Unit 2:

Dividend Decisions
 Content
• Forms of dividends: Cash, Stock dividend, Stock
Splits
• Theories: Relevant and Irrelevant theories
• Determinants of Dividend

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 Theories
1. Walter’s Model (Relevance)
2. Gordon’s Model (Relevance)
3. MM Hypothesis (Irrelevance)
4. Bird-in-the-hand theory (Uncertainty)

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 Theories: Walter’s Model (Relevance)
Assumptions:
a) Internal financing
b) Constant return and cost of capital
c) Perfect capital market
d) Constant EPS and DPS
e) Infinite time

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 Theories: Walter’s Model (Relevance) cont.
The model depends on two things:
r, firm’s rate of return
k, cost of capital

a) Growth firm (r > k)

b) Normal firm (r = k)
c) Declining firm (r < k)

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 Theories: Walter’s Model (Relevance) cont.

P = market price per

share DIV = dividend per
share EPS = earning per Present value of
Present value
constant dividend
share
r = Firm’ rate of of capital
gains
return k = cost of capital
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 Theories: Walter’s Model (Relevance) cont.

OR

ke = cost of equity capital

g = Expected growth rate of
earnings
r = Expected rate of return
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b = retention rate Faculty
 Theories: Walter’s Model (Relevance) cont.
Numerical:
EPS of a company is Rs. 10 and the rate of capitalisation is 10
%. The company has an option to adopt (a) 0% (b) 40% (c)
80% and (d) 100% payout ratio. Compute the market price of
shares as per Walter model if rate of return is (a) 15% (b) 10%
and (c) 8%.
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 Theories: Walter’s Model (Relevance) cont.
Growth Firm r = 0.15 k = 0.10 EPS = Rs. 10
Case 1: Payout Ratio is 0% Case 2: Payout Ratio is 40%
Div 0 Div 4
P Rs. 150 P Rs. 130

Case 3: Payout Ratio is 80% Case 4: Payout Ratio is 100%

Div Rs. 8 Div Rs. 10
P Rs. 110 P Rs. 100
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 Theories: Walter’s Model (Relevance) cont.
Normal Firm r = 0.10 k = 0.10 EPS = Rs. 10
Case 1: Payout Ratio is 0% Case 2: Payout Ratio is 40%
Div 0 Div 4
P Rs. 100 P Rs. 100

Case 3: Payout Ratio is 80% Case 4: Payout Ratio is 100%

Div Rs. 8 Div Rs. 10
P Rs. 100 P Rs. 100
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 Theories: Walter’s Model (Relevance) cont.
Declining Firm r = 0.08 k = 0.10 EPS = Rs. 10
Case 1: Payout Ratio is 0% Case 2: Payout Ratio is 40%
Div 0 Div 4
P Rs. 80 P Rs. 88

Case 3: Payout Ratio is 80% Case 4: Payout Ratio is 100%

Div Rs. 8 Div Rs. 10
P Rs. 96 P Rs. 100
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 Theories: Walter’s Model (Relevance) cont.
Hence

Retain all earnings when r > k

Distribute all earnings when r < k
Dividend has no effect when r =
k

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 Theories: Walter’s Model (Relevance) cont.
Criticism
a) No external financing
b) Constant return, r
c) Constant cost of capital, k

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 Theories: Gordon’s Model (Relevance)
Assumptions:
1. All equity firms
2. No external financing
3. Constant return
4. Constant cost of capital
5. Perpetual earnings
6. No taxes
7. Constant retention
8. Cost of capital is greater than growth
rate
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 Theories: Gordon’s Model (Relevance) cont.
Market value of share is equal to the present value of
an infinite stream of dividend received.

DIV is expected to grow when earnings are

retained. DIVt = (1 – b)EPSt

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 Theories: Gordon’s Model (Relevance) cont.

Zero Growth rate

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 Theories: Gordon’s Model (Relevance) cont.
Numerical:
EPS of a company is Rs. 10 and the rate of capitalisation is 10
%. The company has an option to adopt (a) 40% (b) 60% and
(c) 90% payout ratio. Compute the market price of shares as
per Gordon model if rate of return is (a) 15% (b) 10% and (c)
8%.
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 Theories: Gordon’s Model (Relevance) cont.
Growth Firm r = 0.15 k = 0.10 EPS = Rs. 10
Case 1: Payout Ratio is 40% Case 2: Payout Ratio is 60%
g = br = 0.09 g = br = 0.06
P Rs. 400 P Rs. 150

Case 3: Payout Ratio is 90%

g = br = 0.015
P Rs. 106
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 Theories: Gordon’s Model (Relevance) cont.
Normal Firm r = 0.10 k = 0.10 EPS = Rs. 10
Case 1: Payout Ratio is 40% Case 2: Payout Ratio is 60%
g = br = 0.06 g = br = 0.04
P Rs. 100 P Rs. 100

Case 3: Payout Ratio is 90%

g = br = 0.01
P Rs. 100
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 Theories: Gordon’s Model (Relevance) cont.
Declining Firm r = 0.08 k = 0.10 EPS = Rs. 10
Case 1: Payout Ratio is 40% Case 2: Payout Ratio is 60%
g = br = 0.048 g = br = 0.032
P Rs. 77 P Rs. 88

Case 3: Payout Ratio is 90%

g = br = 0.008
P Rs. 98
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 Theories: Gordon’s Model (Relevance) cont.
The crux of the theory is
1. Investors are risk averse
2. They put premium on certain return and discount
uncertain returns (future dividend is uncertain w.r.t. the
amount as well as timing). Less importance to future
dividend as compared to current dividend. Retained
earnings are risky promise.

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 Bird – in – hand argument
In reality, Gordan states that dividend policy does affect the
value of a share even when r = k.

Uncertainty increases with futurity.

a) Future dividend
b) Timing
c) Cost of capital or discounting rate is uncertain

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 Irrelevance of Dividends
• Dividend policy of the firm is a residual decision

• Dividend are a passive residuals

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Theories: Miller Modigliani Model (Irrelevance)
• Dividend policy has no effect on the share price of the firm.

• What matters is the investment policy through which

the firm can increase its earnings.

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Theories: Miller Modigliani Model (Irrelevance) cont.

Assumptions:
1. Perfect capital market
2. No taxes
3. Fixed investment policy
4. Risk is certain

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Theories: Miller Modigliani Model (Irrelevance) cont.

Three Situations regarding payment of dividends:

a) The firm has sufficient cash to pay dividends
b) The firm does not have sufficient cash to pay dividends
and therefore it issues new shares to finance the payment
of dividends
c) The firm does not pay dividends but shareholders
need cash.

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Theories: Miller Modigliani Model (Irrelevance) cont.

Value of the firm, when dividends are paid:

(a) Price per share at the end of year 1,
(b) Amount required to raised from the issue of new
shares

(c) Number of additional shares,

(d) Value of the firm,
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Theories: Miller Modigliani Model (Irrelevance) cont.

Value of the firm, when dividends are not paid:

Don’t include D1.

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Theories: Miller Modigliani Model (Irrelevance) cont.

Numerical: (Khan, M.Y. and Jain, P.K., Financial Management, Page 29.8)

A company belongs to a risk class for which the approximate

capitalisation is 10%. It currently has outstanding 25,000
shares at Rs 100. The firm is contemplating the declaration of
a dividend of Rs 5 per share at the end of the current financial
year. It is expected to have a net income of Rs. 2,50,000 and
has a proposal for making new investment of Rs. 5,00,000.
Show that under the MM assumptions, the payment of
dividend does not affect the value of the firm.
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Theories: Miller Modigliani Model (Irrelevance) cont.
Numerical:
(a) Calculate the firm value if dividends are paid
(b) Calculate the firm value if dividends are not paid

1 1
(i) Price per
e
share:Amount
(ii) required to raised from the issue of new shares

(iii) Number of additional shares,

(iv) Value of the firm,
1
1
e
1
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Theories: Miller Modigliani Model (Irrelevance) cont.
Critique:
a) Capital markets are perfect
i. No taxes
ii. Flotation Costs
iii. Transaction costs
iv. Institutional restrictions
b) Resolution of uncertainty
i. Near vs Distant dividend
ii. Informational content of dividends
iii. Sale of stock at uncertain price

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 Determinants of Dividend Policy
a) Dividend payout ratio
b) Stability of dividends (constant DPS, DP ratio)
c) Legal, contractual and internal constraints and restrictions
i. Legal requirements
1) Capital Impairment Rules (paid-up capital)
2) Net Profits
3) Insolvency
ii. Contractual Requirements

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 Determinants of Dividend Policy (cont.)
iii. Internal Constraints
1) Liquid Assets
2) Growth Prospects
3) Financial Requirements
4) Availability of funds
5) Earnings Stability
d) Owner’s consideration
i. Tax status of the shareholders
ii. Opportunities of investment
iii. Dilution of ownership
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 Determinants of Dividend Policy (cont.)
e) Clientele effect
f) Capital market considerations
g) Inflation

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 Forms of dividends
Bonus shares
Stock Splits
 Signalling Hypothesis
 Trading Range Hypothesis
 Liquidity Hypothesis
 Tax-timing Hypothesis
 Cash Substitution
Hypothesis
 Attention Hypothesis
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 Forms of dividends (cont.)
Share repurchase (Buyback of shares)
 Advantages
oSignalling Effect
oTax Advantage
oPrice enhancing effect
oHelps in maintaining stable dividend policy
oFlexibility in dividend payment
oUseful for employee stock option plan

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