of the firm.

➢ A firm which intends to pay dividends and also needs funds to finance its
investment opportunities will have to use external sources of financing, such as
the issue of debt or equity.
Importance of Dividend Policy
 Importance of Dividend Policy
➢ Develop Shareholders’ Trust: When the company has a constant net earnings
percentage, it secures a stable market value and pays suitable dividends. The
shareholders also feel confident about their investment decision, in such an
organization.
➢ Influence Institutional Investors: A fair policy means a strong reputation in the
financial market. Thus, the company’s strong market position attracts organizational
investors who tend to leverage a higher sum to the company.
➢ Future Prospects: The fund adequacy for next project undertaking and investment
opportunities is planned, decides its dividend policy such that to avoid illiquidity.
(Illiquid refers to the state of a stock, bond, or other assets that cannot easily and
readily be sold or exchanged for cash without a substantial loss in value)
 Importance of Dividend Policy

➢ Equity Evaluation: The value of stocks is usually determined through its

dividend policy since it signifies the organizational growth and efficiency.
➢ Market Value Stability of Shares: A suitable dividend policy means satisfied
investors, who would always prefer to hold the shares for the long term.
This leads to stability and a positive impact on the stocks’ market value.
➢ Market for Preference Shares and Debentures: A company with the
proficient dividend policy may also borrow funds by issuing preference
shares and debentures in the market, along with equity shares.
 Importance of Dividend Policy

➢ Degree of Control: It helps the organization to exercise proper control over

business finance. Since, the company may land up with a shortage of funds for
future opportunities, if the company distributes maximum profit as dividends.
➢ Raising of Surplus Funds: It also creates organizational goodwill and image in
the market because of which the company becomes capable of raising
additional capital.
➢ Tax Advantage: The tax rates are less on the qualified dividends, which are
received as a capital gain when compared to the percentage of income tax
charged.
Types of Dividend Policies
 Types of Dividend Policies
➢ Regular Dividend Policy:
Here, a certain percentage of the company’s profit is allowed as dividends to the
shareholders. When the gain is high, the shareholders’ earnings will also hike
and vice-versa. It is one of the most appropriate policy to be adopted for
creating goodwill.
➢ Stable Dividend Policy:
In this policy, the company decides a fixed amount of dividend for the
shareholders, which is paid periodically. There is no change in the dividend
allowed even if the company incurs loss or generates high profit.
 Types of Dividend Policies
➢ Irregular Dividend Policy:
Under this changeable policy, the company may or may not pay dividends to the
shareholders. The top management i.e., the board of directors solely take all
dividend decisions, as per their priorities.
➢ No Dividend Policy:
Here, the company always retain the profits to fund further projects. Moreover, it
has no intention of declaring any dividends to its shareholders. This strategy may
seem to be beneficial for business growth but usually discourages the investors
aiming for sustainable income.
TYPES OF DIVIDENDS
 Essentials of a Sound Dividend Policy
A company’s dividend decisions and policy signify its future and financial well-
being. Therefore, it needs to be systematically framed and implemented.
Three essential steps to take flawless dividend decisions:
 Essentials of a Sound Dividend Policy

1.Lower Dividends in Initial Stage: When the company is at the beginning stage
and earns little profit, it should still provide dividends to the shareholders, though
less.
2.Gradual Increase in Dividends: As the company prosper and grow, the dividend
should be kept on increasing proportionately, to build shareholders’ confidence.
3.Stability: It is one of the crucial features of a superior dividend policy. When the
company can survive in the market, it should ensure a stable rate of return in the
form of dividends to its shareholders. This leads to retention of shareholders and
gains investors interest, all resulting in the enhancement of shares market value.
 Factor’s Affecting Dividend Policy
➢ Funds Liquidity: It should be framed in consideration of retaining adequate
working capital and surplus funds for the uninterrupted business functioning.
➢ Past Dividend Rates: There should be a steady rate of return on dividends to
maintain stability; therefore previous year’s allowed return is given due
consideration.
➢ Earnings Stability: When the earnings of the company are stable and show
profitability, the company should provide dividends accordingly.
➢ Debt Obligations: The organization which has leveraged funds through debts
need to pay interest on borrowed funds. Therefore, such companies cannot
pay a fair dividend to its shareholders.
 Factor’s Affecting Dividend Policy
➢ Investment Opportunities: One of the significant factors of dividend policy decision
making is determining the future investment needs and maintaining sufficient surplus
funds for any further project.
➢ Control Policy: When the company does not want to increase the shareholders’
control over the organization, it tries to portray the investment to be unattractive, by
giving out fewer dividends.
➢ Shareholders’ Expectations: The investment objectives and intentions of the
shareholders determine their dividend expectations. Some shareholders consider
dividends as a regular income, while the others seek for capital gain or value
appraisal.
 Factor’s Affecting Dividend Policy

➢ Nature and Size of Organization: Huge entities have a high capital requirement
for expansion, diversification or other projects. Also, some business may require
enormous funds for working capital and other entities require the same for fixed
assets. All this impacts the dividend policy of the company.
➢ Company’s Financial Policy: If the company’s financial policy is to raise funds
through equity, it will pay higher dividends. On the contrary, if it functions more
on leveraged funds, the dividend payouts will always be minimal.
 Factor’s Affecting Dividend Policy
➢ Impact of Trade Cycle: During inflation or when the organization lacks adequate
funds for business expansion, the company is unable to provide handsome
dividends.
➢ Borrowings Ability: The company’s with high goodwill has excellent credibility
in the capital as well as financial markets. With a better borrowing capability,
the organization can give decent dividends to the shareholders.
➢ Legal Restrictions: In India, the Companies Act 1956 legally abide the
organizations to pay dividends to the shareholders; thus, resulting in higher
goodwill.
 Factor’s Affecting Dividend Policy

➢ Corporate Taxation Policy: If the organization has to pay substantial corporate

tax or dividend tax, it would be left with little profit to pay out as dividends.
➢ Government Policy: If the government intervenes a particular industry and
restricts the issue of shares or debentures, the company’s growth and dividend
policy also gets affected.
➢ Divisible Profit: The last but a crucial factor is the company’s profitability itself.
If the organization fails to generate enough profit, it won’t be able to give out
decent dividends to the shareholders.
Dividend policy theories
 Dividend policy theories

➢Irrelevance of Dividend

✓ Traditional approach: Residual dividend Approach

✓ MM Approach

➢ Relevance of Dividend

✓ Walter’s Model

✓ Gordon’s Model
 Residual Dividend Approach
➢ Firms with higher dividend payouts will have to sell stock more often. Such sales are
not very common, and they can be very expensive.
➢ Consistent with this, we will assume that the firm wishes to minimize the need to sell
new equity. We will also assume that the firm wishes to maintain its current capital
structure.
➢ If a firm wishes to avoid new equity sales, then it will have to rely on internally
generated equity to finance new positive NPV projects. Dividends can only be paid out
of what is left over. This leftover is called the residual, and such a dividend policy is
called a residual dividend approach.
➢ With a residual dividend policy, the firm’s objective is to meet its investment needs
and maintain its desired debt-equity ratio before paying dividends.
 Modigliani-Millar (MM) Approach

➢ Modigliani-Miller hypothesis provides the irrelevance concept of dividend in

a comprehensive manner.
➢ According to them, the dividend policy of a firm is irrelevant since, it does
not have any effect on the price of shares of a firm, i.e., it does not affect
the shareholders’ wealth.
➢ They expressed that the value of the firm is determined by the earnings
power of the firms’ assets or its investment policy and not the dividend
decisions by splitting the earnings of retentions and dividends.
 M-M Hypothesis — Assumptions
(i) Taxes do not exist:
That is, there is no difference in tax rates between dividends and capital gains.
(ii) Investors behave rationally:
It means that investors should prefer to maximize their wealth and as such,
they are indifferent between dividends and the appreciation in the value of shares.
(iii) Investment policy is fixed.
(iv) Risk and Uncertainty do not exist
In other words, investors may predict future prices and dividends with certainty and
one discount rate is used for all types of securities at all times — this was
subsequently dropped by M-M.
 Proof for MM approach

The MM approach can be proved with the help of the following formula:

Po = D1 + P1 / (1 + Ke) P1 = Po (1+Ke) – D1

Where,

Po = 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 the share at the end of period one.

P1 can be calculated with the help of the following formula.

 Proof for MM approach
The number of new shares to be issued can be determined by the following formula:

M × P1 = I – (X – nD1)

Further, the value of the firm can be ascertained with the help of the following formula:

n Po = [(n + M) P1 - (I - X)] / (1+ Ke)

Where,

M = Number of new shares to be issued. P1 = Price at which new issue is to be made.

I = Amount of investment required. X = Total net profit of the firm during the period.

D1= Dividend to be paid at the end of the period.

n = No. of shares outstanding at the beginning of the period. nPo =Value of the firm
 MM approach
Exercise :

X Company Ltd. has 100,000 shares outstanding the current market

price of the shares Birr. 15 each. The company expects the net profit of Birr.
200,000 during the year and it belongs to a rich class for which the
appropriate capitalization rate has been estimated to be 20%. The company
is considering dividend of Birr. 2.50 per share for the current year. What will
be the price of the share at the end of the year (i) if the dividend is paid and
(ii) if the dividend is not paid.
 MM approach
Solution: Po = D1 + P1 / (1 + Ke) P1 = Price at which new issue is to be made.

(i) If the dividend is paid: Po = Birr.15; Ke = 20%; D1 = Birr. 2.50; P1 =?

15 = 2.50 + P1 / 1 + 20%

15 = 2.50 + P1 / 1.2

2.50 + P1 =15 x 1.2

P1 = 18 – 2.50 P1 = Birr. 15.50

(ii) If the dividend is not paid: Po = 15; Ke = 20%; D1 = 0; P1 = ?

15 = 0 + P1 / 1 + 20%; 15 = 0 + P1 / 1.2; 0 + P1 =15 x 1.2 P1 = Birr.18

n Po = [(n + M) P1 - (I - X)] / (1+ Ke)

 MM approach
Qmega Company has a cost of equity capital of 10%, the current market value of the
firm (V) is Rs 20,00,000 (@ Rs. 20 per share). Assume values for I (new investment), Y
(earnings) and D = (Dividends) at the end of the year as I = Rs. 6,80,000, Y = Rs. 1,50,000
and D = Re. 1 per share. Show that under the M-M (Modigliani-Miller) assumptions, the
payment of D does not affect the value of the firm.
Since the value of the firm in both the cases (i.e., when dividends are not paid and
when paid) is Rs. 20, 00, 000. It can be concluded that the payment of dividend (D)
does not affect the value of the firm.
 Criticism of MM approach

➢ The MM approach assumes that tax does not exist. It is not applicable in the practical
life of the firm.
➢ The MM approach assumes that, there is no risk and uncertain of the investment. It is
also not applicable in present day business life.
➢ The MM approach does not consider floatation cost and transaction cost. It leads to
affect the value of the firm.
➢ The MM approach considers only single decrement rate, it does not exist in real
practice.
➢ The MM approach assumes that, investor behaves rationally. But we cannot give
assurance that all the investors will behave rationally.
 RELEVANCE OF DIVIDEND
➢ According to this concept, dividend policy is considered to affect the value of
the firm.

➢ Dividend relevance implies that shareholders prefer current dividend and

there is no direct relationship between dividend policy and the value of the
firm

➢ Relevance of dividend concept is supported by two eminent persons like

Walter and Gordon.
 Walter’s model

➢ Professor, James, E. Walter’s model suggests that dividend policy and investment
policy of a firm cannot be isolated rather they are interlinked as such, choice of
the former affects the value of a firm.
➢ His proposition clearly states the relationship between the firms’ internal rate of
return (i.e., r) and its cost of capital or the required rate of return (i.e., k).
➢ That is, in other words, an optimum dividend policy will have to be determined
by the relationship of r and k. In short, a firm should retain its earnings it the
return on investment exceeds the cost of capital and in the opposite case, it
should distribute its earnings to the shareholders.
 Walter’s model

(a) When r > k (Growth Firms):

When r > k, it implies that a firm has adequate profitable investment oppor-
tunities, i.e., it can earn more what the investors expect. They are called growth
firms. The optimum dividend policy, in case of those firms, may be given by a D/P
ratio (Dividend pay-out ratio) of 0. It means a firm should retain its entire
earnings within itself and as such, the market value of the share will be
maximised.
 Walter’s model
(b) When r<k (Declining Firms):
On the contrary, when r<k, it indicates that a firm does not have profitable
investment opportunities to invest their earnings. They are known as declining
firms. In this case, rate of return from new investment (r) is less than the required
rate of return or cost of capital (k), and as such, retention is not at all profitable.
The investors will be better-off if earnings are paid to them by way of dividend and
they will earn a higher rate of return by investing such amounts elsewhere. In that
case, the market price of a share will be maximised by the payment of the entire
earnings by way of dividends amongst the investors. There will be an optimum
dividend policy when D/P ratio is 100%.
 Walter’s model

(c) When r = k (Normal Firms)

If r = k, it means there is no one optimum dividend policy and it is not a matter
whether earnings are distributed or retained due to the fact that all D/P ratios,
ranging from 0 to 100, the market price of shares will remain constant.
In other words, when the profitable investment opportunities are not available,
the return from investment (r) is equal to the cost of capital (k), i.e., when r = k,
the dividend policy does not affect the market price of a share.
 Assumptions
(i) All financing through retained earnings is done by the firm, i.e., external sources of
funds, like, debt or new equity capital is not being used;
(ii) It assumes that the internal rate of return (r) and cost of capital (k) are constant;
(iii) It assumes that key variables do not change, viz., beginning earnings per share, E,
and dividend per share, D, may be changed in the model in order to determine results,
but any given value of E and D are assumed to remain constant in determining a given
value;
(iv) All earnings are either re-invested internally immediately or distributed by way of
dividends;
(v) The firm has perpetual or very long life.
 Walter’s model
Professor Walter has evolved a mathematical
formula in order to arrive at the appropriate
dividend decision to determine the market price of
a share which is reproduced as under:
where, P = Market price per share;
D = Dividend per share;
E = Earning per share;
r = Internal rate of return;
k = Cost of capital or capitalization rate.
In this proposition it is evident that the optimal D/P ratio is determined by varying ‘D’
until and unless one receives the maximum market price per share.
 Walter’s model
Illustration:
Cost of Capital (k) = 10%
Earnings per share (E) = Rs. 10.
Assume Internal Rate of Return (r):
(i) 15%; (ii) 10%; and (iii) 8% respectively
Assuming that the D/P ratios are: 0; 40%; 76% and 100% i.e., dividend
share is (a) Rs. 0, (b) Rs. 4, (c) Rs. 7.5 and (d) Rs. 10, the effect of different
dividend policies for three alternatives of r may be shown as under:
Thus, according to the Walter’s
model, the optimum dividend policy
depends on the relationship
between the internal rate of return r
and the cost of capital, k. The
conclusion, which can be drawn up
is that the firm should retain all
earnings if r > k and it should
distribute entire earnings if r < k and
it will remain indifferent when r = k.
 Criticisms
Walter’s model has been criticized on the following grounds since some of its
assumptions are unrealistic in real world situation:
They are:
(i) Walter assumes that all investments are financed only by retained earnings and
not by external financing which is seldom true in real world situation and which
ignores the benefits of optimum capital structure. Not only that, even when a firm
reaches the optimum capital structure level, the same should also be maintained in
future. In this context, it can be concluded that Walter’s model is applicable only in
limited cases.
 Criticisms

(ii) Walter also assumes that the internal rate of return (r) of a firm will
remain constant which also stands against real world situation. Because,
when more investment proposals are taken, r also generally declines.
(iii) Finally, this model also assumes that the cost of capital, k, remains
constant which also does not hold good in real world situation. Because if the
risk pattern of a firm changes there is a corresponding change in cost of
capital, k, also. Thus, Walter’s model ignores the effect of risk on the value of
the firm by assuming that the cost of capital is constant.
 Gordon’s model Assumptions

(i) The firm is an all-equity firm;

(ii) No external financing is available or used. Only retained earnings are used to finance
the investment programmes;
(iii) The internal rate of return, r, and cost of capital, k, is constant;
(iv) The firm has perpetual or long life;
(v) Corporate taxes do not exist;
(vi) The retention ratio, b, is constant. Thus the growth rate, g = br, is also constant;
(vii) k > br = g.
 Gordon’s model

According to Gordon’s model, the market value of a share is equal to the present
value of an infinite future stream of dividends.
 Gordon’s model
Gordon clearly states the relationship between internal rate of return, r, and the
cost of capital, k. He also contends that dividend policy depends on the profitable
investment opportunities.
(a) When r > k (Growth Firms):
When r > k, the value per share P increases since the retention ratio, b, increases,
i.e., P increases with decrease in dividend pay-out ratio. In short, under this
condition, the firm should distribute smaller dividends and should retain higher
earnings.
 Gordon’s model

(b) When r < k (Declining Firms):

When r<k, the value per share P decreases since the retention ratio b, increases, i.e.,
P increases with increase in dividend pay-out ratio. It can be proved that the value of
b increases, the value of the share continuously falls.
If the internal rate of return is smaller than k, which is equal to the rate available in
the market, profit retention clearly becomes undesirable from the shareholders’
viewpoint. Each additional rupee retained reduces the amount of funds that
shareholders could invest at a higher rate elsewhere and thus it further reduces the
value of the company’s share.
 Gordon’s model

(c) When r = k (Normal Firms):

When r = k, the value of the firm is not affected by dividend policy and is equal to the
book value of assets, i.e., when r = k, dividend policy is irrelevant.
It implies that under competitive conditions, k must be equal to the rate of return, r,
available to investors in comparable shares in such a manner that any funds distrib-
uted as dividends may be invested in the market at the rate which is equal to the
internal rate of return of the firm.
Consequently, shareholders can neither lose nor gain by any change in the company’s
dividend policy and the market value of the shares must remain unchanged.
Illustration:
 Criticism of Gordon’s Model

Gordon’s model consists of the following important criticisms:

❖ Gordon model assumes that there is no debt and equity finance used by
the firm. It is not applicable to present day business.
❖ Ke and r cannot be constant in the real practice.
❖ According to Gordon’s model, there is no tax paid by the firm. It is not
practically applicable.
 Arguments
Gordon’s model contends that dividend policy of the firm is relevant and that
investors put a premium on current incomes / dividends.
As investors are rational, they want to avoid risk. The payment of current dividends
completely removes any chance of risk.
If current dividends are with held, the investors can expect to get a dividend in
future. The future dividend is uncertain, both with respect to the amount as well as
the timing.
Thus the rational investors can reasonably be expected to prefer current dividend.
They will placeless importance on future dividend as compared to current dividend.
The retained earnings are evaluated by the investors as a risky promise, thus if
earnings are retained, the market price of share would be adversely affected.