DIVIDEND Decision

BBA 204 1/7/2020 1

 Outline

1. Dividend Concept
2. Dividend Decision and Valuation of the Firm
3. Relevance of Dividend Policy
a. Walter’s Model
b. Gordon’s Model
4. Irrelevance of Dividend Policy
a. Residual Theory
b. MM Model
5. Practical Questions
1/7/2020 BBA 204 2
 Dividend

• Dividend refers to that portion of profit(after tax) which is

distributed among the owners/shareholders of the firm.
• In dividend decision, financial manager is concerned to decide one
or more of the following:
1. Should the profits be retained back to finance the investment
decision.
2. Whether any dividend be paid ? If ,yes , how much dividends be
paid ?
3. When these dividends be paid? Interim or final?
4. In what form should the dividends be paid ? Cash dividend or Bonus
shares?

• All these decisions are inter related and have bearing on the growth
plans of the firm.

1/7/2020 BBA 204 3

 Dividend Policy and its Significance
• Dividend policy is the policy which the management
formulates in regard to earnings for distribution as
dividends among shareholders. It determines the
division of earnings between payments to
shareholders and retained earnings.
• It is basically concerned with deciding whether to
pay dividend in cash now or to pay increased
dividends at a later stage or distribution of profits in
the form of bonus shares

1/7/2020 BBA 204 4

Continued

• The basic question to be resolved while framing the dividend

policy is ;
1. What is the rationale for dividend payments?
2. Given the firm’s investment and financing decisions , what is
the effect of the firm’s dividend policies on the share price?
3. Does a high dividend payment decrease, increase, or does not
affect at all the share price.
• Different models have been proposed to evaluate the dividend
policy decision in relation to value of the firm

1/7/2020 BBA 204 5

 School of Thoughts

• There are two school of thoughts associated with

dividend policy
1. Dividend relevance theories as given by :
- James E.Walter (Walter’s model)
– Myron Gordon (Gordon’s model)
2. Dividend irrelevance theories as given by :
- Residuals Theory of Dividends
- Modigliani and Miller

1/7/2020 BBA 204 6

 Dividend relevance theories
These are theories whose propagatorsargue that the dividend
policy of a firm affects the value of the firm. According to
the propagators current cash dividend reduce investors
uncertainty, the investors will discount the firm's
earnings at a lower rate , ke thereby placing a higher
value on the shares .If dividends are not paid then the
uncertainty will increase , raising the required rate of
return, thus lowering the market price of the share. So,
dividend policy has an effect on the market value of the
share and thus on value of firm

1/7/2020 BBA 204 7

 Walter’s Model
J.E Walter supports the relevance of dividend theory and
give his model based on following assumptions:

1. Internal financing – the firmfinances all its investments

through retained earnings; debt or new equity is not
issued.
2. Constant return and cost of capital – the firm’s rate of
return, r, and its cost of capital k areconstant
3. Infinite time – the firm has a very long or infinite life

1/7/2020 BBA 204 8

• Walter’s formula to calculate the market price per share
(P) is:
P = D/ke + {(E-D)*r/ke}/ke,
where
P = market price per share
D = dividend per share
E = earnings per share
r = internal rate of return of the firm
k = cost of capital of the firm
The mathematical equation indicates that the market price
of the company’s share is the total of the present values
of:
• An infinite flow of dividends, and
• An infinite flow of gains on investments from retained
earnings.
1/7/2020 BBA 204 9
 Question
A company has an EPS of Rs. 15. The market rate of
discount applicable to the company is 12.5%. Retained
earnings can be reinvested at IRR of 10%. The company
is paying out Rs.5 as a dividend. Calculate the market
price of the share
Solution :
D = 5, E = 15, k = 12.5%, r = 10%
P = 5/.125 + {.10 * (15-5)/.125} /.125 = 104

1/7/2020 BBA 204 10

Find out the MP of share under different rate of return and
dividend payout ratios .

1/7/2020 BBA 204 11

 Implications of Walter’s Model
• GROWTH FIRM : Growth firms are characterized by an internal rate of
return > cost of the capital i.e. r > k. These firms can earn more return for
their shareholders in comparison to what the shareholders can earn if they
reinvested the dividends somewhere else. Hence, for growth firms, the
optimum payout ratio is 0%.
• NORMAL FIRM : Normal firms have an internal rate of return = cost of
the capital i.e. r = k. The firms in normal phase will make returns equal to
that of a shareholder. So, there is no optimum payout ratio for firms in the
normal phase. Any payout is optimum.
• DECLINING FIRM : Declining firms have an internal rate of return <
cost of the capital i.e. r < k. Declining firms make returns that are less than
what shareholders can make on their investments. The optimum dividend
payout ratio, in such situations, is 100%.

1/7/2020 BBA 204 12

 Practice Question
• The earnings per share of the face value of Rs.100 of
PQR Ltd is Rs.20 . It has a rate of return of 25%.
Capitalization rate of its risk class is 12.5%. If
Walter’s model is used:
a. What should be the optimum payout ratio ?
b. What should be the market price per share if payout
ratio is Zero ?
c. Suppose, the company has a payout of 25% of EPS ,
what would be the price per share ?

1/7/2020 BBA 204 13

 Criticism of Walter’s Model

• NO EXTERNAL FINANCING
• CONSTANT R AND K
• CONCLUSION OF RETAINING 100 % OF
EARNING IN CASE OF R > KE
• Assumption of no debt financing, preference share
capital financing, no flotation cost transaction cost,
etc

1/7/2020 BBA 204 14

 Gordon’s Model
Myron Gordon supports the relevance of dividend theory and
give his model based on following assumptions :

1. Internal financing – the firmfinances all its investments through

retained earnings; debt or new equity is notissued.
2. Constant return and cost of capital – the firm’s rate of return, r,
and its cost of capital k areconstant
3. Infinite time – the firm has a very long or infinite life
4. Growth rate of firm “g” is product of its retention ratio b and
rate of return r i.e. g = br
5. Cost of capital is more than growth rate ie. Ke > g

1/7/2020 BBA 204 15

Gordon’s formula to calculate the market price per share (P) is
P = {EPS * (1-b)} / (k-g)
Where,
P = market price per share
EPS = earnings per share
b= retention ratio of the firm
(1-b) = payout ratio of the firm
k = cost of capital of the firm
g = growth rate of the firm = b*r

The above model indicates that the market value of the company’s
share is the sum total of the present values of infinite future dividends
to be declared.

1/7/2020 BBA 204 16

 Question
The EPS of the company is Rs. 15. The market rate of discount
applicable to the company is 12%. The dividends are expected to
grow at 10% annually. The company retains 70% of its earnings.
Calculate the market value of the share using Gordon’s model.
Solution :
E = 15
b = 70%
k = 12%
g = 10%
P = {15 * (1-.70)} / (.12-.10) = 15*.30 / .02 = 225

1/7/2020 BBA 204 17

 Implications of Gordon’s Model
• GROWTH FIRM : A growth firm’s internal rate of return (r) > cost
of capital (k). It benefits the shareholders more if the company
reinvests the dividends rather than distributing it. So, the optimum
payout ratio for growth firms is zero.
• NORMAL FIRM : A normal firm’s internal rate of return (r) = cost
of the capital (k). So, it does not make any difference if the company
reinvested the dividends or distributed to its shareholders. So, there
is no optimum dividend payout ratio for normal firms.
• DECLINING FIRM : The internal rate of return (r) < cost of the
capital (k) in the declining firms. The shareholders are benefitted
more if the dividends are distributed rather than reinvested. So, the
optimum dividend payout ratio for declining firms is 100%.

1/7/2020 BBA 204 18

 Irrelevance of Dividend Theory
These are theories whose propagatorsargue that the dividend
policy of a firm does not affects the value of the firm.
According to the propagators, shareholders don't
differentiate between the present dividend or future
capital gains as firms that pay more dividends offer less
price appreciation but provide the same total return to
shareholders ,given the risk characteristics of the firm

1/7/2020 BBA 204 19

 Residual Theory of Dividend Policy
• The residual theory of dividend policy holds that the firm will
only pay dividend from residual earnings, that is dividends
should be paid only if funds remain after the optimum level of
capital expenditures is incurred i.e. all suitable investment
opportunities have been financed. With a residual dividend
policy, the primary focus of the firm is on investments and
hence dividend policy is a passive decision variable. The value
of a firm is a direct function of its investment decisions thus
making dividend policy irrelevant.
• Thus a firm does not decide as to how much dividends be paid
rather it decides as to how much profits should be retained .
The profits not required to be retained may be distributed as
dividends.
1/7/2020 BBA 204 20
 Modigliani and Miller Approach
MM have argued that market price of a share is affected by the
earnings of the firm and not by pattern of income distribution.
Dividend policy is immaterial , whereas investment policy is the
one who affect the value of the firm.
Assumptions :
1. Capital markets are perfect and investors behave rationally.
2. All information is freely available to the investors
3. No transaction cost and no time lag
4. Securities are divisible perfectly
5. No taxes, no flotation cost
6. Firm has defined investment policy and the future profits are
known with certainty.
1/7/2020 BBA 204 21
 MM Model
• MM approach can be proved with the help of the following formula:
Po = D1 +P1
1+Ke
Where, Po = Prevailing market price of a share.
Ke = Cost of equity capital.
D1 = Dividend to be received at the end of period one.
P1 = Market price of the share at the end of period one.

If company has “n” number of shares outstanding, then, value of the firm is :
nPo = nD1 +nP1
1+Ke
Now, company plans to issue “m” number of equity shares at a price P1 to
finance the investment opportunities at the end of the year.
New value of the firm

1/7/2020 BBA 204 22

Continued

nPo = 1* (nD1 +nP1+ mp1-mp1)

1+Ke
Where: mp1 = Investment – ( total Earnings- Dividend Paid)
= I –E + nD1
Hence
nPo = 1 * ( nD1 + (n+m)P1 – ( I –E + nD1)
1+ke
= 1 * { nD1 + (n+m)P1 –I +E –nD1 }
1+ ke

= 1 * { (n+m)P1 –I +E}
1+ ke

1/7/2020 BBA 204 23

• Ram company belongs to a risk class for which the appropriate
capitalization rate is 12%. It currently has outstanding 30000 shares selling
at Rs. 100 each. 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 Rs. 3,00,000 and a proposal for making
new investments of Rs. 6,00,000. Show that under the MM assumptions,
the payment of dividend does not affect the value of the firm. How many
new shares issued and what is the market value at the end of the year?
• Po = D1+P1/1+ke
Po = 100 , D1 = Rs. 6 , P1 =? , Ke = 12%
100 = 6+P1/1+12%
100 = 6+P1/1.12
6+P1 = 112
P1 = 106
Dividend is not declared Ke = 12%, Po = 100, D1 = 0, P1 = ?
100 = 0+P1/1+0.12
100 = 0+P1/1.12
P1 = Rs. 112
1/7/2020 BBA 204 24
• Calculation of number of new shares to be issued
Dividends Paid Dividends not Paid
Net Income 300000 300000
Total Dividends 180000 –
Retained Earnings 120000 300000
Investment Budget 600000 600000
Amount to be raised as
As new shares 480000 300000 (Investment
– Retained Earnings)
Relevant – Market Price per share Rs. 106 Rs. 112
No. of new shares to be issued 4528.3 2678.6
Total number of shares
at the end of the year
Existing shares 300000 300000
(+) new shares issued 4528.3 2678.6
34528.3 32678.6
Market price per share Rs. 106 Rs112
Market value for shares Rs. 3660000 Rs.3660000

Thus, the expected market value of the firm is same whether the firms pays dividend or not.

1/7/2020 BBA 204 25

 Conclusions of themodel
• Afirm which pays dividends will have to raise funds
externally in order to finance its investment plans. When a
firm pays dividend therefore, its advantage is offset by
external financing.
• This means that the terminal value of theshare declines
when dividends are paid. Thus the wealth of the
shareholders – dividends plus the terminal share price –
remains unchanged.
• Consequently the present value per share after dividends and
external financing is equal to the present value per share
before the payment of dividends.
• Thus the shareholders are indifferent between the payment of
dividends and retention ofearnings.

1/7/2020 BBA 204 26

 Criticism of MM Model

• Presence of Market Imperfections:

• Taxdifferentials (low-payoutclientele)
• Floatation costs
• Transaction and agencycosts
• Information asymmetry
• Diversification
• Uncertainty (high-payout clientele)
• Desire for steadyincome
• No or low taxes ondividends
1/7/2020 BBA 204 27
 Practice Question
ABC Ltd. belongs to a risk class for which the appropriate
capitalization rate is 10%. It currently has outstanding 5,000
shares selling at Rs.100 each. 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 net income of
Rs.50,000 and has a proposal for making new investments of
Rs.1,00,000. Show that under the MM hypothesis, the payment of
dividend does not affect the value of the firm.

1/7/2020 BBA 204 28

 Practice Question
Expandent Ltd. had 50,000 equity shares of Rs. 10 each
outstanding on January 1. The shares are currently being
quoted at par the market. In the wake of the removal of
dividend restraint, the company now intends to pay a
dividend of Rs. 2 per share for the current calendar year. It
belongs to a risk-class whose appropriate capitalization rate
is 15%. Using MM model and assuming no taxes, ascertain
the price of the company's share as it is likely to prevail at
the end of the year (i) when dividend is declared, and (ii)
when no dividend is declared. Also find out the number of
new equity shares that the company must issue to meet its
investment needs of Rs. 2 lakhs, assuming a net income of
Rs. 1.1 lakhs and also assuming that the dividend is paid

1/7/2020 BBA 204 29

 Practice Question
• Ques :1
The earnings per share of company are Rs. 8 and the rate of capitalization
applicable to the company is 10%. The company has before it an option of
adopting a payout ratio of 25% or 50% or 75%. Using Walter's formula of
dividend payout, compute the market value of the company's share if the
productivity of retained earnings is (i) 15% (ii) 10% and (iii) 5%

• Ques:2
The earnings per share of a share of the face value of Rs.100 to PQR Ltd.
is Rs.20. It has a rate of return of 25%. Capitalization rate of its risk class
is 12.5%. If Walter's model is used:
a) What should be the optimum payout ratio?
b) What should be the market price per share if the payout ratio is zero?
c) Suppose, the company has a payout of 25% of EPS, what would be the
price per share?

1/7/2020 BBA 204 30

 Practice Question
From the following information supplied to you, ascertain
whether the firm is following an optimal dividend policy as
per Walter's model:
Total Earnings Rs.2,00,000
Number of equity shares (of Rs.100 each) 20,000
Dividend paid 1,50,000
Price/Earning ratio 12.5
r 10%
The firm is expected to maintain its rate of return on fresh
investment.

1/7/2020 BBA 204 31