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By ANUP K SUCHAK

What is Dividend Policy
Dividend Policies involve the decisions,
whether-
To retain earnings for capital investment and
other purposes; or
To distribute earnings in the form of dividend
among shareholders; or
To retain some earning and to distribute
remaining earnings to shareholders.
Determinant or Factors affecting
Dividend Policy
• Availability of Divisible Profits
• Availability of Profitable Reinvestment Opportunities
• Availability of Liquidity
• Inflation
• Effect on Market Prices
• Composition of Shareholding
• Company’s own policy regarding stability of dividend
• Contractual restrictions by Financial Institutions
• Extent of access to external sources
• Attitude and Objectives of Management
Dividend
Theories

Relevance Irrelevance
Theories Theories
(i.e. which consider (i.e. which consider
dividend decision to dividend decision to
be relevant as it be irrelevant as it
affects the value of does not affects the
the firm) value of the firm)

Modigliani
Walter’s Gordon’s and Miller’s
Model Model Model
GORDON’S MODEL OF
DIVIDEND POLICY
• According to Prof. Gordon, Dividend Policy
almost always affects the value of the firm. He
Showed how dividend policy can be used to
maximize the wealth of the shareholders.
• The main proposition of the model is that the
value of a share reflects the value of the future
dividends accruing to that share. Hence, the
dividend payment and its growth are relevant in
valuation of shares.
• The model holds that the share’s market price is
equal to the sum of share’s discounted future
dividend payment.
Assumptions of Gordon
Growth Valuation Model.
• The firm is an all equity firm and has no debt
• External financing is not used in the firm. Retained earnings
represent the only source of financing.
• The internal rate of return is the firm’s cost of capital ’k’. It
remains constant and is taken as the appropriate discount rate.
• Future annual growth rate dividend is expected to be constant.
• Growth rate of the firm is the product of retention ratio and its
rate of return.
• Cost of Capital is always greater than the growth rate.
• The company has perpetual life and the stream of earnings are
perpetual.
• Corporate taxes does not exist.
• The retention ratio ‘b’ once decided upon, remain constant.
Therefore, the growth rate g=br, is also constant forever.
Walter’s Valuation Model
Prof. James E Walter argued that in the long-
run the share prices reflect only the present
value of expected dividends. Retentions
influence stock price only through their effect
on future dividends. Walter has formulated
this and used the dividend to optimize the
wealth of the equity shareholders.
Formula of Walter’s
Model
D + r (E-D)
k
P= k
Where,
P = Current Market Price of equity share
E = Earning per share
D = Dividend per share
(E-D) = Retained earning per share
r = Rate of Return on firm’s investment or Internal Rate of
Return
k = Cost of Equity Capital
Assumptions of Walter’s
Model
All financing is done through retained earnings and
external sources of funds like debt or new equity
capital are not used. Retained earnings represents
the only source of funds.
With additional investment undertaken, the firm’s
business risk does not change. It implies that firm’s
IRR and its cost of capital are constant.
The return on investment remains constant.
The firm has an infinite life and is a going concern.
All earnings are either distributed as dividends or
invested internally immediately.
There is no change in the key variables such as EPS
or DPS.
Effect of Dividend Policy on
Value of Share
Case If Dividend Payout If Dividend Payout
ratio Increases Ration decreases
1. In case of Growing Market Value of Share Market Value of a share
firm i.e. where r > k decreases increases
2. In case of Declining Market Value of Share Market Value of share
firm i.e. where r < k increases decreases
3. In case of normal No change in value of No change in value of
firm i.e. where r = k Share Share
Criticisms of Walter’s
Model
No External Financing
Firm’s internal rate of return does not always
remain constant. In fact, r decreases as more
and more investment in made.
Firm’s cost of capital does not always remain
constant. In fact, k changes directly with the
firm’s risk.
Illustration 1 (In case of Growing Firm)
The earnings per share of a company are Rs.
10. The Equity Capitalization rate is 10%.
Internal Rate of return on retained earnings is
20%. Using Walter’s formula:
What should be the optimum payout ratio of
the company?
What should be the price of share at optimum
payout ratio?
How shall this price be affected if different
payout (say 80%) were employed?
Illustration 2 (In case of Normal Firm)
The earnings per share of a company are Rs.
10. The Equity Capitalization rate is 10%.
Internal Rate of return on retained earnings is
10%. Using Walter’s formula:
What should be the optimum payout ratio of
the company?
What should be the price of share at optimum
payout ratio?
How shall this price be affected if different
payout (say 80%) were employed?
Illustration 3 (In case of Declining Firm)
The earnings per share of a company are Rs. 10.
The Equity Capitalization rate is 20%. Internal
Rate of return on retained earnings is 10%.
Using Walter’s formula:
 What should be the optimum payout ratio of the
company?
 What should be the price of share at optimum
payout ratio?
 How shall this price be affected if different payout
(say 80%) were employed?
Illustration 4
The earning per share of a company are Rs.
10 and the rate of capitalization applicable to
it is 10%. The company has before it the
option of adopting a payout of 20% or 40% or
80%. Using Walter’s formula, compute the
market value of the company’s share if the
productivity of retained earning is (a) 20% (b)
10% and (c) 8%. What inference can be drawn
from the above exercise?
Modigliani & Miller’s
Irrelevance Model
According to M-M, under a perfect market
situation, the dividend policy of a 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 and firm’s
earnings are influenced by its investment
policy and not by the dividend policy
Modigliani & Miller’s
Irrelevance Model

Depends on

Depends on
Assumption of M-M Model
Perfect Capital Market: This means that:
 The investors are free to buy and sell securities.
 The investors behave rationally.
 There are no transaction cost/ flotation cost.
 They are well informed about the risk-return on all
types of securities.
 No investor is large enough to affect the market price
of a share.
No Taxes
Fixed Investment Policy
No Risk
Formulae of M-M Model
According to M-M model the market price of a share,
after dividend declared, is calculated by applying the
following formula:
P1 + D1
1 + Ke P =
0
Where,
P0 = Prevailing market price of a share
P1 = Market Price of a share at the end of the period one
D1 = Dividend to be received at the end of period one
Ke = Cost of equity capital
Formulae of M-M Model
The number of shares to be issued to implement the
new projects is ascertained with the help of the
following:
I – (E-nD1)
ΔNP1
=
Where,
ΔN = Change in the number of shares outstanding during the period.
I = Total Investment amount required for capital budget
E = Earning of net income of the firm during the period
n = Number of shares outstanding at the beginning of the period
D1 = Dividend to be received at the end of period one
P1 = Market price of a share at the end of period one
Criticism of M-M Model
No perfect Capital Market
Existence of Transaction Cost
Existence of Floatation Cost
Lack of Relevant Information
Taxes Exist
No fixed investment Policy
Investor’s desire to obtain current income