Dividend and Distribution

Policy
Concept Diary
• Traditional position

• Walter model

• Gordon’s model

• Bird in the hand argument

• Modigliani and Miller theory of irrelevance

• Tax clienteles
Concept Diary
• Firm growth and payout ratio

• Share repurchase

• Bonus issue

• Stock split

• Determinants of dividends
Dividend
• Dividend refers to sharing of profits.
• The part of the profits that are distributed to shareholders
• Dividend can be distributed in the form of cash or bonus shares
What is “distribution policy”?
• The distribution policy defines:
• The level of cash distributions to shareholders
• The form of the distribution (dividend vs. bonus issue vs. stock repurchase)
• The stability of the distribution

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Dividend Yields for Selected Industries

Industry Div. Yield %

Airline 0.2
Software & Programming 0.3
Biotechnology & Drugs 0.3
Restaurants 1.0
Chemical Manufacturing 2.2
Paper & Paper Products 2.7
Electric Utilities 4.4
Tobacco 5.6
Source: Yahoo Industry Data 6
Do investors prefer high or low payouts? There are
three theories:
• Traditional investors believe dividends matter. Dividends prefer high
dividends
• Dividends are irrelevant: Investors don’t care about payout.
• Bird-in-the-hand: Investors prefer a high payout.
• Tax preference: Investors prefer a low payout, hence growth.

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 Traditional
Theory P = Market Price
The traditional approach to the dividend policy, which
was given by B Graham and D L Dodd lays a clear
emphasis on the relationship between the dividends and
m = Multiplier
the stock market.

According to this approach, the stock value responds

D = Dividend per share
positively to higher dividends and negatively when

there are low dividends.

The following expression, given by traditional

E = Earnings per share
approach, establishes the relationship between market

price and dividends using a multiplier:

P =m (D + E/3)

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Traditional Theory

• The traditional approach to the

dividend policy, which was
given by B Graham and D L P = Market Price
Dodd lays a clear emphasis on
the relationship between the
dividends and the stock market.
• According to this approach, the
stock value responds positively m = Multiplier
to higher dividends and
negatively when there are low
dividends.
• The following expression,
given by traditional approach, D = Dividend per share
establishes the relationship
between market price and
dividends using a multiplier: E = Earnings per share
• P =m (D + E/3)

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Walters Model
• Similar to the traditional approach, the dividend policy given by James
E Walter also considers that dividends are relevant and they do affect
the share price.
• In this model he studied the relationship between the internal rate of
return (r) and the cost of capital of the firm (k), to give a dividend
policy that maximizes the shareholders’ wealth.
Assumptions
• The relevance of the dividend policy as explained by the Walter’s Model is based on a few
assumptions, which are as follows:
i. Retained earnings is the only source of finance available to the firm, with no outside debt or additional
equity used.
ii. r and k are assumed to be constant and thus additional investments made by the firm will not change its
risk and return profiles.
iii. Firm has an infinite life.
iv. For a given value of the firm, the dividend per share and the earnings per share remain constant.
Walters Model
• The model studies the relevance of the dividend policy in three
situations:
• (i) r > ke
• (ii) r < ke
• (iii) r = ke.
• According to the Walter Model, when the return on investment is
more than the cost of equity capital, the earnings can be retained by
the firm since it has better and more profitable investment
opportunities than the investors.
Walters Model

• P = D/ke + (r (E-D)*ke)/ke
E = Earnings per share
• Where
r = Internal rate of return
ke
= Cost of equity capital

DP = Change in the price

g = Growth rate of earnings
Illustration

• Given the following information about ZED Ltd, show the effect of
the dividend policy on the market price of its shares, using the
Walter’s model:
• Equity capitalization rate (ke) = 12% Earnings
per share (E) = Rs.8
• Assumed return on investments (r) are as follows:
i. r = 15%
ii. r = 10%
iii.r = 12%
Solution - i
•• To
  show the effect of the different dividend policies on the share value of the firm for the three levels of r
let us consider the dividend pay-out (D/P) ratios of zero, 25%, 50%, 75% and 100%.
• i. r > ke (r = 15%, ke = 12%)
• P = D/ke + (r (E-D)*ke)/ke
a. D/P ratio = 0; dividend per share = zero
P = (0 + ((0.15/0.12) * (8 - 0)))/0.12 = 83
D/P ratio = 25%; dividend per share = 8*25% = Rs.2.00
()/0.12 = 79
D/P ratio = 50%; dividend per share = 8*50% = Rs.4.00
()/0.12 = 75
Solution - i
•   D/P ratio = 75%; dividend per share = 75%* 8 = 6
a.
P = (6 + ((0.15/0.12) * (8 - 6)))/0.12 = Rs. 71
D/P ratio = 25%; dividend per share = 8*100% = Rs. 8.00
()/0.12 =Rs. 67
Interpretation
• From the above calculations it can be observed that when the return on
investment is greater than the cost of capital, there is an inverse relation between
the value of the share and the pay-out ratio.
• Thus, the value of ZED Ltd. is the highest when the D/P ratio is zero (P = Rs.83)
and this goes on declining as the D/P ratio increases.
• Hence the optimum dividend policy for a growth firm is a zero dividend pay-out
ratio.
Solution - ii
•  • r < ke (r = 10%, ke =12%)
• P = D/ke + (r (E-D)*ke)/ke
a. D/P ratio = 0; dividend per share = zero
P = (0 + ((0.10/0.12) * (8 - 0)))/0.12 = 56
D/P ratio = 25%; dividend per share = 8*25% = Rs.2.00
()/0.12 = 58
D/P ratio = 50%; dividend per share = 8*50% = Rs.4.00
()/0.12 = 61
Solution - ii
•   D/P ratio = 75%; dividend per share = 75%* 8 = 6
a.
P = (6 + ((0.10/0.12) * (8 - 6)))/0.12 = Rs. 64
D/P ratio = 25%; dividend per share = 8*100% = Rs. 8.00
()/0.12 =Rs. 67
Interpretation
• When the return on investment is less than the cost of equity
capital, calculations reveal that the firm’s value will enhance as
the D/P ratio increases.
• Due to this positive correlation between
• the share price and the dividend payout ratio,
• firms that have their returns on investment less than the cost of
equity capital
• should prefer a higher dividend payout ratio in order to maximize the share value.
Solution - iii
•  • r =ke (r = 10%, ke =10%)
• P = D/ke + (r (E-D)*ke)/ke
a. D/P ratio = 0; dividend per share = zero
P = (0 + ((0.10/0.10)* (8 - 0)))/0.10 = 67
D/P ratio = 25%; dividend per share = 8*25% = Rs.2.00
()/0.10 = 67
D/P ratio = 50%; dividend per share = 8*50% = Rs.4.00
()/0.10 = 67
Solution - iiI
•   D/P ratio = 75%; dividend per share = 75%* 8 = 6
a.
P = (6 + ((0.10/0.10) * (8 - 6)))/0.12 = Rs. 67
D/P ratio = 25%; dividend per share = 8*100% = Rs. 8.00
()/0.12 =Rs. 67
Interpretation
• Interpretation: In the final case where the firm has its’ return on
investment equal to the cost of equity capital, the dividend
policy does not affect the share price of the firm.
• The price of the firm remains Rs.67 for all the given levels of
the D/P ratio.
• However, in actual practice r and k will not be the same and it
can only be a hypothetical case.
• Excepting the hypothetical cases of r = ke in other cases where
r < ke or r > ke,
• according to Walter model, the dividend policy of a firm, as shown
above is relevant for maximizing the share price of the firm.
Walter Model - Limitation of the model
• Most of the limitations for this model arise due to the assumptions made. The
first assumption of exclusive financing by retained earnings makes the model
suitable only for all-equity firms.
• Secondly, Walter assumes the return on investments to be constant. This again
will not be true for firms making high investments.
• Finally, Walter’s model on dividend policy ignores the business risk of the firm
which has a direct impact on the value of the firm. Thus, k cannot be assumed to
be constant.
Bird-in-the-Hand Theory
• Investors think dividends are less risky than potential future capital
gains, hence they like dividends.
• If so, investors would value high payout firms more highly, i.e., a high
payout would result in a high stock price.

25
 Gordon explains this preference for current income by the bird-
in-hand argument.

Since a bird-in-hand is worth two in the bush, the investors

Gordons would prefer the income that they earn currently to that income
in future which may or may not be available.

Model Thus, investors would prefer to pay a higher price for the stocks
which earn them current dividend income and would discount
those stocks which either postpone/ reduce the current income.

The discounting will differ depending on the retention rate

(percentage of retained earnings) and the time.
 • 
ke –b)
Gordons Model

where,  
  P = Share price

  E = Earnings per share

  B = Retention ratio

  (1 – b) = Dividend pay-out ratio

  Ke = Cost of equity capital (or cost of capital of the firm)

  Br = Growth rate (g) in the rate of return on investment

27
 • If ke = 11%, and E = Rs.15 calculate the stock
value of Swan Ltd. for (i) r = 12%
Illustration • (ii) r = 11% (iii) r = 10% for the various levels of
the D/P ratios.

  D/P Ratio (1 – b) Retention Ratio

a. 10% 90%
b. 20% 80%
c. 30% 70%
d. 40% 60%
e. 50% 50%
Solution - i
•  • r > ke (r = 12%, ke = 11%)
a. D/P ratio =10%
• b = 90%
• g = br = 0.90 x 0.12 = 0.108

• ke –b)
• 11% –10.8%)) =
Rs. 750
Solution - i
•  a. D/P ratio =20%
• = 80%
• g = br = 0.80 x 0.12 = 0.096 = 9.6%

• ke –b)
• 11% –9.6%)) =
Rs.214.28
Solution - i
•  a. D/P ratio =30%
b= 70%
• g = br = 0.70 x 0.12 = 0.084 = 8.4%

• ke –b)
• 11% –8.4%)) =
Rs.173.08
Solution - i
•  a. D/P ratio =40%
• = 60%
• g = br = 0.60 x 0.12 = 0.072 = 7.2%

• ke –b)
• 11% –7.2%)) =
Rs.158
Solution - i
•  a. D/P ratio =50%
• = 50%
• g = br = 0.50x 0.12 = 0.06 = 6%

• ke –b)
• 11% –6%)) =
Rs.150
Solution - ii
•  • r = ke (r = 11%, ke = 11%)
a. D/P ratio =10%
• b = 90%
• g = br = 0.90 x 0.11 = 0.99

• ke –b)
• 11% –9.9%)) =
Rs. 136.36
Solution - ii
•  a. D/P ratio =20%
• = 80%
• g = br = 0.80 x 0.11 = 0.088= 8.8%

• ke –b)
• 11% –8.8%)) =
Rs.136.36
Solution - ii
•  a. D/P ratio =30%
b= 70%
• g = br = 0.70 x 0.11 = 0.077 = 7.7%

• ke –b)
• 11% –7.7%)) =
Rs.136.36
Solution - ii
•  a. D/P ratio =40%
• = 60%
• g = br = 0.60 x 0.12 = 0.072 = 7.2%

• ke –b)
• 11% –7.2%)) =
Rs.136.36
Solution - ii
•  a. D/P ratio =50%
• = 50%
• g = br = 0.50x 0.12 = 0.06 = 6%

• ke –b)
• 11% –6%)) =
Rs.136.36
Tax Preference Theory
• Low payouts mean higher capital gains. Capital gains taxes are
deferred.
• This could cause investors to prefer firms with low payouts, i.e., a high
payout results in a low stock price.

39
Dividend Irrelevance Theory
• Investors are indifferent between dividends and retention-generated
capital gains. If they want cash, they can sell stock. If they don’t want
cash, they can use dividends to buy stock.
• Modigliani-Miller support irrelevance.
• Theory is based on unrealistic assumptions (no taxes or brokerage
costs), hence may not be true. Need empirical test.

40
Implications of 3 Theories for Managers

Theory Implication

Irrelevance Any payout OK

Bird-in-the-hand Set high payout

Tax preference Set low payout

41
Which theory is most correct?
• Empirical testing has not been able to determine which theory, if any,
is correct.
• Thus, managers use judgment when setting policy.
• Analysis is used, but it must be applied with judgment.

42
What’s the “clientele effect”?
• Different groups of investors, or clienteles, prefer different dividend
policies.
• Firm’s past dividend policy determines its current clientele of
investors.
• Clientele effects impede changing dividend policy. Taxes & brokerage
costs hurt investors who have to switch companies due to a change in
payout policy.

43
Solution - iii
•  • r = ke (r = 10%, ke = 11%)
a. D/P ratio =10%
• b = 90%
• g = br = 0.90 x 0.10 = 0.09

• ke –b)
• 11% –9.0%)) =
Rs. 75
Solution - iii
•  a. D/P ratio =20%
• = 80%
• g = br = 0.80 x 0.10 = 0.08= 8.%

• ke –b)
• 11% –8 %)) =
Rs.100
Solution - iii
•  a. D/P ratio =30%
b= 70%
• g = br = 0.70 x 0.10 = 0.07 = 7.0%

• ke –b)
• 11% –7.0%)) =
Rs.112.5
Solution - iii
•  a. D/P ratio =40%
• = 60%
• g = br = 0.60 x 0.10 = 0.06 = 6%

• ke –b)
• 11% –6%)) =
Rs.120
Solution - iii
•  a. D/P ratio =50%
• = 50%
• g = br = 0.50x 0.10 = 0.05 = 6%

• ke –b)
• 11% –5%)) =
Rs.125
Interpretation
• The above illustration explains the relevance of dividends as given by the Gordon’s Model. In the given three
situations, the firm’s share value is positively correlated with the pay-out ratio when re < ke and decreases
with an increase in the pay-out ratio when r > ke. Thus, firms with a rate of return greater than the cost of
capital should have a higher retention ratio and those firms which have a rate of return less than the cost of
capital should have a lower retention ratio. The dividend policy of firms which have a rate of return equal
to the cost of capital will, however, not have any impact on its share value.
Miller and Modigliani
• Miller and Modigliani have propounded the MM hypothesis to explain
the irrelevance of a firms’ dividend policy.
• This model which was based on a few assumptions, sidelined the
importance of the dividend policy and its effect thereof on the share
price of the firm.
• According to the model, it is only the firms’ investment policy that will
have an impact on the share value of the firm and hence should be
given more importance.
Assumptions – Miller and Modigliani
• Critical Assumptions: Before discussing the details of the model let us first look into the
assumptions upon which the model is based:
 The first assumption is the existence of a perfect market in which all investors are rational. In perfect
market condition there is easy access to information and the floatation and the transaction costs do not
exist. The securities are infinitely divisible and hence no single investor is large enough to influence the
share value.
 Secondly, it is assumed that there are no taxes, implying that there is no differential tax rates for the
dividend income and the capital gains.
 The third assumption is a constant investment policy of the firm, which will not change the risk
complexion nor the rate of return even in cases where the investments are funded by the retained earnings.
•
 
 Finally, it was also assumed that the investors are able to forecast the future earnings, the dividends and
the share value of the firm with certainty. This assumption was however, dropped out of the model.
Calculating Price
• P= 1/(1+ke) (Dt+ Pt)
• Where
• P0 = Current market price of the share (t = 0)
• P1 = Market price of the share at the end of the period (t = 1) D1 =
Dividends to be paid at the end of the period (t = 1)
• ke = Cost of equity capital
Illustration
• The capitalization rate of A1 Ltd. is 12%. This company has outstanding shares to the extent of 25,000 shares
selling at the rate of Rs.100 each. Anticipating a net income of Rs.3,50,000 for the current financial year, A1
Ltd. plans to declare a dividend of Rs.3 per share. The company also has a new project the investment
requirement for which is Rs.5,00,000. Show that under the MM model, the dividend payment does not affect
the value of the firm.
• To prove that the MM model holds good, we have to show that the value of the firm remains the
same whether the dividends are paid or not.
• i. The value of the firm, when dividends are paid:
• Step 1: Price per share at the end of year 1

• P0= (1/(1+ke))* (Dt+ Pt)

• 100= 1/(1+0.12)* (3+ Pt)
• P1 = 109
• Step 2: Amount to be raised by the issue of new shares
• n1P1 = I – (E – nD1)
• = 500000- 350000- 75000)
• = 225000
• Number of additional shares = 225000/109
• Value of the firm = (25, 000 + 2, 25, 000/109) 109 - (5, 00, 000 - 3,50, 000)
• Value of the firm = 2500000
Calculating Price
• P= 1/(1+ke) (Dt+ Pt)
• Where
• P0 = Current market price of the share (t = 0)
• P1 = Market price of the share at the end of the period (t = 1) D1 =
Dividends to be paid at the end of the period (t = 1)
• ke = Cost of equity capital
Illustration
• Step 1: Price per share at the end of year 1

• P0= (1/(1+ke))* (Dt+ Pt)

• 100= 1/(1+0.12)* (0+ Pt)
• P1 = 100*1.12 = 112
Illustration
• Step 2: Amount to be raised by the issue of new shares
• n1P1 = I – (E – nD1)
• = 500000- 350000)
• = 350000
Illustration
• Number of additional shares = 350000/112
• Value of the firm = (25, 000 + (3500000/112) 112 - (5, 00, 000 - 3,50,
000)/1.12
• Value of the firm = Rs.2500000
Tax Preference Theory
• Low payouts mean higher capital gains. Capital gains taxes are
deferred.
• This could cause investors to prefer firms with low payouts, i.e., a high
payout results in a low stock price.

60
Dividend Irrelevance Theory
• Investors are indifferent between dividends and retention-generated
capital gains. If they want cash, they can sell stock. If they don’t want
cash, they can use dividends to buy stock.
• Modigliani-Miller support irrelevance.
• Theory is based on unrealistic assumptions (no taxes or brokerage
costs), hence may not be true. Need empirical test.

61
Implications of 3 Theories for Managers

Theory Implication

Irrelevance Any payout OK

Bird-in-the-hand Set high payout

Tax preference Set low payout

62
Which theory is most correct?
• Empirical testing has not been able to determine which theory, if any,
is correct.
• Thus, managers use judgment when setting policy.
• Analysis is used, but it must be applied with judgment.

63
What’s the “clientele effect”?
• Different groups of investors, or clienteles, prefer different dividend
policies.
• Firm’s past dividend policy determines its current clientele of
investors.
• Clientele effects impede changing dividend policy. Taxes & brokerage
costs hurt investors who have to switch companies due to a change in
payout policy.

64
What’s the “information content,” or “signaling,”
hypothesis?
• Investors view dividend changes as signals of management’s view of
the future. Managers hate to cut dividends, so won’t raise dividends
unless they think raise is sustainable.
• Therefore, a stock price increase at time of a dividend increase could
reflect higher expectations for future EPS, not a desire for dividends.

65
What’s the “residual distribution model”?
• Find the reinvested earnings needed for the capital budget.
• Pay out any leftover earnings (the residual) as either dividends or
stock repurchases.
• This policy minimizes flotation and equity signaling costs, hence
minimizes the WACC.

66
 Using the Residual Model to
Calculate Distributions Paid

Net

[( )( )]
Income Target Total
Distr. = – equity
. capital
ratio budget

67
Data for SSC
• Capital budget: $800,000. Given.
• Target capital structure: 40% debt, 60% equity. Want to maintain.
• Forecasted net income: $600,000.
• If all distributions are in the form of dividends, how much of the
$600,000 should we pay out as dividends?

68
• Of the $800,000 capital budget, 0.6($800,000) = $480,000 must be
equity to keep at target capital structure. So 0.4($800,000) = $320,000
will be debt.
• With $600,000 of net income, the residual is $600,000 - $480,000 =
$120,000 = dividends paid.
• Payout ratio = $120,000/$600,000
= 0.20 = 20%.

69
How would a drop in NI to $400,000 affect the dividend? A
rise to $800,000?
• NI = $400,000: Need $480,000 of equity, so should retain the whole
$400,000. Dividends = 0.
• NI = $800,000: Dividends = $800,000 - $480,000 = $320,000. Payout
= $320,000/$800,000 = 40%.

70
How would a change in investment opportunities affect dividend under
the residual policy?

• Fewer good investments would lead to smaller capital budget, hence

to a higher dividend payout.
• More good investments would lead to a lower dividend payout.

71
Advantages and Disadvantages of the Residual
Dividend Policy
• Advantages: Minimizes new stock issues and flotation costs.
• Disadvantages: Results in variable dividends, sends conflicting signals,
increases risk, and doesn’t appeal to any specific clientele.
• Conclusion: Consider residual policy when setting target payout, but
don’t follow it rigidly.

72
Stock Repurchases
• Repurchases: Buying own stock back from stockholders.

• Reasons for repurchases:

• As an alternative to distributing cash as dividends.
• To dispose of one-time cash from an asset sale.
• To make a large capital structure change.

73
Advantages of Repurchases
• Stockholders can tender or not.
• Helps avoid setting a high dividend that cannot be maintained.
• Repurchased stock can be used in takeovers or resold to raise cash as
needed.
• Income received is capital gains rather than higher-taxed dividends.
• Stockholders may take as a positive signal--management thinks stock
is undervalued.

74
Disadvantages of Repurchases
• May be viewed as a negative signal (firm has poor investment
opportunities).
• IRS could impose penalties if repurchases were primarily to avoid
taxes on dividends.
• Selling stockholders may not be well informed, hence be treated
unfairly.
• Firm may have to bid up price to complete purchase, thus paying too
much for its own stock.

75
Setting Dividend Policy
• Forecast capital needs over a planning horizon, often 5 years.
• Set a target capital structure.
• Estimate annual equity needs.
• Set target payout based on the residual model.
• Generally, some dividend growth rate emerges. Maintain target
growth rate if possible, varying capital structure somewhat if
necessary.

76
Stock Dividends vs. Stock Splits
• Stock dividend: Firm issues new shares in lieu of paying a cash
dividend. If 10%, get 10 shares for each 100 shares owned.
• Stock split: Firm increases the number of shares outstanding, say 2:1.
Sends shareholders more shares.

77
• Both stock dividends and stock splits increase the number of shares
outstanding, so “the pie is divided into smaller pieces.”
• Unless the stock dividend or split conveys information, or is
accompanied by another event like higher dividends, the stock price
falls so as to keep each investor’s wealth unchanged.
• But splits/stock dividends may get us to an “optimal price range.”

78
When should a firm consider splitting its
stock?
• There’s a widespread belief that the optimal price range for stocks is
$20 to $80.
• Stock splits can be used to keep the price in the optimal range.
• Stock splits generally occur when management is confident, so are
interpreted as positive signals.

79
What’s a “dividend reinvestment
plan (DRIP)”?
• Shareholders can automatically reinvest their dividends in shares of
the company’s common stock. Get more stock than cash.
• There are two types of plans:
• Open market
• New stock

80
Open Market Purchase Plan
• Dollars to be reinvested are turned over to trustee, who buys shares
on the open market.
• Brokerage costs are reduced by volume purchases.
• Convenient, easy way to invest, thus useful for investors.

81
New Stock Plan
• Firm issues new stock to DRIP enrollees, keeps money and uses it to
buy assets.
• No fees are charged, plus sells stock at discount of 5% from market
price, which is about equal to flotation costs of underwritten stock
offering.

82
• Optional investments sometimes possible, up to $150,000 or so.
• Firms that need new equity capital use new stock plans.
• Firms with no need for new equity capital use open market purchase
plans.
• Most NYSE listed companies have a DRIP. Useful for investors.

83