AGBS - INDORE

Dividend Decisions
• What is Dividend ?
• What is Retained Earnings?
• Who takes dividend decisions?
• What is Dividend Policy?
• What should be the objective of dividend policy?
• Does dividend policy affect the market value of the firm?
Dividend Theories
• Relevance theories
• Walter’s Model
• Gordon’s Model
• Irrelevance theories
• Modigliani and Miller’s Model
Walter’s Model of Dividend Policy
• According to J. E Walter, Dividend Policy almost always affect the value of the firm.

• He showed how divided policy can be used to maximise the wealth of the
shareholders.

P = D + r/k (E-D)
k
where, P = Market Price of share
r = internal rate of return
k = cost of capital
E = Earning per share
D = Dividend per share
Q.1 EPS Rs.50, Equity
Capitalization rate =10 %,
Internal rate of return = 20 %.
Using Walter’s formula,
calculate price of a share at (a) 0
% payout ratio (b) 60 % payout
ratio and © 80 % payout ratio.
Also, tell us what should be the
optimum pay out ratio?
Q.2 EPS Rs.50, Equity
Capitalization rate =10 %,
Internal rate of return = 10 %.
Using Walter’s formula,
calculate price of a share at (a)
0 % payout ratio (b) 60 %
payout ratio and © 80 % payout
ratio. Also, tell us what should
be the optimum pay out ratio?
Q.3 EPS Rs.50, Equity Capitalization
rate =20 %, Internal rate of return =
10 %. Using Walter’s formula,
calculate price of a share at (a) 100 %
payout ratio (b) 80 % payout ratio
and (c ) 60 % payout ratio. Also, tell
us what should be the optimum pay
out ratio?
Gordon’s Model of Dividend Policy
• According to Myron Gordon, dividend policy almost always affects the value of the firm. He showed how dividend
policy can be used to maximise the wealth of shareholders.
•
• Assumptions:
(A) No external financing
(B) Constant internal rate of return (r)
(C) Constant cost of capital (k)
(D) Constant Retention Ratio (b)
(E) Constant Growth (g)
(F) The firm is using only equity.
(G) No taxes
(H) Firm has infinite life.
Formula used
• According to Gorden, the price of share is calculated using the formula:

P= D1 ÷ (ke- g) or, P = E (1-b) ÷ (ke- br)

Where , P = Market Price of share,

D1 = Dividend declared at the end of year 1, {D1= E (1-b)}
ke = Equity capitalization rate, or cost of equity capital,
g= growth rate =br
(1-b) = Dividend pay out ratio ,
b = retention ratio,
r = Internal rate of return
Numericals of Gordon
Model
Q.1 The EPS of a company is Rs.10. The equity capitalization rate is 10 %. Internal
rate of return is 20 %. Using Gordon’s formula, calculate the price of equity share at

(a) 55 % payout ratio

(b) 80 % Payout Ratio

Formula:
P = E (1-b)
ke- br
P = Market Price of share,
E = EPS
Ke = Equity capitalization rate,
or cost of equity capital,
(1-b) = Dividend pay out ratio
,
b = retention ratio,
r = Internal rate of return
Q.2 The EPS of a company is Rs.10. The equity capitalization rate is 10 %. Internal
rate of return is 10 %. Using Gordon’s formula, calculate the price of equity share at

(a) 10 % payout ratio

(b) 80 % Payout Ratio

Formula:
P = E (1-b)
ke- br
P = Market Price of share,
E = EPS
Ke = Equity capitalization rate,
or cost of equity capital,
(1-b) = Dividend pay out ratio
,
b = retention ratio,
r = Internal rate of return
Q.3 The EPS of a company is Rs.10. The equity capitalization rate is 20 %. Internal
rate of return is 10 %. Using Gordon’s formula, calculate the price of equity share at

(a) 100 % payout ratio

(b) 80 % Payout Ratio

Formula:
P = E (1-b)
ke- br
P = Market Price of share,
E = EPS
Ke = Equity capitalization rate,
or cost of equity capital,
(1-b) = Dividend pay out ratio
,
b = retention ratio,
r = Internal rate of return
Modigliani and Miller’s
Hypothesis-Dividend
Irrelevance
• According to MM, under a perfect market situation, the dividend policy of
a firm is irrelevant as it does not affect the value of the firm.

• They argue that the value of the firm depends on the firm’s earnings and
firm’s earnings are influenced by its investment policy and not by
dividend policy.

• Value of the firm -----------> Firm’s Earnings ----------> Firm’s Investment Policy and not Dividend Policy
• Assumptions
(1) There is a perfect capital market.
a) The investors are free to buy and sell securities.
b) The investors behave rationally.
c) There are no transaction cost/floatation costs.
d) They are well informed about the risk – return on all types of
securities.
e) No investor is large enough to affect the market price of a share.
(2) There are no corporate taxes.
(3) Organization has a fixed investment policy.
(4) Investors are able to forecast future prices, profits, and dividend with
certainity.
 • P1 = Market price of share at the end
Formulae's of year 1
• P0 = Current Market Price
• Price of share under MM Model is • Ke = Equity capitalization rate
calculated using formula: • D1 = Dividend declared at the end of
year 1
• V = Value of the firm
P1 = P0 (1+Ke)-D1
• n = number of old shares
• ∆n = No. of new shares to be issued =
• Value of the firm is calculated using E/P
1
formula:
• E = External financing = I-(Y-nD1)
V = nD1+(n+∆n)P1-E • I = Investments to be made
(1+Ke) • (Y-nD1)= Retained Earnings
Q.1 The capital structure of Tulsian Ltd is as follows:
Equity Share Capital (Rs.100 each) Rs 100 lakhs
Earning for Equity Shareholders Rs. 10 lakhs
Price of share in the beginning Rs 100
Equity Capitalization Rate 10 %
Calculate Price of Equity Share under MM Model if payout ratio is 80 % and also calculate the value of the firm if
the company proposes to make a new investment of Rs. 12,20,000.

• P1 = P0 (1+Ke)-D1

V = nD1+(n+∆n)P1-E
(1+Ke)
Q.1 The capital structure of Tulsian Ltd is as follows:
Equity Share Capital (Rs.100 each) Rs 100 lakhs
Earning for Equity Shareholders Rs. 15 lakhs
Price of share in the beginning Rs 100
Equity Capitalization Rate 10 %
Calculate Price of Equity Share under MM Model if payout ratio is 50 % and also calculate the value of the firm if
the company proposes to make a new investment of Rs. 20,50,000.

• P1 = P0 (1+Ke)-D1

V = nD1+(n+∆n)P1-E
(1+Ke)
 Q.2 The expected earnings per share of a company are Rs.10. The equity capitalization rate is 10 %.
The current market value of share is Rs.100. Under MM Model, determine the market price of share
at the end of period 1:
(a) When dividends are not declared.
(b) When dividends are declared, and payout ratio is 60 %.
(c) When dividends are declared, and payout ratio is 100 %.

P1 = P0 (1+Ke)-D1
• P1 = Market price of share at
the end of year 1
• P0 = Current Market Price
• Ke = Equity capitalization rate
• D1 = Dividend declared at the
end of year 1
Determinants of Dividend Policy
• Availability of profits
• Availability of profitable reinvestment opportunities
• Availability of Liquidity
• Inflation
• Effect on Market Prices.
• Company’s own policy regarding stability of dividend.
• Contractual restrictions by Financial Institutions.
• Extent of access to external sources.
• Attitude and objectives of Management.
Bonus Shares
• Issue of bonus shares means Effects of Bonus Shares
capitalization of accumulated profits
1. Increase in number of outstanding
and reserves.
shares.
• Bonus shares is also called stock
dividend. 2. No cash flow is involved.
• Issue of Bonus shares is an integral part 3. Future EPS will decrease.
of the dividend policy. 4. Price of share decreases.
• Bonus shares do not affect the wealth 5. Capital base of company
of shareholders. increases.
• It represents simply division of
6. More Investor can buy shares of
corporate pie into a large number of
pieces.
company due to decrease in price.
Shares Split (Sub-division)
• Share split means the
subdivision of nominal value of a
share into small denominations.
• Example: Division of 1 share of
Rs.10 into 5 shares of Rs.2 each.
Effect of share split
1. Number of outstanding shares
increases.
2. No cash flow involved.
3. Future EPS will decrease.
4. Price of share decreases.
5. Face value of share decreases.
6. More Investor can buy shares of
company due to decrease in
price.
Buy-Back of shares
• Buy back of shares is also called
as Share Repurchase.
• In this, companies repurchase or
buy back its own shares.
Effect of Buyback of shares
1. Number of outstanding shares
decreases.
2. Cash outflow involved.
3. Future EPS will increase.
4. Price of share increase.