DIVIDEND POLICY

Introduction
Dividend decision is one of the important areas of financial management. The key point here is that the
firm will have to decide how much of earnings will be distributed as dividends among the shareholders
and how much to be reinvested. Retained earnings are the internal source of equity. Thus dividend
decision is related to financing decision. At the same time from the view point of shareholders, dividend
is considered as current returns and they tend to increase it. Thus dividend decision requires a careful,
detailed analysis considering the internal and external factors of firm to achieve the goal of the firm at
the same time by satisfying different group of shareholders.

Definition of Dividend :
Shareholders are the owners of the joint stock company. Generally the company distributes a portion of
its earnings to the shareholders. The part of the earnings which is distributed among the shareholders is
called dividend.

Dividends are the amounts of profits that a company pays to the people who own shares in the company.
That means it refers to that portion of a firm’s net earnings which are paid out to the shareholders.

Dividend Payout Ratio :

Dividend payout is the percentage or portion of net earnings that are paid to the shareholders. The
dividend payout ratio can be calculated by using the following formula :

Dividend
D/P Ratio = × 100

Earnings

Example – 1
Assume that EPS of Star Co. Ltd. is Tk. 10. The company decided to pay Tk. 3 per share as dividend.
What is the dividend payout ratio ?

Solution :

1
 3
D/P Ratio = × 100

10
= 30%

Retention Ratio :
Retained earnings are that portion of net income which is not distributed as dividend among the
shareholders. The ratio of retained earnings to net income is called retention ratio. It is the percentage or
portion of net earnings that are kept in the business for further investment.
Formula :
Retention Ratio = 1 – DPR

Example – 2
If the DPR is 60%, what is the retention ratio ?
Solution :
Retention Ratio = 1 – DPR
= 1 – 0.60
= 0.40
= 40%

Forms of Dividend:
Generally a company pays dividend in two ways
 Cash Dividend
 Stock Dividend
Cash Dividend :
When a company directly pays dividend in cash to the shareholders is called cash dividend. A company
should have enough cash in its bank account when cash dividends are declared. If it does not have
enough bank balance, arrangement should be made to borrow funds. When the company follows a stable
dividend policy, it should prepare a cash budget to meet the regular dividend payments of the company.
 The cash account and the reserves account of a company will be reduced when the cash dividend
is paid.
 Both the total assets and the net worth of the company are reduced when the cash dividend is
distributed.

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  The market price of the share drops in most cases by the amount of the cash dividends
distributed.

Stock Dividend :
A stock dividend (bonus share) is the payment, to existing owners, of a dividend in the form of stock.
Often firms pay stock dividends as a replacement for or a supplement to cash dividends. Issuing bonus
shares increases the number of outstanding shares of the company. The bonus shares are distributed
proportionately to the existing shareholder.

For example : If a shareholder owns 100 shares at the time when a 10 percent bonus issue is made, he
will receive 10 additional shares.
 Increase the paid-up share capital and reduce the reserves and surplus (retained earnings) of
the company.
 The total net worth is not affected by the bonus issue.

Advantages of Stock Dividend :

 Tax Benefit
 Indication of higher future profits.
 Future dividends may increase
 Psychological value.

Example – 3
Following is the capital structure of a company
Common Stock Capital ( Tk. 100 per share ) 10,00,000
Paid in Capital (Premium) 5,00,000
Reserve & Surplus (Retained Earnings) 40,00,000
Long Term Debt 15,00,000
12% Preferred Stock Capital 5,00,000
Total Capital 75,00,000

You are required to restructure the capital structure if the company decides to declare stock dividend at :
a) 1 share for 1 and
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 b) 2 shares for 1 share
Solution :
1) Total number of existing common stock = 10,00,000 / 100
= 10,000 shares.
2) Share Premium = 5,00,000 / 10,000 shares
= Tk. 50 per share.

a) If the company issues 1 share for 1 as stock dividend, the capital structure will be as follows :

Common Stock Capital ( 10,000 + 10,000 shares @ Tk. 100) 20,00,000

Paid in Capital (20,000 shares @ Tk. 50) 10,00,000
Reserve & Surplus (40 – 10 - 5) = 25 lacs 25,00,000
Long Term Debt 15,00,000
12% Preferred Stock Capital 5,00,000
Total Capital 75,00,000

b) If the company issues 2 shares for 1 as stock dividend, the capital structure will be as follows :

Common Stock Capital ( 10,000 + 20,000 shares @ Tk. 100) 30,00,000

Paid in Capital (30,000 shares @ Tk. 50) 15,00,000
Reserve & Surplus (40 –20 - 10) = 10 lacs 10,00,000
Long Term Debt 15,00,000
12% Preferred Stock Capital 5,00,000
Total Capital 75,00,000

Walter Model

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Professor James Walter argues that the choice of dividend policies almost always affect the value of the
firm. His model, one of the earlier theoretical works, shows the importance of the relationship between
the firm’s rate of return ( R ) and its cost of capital ( K ), in determining the dividend policy that will
maximize the wealth of the shareholders.
Formula
D + {(R / K) (E – D)}
P = Where : P = Market Price per Share
K D = Dividend per share

R = Internal Rate of Return

K = Cost of Capital
E = Earnings Per Share.
Payout Ratio Growth Firm ( R > K) Normal Firm ( R = K) Declining Firm ( R < K)
Basic Data R = 16% R = 10% R = 9%
K = 10% K = 10% K = 10%
E = Tk. 10 E = Tk. 10 E = Tk. 10

Payout Ratio = 0% 0+{(0.16 / 0.10) (10 – 0)} 0+{(0.10 / 0.10) (10 – 0)} 0+{(0.09 / 0.10) (10 – 0)}

D = Tk. 0 P= P= P=
0.10 0.10 0.10
= Tk. 160 = Tk. 100 = Tk. 90

Payout Ratio = 30% 3+{(0.16 / 0.10) (10 – 3)} 3+{(0.10 / 0.10) (10 – 3)} 3+{(0.09 / 0.10) (10 – 3)}

D = Tk. 3 P= P= P=
0.10 0.10 0.10
= Tk. 142 = Tk. 100 = Tk. 93

Payout Ratio = 100% 10+{(0.16 / 0.10) (10 – 10)} 10+ (0.10 / 0.10) (10 – 10) 10+(0.09 / 0.10) (10 – 10)
D = Tk. 10 P= P= P=
0.10 0.10 0.10
= Tk. 100 = Tk. 100 = Tk. 100

Gordon Model
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Myron J. Gordon suggests that there is in fact a direct relationship between the firm’s dividend policy
and its market value by giving the key argument in support of dividend relevance theory.
Formula
E(1–b)
Po = Where : Po = Market Price per Share
K – br b = Retention Ratio

br = g = Rate of Return on investment

K = Cost of Capital
E = Earnings Per Share.
Payout Ratio Growth Firm ( R > K) Normal Firm ( R = K) Declining Firm ( R < K)
Basic Data R = 13% R = 12% R = 8%
K = 12% K = 12% K = 12%
E = Tk.20 E = Tk.20 E = Tk.20

Payout Ratio = 30% G = br = 0.7 × 0.13 = 0.091 G = br = 0.7 × 0.12 = 0.084 G = br = 0.7 × 0.08 = 0.056
Retention Ratio = 20 ( 1 – 0.7 ) 20 ( 1 – 0.7 ) 20 ( 1 – 0.7 )

70% P= P= P=
0.12 – 0.091 0.12 – 0.084 0.12 – 0.056

= Tk. 207 = Tk. 167 = Tk. 94

Payout Ratio = 40% G = br = 0.6 × 0.13 = 0.078 G = br = 0.6 × 0.12 = 0.072 G = br = 0.6× 0.08 = 0.048
Retention Ratio = 20 ( 1 – 0.6 ) 20 ( 1 – 0.6 ) 20 ( 1 – 0.7 )

60% P= P= P=
0.12 – 0.078 0.12 – 0.072 0.12 – 0.048

= Tk. 190 = Tk. 167 = Tk. 111

Payout Ratio = 50% G = br = 0.5 × 0.13 = 0.065 G = br = 0.5 × 0.13 = 0.060 G = br = 0.5 × 0.08 = 0.04
Retention Ratio = 20 ( 1 – 0.50 ) 20 ( 1 – 0.50 ) 20 ( 1 – 0.7 )

50% P= P= P=
0.12 – 0.065 0.12 – 0.06 0.12 – 0.04

= Tk. 182 = Tk. 167 = Tk. 125

Modigliani & Miller (MM) Model

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According to Modigliani & Miller (MM) Model, under a perfect capital market situation, the dividend
policy of the firm is irrelevant, as it does not affect the value of the firm. They argue that the value of the
firm depends on the firm’s earnings that result from its investment policy.

i) D1 + P1
Po = Where : P1 = Market Price per Share
1+K K = Cost of Capital
D1 = Dividend

ii ) M × P1 = I – ( E – N D1 )
Where : M = Number of New Share
I = Investment Requirement
E = Expected Profit
N = Outstanding share
D1 = Dividend at the end of the Year – 1.
iii) Value of the Firm
P1 ( N + M ) – I + E
1 + Ke

Example :
Vector electronics limited currently has outstanding 200,000 shares selling at Tk. 100/- each. The cost of
capital of the company is 10%. The company is expecting a profit of Tk. 20 lakh in the next year and
also thinking for declaring dividend of Tk. 15 per share. The company is also planning to invest Tk. 40
lac in the available investment opportunities.
i) What will be the price of the share in the next year if dividend is paid ?
ii) What will be the price of the share in the next year if dividend is not paid ?
According to MM Model,
iii) How many new shares must be issued to finance the new investment (if dividend is paid)?
iv) How many new shares must be issued to finance the new investment (if dividend is not
paid)?
v) Calculate the value of the firm in both the cases.

Solution :

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 i) If dividend is paid
D1 + P1
Po =

1+K
Or, P1 = Po (1 + K ) - D1
= 100 ( 1 + 0.10 ) – 15
= 110 – 15
= 95
ii) If dividend is paid
D1 + P1
Po =

1+K
Or, P1 = Po (1 + K ) - D1
= 100 ( 1 + 0.10 ) – 0
= 110 – 0
= 110
iii) Number of additional shares to be issued if dividend is paid
We know,
M × P1 = I – ( E – N D1 )
95 M = 40,00,000 - ( 20,00,000 – 30,00,000 )
95 M = 50,00,000
M = 52,632 Shares.

Value of the Firm :

P1 ( N + M ) – I + E
1 + Ke

= 95 ( 200000 + 52632 ) – 40,00,000 + 20,00,000

1 + 0.10

= 2,00,00,036

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 iv) Number of additional shares to be issued if dividend is not paid
We know,
M × P1 = I – ( E – N D1 )
110 M = 40,00,000 - ( 20,00,000 – 0 )
110 M = 20,00,000
M = 18,182 Shares.

Value of the Firm :

P1 ( N + M ) – I + E
1 + Ke

= 110 ( 200000 + 18182 ) – 40,00,000 + 20,00,000

1 + 0.10

= 2,00,00,018