Dividend Policy

It is the reward for investment made by them in the shares of the company. .Meaning of dividend The part of earning that is distributed among shareholder is called dividend.

(i) To retain 100% of the earnings in the business & deploy them for business (ii) To distribute 100% of the earnings among shareholders (iii) To retain a part and distribute the remainder to shareholders .Meaning of dividend policy To determine the amount of earnings to be distributed to shareholders and the amount to be retained in the firm.

(i) The irrelevance concept of dividend (ii) The relevance concept of dividend .Dividend Decision There are two schools of thought regarding dividend policy. One set of people believes that dividend policy affects the value of firm. while the other set of people as irrelevant to the value of firm.

Theory of Relevance According to them dividends communicate information to the investors about the firms profitability and hence dividend decision becomes relevant. . The firms which pay higher dividends will have greater value as compared to those which do not pay dividends or have a lower dividend pay out ratio.

. then firm should retain earnings. The following observations have been made: (a) If the firm earns a higher rate of return on its investment that the required rate of return. Such firms are growing firms & optimum pay out is zero so it will maximize the value of shares.Walters Approach According to this the relationship between the internal rate of return earned by the firm and the cost of capital is very significant in determining dividend policy to maximize the goal of wealth of shareholders.

(c) For a normal firm investors are indifferent to the dividend policy because retained earnings will yield the same return as distributed earnings.(b) For a declining firm the shareholders can earn more on distributed earnings than the firm can provide from retained earnings. . Thus share price is constant .

Assumptions ‡ ‡ ‡ ‡ ‡ Internal financing: Constant return and cost of capital: 100% pay out or retention: Infinite time or very long life of firm: Earnings or dividends do not change while determining the value: .

.Criticism ‡ No external financing ‡ Constant rate of return: ‡ Constant cost of capital: it changes directly with the firms risk.

Gordon s Approach 1. When the rate of return of firm on its investment is greater than the required rate of return .the price per share increases as the dividend pay out ratio decreases. 2. When rate of return is less than required rate of return price per share increases due to increase in dividend pay out ratio . When the rate or return is equal to the required rate of return the price per share remains unchanged & not affected by dividend policy 3.

Assumptions ‡ ‡ ‡ ‡ ‡ ‡ ‡ All equity firm and has no debts No external financing Constant return Constant cost of capital No corporate taxes Constant retention Cost of capital greater than growth rate .

For shareholders wealth. it is immaterial how the earnings are distributed or retained.Irrelevance Theory of Dividend According to this there is no relation between dividend policy and market value of shares and the value of firm is determined by the earning capacity of the firm or its investment policy. Dividend is relevant to shareholders wealth not the dividend policy .

buying and selling actions of investors do not influence the price. all investors are equally well informed and interpret information in same way. ‡ No uniform taxes: ‡ Investors are indifferent to dividend income and capital gains .Assumptions ‡ Uniform/homogeneous expectations: ‡ Perfect capital market: no transaction cost.

P0 = D1 + P1 P0= mkt price per share in begning 1 + Ke D1 = dividend at end Ke = cost of equity capital P1 = mkt price per share at end .Explanation The increase in the value of the firm results from the payment of dividend. will be exactly off set by the decline in the market price of shares because of external financing and there will be no change in the total wealth of the shareholders.

Criticism ‡ Investment and dividend policy are linked and not independent of each other ‡ Existence of taxes ‡ Firms has to incur transaction cost ‡ Perfect capital market does not exist in reality ‡ Information is not available to all the persons .

Considerations in Dividend Policy ‡ ‡ ‡ ‡ ‡ ‡ ‡ Legal restrictions Magnitude and trend of earnings Desire and type of shareholders Nature of industry Age of company Future financial requirements Governments economic policy .

‡ ‡ ‡ ‡ ‡ ‡ Taxation policy Inflation Control objectives Requirements of institutional investors Stability of dividends Liquid resources .

Types of dividend policy ‡ Regular dividend policy: usual rate ‡ Stable dividend policy: consistency or lack of variability ‡ Irregular dividend policy: uncertainty ‡ No dividend policy: due to unfavorable conditions or requirement of funds .