Amity Business School

Amity Business School

Financial Management

1
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Dividend
Meaning Definition
It is that part of profits which According to Companies Act
is distributed to the 2013, Dividend is defined as,
shareholder “the profit of the company
which is not retained in the
business and is distributed
among the shareholders in
proportions to the amount
paid up on the shares held by
them”
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A Cash dividend is the most common form of
the dividend. The shareholders are paid in cash
Cash per share.
Dividend
Scrip dividend is a promissory note to pay the
Scrip shareholders later.
Dividend
Bonus share is also called as the stock dividend.
Bonus shares are issued by the company when
Bonus
Dividend they have low operating cash. In simple a stock
Dividend dividend is a payment to shareholders that is
made in shares rather than in cash
Property The company makes the payment in the form of
assets in the property dividend.

Liquidating
When the company returns the original capital
contributed by the equity shareholders as a
dividend, it is termed as liquidating dividend.
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Under this type of Under this type of Under this type of Under this type of
dividend policy, the dividend policy, the dividend policy policy, the
company follows company follows the company states that company follows
the procedure to procedure to pay out a it has no obligation the procedure of
pay out a dividend defined fixed percentage in respect of paying paying no dividend
to its shareholders of profits as dividends a dividend to the to the shareholders
every year every year shareholders. irrespective of its
profit or loss.
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The Value of the firm is maximized by maximizing the wealth of the share
holders. There are conflicting views regarding the impact of dividend
declaration on the Valuation of the Firm. There are two school of thoughts
regarding Dividend declaration and its impact on the Value of the firm

Theories of
Dividend

Irrelevance Relevance
Approach Approach

Residual MM Walter’s Gordon’s

Theory Theory Model Model
 IRRELEVANCE THEORY
Residual Theory MM Theory
According to this theory, Dividend
decision has no impact on the
Wealth of the shareholder or the
market price of the share and
hence it Is irrelevant so far, the
valuation of the firm is concerned.
This theory regards dividend
decision merely a part of the
financing decision because the
earnings available may be retained
in the business for the
reinvestment. But if the funds are
not required in the business it may
be distributed as dividend. Thus the
decision to pay dividend or
retained the earnings may be taken
as a residual decision.
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According to this theory the dividend policy
has no effect on the Market price of the share
and the value of the firm is determine by the
earning Capacity of the firm or its investment
policy. The division of the earning between
retention and dividend may be in any
manner, it will have no impact on the value of
the firm
ASSUMPTIONS
a.There is perfect capital market
b.Investors behave rationally
c.Information about the company is available
to all without any cost
d.There is no flotation and transaction cost
e.There are either no taxes or no difference in
tax rates applicable to dividend &capital gain
f. The firm has a rigid investment policy
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P1 = P0 (1+ke) – D1 Argument
P1 is price at the end of the period The argument given by MM is that what ever
P0 is price at the beginning of the increase in the value of the firm result from
period the payment of the dividend, will be exactly
D1 is Dividend off set by the decline in the Market price of
the shares because of the external financing
m = [ I – (E –nD1)] and there will be no Change in the total
P1 wealth of the shareholder. e.g.
m is the number of shares to be issued The cost of capital of R ltd is 10%. It
I is the investment currently has outstanding 5000 shares
E is the earning Selling price is Rs.100. each. The firm is
D1 is the dividend contemplating the declaration of dividend
n is the no of outstanding shares at the of Rs.6 per share at the end of the current
beginning of the period financial year. The company expects Rs
50000 earnings and has a proposal for
np = (n+m)P1 – (I- E) making new investment of Rs.100000
Prove under MM Hypothesis that payment
1+Ke
of dividend does not have impact on the
np is the value of the firm Value of the Firm
 Walter ‘s approach
According to Prof. Walter dividend decision
is relevant and do have impact on the Value
of the Firm.
The relationship between internal rate of
return (r) and cost of capital (k) is very
Significant in determining the dividend
policy to achieve the ultimate goal of
Maximizing the wealth of the shareholder
If r > k 100% retention
If r< k 100% payout.
Assumptions
a. The investments of the firm are financed
through the retained earnings and the
firm does not use external sources of
funds
b. The internal rate of return and the cost of
capital of the firm are constant
c. The life of the firm is infinite
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P is the market price of the share
Ke is the cost of Capital or Equity
Capitalization rate
D is the Dividend
E is the Earnings
r is the internal rate of return
Example: Cost of capital is 10%
Earning per share is Rs.50
Assume Rate of return
i. 12% , ii. 8%, iii. 10%
Show the effect of dividend policy on the
market price of the share using Walter
Model when dividend payout are as
follows
i. 20%, ii. 50%, iii. 70%, iv 100%
 Gordon Model
Gordon has also developed a model on
the lines of Prof. Walter suggesting that
Dividends are relevant, and it do effect
the value of the firm.
The theory is based on the following
assumptions
a. The firm is all equity firm
b. No external financing is available or
used. RE is the only source of
financing new investments
c. The rate of return on the firm's
investment is constant
d. The retention ratio once decided upon
will remain constant
e. The firm has perpetual life
f. Corporate taxes do not exist.
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P = E(1-b)/ Ke – br
E is the earnings
b is the Retention
r is the rate of return
Ke is the cost of capital
e.g.
Rate of return on investment (r)
i. 15% ii. 12% iii. 10%
Cost of Capital (k) 12%
Earning per share Rs.10
Determine the Market value of
the firm using Gordon Model
If Dividend payout ratio is
i. 30%
ii. 50%
iii. 80%
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Gordon’s model believes that the dividend policy impacts the company in various
scenarios as follows:
Growth Firm: A growth firm’s internal rate of return (r) > cost of capital (k). It
benefits the shareholders more if the company reinvests the dividends rather than
distributing it. So, the optimum payout ratio for growth firms is zero.
Normal Firm: A normal firm’s internal rate of return (r) = cost of the capital (k).
So, it does not make any difference if the company reinvested the dividends or
distributed to its shareholders. So, there is no optimum dividend payout ratio for
normal firms.
However, Gordon revised this theory later and stated that the dividend policy of
the firm impacts the market value even when r=k. Investors will always prefer a
share where more current dividends are paid.
Declining Firm: The internal rate of return (r) < cost of the capital (k) in the
declining firms. The shareholders are benefitted more if the dividends are
distributed rather than reinvested. So, the optimum dividend payout ratio for
declining firms is 100%.
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Question 2
Rara Ltd has a cost of equity capital of 10% and the current value of the
firm is ₹2000000 (@₹20 per share)
Assume that the new Investment requirement is ₹680000, and the Earning
of the firm is assumed to ₹ 150000.
The company is required to pay Dividend of ₹1 per share.
Show under MM hypothesis that the payment of dividend and non-payment
of dividend does not affects the value of the firm.

Question 3
(i)The Apex company has earned ₹5 per share and the has a capitalization
rate of 10% with Rate of return of 12%. Using Walter Model determine the
optimum pay-out and price of the shares at this pay-out.
(ii)Assume that the shares of these companies are trading at ₹100, and the
firm is contemplating the declaration of ₹5 as dividend at the end of the year.
What will be the price of share at the end of the year if (i) dividend is declared (ii)
dividend is not declared. (Using MM approach answer the question).
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Question 4. Following information related to affirm is available

Show the effect of dividend payout on the Market price of share using
Walter Model at
(i) 0%
(ii) 25%
(iii) 50%
(iv) 75%
(v) 100
The Capitalization Rate is 10%
Earning per Share is ₹10
The Rate of Investment (r) is (i)15% (ii) 8% (iii) 10%

Question5. Omega earns ₹5 per share and the Capitalization rate is 10%
and Rate of Return on Investment is 18%. According to Walter model
what will be the price at 25% pay-out? Do you think the pay-out is
optimum?
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Q4. A company is expected to pay a dividend of ₹6, the dividend is

expected to growth perpetually at 9%. What is the value of its shares
if the required rate of return is 15%

Q5. The current market price of Rex Limited Shares is ₹200. The
company is expected to pay a dividend of ₹5 per share next year with
the annual growth rate of 10%. If an investor required rate of return
is 12%, should he buy this share
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Question 6
For each of the companies describe below, would you expect it to
have a medium/high or a low dividend payout ratio? Explain
why?
• A company with a large proportion of inside ownership, all of
whom are high income individual
• A growth company with an abundance of good investment
opportunities
• A company experiencing ordinary growth that has liquidity and
much unused borrowing capacity
• A dividend paying company that experiences an unexpected
drop in earnings from a trend
• A company with volatile earnings and high business risk