DIVIDEND POLICY

      

  

BY ---------

SWETA

AGARWAL
 

1stYEAR PGDBM ; SEC - B

INTRODUCTION
 The

term dividend refers to that portion of company’s net earning that is to be paid out to the equity shareholders  Dividend policy of a firm decides the same and the portion that is ploughed back in the firm for investment purpose

THEORY

The value of the firm can be maximised if the shareholders’ wealth is maximised. According to one school of thought, dividend decision does not affect the shareholders wealth and valuation of the firm. on the other hand, If the choice of the dividend policy affects the value of the firm, it is considered as relevant theory

e.e. Based on the following assumption:  The firm finances its entire retained earning only.  R and K of the firm remains constant.  . i.WALTER’S MODEL(RELEVANT) Prof. r The cost of capital or the required rate of return. i. k. Walter's model is based on the relationship between the firm’s: Return on investment.  The firm earning are either distributed as dividend or reinvested internally.

D)/Ke Ke Ke  P = Market price per share  D = Dividend per share  E = Earning per share  R = internal rate of return  Ke = Cost of capital  . The firm has a very long or infinite life.• BEGINNING EARNING AND DIVIDEND OF THE FIRM WILL NEVER CHANGE WHILE DETERMING THE VALUE. P=D+ r(E.

 The assumption that cost of capital remains constant does not hold good. As the firms risk pattern does not remain constant it is not proper to assume K remains constant.  The internal rate of return does not remain constant with the increased investment the rate of return also changes. Firms do raise funds from external financing.CRITICISM OF WALTER'S MODEL Investments are financed through retained earnings only is seldom true in real world.  .

So all OPR are optimum.WALTERS VIEW ON OPTIMUM DIVIDENED PAYOUT    Growth firms ( R>K ): Firms can naturally earn a return which is more than what shareholders could earn on their own. DECLINING FIRMS(R<K): Here company earns a return which is less than what the shareholders can earn on their investments . So Entire earning OPR for a firm is 100% . NORMAL FIRMS (R=K): Firms earn a rate of return which is equal to that of shareholders in that case dividend policy will not have any influence on the price per share.it should not make any sense to retain earnings. So OPR for growth is 0%.

PRACTICAL PROBLEMS Question1 : EPS = RS 8 Assumed rate of return Cost of capital (K) = 12% a) 15% b) 10 % c) 12 % Solution: To show the effect of dividend policy. 100%. let us consider 0%. . 50%.

I WHEN R>K (15>12) At 0% payout ratio (dividend = 0) P = D + R(E – D)/ Ke Ke = 0 + 0.12(8-8) = Rs 66.33 O.12 Price per share decreases as and when payout ratio is increased .67 0.15/0.12(8-4) = Rs 75 0.15/0.15/0.12 At 50% payout ratio = 4 + 0.12 At 100% payout ratio = 8 + 0.12(8-0) = Rs 83.

10/0. WHEN R<K(10%<12%) At 0% payout ratio P = 0 + 0.55 0.11 0.12(8-4) = Rs 61.II.12 At 100% payout ratio P = 8 + 0.12(8-0) = Rs 55.12 At 50% payout ratio P = 4 + 0.12(8-8) = Rs 66.12 Price per share increases as and when the payout ratio is increased .10/0.10/0.66 0.

12 Price per share remains the same at all payout ratios.12/0.12/0.12/0.12 At 50% payout ratio P = 4 + 0.12(8-0) = Rs 66.12 At 100% payout ratio P = 8 + 0. WHEN R=K (12% = 12%) At 0% payout ratio P = 0 + 0. which is optimum.12(8-8) = Rs 66. So there is no one payout ratio.III. .12(8-4) = Rs 66.66 0.66 0.66 0.

 K also remains constant  Firm derives its earning in perpetuity.2.  The retention ratio (b) once decided upon is constant thus.GORDON’S MODEL(RELEVANT) ASSUMPTIONS:  The firm is an all equity firm ( no debt)  No outside financing and all investments are financed by retained earning  (R) remains constant. the growth rate (g ) is also constant (g=b)  K>g  A corporate tax does not exit. .

When R<K the price per share increases as the dividend payout ratio increases. ( r = internal rate of return). The price per share increases as the dividend payout ratio decreases. According to Gordon. when R>K. When R= K the price per share remains unchanged to the change in the payout ratio .FORMULA P = E (1 – b) Ke – br P = Price per share K = cost of capital E = earning per share b = retention ratio (1 – b) = payout ratio G = b growth rate.

10% 2. 50% 50% . 11%. 10% for the following levels of D/ P PROBLEMS: Ratios. For r = 12%. calculate price per share.If K= 11% and earning per share = Rs 15. D/P RATIO RETENTION RATIO 90% 1.

b = 50% P = 15 (1 – 0.12  b).9*0.5 *0. D/P RATIO OF 50%.11-0.12 Price per share increases and the payout ratio decreases .0.0.SOLUTION: If R>K(12>11) P = E( 1-b) Ke -br a). D/P ratio of 10%.11.9 ) = Rs 750 0.5 ) = Rs 150 0. Retention = 90% P = 15 ( 1.

R = 50% P = 15(1-0.R=K (11%=11%) a) D/P RATIO OF 10% .6 0.6 0.11.11 Price per share remains same at all payout ratio  .9*0.5) = Rs 136.11–0.5 *0.0.11 b) D/P RATIO OF 50%. R = 90% P = 15(1 – 0.9) = Rs 136.

11-0.10 b) d/p of 50% . R = 90% P = 15(1-0.R = 50% P= 15(1-0.If R< K (10% <11%) a) d/p ratio of 10%.5) = Rs 125 0.5*0.9) = Rs 75 0.11-0.10 Hence price per share increases with the increases in the payout ratio  .9*0.

THE THEORY OF IRRELEVANCE The theory of irrelevance says that the value of firm is independent of its dividend policy. A. Residual approach B. Modigliani and miller approach(MM model) .

dividend decision has no affect on the wealth of the shareholders or the prices of the shares and hence it is irrelevant as far as the valuation of the firm is concerned. Thus . decision to pay the dividend or retain the earnings may be taken as a residual decision. Their basic desire to earn a higher rate of return   . Dividend decision merely decision because the earnings available may be retained in the business for re-investment as a part of financing decision .THE IRRELEVANCE CONCEPT OF DIVIDEND RESIDUAL APPROACH – According to this theory. It assumes that investors do not differentiate between dividend and retentions by the firm.

But.  Thus. if the funds are not required in the business they may be distributed as dividends. the decision to pay dividends or retain the earnings may be taken as residual decision.  This theory assumes that investors do not differentiate between dividends and retention by the firm  .

the dividend policy of the firm is irrelevant.  .MODIGLIANI – MILLER MODEL (IRRELEVANCE THEORY) According to MM.  Splitting of earning between retention and dividends may be in any manner the firm likes does not affect the value of the firm. as it has no effect on the market price of the shares and the value of the firm is determined by the earning capacity of the firm or its investment policy.

paying the underwriters. There are either no taxes or there are no differences in the tax rates applicable to dividends and capital gains. . Investors behave rationally Information about the company is available to all without any costs. government fees) and transaction costs. No investor is large enough to affect the market price of shares. There are no floatation(costs of printings.ASSUMPTIONS       There are perfect capital markets.

 .The firm has a rigid investment policy.  There is no risk or uncertainty in regard to future of the firm.

g. having investment opportunities.  For e.THE ARGUMENT OF MM The argument given by MM in support of their hypothesis is that whatever increase in the value of the firm results from the payment of the dividend. distributes all its earnings among the shareholders.  . will be exactly off set by the decline in the market price of shares because of external financing and there will no change in the total wealth of the shareholders. if a co.it will have to raise additional funds from external sources.

 Thus whatever a shareholder gains on account of dividend payment is neutralised completely by the fall in the market price of shares due to decline in expected future earnings per share. resulting in fall in the earnings per share in the future. of shares or payment of interest charges.This will result in the increase in no.  .

Po = Market price per share at the beginning of the period.This can be put in the form of the following: Po = D1 + P1 1 + Ke Where. or prevailing market price of a share D1 = Dividend to be received at the end of the period  .

P1 = Market price per share at the end of the period. The value of P1 can be derived by the above equation as under: P1 = Po (1 + Ke ) – D1 . Ke = cost of equity capital .

In such case no of shares to be issued can be computed as: M = I ( E – Nd1) P1 .  The MM hypothesis can be explained in another form also presuming that investment required by the firm on account of payment of dividends is financed out of the new issue of equity shares.

 Further . D1 = dividend to be paid at the end of the period. E = total earning of the firm during the period. npo = value of the firm         . the value of the firm can be ascertained with the help of the following formula: nPo = (n + m)P1 – ( I – E) 1 + Ke m = no of shares to be issued. I = investment required . n = no of shares outstanding at the beginning of the period. Ke = cost of equity capital.

000 and has a proposal for making new investments of Rs 1.Q. show that under the MM hypothesis the payment of dividend does not affect the value of the firm . The firm is contemplating the declaration of dividend of Rs 6 per share at the end of the current financial year. The company expects to have a net income of Rs50.000. It currently has outstanding 5000 shares selling at Rs 100 each. ABC ltd belongs to a risk class for which the appropriate capitalisation rate is 10%.00.

10) – 6 = 100 * 1.(A)Value of the firm when dividend are paid : (1) Price of the share at the end of the current financial year P1 = Po (1 + Ke) – D1 = 100 (1+.10 – 6 = 110 -6 = RS 104 .

nD1) P1 = 1.00.(2) No of the shares to be issued m = I – (E.000 = 769 104 3) Value of the firm nPo = (n+ m )P1 – (I-E) I + Ke .000 – (50.000 – 5000 * 6) 104 = 80.

10 .000 + .00.00.3) Value of the firm nPo = (n+ m )P1 – (I-E) I + Ke = (5000+ 80.000/104 ) *104 – (1.000 –50000) 1 = 5.

( b) Value of the firm when dividend are not paid: Price per share at the end of the financial year P1 = Po (1 + Ke) – D1 = 100(1+.10 = RS 110 2) No of the shares to be issued m = I – ( E.nD1) = 1.000-(50000-0) = 455 P1 110 1) .00.0 = 100 * 1.10).

000) 1 + .3) Value of the firm npo = (n+m)P1 –(I-E) 1 + Ke = (5000+50000/110)110 – (1.000 .00. whether dividends are paid or not the value of the firm remains the same Rs 5.000-50.00.10 = 5.00.000 Hence.

 .  Shareholders may prefer current income as compared to further gains.  Taxes do exist and there is normally different tax treatment for dividends and capital gains.  The firms do not follow a rigid investment policy.CRITICISM OF MM APPROACH Perfect capital market does not exist in reality.  Information about the co. is not available to all the persons.  The firms have to incur floatation costs while issuing securities.