Dividends Decision

Dividend decision and valuation of firm -

Relevance of dividend policy - Walter model -
Gorden model Residual theory of dividend
policy - Modigliani and Miller theory -
Dividend policy retained earning - Dividend
payout ratio - Stability of dividend - Forms of
dividend
 Dividend Decision
• Overview of Dividend Decision
• Dividend decision refers to the policy that the
management formulates in regard to earnings
for distribution as dividends among
shareholders. Dividend decision determines
the division of earnings between payments to
shareholders and retained earnings .
• The Dividend Decision, in Corporate finance, is
a decision made by the directors of a company
about the amount and timing of any cash
payments made to the company’s
stockholders. The Dividend Decision is an
important part of the present day corporate
world.
• The Dividend decision is an important one for
the firm as it may influence its
capital structure and stock price. In addition,
the Dividend decision may determine the
amount of taxation that stockholders pay.
Factors influencing Dividend Decisions

• There are certain issues that are taken into

account by the directors while making the
dividend decisions:
– Free Cash Flow
– Signaling of Information
– Clients of Dividends
 Free Cash Flow Theory
• The free cash flow theory is one of the prime
factors of consideration when a dividend
decision is taken. As per this theory the
companies provide the shareholders with the
money that is left after investing in all the
projects that have a positive net present
value.
 Signaling of Information
• It has been observed that the increase of the
worth of stocks in the share market is directly
proportional to the dividend information that
is available in the market about the company.
Whenever a company announces that it would
provide more dividends to its shareholders,
the price of the shares increases.
 Clients of Dividends
• While taking dividend decisions the directors
have to be aware of the needs of the various
types of shareholders as a particular type of
distribution of shares may not be suitable for a
certain group of shareholders.
• It has been seen that the companies have been
making decent profits and also reduced their
expenditure by providing dividends to only a
particular group of shareholders.
Different forms of Dividend
 Following are the different forms of
Dividend :
1. Scrip Dividend– An unusual type of dividend
involving the distribution of promissory notes
that calls for some type of payment at a future
date.
2. Bond Dividend– A type of liability dividend
paid in the dividend payer’s bonds.
3. Property Dividend– A stockholder dividend
paid in a form other than cash, scrip, or the
firm’s own stock.
4. Cash Dividend– A dividend paid in cash to a
company’s shareholders , normally out of the
its current earnings or accumulated profits
5. Debenture Dividend
6. Optional Dividend– Dividend which the
shareholder can choose to take as either cash
or stock.
 Significance of dividend decision
• The firm has to balance between the growth of
the company and the distribution to the
shareholders.
• It has a critical influence on the value of the firm.
• It has to also to strike a balance between the long
term financing decision( company distributing
dividend in the absence of any investment
opportunity) and the wealth maximization.
• The market price gets affected if dividends paid
are less.
• Retained earnings helps the firm to concentrate
on the growth, expansion and modernization of
the firm.
• To sum up, it to a large extent affects the
financial structure, flow of funds, corporate
liquidity, stock prices, and growth of the
company and investor’s satisfaction.
 Irrelevance of Dividend
• According to professors Soloman, Modigliani
and Miller, dividend policy has no effect on the
share price of the company.
• There is no relation between the dividend rate
and value of the firm.
• Dividend decision is irrelevant of the value of
the firm. Modigliani and Miller contributed a
major approach to prove the irrelevance
dividend concept.
 Modigliani and Miller’s Approach
• According to MM, under a perfect market
condition, the dividend policy of the company is
irrelevant and it does not affect the value of the
firm.
• “Under conditions of perfect market, 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”.
 Assumptions
• MM approach is based on the following
important assumptions:
1. Perfect capital market.
2. Investors are rational.
3. There are no tax.
4. The firm has fixed investment policy.
5. No risk or uncertainty.
 Proof for MM approach
• MM approach can be proved with the help of the
following formula:

• 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.
• X Company Ltd., has 100000 shares outstanding the
current market price of the shares Rs. 15 each. The
company expects the net profit of Rs. 2,00,000
during the year and it belongs to a rich class for
which the appropriate capitalisation rate has been
estimated to be 20%. The company is considering
dividend of Rs. 2.50 per share for the current year.
– What will be the price of the share at the end of the year
• (i) if the dividend is paid and
• (ii) if the dividend is not paid.
 Criticism of MM approach
1. MM approach assumes that tax does not exist. It is not
applicable in the practical life of the firm.
2. MM approach assumes that, there is no risk and uncertain
of the investment. It is also not applicable in present day
business life.
3. MM approach does not consider floatation cost and
transaction cost. It leads to affect the value of the firm.
4. MM approach considers only single decrement rate, it does
not exist in real practice.
5. MM approach assumes that, investor behaves rationally.
But we cannot give assurance that all the investors will
behave rationally.
 Residual approach:
• As per this approach dividend decision does not
affect the shareholders wealth as well as value of
the firm. The investors don’t want to earn dividend
only they want to earn high return on their
investment. This means that if the firm is in the
situation to gain high profit then the shareholders
would like to keep their money with the firm and on
the other hand if the firm is not in a position to get
profitable opportunity then the shareholders would
like to receive the earning in form of dividend.
 RELEVANCE OF DIVIDEND
• According to this concept, dividend policy is
considered to affect the value of the firm.
• Dividend relevance implies that shareholders
prefer current dividend and there is no direct
relationship between dividend policy and
value of the firm.
• Relevance of dividend concept is supported by
two eminent persons like Walter and Gordon.
 Walter’s Model
• Prof. James E. Walter argues that the dividend
policy almost always affects the value of the
firm.
• Walter model is based in the relationship
between the following important factors:
– Rate of return I
– Cost of capital (k)
• If r>K, the firm should retain the earnings because it possesses
better investment opportunities and can gain more than what the
shareholder can by re-investing. The firms with more returns than
a cost are called the “Growth firms” and have a zero payout ratio.
• If r<K, the firm should pay all its earnings to the shareholders in
the form of dividends, because they have better investment
opportunities than a firm. Here the payout ratio is 100%.
• If r=K, the firm’s dividend policy has no effect on the firm’s value.
Here the firm is indifferent towards how much is to be retained
and how much is to be distributed among the shareholders. The
payout ratio can vary from zero to 100%.
 Assumptions
• Walters model is based on the following
important assumptions:
1. The firm uses only internal finance.
2. The firm does not use debt or equity finance.
3. The firm has constant return and cost of capital.
4. The firm has 100 recent payout.
5. The firm has constant EPS and dividend.
6. The firm has a very long life.
Walter has evolved a mathematical formula for
determining the value of market share.

• Where,
– P = Market price of an equity share
– D = Dividend per share
– r = Internal rate of return
– E = Earning per share
– Ke = Cost of equity capital
 Criticism of Walter’s Model
• The following are some of the important criticisms
against Walter model:
1. Walter model assumes that there is no extracted
finance used by the firm. It is not practically applicable.
2. There is no possibility of constant return. Return may
increase or decrease, depending upon the business
situation. Hence, it is applicable.
3. According to Walter model, it is based on constant cost
of capital. But it is not applicable in the real life of the
business.
 Gordon’s Model
• Myron Gorden suggests one of the popular model which
assume that dividend policy of a firm affects its value,
and it is based on the following important assumptions:
– 1. The firm is an all equity firm.
– 2. The firm has no external finance.
– 3. Cost of capital and return are constant.
– 4. The firm has perpectual life.
– 5. There are no taxes.
– 6. Constant relation ratio (g=br).
– 7. Cost of capital is greater than growth rate (Ke>br).
• Gordon’s model can be proved with the help of the following
formula:

• Where,
– P = Price of a share
– E = Earnings per share
– 1 – b = D/p ratio (i.e., percentage of earnings distributed as
dividends)
– Ke = Capitalization rate
– br = Growth rate = rate of return on investment of an all equity firm.
 Criticism of Gordon’s Model
• Gordon’s model consists of the following
important criticisms:
1. Gordon model assumes that there is no debt and
equity finance used by the firm. It is not
applicable to present day business.
2. Ke and r cannot be constant in the real practice.
3. According to Gordon’s model, there are no tax
paid by the firm. It is not practically applicable.
FACTORS DETERMINING DIVIDEND POLICY

1. Profitable Position of the Firm

– Dividend decision depends on the profitable position
of the business concern. When the firm earns more
profit, they can distribute more dividends to the
shareholders.
2. Uncertainty of Future Income
– Future income is a very important factor, which
affects the dividend policy. When the shareholder
needs regular income, the firm should maintain
regular dividend policy.
3. Legal Constrains
– The Companies Act 1956 has put several
restrictions regarding payments and declaration of
dividends. Similarly, Income Tax Act, 1961 also lays
down certain restrictions on payment of dividends.
4. Liquidity Position
– Liquidity position of the firms leads to easy
payments of dividend. If the firms have high
liquidity, the firms can provide cash dividend
otherwise, they have to pay stock dividend.
5. Sources of Finance
– If the firm has finance sources, it will be easy to
mobilise large finance. The firm shall not go for
retained earnings.
6. Growth Rate of the Firm
– High growth rate implies that the firm can
distribute more dividend to its shareholders.
7. Tax Policy
– Tax policy of the government also affects the
dividend policy of the firm. When the
government gives tax incentives, the company
pays more dividend.
8. Capital Market Conditions
– Due to the capital market conditions, dividend
policy may be affected. If the capital market is
prefect, it leads to improve the higher dividend.