Dividend Theories

Unit 4
of
Financial Management
MBA 2nd Semester,
Department of Business
Administration,
University of Lucknow
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Dividend Theories

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Dividend Theories
Dividend theories are based on the relationship
between dividend and the value of the firm. Some
theories advocate that payment of dividend affect
the value of firm and hence dividend policy is
relevant in order to have the benefits out of the
dividend payout. Other theories on the other hand
say that dividend payment decision does not affect
the value of the firm hence, it payment of any
dividend is relevant in a given organization.
Important theories advanced in this regard as under:
1. Walter’s Model
2. Gordon’s Model
3. Modigliani and Miller’s Hypothesis
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Walter’s Model: Dividend Relevance
Professor James E. Walter argues that the choice of dividend policies almost
always affects the value of the enterprise. His model shows clearly the importance
of the relationship between the firm’s internal rate of return (r) and its cost of
capital (k) in determining the dividend policy that will maximize the wealth of
shareholders.
Walter’s model is based on the following assumptions:
1. The firm finances all investment through retained earnings; that is debt or
new equity is not issued;
2. The firm’s internal rate of return (r), and its cost of capital (k) are constant;
3. All earnings are either distributed as dividend or reinvested internally
immediately.
4. Beginning earnings and dividends never change. The values of the earnings
per share (E), and the divided per share (D) may be changed in the model to
determine results, but any given values of E and D are assumed to remain
constant forever in determining a given value.
5. The firm has a very long or infinite life.

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Criticism of Walter’s Model:
Walter’s model is quite useful to show the effects of dividend
policy on an all equity firm under different assumptions, but the
model is criticized on the following grounds:
1. Mixing up dividend and investment policies:
2. The model assumes that the investments of the firm are
financed by retained earnings only. Under this situation,
either the firm’s investment or its dividend policy or both
will be sub-optimum. The wealth of the owners will not be
maximized.
3. Walter’s model is based on the assumption that return (r) is
constant. In fact, this assumption is not practical.
4. A firm’s cost of capital or discount rate, K, does not remain
constant; it changes directly with the firm’s risk.
5
Gordon’s Model: Dividend Relevance
One very popular model explicitly relating the market value of
the firm to dividend policy is developed by Myron Gordon.
Assumptions:
Gordon’s model is based on the following assumptions:
1. The firm is an all Equity firm
2. No external financing is available
3. The internal rate of return (r) of the firm is constant.
4. The appropriate discount rate (K) of the firm remains
constant.
5. The firm and its stream of earnings are perpetual
6. The corporate taxes do not exist.
7. The retention ratio (b), once decided upon, is constant. Thus,
the growth rate, g = (b) (r), is constant forever.
8. Growth rate (g) and discount rate (k) together decide the
value of the firm, higher or lower.
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Modigliani and Miller’s hypothesis: Dividend Irrelevance
According to Modigliani and Miller (M-M), dividend policy of a
firm is irrelevant to the value of the firm as it does not affect the
wealth of the shareholders. They argue that the value of the firm
depends on the firm’s earnings which result from its investment
policy.
Thus, when investment decision of the firm is given, dividend
decision, the split of earnings between dividends and retained
earnings is of no significance in determining the value of the
firm.
Assumptions:
M–M’s hypothesis of irrelevance is based on the following
assumptions:
1. The firm operates in perfect capital market
2. Taxes do not exist
3. The firm has a fixed investment policy
4. Risk of uncertainty does not exist.
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MM Hypothesis of Irrelevance of Dividend Policy: Criticism
M-M’s hypothesis lacks practical relevance in the real world
situation. Thus, it is being criticized on the following grounds.
1. The assumption that taxes do not exist is far from reality.
2. M-M argue that the internal and external financing are
equivalent. This cannot be true if the flotation cost new exist.
3. According to M-M’s hypothesis the wealth of a shareholder will
be same whether the firm pays dividends or not. But, because of
the transactions costs and inconvenience associated with the
sale of shares to realize capital gains, shareholders prefer
dividends to capital gains.
4. The discount rate (k) for external and internal financing will be
different.
5. M-M argues that, even if the assumption of perfect certainty is
dropped and uncertainty is considered, dividend policy
continues to be irrelevant. But according to number of writers,
dividends are relevant under conditions of uncertainty.

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9
Dividend Policy Determinants,
Financial Management
Unit 4
Department of Business
Administration, University of
Lucknow,
Lucknow

1
Optimum Dividend Policy Objectives

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Optimum Dividend Policy
Meaning:
Optimum dividend policy means that
the company should formulate a
dividend distribution and profit
retention policy which fulfills the
underlying objectives of the company
as well as the objectives of
shareholders of the company.
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Optimum Dividend Policy Considerations
Following consideration contribute in the optimum dividend
policy of the organization:
1. Fulfilling Internal capital requirement of business
2. Meeting the dividend expectations of shareholders
3. Liquidity of business
4. Fulfilling legal rules/covenants
5. Availing profitable projects
6. Capital market conditions for raising fresh capital
7. Dividend policy of other competitors
8. Prevailing Inflation
9. Past dividend distribution behavior of the company
10. Control of shareholders
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Internal Capital Requirements
1. Capital may be required for various purpose
at short notice for short term as well as long
term needs.
2. Internal source or retained earnings is a
hassle free source of funds.
3. It take no time to avail internally retained
funds.
4. Flotation cost is saved
5. It manages the emergent requirements of
funds
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Dividend Expectations of shareholders
1. Share holders have two types of benefits in investing
into equity shares:
a) Dividend from company
b) Capital gain at the time of sale of shares
2. Dividend is a recurring income for shareholders.
3. Majority of shareholders are very keen to receive
this dividend income.
4. Dividend is a strong reason for their holding of
shares with them.
5. Share holders are very positive for the companies
regularly distributing dividends.
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Liquidity Requirement of Business
1. Liquidity means ready cash or other current
assets to meet short term business obligations
of business operation.
2. Some times business may face liquidity
crunch or crisis.
3. At this hard time internal reserve may be of
great help.
4. Liquidity support is always extendable with
internal reserve capital
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Fulfilling Legal Requirements
1. There are many business having government
interference with respect to maintaining liquidity
into business.
2. Government or financing institutions generally
have the covenants for maintaining sufficient
reserves in order to pay interest, loans, salaries to
employees, payment to suppliers timely.
3. Business may be in problems if such conditions
are not followed.
4. For this purpose the dividend policy has to be
moulded accordingly.

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Availing Profitable Projects
1. Some times very profitable or important projects
are available for investment at a very short
notice.
2. It becomes difficult to arrange funds externally
within such a short time.
3. Internal capital may serve this purpose of
investment and carry the business forward.
4. These projects can increase the profitability by
way of enhancement in technology, fulfilling
some legal requirement, increasing efficiency of
business etc.
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Unfavorable Capital Market Conditions
1. Capital market may be continuously in a bad
shape for raising fresh capital.
2. There may some sort of financial recession and
apprehensiveness of financing institution and
investors to extend funds for business.
3. The given business may be doing exceptionally
well in the market and there may be rising
requirements of funds.
4. At this point of time dividend policy
consideration for more retention of funds is a
priority.
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Dividend policy of Competitors
1. Generally there is an industry practice to
motivate investors by distributing dividends
regularly to them.
2. For such industry practice dividend
distribution becomes a necessity.
3. If dividend is not distributed to shareholders
or distributed very less then the value of
shares may fall in the market leading to fall
in the company reputation and crisis to raise
fresh capital.
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Prevailing Inflation Level
1. Rise in inflation is very common in present
economic situation.
2. At the time of rising inflation the dividend
distribution has to be increased according.
3. In inflationary situations the expectations of
shareholders are to receive more dividend from
the their company.
4. For this purpose companies are required to
enhance their profits by increasing the prices of
their goods and services so that more dividend
can be distributed to shareholders.
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Past Dividend Distribution Behavior
1. If the company has done business for several
years it has to see how much dividend it has
been distributing in earlier years.
2. It is supposed that the company would not
give dividends to shareholders less than what
it has given them in previous years on an
average.
3. If a company chooses to adopt such practice
of less dividend as compared to the previous
years then it is may be harmful for the market
price of shares of such company.
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Control of shareholders in the Company
1. What is meant by control of shareholders? And how is
it affected by dividend policy?
2. Equity Shareholders being the owners of the company
have voting right and play an important part in the
crucial decisions of the company such as electing
board of directors.
3. When the number of equity shares increase there is a
dilution in this voting power of equity shareholders.
4. It is therefore required that the company should avoid
any action which lead to increase in equity shares.
5. This may be possible when bonus shares are given to
shareholders instead of cash dividends.
6. It means that the issue of bonus shares in the place of
cash dividends is not a good practice.
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Concluding Remarks
1. Dividend policy being a strategic decision
should not be taken casually.
2. Dividend policy is a part of financing policy
3. Dividend policy serves an important source of
internal financing.
4. In dividend policy the shareholders and company
both should be considered properly.
5. The dividend should be distributed annually
preferably in cash.
6. There should be consistency and stability in
dividends payment.
7. Bonus shares should be avoided to pay.
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 Bonus Shares
Meaning:
Bonus shares are the additional shares that a company gives to
its existing shareholders on the basis of shares owned by them.
Bonus shares are issued to the shareholders without any
additional cost.
All the companies under dividend policy try to ensure:
1. An effective tax planning
2. Strengthen market price of shares
3. Motivate shareholders
4. Avoid dilution of ownership
For these objective, the companies always want to pay cash
dividend because cash dividend received by the shareholders is
exempt to tax in case of domestic company. It is because the
companies pay the corporate profit tax on the profits earned by
them. Cash dividend also fulfills the other objectives as
mentioned above.
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Why companies Issue Bonus Shares
Bonus shares are issued by a company when it is not
able to pay a dividend to its shareholders due to
shortage of funds in spite of earning good profits for
that quarter. In such a situation, the company issues
bonus shares to its existing shareholders instead of
paying dividend. These shares are given to the
current shareholders on the basis of their existing
holding in the company. Issuing bonus shares to the
existing shareholders is also called capitalization of
profits because it is given out of the profits or
reserves of the company
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Benefits of Bonus Shares
1. It is beneficial for the long-term shareholders of the
company who want to increase their investment.
2. Bonus shares enhance the faith of the investors in the
operations of the company because the cash is used by the
company for business growth.
3. When the company declares a dividend in the future, the
investor will receive higher dividend because now he
holds larger number of shares in the company due to bonus
shares.
4. Bonus shares give positive sign to the market that the
company is committed towards long term growth story.
5. Bonus shares increase the outstanding shares which in turn
enhances the liquidity of the stock.
6. The perception of the company's size increases with the
increase in the issued share capital.
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Disadvantages of Bonus shares
The companies avoid payment of Bonus Shares. It is only
in case of high urgencies that the bonus shares are issued.
There are two disadvantages for issuing bonus shares:
1. Decrease in the EPS of the company after bonus issue.
2. Challenge for managers to earn higher in order to
compensate the decrease in EPS.
3. Tax liability of the shareholders to pay capital gain tax
at the time of selling bonus shares.
4. There is dilution in the ownership and voting power of
the employees leading to de-motivation to the existing
shareholders.
5. There may be an adverse impact on the market value
of the shares and share value may come down as a
result of excess shares in the market.
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Buy Back of shares
Meaning:
Buy-Back is a corporate action in which a
company buys back its shares from the
existing shareholders usually at a price
higher than market price in order to
motivate the existing shareholders to
handover their shares to the company.
When it buys back, the number of shares
outstanding in the market reduces leading
to some implication and after effects of this
buy back in the market.
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Two Methods of Buy Back
A buyback allows companies to invest in themselves. By
reducing the number of shares outstanding on the market,
buybacks increase the proportion of shares a company owns.
Buybacks can be carried out in two ways:
1. Shareholders may be presented with a tender offer whereby
they have the option to submit (or tender) a portion or all of
their shares within a certain time frame and at a premium to
the current market price. This premium compensates
investors for tendering their shares rather than holding on to
them.
2. Companies buy back shares on the open market over an
extended period of time.

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The reasons for buy-back
1. To improve earnings of the company,
2. To improve return on capital, return on net worth
and to enhance the long-term shareholder value;
3. To enhance consolidation of stake in the
company;
4. To return surplus cash to shareholders;
5. To make the capital structure optimum;
6. To support share price during periods of sluggish
market conditions;
7. To service the equity more efficiently.

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Advantages of Buy Back
1. It is an alternative mode of reduction in capital without requiring
approval of the Court/CLB(NCLT),
2. To improve the earnings per share;
3. To improve return on capital, return on net worth and to enhance
the long-term shareholders value;
4. To provide an additional exit route to shareholders when shares are
undervalued or thinly traded;
5. To enhance consolidation of stake in the company.
6. To prevent unwelcome takeover bids;
7. To return surplus cash to shareholders;
8. To achieve optimum capital structure;
9. To support share price during periods of sluggish market
condition;
10. To serve the equity more efficiently.
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Limitations of Buyback of Shares:
1. The companies may misuse the practice of buyback at the cost of innocent and
scattered shareholders.
2. Buyback may be misused by promoters to enhance and consolidate their holdings
in the companies as a result of which the interest of minority shareholders may be
effected badly.
3. The practice of buyback of shares may prompt the promoters to adopt insider
trading for their selfish motives. They may understate the profits of the company
by manipulating company’s accounting policies and by adopting other means, and
then may resort to buy back company’s shares at low rates. In this way, the
insiders would make extra money when company purchases these shares at higher
prices from the promoters.
4. The mechanism of buyback of shares leads to artificial manipulations of shares
and stock prices in the market (stock exchange) through influential groups which
have vested interests in the company.
5. Fluctuations (frequent) in the shares prices may create confusions in the minds of
minority shareholders which cause them unbearable losses.