By Nitin Gogia

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
• Attitude and Objectives of Management
 Dividend Theories

Relevance Irrelevance Theories

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

Modigliani and
Gordon’s Miller’s Model
Walter’s 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 firm Market Value of Share Market Value of a share
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 firm No change in value of No change in value of
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.
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
P0 =
1 + Ke
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)
ΔN =
P1
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