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Dividend Policy

 The dividend decision requires a financial manager to decided about the distribution of profits as dividends. of significant importance to the firm’s overall objective.  The profits may be distributed in the form of cash dividends to shareholders or in the form of stock dividends (bonus shares).Concept and Significance  The term dividend refers to that portion of profit 2 which is distributed among the shareholders of the firm.  The establishment and determination of an effective dividend policy is therefore. .

Dividend Policy  Different models have been proposed to evaluated the dividend policy decision in relation to value of the firm.  Two schools of thoughts have emerged on the relationship between the dividend policy and value of the firm.  Relevance of dividend policy  Walter’s model  Gordon’s model  Irrelevance of dividend policy  Residuals theory of dividends 3  Modigliani and Miller approach .

E. supports the view that the dividend policy has a bearing on the market price of the share and has presented a model to explain the relevance of dividend policy for valuation of the firm based on the following assumptions:  All investment proposals of the firm are to be financed through retained earnings only and no external finance is available to the firm. rate of return on investment ‘r’ and the cost of capital of the firm ‘ke’ are constant.  The firm has an infinite life.e. i.  The business risk complexion of the firm remains same even after fresh investment decisions are taken. 4 .Relevance of Dividend Policy – Walter’s Model  Walter J.

had the dividends been paid to them.Relevance of Dividend Policy – Walter’s Model  If the firm pays dividend to shareholders. r. and instead retains. then these retained earnings will be reinvested by the firm to get return on these investment. they in turn. will invest this income to get further returns. of the firm must be at least equal to ke.  This expected return to shareholders is the opportunity cost of the firm and hence the cost of capital. that means the firm is earning a return just equal to what the shareholders could have earned.  On the other hand. ke.  This rate of return on the investment. 5 . if the firm does not pay dividends.

therefore.  If r=ke.  If r<ke.Relevance of Dividend Policy – Walter’s Model  In nutshell.  If r>ke. then the firm should have 100% payout ratio and let the shareholders reinvest their dividend income to earn higher returns. the dividend policy of a firm depends upon the relationship between r and ke. 6 . the firm should have zero payout and reinvest the entire profits to earn more than the investors. the dividend is irrelevant and the dividend policy is not expected to affect the market value of the share.

Walter has suggested a mathematical model. P = Market price of Equity share D = Dividend per share paid by the firm r = rate of return on investment of the firm ke = cost of equity share capital E = EPS of the firm 7 . i.e. P = (D/ke) + ((r/ke)(E-D))/ke Where.Relevance of Dividend Policy – Walter’s Model  In order to testify the above.

is the product of its retention ratio ‘b’ and its rate of return ‘r’. i. rate of return on investment ‘r’ and the cost of capital of the firm ‘ke’ are constant.e.Relevance of Dividend Policy – Gordon’s Model  Myron Gordan has also proposed a model suggesting that the dividend policy is relevant and can affect the value of the share and that of the firm. i. The cost of capital besides being constant is more than the growth rate. The business risk complexion of the firm remains same even after fresh investment decisions are taken. g = br.e. ke>g . The growth rate of the firm ‘g’. It is based on the following assumptions:  All investment proposals of the firm are to be financed through     8 retained earnings only and no external finance is available to the firm. The firm has an infinite life.e. i.

rate of return ‘r’ and the market value of the share.  When the investors are certain about their returns. they discount the firm’s earnings at a lower rate and therefore. cost of capital ‘ke’.Relevance of Dividend Policy – Gordon’s Model  This model suggests that the dividend policy is relevant as the investors prefer current dividends as against the future uncertain capital gains. placing higher value for the share and that of the firm.  This model shows that there is a relationship between payout ratio. 9 .

P = Market price of equity share E = EPS of the firm b = Retention ratio (1-dividend payout ratio) r = rate of return on investment of the firm Ke = cost of equity share capital Br = growth rate of the firm 10 . the market price of a share can be calculated as follows: P = (E(1-b))/(ke-br) Where.Relevance of Dividend Policy – Gordon’s Model  Under this model.

 Residual theory of dividends is based on the assumption that either the external financing is not available to the firm or if available. then the wealth of the shareholders will be maximized by retaining profits and reinvesting them in the financing of investment opportunities either by reducing or even by paying no dividend to the shareholders. . cannot be used due to its excessive costs for financing the profitable investment opportunities of the firm.Irrelevance of Dividend Policy – Residuals Theory of Dividends  Two theories have been discussed here to focus 11 on the irrelevance of dividend policy for valuation of the firm.  If a firm has sufficient profitable investment opportunities.

Hence in Residual theory. where .  Kr<ke (new equity).Irrelevance of Dividend Policy – Residuals Theory of Dividends Under the Residuals Theory.  Using the optimal financing mix. If the available profits are more than this need. the firm would treat the dividend decision in 3 steps:  Determining the level of capital expenditure which is determined by the investment opportunities. find out the amount of equity financing needed to support the capital expenditures as above. the dividend policy is influenced by: 12  The company’s investment opportunities and  The availability of internally generated funds. the retained earnings would be used to meet the equity portions financing in the above step. then the surplus may be distributed as dividends to shareholders.

Irrelevance of Dividend Policy – Modigliani and Miller Approach  As per MM Model the dividend policy is immaterial and is of no consequence to the value of the firm.  What matters is the investment decisions which determine the earnings of the firm and thus affect the value of the firm. The implication . There is no taxes an no flotation cost. All information's are freely available to all the investors. There is no transaction cost and no time lag. The firm has a defined investment policy and the future profits are known with certainty. 3. 4. 5. 2. 13 The capital markets are perfect and the investors behave rationally. Securities are divisible and can be split into any fraction. 6.  Assumptions of the MM Approach: 1.

Irrelevance of Dividend Policy – Modigliani and Miller Approach  The model has used the arbitrage process to 14 show that the division of profits between dividends and retained earnings is irrelevant from the point of view of the shareholders.  The amount of dividends paid to existing shareholders will be replaced by new share capital raised externally.  The benefit of increase in market value as a .  The model shows that given the investment opportunities. a firm will finance these either by ploughing back profits or if pays dividends. then will raise an equal amount of new share capital externally by selling new shares.

Po = Present market price of the share Ke = Cost of equity share capital D1 = Expected dividend at the end of year 1 P1 = Expected market price of the share at the end of year 1 If the firm is going for fresh share capital: nPo = 1/(1+ke) * [(n+m)P1 – I + E] Where.Irrelevance of Dividend Policy – Modigliani and Miller Approach Po = 1 / (1+ke) * (D1 + P1) Where. nPo = Value of the firm Ke = Cost of equity share capital n = existing no of equity shares m = New no of equity shares P1 = Expected market price of the share at the end of year 1 I = Total funds required for investments E = Total Earnings 15 .

replacement of amount paid as dividend by the issue of fresh capital.  The arbitrage process involves 2 simultaneous actions:  Payment of dividend by the firm and  Raising of fresh capital  With the help of arbitrage process. .e.Irrelevance of Dividend Policy – Modigliani and Miller Approach  The success of the MM model depends upon the arbitrage process i. MM have 16 shown that the dividend payment will not have any effect on the value of the firm.