Dividend Decision

Prof. Geetanjali Pinto

Institute of Technology and Management.

 Meaning:
 Meaning The term ‘dividend’ refer to
that part of divisible profits among its
shareholders. In other words,
dividend is that portion of company’s
profit which is distributed among its
shareholders as a percentage of per
value of share or at a fixed rate per
share according to the decision of its
board of directors.
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 Pay-out

Retention

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Dividend Policy :

 Dividend policy is a very significant

financial decision . It determines the
divisions of earnings between
payments to shareholders and
retained earnings. If the value of firm
is a function of its dividend-pay-out
ratio , the dividend policy will affect
directly the firms cost of capital and
hence the value of the firm.
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   aning :
e
M
Meaning ‘Dividend policy’ is a flexible and
wide meaning word. This word is
constituted with two words, dividend and
policy. Dividend is that portion of profits of
company which is distributed among its
shareholders whereas policy means plan of
action. Thus , the term dividend policy
refers to the policy concerning quantum of
profits to be distributed as dividend.
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Types of Dividend Policy :

 Conservative Vs liberal

Regular Vs Irregular
 Stable dividend policy
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 es :
eori
Th
1.Relevance concept
2.Irrelevance concept
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Relevance Theory :

 Dividend policy is very essential for any

business firm as it affects the overall
value of the firm. Dividend policy is
relevant & dividend decision form a very
integral part of the investment &
financing decision of the firm.
Shareholders prefer current dividends &
hence there is a direct relationships
between the dividend policy & the
market value of the firm.
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Walter Model :

WALTER MODEL Dividend

policy affects the value of the
firm.
 Assumptions
 Valuation
 Optimum Payout Ratio
 Criticism
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Walter Model - assumptions :

 The firm finances all investment through

retained earnings while debt and new
equity is not used(Internal Financing).
 Business risk remains constant i.e.,r and
k are constant
 Constant EPS and DIV.
 The firm has infinite life.
 The firm either goes for a 100% pay-out
or a 100% retention.
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 i o n
u a t
al
V Market price per share is the sum of
the present value of the infinite
stream of constant dividends and
present value of the infinite stream of
capital gains.

(r / k)
P  (DIV/ k )  (EPS – DIV)
k
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 Example
r  0 .1 5 , 0 .1 0 , 0.0 8
k  0 .1 0
EPS  R s 10
D PS  40%
( 0 .1 5 / 0 .1)
P  ( 4 / 0 .1)  (1 0  4 )  R s 1 3 0
0 .1
( 0 .1 0 / 0 .1)
P  ( 4 / 0 .1)  (1 0  4 )  R s 1 0 0
0 .1
( 0 .0 8 / 0 .1)
P  ( 4 / 0 .1)  (1 0  4 )  R s 8 8
0 .1
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Optimum Payout Ratio
 Growth Firms – Retain all
earnings
 Normal Firms – Distribute all
earnings
 Declining Firms – No effect

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 sm
ci
ti
ri
C
 No external Financing
 Constant Rate of Return
 Constant opportunity cost
of capital
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Gordon’s Model :

 GORDON’S MODEL Dividend

policy is relevant to the value of
the company.
 Assumptions
 Valuation
 Optimum Payout Ratio
 Criticism
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Assumptions
 All Equity Firm
 No External Financing
 Constant Return and Cost of Capital
 Perpetual Life
 No Taxes
 Constant Retention
 Cost of Capital greater than Growth
Rate
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 tio n
al ua
V
Market value of a share is equal to the
present value of an infinite stream of
dividends to be received by
shareholders

P  EPS(1  b) /(k  br )
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Example
r  0.15, 0.10, 0.08
k  0.10
EPS  Rs 10
b  60%
P  (1 – 0.6) / 0.10 – (0.15 * 0.6) = Rs 400
P  10(1 – 6) / 0.10 – (0.10 * 0.6) = Rs 100
P  10(1 – 0.6) / 0.10 – (0.08 * 0.6) = Rs 77

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Optimum Payout Ratio
 Growth Firms – Retain all
earnings
 Normal Firms – Distribute
all earnings
 Declining Firms – No effect

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The Bird In The Hand
Investors are risk averters. They
consider distant dividends as less
certain than near dividends. Rate at
which an investor discounts his dividend
stream from a given firm increases with
the futurity of dividend stream and
hence lowering share prices.

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Irrelevance Theory :

 IRRELEVANCE THEORY Dividend

policy is irrelevant to maximizing the
shareholders wealth. Value of the firm
is affected by the earning capacity of
the firm i.e., the investment policy
and not the dividend policy. Whether
the firm retains its earnings or pays
dividend, the market price of the
share is indifferent towards it.
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Modigliani & Miller Model :

 MODIGILANI & MILLER MODEL The

value of the firm is not affected by the
decision of pay-out or plough-back..
Firms’ dividend policy have no
influence on the market price of the
shares. Modigliani and Miller were
two staunch supporters of the
irrelevance concept.
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M-M Model -- assumptions :

 Perfect capital market.

 There are no taxes.
 Investment policy is fixed.
 No flotation cost on issue of
shares.
 Investors behave rationally.

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M-M Model - concept :
 M-M MODEL - concept Crux of MM position is
arbitrage argument. Arbitrage is entering
simultaneously in two transactions which
balance each other. Between dividend and
retention of earnings the investors would be
indifferent due to balancing nature of internal
financing and external financing. So, the firm
is indifferent towards the dividend decision.
 Proof in support of their argument

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M-M Model -- criticisms :

 There is perfect capital market - not

always true.
 there are no taxes,
 Flotation costs do not exist and
 Absence of transaction costs.
 Institutional Restrictions
 Resolution of Uncertainity
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Factors influencing dividend policy :
 D/P Ratio
 Stability of Dividends – 3 forms
 Past dividend rate
 Legal requirements – Capital
impairment, NP and
Insolvency
 Contractual requirements
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Factors influencing dividend policy :
 Internal Constraints
•Liquidity of funds
•Growth Prospects
•Financial requirements
•Stability of Earnings
•Expectations of shareholders
•Control
•Investment opportunities
 Inflation
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Different types of dividend

 Dividends
 Cash
 Stock
 Dividend Equivalents
 Bonus Shares
 Stock split
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Stock Dividend
 Stock Dividend (Bonus Shares) - Where a company has
accumulated reserves, it may distribute these
to existing shareholders by making a bonus
issue of additional shares. Often used in place
of or in addition to a cash dividend
 Payment of additional shares of stock
 50% stock dividend would give you 1 extra share for
every 2 you already own

 You own 100 shares @ Rs 12 each (Rs 1200)

 After the stock dividend you have 150 shares at Rs 8 (RS
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Stock Split
 Change in number of shares
outstanding
 3 for 2 split
 You owned 100 shares at Rs 12 each (Rs
1200)
 After the split you have 150 at Rs 8
each (Rs 1200)
 Same impact as a stock dividend
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Equivalence of Splits and Stock
Dividends
SPLIT STOCK DIVIDEND

2:1 (2/1)-1 = 100%

3:2 (3/2)-1 = 50%

5:4 (5/4)-1 = 25%

11:10 (11/10)-1 = 10%

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 Reference
 Financial management –
I.M. PANDEY
 Financial management –
KHAN & JAIN
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