FINANCIAL MANAGEMENT:

MODULE 5

PREPARED BY:
AKHILESH SHARMA,
GEU
 MODULE-5
• Dividend Policy
• Retained Earnings
• Dividend Pay- Out Ratio
• Factors affecting to dividend policy
• Approaches of Dividend Policy

12/12/21 AKHILESH SHARMA, GEU 2

 DIVIDEND: INTRODUCTION & MEANING

• Term Dividend refers to that part of profits of a

company which is distributed among shareholders.
• Dividend is that portion of company’s profit which is
distributed among its shareholders as a percentage
of par value of share or at a fixed rate per share
according to the decision of its board of directors.
• That part of company’s profit which is distributed
among its shareholders as reward of investment
made in the company.

12/12/21 AKHILESH SHARMA, GEU 3

 Contd…
• “Dividend is the income received by the owners of
corporation which they receive in the capacity of its
owners.” - Hunt
• “ Dividend is a distribution to shareholders out of
profits or reserves available for this purpose” - ICAI
• Must be paid out of divisible profits.
• While declaring dividend Board must keep following
two points in mind:
a) Reasonable Return to Shareholders
b) Needs of the Company

12/12/21 AKHILESH SHARMA, GEU 4

 TYPES OF DIVIDEND
1. Cash Dividend : Cash dividend is traditional, simple and
popular form of distribution of income.
2. Stock Dividend : In this case companies does not distribute
dividend in cash rather it allots new shares to shareholders
for an amount equal to dividend declared without payment
being received in cash. Such shares are known as bonus
shares.
3. Bond dividend : Such type of dividend is distributed only
when the company is capable of bearing the increased
burden of interest on debentures. Sometimes promissory
notes are given in lieu of dividend and interest may also paid
on such notes.
4. Scrip Dividend: in form of promissory notes. Similar to bond
dividend but differs in maturity period.
12/12/21 AKHILESH SHARMA, GEU 5
 TYPES OF DIVIDEND
6. Property Dividend: Dividend can also be paid in the form of
property instead of cash. Property may be securities of other
companies.
7. Composite Dividend : When dividend is paid partly in cash
and partly in the form of securities of other companies, then
it is known as composite dividend.
8. Interim Dividend : Interim dividend is paid by a company for
the current year before the accounts for that period have
been closed. Such dividend is paid when the company has
heavy earnings during the year.

12/12/21 AKHILESH SHARMA, GEU 6

 DIVIDEND POLICY
• Policy concerning quantum of profit to be distributed
as dividend.
• “ Dividend Policy determines the division of earnings
between payments to shareholders and retained
earnings.” - Weston & Brigham
• Includes principles of dividend distribution & its
planning.
• Determination of principles, policies & procedure of
dividend distribution, determination of dividend rate
and formulating plans for its distribution.

12/12/21 AKHILESH SHARMA, GEU 7

 FACTORS AFFECTING DIVIDEND
POLICY
1. Stability of Earnings
2. Liquidity of funds
3. Past dividend rates
4. Expectation of shareholders
5. Age of company
6. Future financial requirements
7. Composition of ownership
8. Legal restrictions
9. Loan contract restrictions
10. Corporation tax policy
11. Control objective
12. Capital market consideration
12/12/21 AKHILESH SHARMA, GEU 8
 Types of Dividend Policy
1. Conservative or strict dividend policy : In this policy only a
small part of earnings is distributed as dividend and major
part is retained in the business for reinvestment and growth.
Dividend payout ratio (dividend per share / Earnings per
share) is very low.
2. Liberal or Aggressive Dividend Policy : A major portion of
earnings is distributed among the shareholders as dividend.
Dividend payout ratio is very high.
3. Stable dividend Policy
i. Constant dividend per share : A company that follows this
policy will pay a fixed amount per share as dividend.
ii. Constant payout ratio : A fixed percentage of earnings are
paid as dividends each year. Here, the ratio is fixed but DPS
varies according to the fluctuations in the earnings.
iii. Stable rupee dividend plus extra dividend
 Dividend Theories or Approaches
Relevant Theory : Dividends are relevant to the valuation of the
firm.
Irrelevant Theory : Opine that dividends does not affect the
value of the firm and market price per share of the company.

RELEVANCE THEORY
(A)WALTER’S MODEL
Prof. James E Walter argues that the choice of dividend payout
ratio almost always affects the value of the firm.
The significance of the relationship between internal rate of
return (r) and cost of capital (k) has been studied.
Assumptions :
1. The firm finances its entire investments by means of retained
earning only.
2. Internal rate of return (r) and cost of capital (k) of the firm remains
constant
3. The firms’ earning are either distributed as dividend or reinvested
internally.
4. The firm has a very long or infinite life.

P = D + r/k(E – D)
k
P= Market price per share
D = Dividend per share
E= Earning per share
R = Internal rate of return
k= Cost of capital
a) Growth firm (r > k) : Optimum payout ratio for growth firm is
0%.
b) Normal firm (r = k) : There is nothing like optimum payout
ratio for a normal firm.
c) Declining firm (r < k) : Optimum payout ratio for a declining
firms is 100%.
(B) GORDON’S MODEL
Assumptions :
a. The firm is an all equity firm (no debt)
b. There is no outside financing and all investments are financed
exclusively by retained earnings.
c. Internal rate of return (r) of the firm remains constant
d. Cost of capital remains same
e. The retention ratio (b) once decided upon is constant. Thus,
the growth rate (g) is also constant (g = b x r).

P = E (1 – b)
k – br
1 – b = payout ratio
b = retention ratio
E = Earning per share
1. Given the following information about a company, show the
effect of the dividend policy on the market price per share,
using Walter’s model
EPS = Rs. 8
k = 12%
r = a) 15% b) 10% c) 12%
Show the effect of different dividend policies on the market
price of the shares when dividend payout ratio is :
a. 0%
b. 25%
c. 75%
d. 100%
 Modigliani-Miller Model
According to MM, the dividend policy of a firm is irrelevant, as it
does not affect the wealth of shareholders. According to this
theory, the value of the firm depends solely on its earnings
power resulting from the investment policy and not
influenced by the manner in which its earnings are split
between dividends and retained earnings.
ASSUMPTIONS :
1. Capital markets are perfect
2. There are no taxes
3. The firm has a fixed investment policy
4. Floatation cost does not exist
ARGUMENT : Whatever increase in the value of the firm results
from the payment of dividend, will be exactly off set by the
decline in the market price of shares because of external
financing and there will be no change in the total wealth of
shareholders.
External financing increase in number of shares/payment of
interest fall in EPS
The market price of a share in the beginning of a period is equal
to the present value of dividends paid at the end of the period
plus the market price of the shares at the end of the period.
Po = D1 + P1
1 + Ke
Po = market price per share at the beginning of the period
D1 = dividend to be received at the end of the period
P1 = market price per share at the end of the period
Ke = cost of equity capital or rate of capitalization
Step 1 : P1 = Po (1 + ke) – D1

Step 2 : Investment required by the firm on account of payment

of dividends is financed out of the new issue of equity shares.
The number of shares to be issued can be computed :

m = I – (E – nD1)
P1
Step 3 : the value of the firm can be ascertained with :

nPo = (n + m)P1 – (I – E)
1 + ke
m = number of shares to be issued
I = Investment required
E = total earnings of the firm during the period
n = number of shares outstanding at the beginning of the period
nPo = Value of the firm
 CRITICISM TO MM MODEL
1. Tax differentials : MM’s assumption that taxes does
not exist is far from reality.
2. Floatation cost : There is a presence of floatation
cost. So a rupee of dividend cannot be replaced by a
rupee of external fund.
3. Transaction cost : MM states that if the dividends are
not paid, the shareholders desiring current income
can sell a part of their holdings without incurring
transaction cost.
4. Uncertainty : MM argues that the prices of the 2 firms
which are exactly identical in all respect except with
the dividend policy cannot be different. But this is not
true due to ‘bird in hand argument’.