Amity Global Business School Amity Global Business School: Dividend Decision-Ii

AMITY GLOBAL
BUSINESS SCHOOL
Noida
DIVIDEND DECISION-II
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BUSINESS SCHOOL OUTLINE
Noida
• Theories of dividend decision
• Dividend policies in practice

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BUSINESS SCHOOL Theories of dividend decision
Noida
Theories on dividend are classified into two groups:
a) Relevant Theory
b) Irrelevant Theory
Relevant theory : These theories states that a dividend decision of the company affects its valuation. In this class
following two theories are most important:
c) Walter’s Model
d) Gordon’s Model
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Gordon’s Model
• It is also called as ‘Bird-in-the-hand’ theory that states that the current dividends are important in determining the value of the firm.
• This theory relates the market value of the company to its dividend policy.
• The determinants of the market value of the share are
a) the perpetual stream of future dividends to be paid,
b) the cost of capital ( k) and
c) the expected annual growth rate of the company (g)

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Gordon’s Model
• The Gordon’s theory on dividend policy states that the company’s dividend policy and the relationship between its rate of return (r) and the cost of capital (k)
influence the market price per share of the company.
Relationship between r and

Increase in Dividend Payout
k
r>k Price per share decreases
r<k Price per share increases
No change in the price per
r=k
share
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Gordon’s Model Assumptions:
• No debt
• The model assumes that the company is an all equity company, with no proportion of debt in the capital structure.
• No external financing
• The model assumes that all investment of the company is financed by retained earnings and no external financing is required.
• Constant r and k
• Perpetual earnings
• Gordon’s model believes in the theory of perpetual earnings for the company.
• No Corporate tax
• Constant retention ratio
The model assumes a constant retention ratio (b) once it is decided by the company. Since the
growth rate (g) = b*r, the growth rate is also constant by this logic.
• K>G
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Gordon’s valuation model :
P = {EPS * (1-b)} / (k-br)
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

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Gordon’s model Implication:
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
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X Ltd. has an investment of Rs 5,00,000 in assets and 50,000 shares outstanding at Rs. 10 each. EPS is reported
at Rs 15 per share and has a policy of retaining 50% of the earnings. If the appropriate discount rate is 10%, and
required rate of return is also 15% determine the price of company’s share using Gordon’s Growth Model. What
will be the share price if the company has a payout of 80% or 40%?
If dividend payout is 50% P =payout

If dividend {EPS is* 80%
(1-b)} / (k-br) If dividend payout is 40%
EPS = Rs. 15
EPS = Rs. 15 EPS = Rs. 15
b= 50% b=20% b=60%
k= 10% k=10% k=10%
r = 15% r=15% r=15%
15 (1-.5)/10% -7.5% 15 (1- .2)/10%- 3% 15 (1- .6)/10%- 9%
P = Rs 300 P = Rs 171 P = Rs 600
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Ruchi Soya Ltd. is an established company having its shares quoted in the stock market. The company has distributed dividend at 20%
p.a. The paid-up capital of the company was Rs 50 lakh shares of Rs 10 each. Annual growth rate in dividend expected is 3%. The
expected rate of return on its equity capital is 15%. Calculate the value of shares of Ruchi Soya Ltd. based on Gordon’s dividend
growth model.
E(1-b) = Dividend P = {EPS * (1-b)} / (k-br)
Current dividend D0= Rs 2 (20% of Rs 10)

g= 3%
Dividend paid = 2.06
Ke= 15%
P0= 2.06/ .15-.03
P0= 17.17
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Irrelevant theory of dividend
• Modigliani – Miller theory is a major proponent of ‘Dividend Irrelevance’ notion.

• According to this concept, investors do not pay any importance to the dividend history of a
company and therefore, dividends are irrelevant in calculating the valuation of a company.

• This theory is opposite to the ‘Dividend Relevance’ theory which says dividends is
important in the valuation of a company.

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• Modigliani – Miller theory was proposed by Franco Modigliani and Merton Miller in 1961.
• They were the pioneers in suggesting that dividends and capital gains are equivalent when
an investor considers returns on investment.
• The only thing that impacts the valuation of a company is its earnings, which is a direct
impact of the company’s investment policy and the future prospects.
• The investment decision is, thus, dependent on the investment policy of the company and
not on the dividend policy.

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• Modigliani – Miller theory was proposed by Franco Modigliani and Merton Miller in 1961.
• Miller theory goes a step further and illustrates the practical situations where dividends are
not relevant to investors.
• Irrespective of whether a company pays a dividend or not, the investors are capable enough
to make their own cash flows from the stocks depending on their need for the cash.
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• If the investor needs more money than the dividend he received, he can always sell a part of
his investments to make up for the difference.
• Likewise, if an investor has no present cash requirement, he can always reinvest the received
dividend in the stock.
• Thus, the Modigliani – Miller theory firmly states that the dividend policy of a company has
no influence on the investment decisions of the investors.

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Modigliani –Miller Model Assumptions:
1) Perfect capital market

2) No taxes
3) Fixed investment policy
4) No risk of uncertainty
5) Investor is indifferent between dividend income and capital gain income
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Modigliani –Miller Model Valuation:
Step 1: Calculate P1
P0 = (D1 + P1)/ (1+ ke)
Step 2: Calculate new shares issued
(∆n) =(I- E + nD1)/ P1
(∆n) = New Issue of Equity shares at the end of the year
E = Earning
n = Number of Outstanding Equity shares at the beginning of the year
D1= Dividend Paid to existing shareholders at the end of year
I = Investment to be made at the end of the year

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Modigliani –Miller Model Valuation:
Step 3: Calculate the value of the firm
nP0= (n+∆n) P1- I+E/ 1+Ke

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Modigliani –Miller Model Criticism:
• Perfect capital markets do not exist.

• Taxes are present in the capital markets.
• According to this theory, there is no difference between internal and external financing. However, if the flotation costs of new
issues are considered, it is false.

• This theory believes that the shareholder’s wealth is not affected by the dividends.
• The assumption of no uncertainty is unrealistic.
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Modigliani –Miller Model:
The equity capitalization rate of Jupiter Industries Ltd is 12%.The company has 50,000 shares outstanding which have a market price of Rs 200 each. The expects a net
income of Rs 7,00,000 at the end of one year and plans to declare a dividend of Rs 6 per share. The company also plans to invest Rs 10,00,000 in a project after one
year.
You are required to show that Modigliani-Miller model on dividend policy holds good irrespective of whether dividend paid or not.
Case 1 : Dividend is paid
D1= Rs 6 E = Rs 7,00,000
P0= Rs 200 I = Rs 10,00,000
Ke = 12% n = 50,000 shares
Step 1 : Calculate P1
P0 = (D1 + P1)/(1+Ke)
200 = ( 6 + P1)/(1+12%)
P1= (Rs 200 * 1.12) – Rs 6
P1= Rs 218
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year.
D1= Rs 6 E = Rs 7,00,000
P0= Rs 200 I = Rs 10,00,000
Ke = 12% n = 50,000 shares
Step 2 : Calculate new shares issued for financing the investment
(∆n) =(I- E + nD1)/ P1
(∆n) = {10,00,000 – 7,00,000 + (50,000 *6)}/218
∆n = 6,00,000/218 = 2752 shares (shares can’t be issued in fractions)

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year.
D1= Rs 6 E = Rs 7,00,000
P0= Rs 200 I = Rs 10,00,000
Ke = 12% n = 50,000 shares
Step 3 :Calculate the value of the firm
nP0= (n+∆n) P1- I+E/ 1+Ke
50,000* 200 = {(50,000+2752)* 218 – 10,00,000 + 7,00,000}(1+12%)
1,00,00,000 = 1,00,00,000 (approximately)

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year.
Case 1 : Dividend is not paid
D1= Rs 0 E = Rs 7,00,000
P0= Rs 200 I = Rs 10,00,000
Ke = 12% n = 50,000 shares
Step 1 : Calculate P1
P0 = (D1 + P1)/(1+Ke)
200 = ( 0 + P1)/(1+12%)
P1= Rs 200 * 1.12
P1= Rs 224
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year.
D1= Rs 0 E = Rs 7,00,000
P0= Rs 200 I = Rs 10,00,000
Ke = 12% n = 50,000 shares
Step 2 : Calculate new shares issued for financing the investment
(∆n) =(I- E + nD1)/ P1
(∆n) = {10,00,000 – 7,00,000 + (50,000 *0)}/224
∆n = 3,00,000/224 = 1339 shares( Shares can’t be issued in fractions)

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year.
D1= Rs 0 E = Rs 7,00,000
P0= Rs 200 I = Rs 10,00,000
Ke = 12% n = 50,000 shares
Step 3 :Calculate the value of the firm
nP0= (n+∆n) P1- I+E/ 1+Ke
50,000* 200 = {(50,000+1339)* 224 – 10,00,000 + 7,00,000}(1+12%)
1,00,00,000 = 1,00,00,000 (approximately)

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year.
Conclusion: From the above it is established that as per Modigliani- Miller approach whether company pays a dividend or dividend is
not paid, the value of the firm is not changed. It means the dividend decision is a residual decision as it is not affecting the value of the
firm.
AMITY GLOBAL
BUSINESS SCHOOL Current dividend practices in India
Noida
Some of the important dividend practices are:
1. A fixed rupee amount of dividend
2. Minimum rupee amount
3. Fixed percentage of net profit and
4. Dividends as a fixed percentage of market value

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1. A fixed rupee amount of dividend
• This policy emphasizes the significance of regularity in dividends of a given size above everything else.
• Under this policy, there is no connection between dividends paid and current profits earned.
• This policy tends to treat ordinary shareholders somewhat like preference shareholders and gives no particular consideration to the
role played by the investment of retained earnings.
• The danger in using this policy is that if the dividend payments are too large and it takes a large portion of accumulated working
capital than the company might not be able to accommodate with the situation.
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2. Minimum rupee amount
• This policy is based on the proposal that the present shareholders want a regular rupee amount as dividend, however small it may be.
• The small amount of the fixed dividend aims at reducing the chance of ever missing a dividend.
• At the same time it allows a great deal of flexibility for paying higher dividends and does commit the business to adopt the larger
dividend which may or may not be distributed depending on the capital growth plans of the management.
• This is a popular policy for companies with fluctuating incomes.

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3. Fixed percentage of net profit
• This is the most flexible dividend policy as it is related directly to net profits.
• Under this policy, dividends are a fixed percentage of profits which is called as the payout ratio and will fluctuate at exactly the same
rate as profits.
• In this policy Internal financing with retained earnings becomes automatic and inverse to the payout ratio. For example, a 60% payout
is a 40% pay in ratio and a 30% payout is a 70% pay in ratio.
• In this policy it may be better in the interests of shareholders in the long run that corporate management increases the percentage of
dividends when profits decline and decrease it as profits increase.

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4. Dividends as a fixed percentage of market value
• This requires first determining a typical rate of dividend return as a target rate.
• The target may be the average dividend for the industry or it may be the rate paid by a closely competitive company.
• It is based on the belief that management owned an obligation to the shareholders to adjust dividend payment with the
rates paid by competitors and by the industry.
• skrohatgi@amity.edu
• https://www.moneycontrol.com/stocks/marketinfo/dividends_declared/index.php?sel_year=2020

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AMITY GLOBAL

• Dividend policies in practice

Theories on dividend are classified into two groups:

following two theories are most important:

• The determinants of the market value of the share are

a) the perpetual stream of future dividends to be paid,

b) the cost of capital ( k) and

c) the expected annual growth rate of the company (g)

influence the market price per share of the company.

Relationship between r and

Gordon’s Model Assumptions:

Gordon’s valuation model :

P = {EPS * (1-b)} / (k-br)

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

Gordon’s model Implication:

If dividend payout is 50% P =payout

E(1-b) = Dividend P = {EPS * (1-b)} / (k-br)

Current dividend D0= Rs 2 (20% of Rs 10)

Irrelevant theory of dividend

• Modigliani – Miller theory is a major proponent of ‘Dividend Irrelevance’ notion.

company and therefore, dividends are irrelevant in calculating the valuation of a company.

important in the valuation of a company.

an investor considers returns on investment.

impact of the company’s investment policy and the future prospects.

not on the dividend policy.

not relevant to investors.

his investments to make up for the difference.

dividend in the stock.

no influence on the investment decisions of the investors.

Modigliani –Miller Model Assumptions:

1) Perfect capital market

Modigliani –Miller Model Valuation:

P0 = (D1 + P1)/ (1+ ke)

Step 2: Calculate new shares issued

(∆n) =(I- E + nD1)/ P1

(∆n) = New Issue of Equity shares at the end of the year

n = Number of Outstanding Equity shares at the beginning of the year

D1= Dividend Paid to existing shareholders at the end of year

I = Investment to be made at the end of the year

Modigliani –Miller Model Valuation:

Step 3: Calculate the value of the firm

nP0= (n+∆n) P1- I+E/ 1+Ke

Modigliani –Miller Model Criticism:

• Perfect capital markets do not exist.

issues are considered, it is false.

Modigliani –Miller Model:

Case 1 : Dividend is paid

P0= Rs 200 I = Rs 10,00,000

Ke = 12% n = 50,000 shares

P1= (Rs 200 * 1.12) – Rs 6

Modigliani –Miller Model:

Case 1 : Dividend is paid

P0= Rs 200 I = Rs 10,00,000

Ke = 12% n = 50,000 shares

Step 2 : Calculate new shares issued for financing the investment

(∆n) =(I- E + nD1)/ P1

(∆n) = {10,00,000 – 7,00,000 + (50,000 *6)}/218

∆n = 6,00,000/218 = 2752 shares (shares can’t be issued in fractions)