Dividend Decisions and

Policy
Dividend Decisions
Dividend decision refers to the policy that 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.
In corporate finance, the dividend decision is made by the directors of a
company about the amount and timing of any cash payments made to the
company’s stockholders.
Since dividend decision relate to the amount and timing of any cash
payments made to the company’s stakeholders, the decision is an
important one for the firm as it may influence its capital structure and stock
price.
Main factor that influence the dividend
decisions
• Growth and profitability
• Liquidity
• Cost and availability of alternative forms of financing
• Managerial control
• Legal constraints
• Access to the capital market
• Inflation
• External restrictions
Dividend policy
Dividend policy is a set of guidelines a company uses to decide how
much of its earnings will pay out to shareholders. Dividend policy is
governed by :
 The long-term financing decision, and
Wealth maximization decision
Three main approaches to dividend policy
Residual dividend policy
Companies using the residual dividend policy choose to rely on
internally generated equity to finance any new projects. As a result,
dividend payments can come out of the residual or leftover equity only
after all project capital requirements are met.
These companies usually attempt to balance in their debt/equity ratios
before making any dividend distributions, deciding on dividends only if
there is enough money left over after all operating and expansion
expenses are met.
Three main approaches to dividend policy
Residual dividend policy
The residual dividend model is based on three key pieces: an investment
opportunity schedule (IOS), a target capital structure, and a cost of
external capital.
• The first step in the residual dividend model is to set a target dividend
payout ratio to determine the optimal capital budget.
• Then, management must determine the equity amount needed to
finance the optimal capital budget. This should be primarily done
through the retained earnings.
• The dividends are then paid put with the leftover, or residual, earnings.
Three main approaches to dividend policy
Residual dividend policy
The primary advantage of this approach is that with capital-projects
budgeting, the residual-model is useful in setting longer-term dividend
policy.
The major disadvantage is that dividends may be unstable. Dividend
payment creates volatility which may be undesirable for some
investors.
This approach may be useful for longer-term planning. However, many
firms do not use this model for calculating quarterly dividends.
Three main approaches to dividend policy
Dividend Stability Policy
Under this policy, quarterly dividends are set at a fraction of annual
earnings. This policy significantly contrasts with the uncertainty brought
by residual dividend policy.
This policy reduces uncertainty for investors and provide them with
income.
Three main approaches to dividend policy
Hybrid dividend policy
This approach is a combination of residual and stable dividend policies.
Under this approach, companies tend to view the debt/equity ratio as a
long-term rather than a short-term goal. This approach is commonly
used by companies that pay dividends.
Practical Considerations in Dividend Policy
• Financial needs of the company
• Constraints on paying dividends
• Legal
• Liquidity
• Access to capital market
• Investment opportunities
• Desire of shareholders
• Stability of dividends
• Form of dividend
Theories on Dividend Policies
• 
Traditional position
Under this position, as expounded by Graham and Dodd, the stock market places
considerably more weight on dividends than on retained earnings. This view is
expressed as

Where:
P – Market price per share
D – dividend per share
E – Earnings per share
m – a multiplier
Theories on Dividend Policies
•Traditional
  position
As per this model, in the valuation of shares the weight attached to
dividends is equal to four times the weight attached to retained earnings.
Hence, we replace E with (D+R)

Or
These weights provided by Graham and Dodd are based on their
subjective judgments and not derived from objective empirical analysis.
Notwithstanding the subjectivity, the major contention is that liberal
payout policy has a favorable impact on stock prices.
Theories on Dividend Policies
Walter Approach
The formula for this approach is given by Prof. James E. Walter. The
model shows how dividends can be used to maximize the wealth
position of equity holders. Prof. Walter argues that in the long run,
share prices reflect only the present value of expected dividends.
Retentions influence stock prices only through their effect on further
dividends.
Theories on Dividend Policies
Walter Approach
The formula is easy to understand and easy to compute. It can envisage
different possible market prices in different situations and considers
internal rate of return, market capitalization rate and dividend payout
ratio in the determination of market value per share.
However, the formula does not consider all the factors affecting
dividend policy and share prices. Moreover, determination of market
capitalization rate is difficult. Further, the formula ignores other factors
such as taxation, various legal and contractual obligations, management
policy and attitude towards dividend policy and so on.
Theories on Dividend Policies
• 
Walter Approach
The relationship between dividend and share price on the basis of Walter’s formula is
shown as:

Where:
MV – Market value of the ordinary shares of the company
Ri – Return on internal retention (the rate company earns on retained profits)
C – Cost of capital
E – Earnings per share
D – Dividend per share
Theories on Dividend Policies
Gordon Growth Model
This model explicitly relates the market value of the firm to dividend
policy. In this model, the current ex-dividend at the amount which
shareholders expected date of return exceeds the constant growth rate
of dividends.
Theories on Dividend Policies
Gordon Growth Model
This is based on the following assumptions:
• The firm is an all equity firm, and it has no debt
• No external financing is used and investment programs are financed exclusively by
retained earnings
• The internal rate of return of the firm is constant
• The appropriate discount rate for the firm remains constant
• The firm has perpetual life
• The retention ratio, once decided upon is constant. Thus, growth rate is also constant.
• The discount rate is greater than the growth rate.
Theories on Dividend Policies
•Gordon
  Growth Model
The relationship between dividend and share price on the basis of
Gordon’s formula is shown as:

Where:
MV – Market price per share (ex-dividend)
D – Current year dividend
g – constant annual growth rate of dividends
C – Cost of equity capital
Theories on Dividend Policies
Modigliani and Miller (MM) Hypothesis
This model supports the “dividend irrelevance theory”. Proponents of
this model argue that the firm’s dividend policy has no effect on its
value of assets and is; therefore of no consequence.
According to the proponents, under the conditions of perfect capital
markets, rational investors, absence of tax discrimination between
dividend income and capital appreciation, given the firm’s investment
policy, its dividend policy may have no influence on the market price of
shares.
Theories on Dividend Policies
Modigliani and Miller (MM) Hypothesis
The hypothesis is based on the given assumptions:
 The firm operates in perfect capital markets in which all investors are
rational and information is freely available to all.
 There are no taxes. Alternatively, there are no differences in the tax
rates applicable to capital gains and dividends.
 The firm has a fixed investment policy.
 There are no floatation or transaction costs.
Risk of uncertainty does not exist.
Theories on Dividend Policies
•Modigliani
  and Miller (MM) Hypothesis
Market price of a share after dividend declared on the basis of MM
model is shown as:

Where:
P0 – The prevailing market price of a share
P1 – Market price of a share at the end of period one
C – the cost of equity capital
D1 – dividend to be received at the end of period one.
Theories on Dividend Policies
•Modigliani
  and Miller (MM) Hypothesis
If the firm were to finance all investment proposals, the total amount raised
through new shares will be ascertained with the help of the formula as:

Where:
– change in the number of shares outstanding during the period
n – number of shares outstanding at the beginning of the period
I – total investment amount required for capital budget
E – earnings of net income of the firm during the period
Theories on Dividend Policies
• 
Lintner’s Model
In 1956, John Lintner conducted a study on actual dividend behavior. He conducted
a series of interviews with businessmen to form a view of how they went about
their dividends decisions. From these interviews, he formulated a model as follows:

Where:
D1 – Dividend in year 1
D0 – Dividend in year 0
EPS – Earnings per share
Af – Adjustment factor
Theories on Dividend Policies
Lintner’s model
This model has two parameters: (a) the target payout ratio; and (b) the
spread at which current dividends adjust to the target.
Lintner concluded, based on his interviews, that:
• Companies tend to set long-run target dividends-to-earnings ratios
according to the amount of positive NPV project that are available.
• Earnings increases are not always sustainable. As a result, dividend
policy is not changed until managers can see that new earnings level
is sustainable.
Theories on Dividend Policies
Radical Approach
This approach takes into consideration the tax aspect on dividend (i.e.,
the corporate tax and the personal tax). It also considers the fact that
tax on dividend and capital gains are taxed as different rate. The
approach is based on one premise that if tax on dividends is higher
than tax on capital gains, the share of the company will be attractive if
the company is offering capital gain.
Theories on Dividend Policies
Dividend Discount Model
It is a financial model that values shares at the discounted value of the
future dividend payments. The model provides a means of developing an
explicit expected return for the market. Since shares are valued on the
actual cash flows received by the investors, it is theoretically the correct
valuation model.
Under this model, the price of a share will be traded is calculated by the
net present value of all expected future dividend payment discounted by an
appropriate risk-adjusted rate. This dividend discount model price is the
intrinsic value of the stock. If the stock pays no dividend, then the expected
future cash flows is the sale price of the stock.
Theories on Dividend Policies
Dividend Discount Model
The security with a greater risk must potentially pay a greater rate of
return to induce investors to buy the security. The required rate of
return (capitalization rate) is the rate of return required by the investors
to compensate them for the risk of owning the security.
The capitalization rate can be used to price a stock as the sum of its
present values of its future cash flows in the same way that interest
rates are used to price bonds in terms of its cash flows.
Theories on Dividend Policies
•Dividend
  Discount Model
The dividend discount model price is the intrinsic value of the stock,
computed as follows:

++…++
Where: P – selling price; D – annual dividend payment; k –
capitalization rate; and n – number of years until stock is sold
Theories on Dividend Policies
Dividend Discount Model
In an efficient market, the market price of a stock is considered to be equal
to the intrinsic value of the stock, where the capitalization rate is equal to
the market capitalization rate, the average capitalization rate of all market
participants.
There are 3 models used in the dividend discount model: (a) the zero-
growth which assumes that all dividends paid by a stock remains the same;
(b) constant growth model which assumes that dividends grow by a specific
percent annually; and( c) variable growth model which typically divides
growth into 3 phases: a fast initial phase, then a slower transition phase
that ultimately ends with a lower rate that is sustainable over a long period.
Theories on Dividend Policies
•Zero
  growth DDM
The stock price would be equal to the annual dividends divided by the
required rate of return.

Where:
Ad – Annual dividends
RRoR – Required rate of return
Theories on Dividend Policies
•Constant-growth
  Rate DDM
This model assumes that dividends grow by a specific percentage each
year,

Where:
D1 – dividend next year
k – capitalization rate
g – dividend growth rate
Theories on Dividend Policies
Variable growth rate DDM
The present values of each stage are added together to derive the
intrinsic value of the stock.