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# Dividend Theories

Relevance Theories (i.e. which consider dividend decision to be relevant as it affects the value of the firm)

Irrelevance Theories (i.e. which consider dividend decision to be irrelevant as it does not affects the value of the firm)

Walters Model

Gordons Model

## Modigliani and Millers Model

Residual Theory

Relevance Theories

Irrelevance Theories

Dividends are irrelevant, or are a passive residual, is based on the assumption that the investors are indifferent between dividends and capital gains. No effect on the market price of share. Pre condition:o Investment and financing decision are fixed. o No transaction cost and floatation cost.

## Residual Theory of Dividends

The residual theory of dividends suggests that dividend payments should be viewed as residualthe amount left over after all acceptable investment opportunities have been undertaken. Using this approach, the firm would treat the dividend decision in three steps as follows:

Step 1: Determine the optimal level of capital expenditures which is given by the point of intersection of the investment opportunities schedule (IOS) and weighted marginal cost of capital schedule (WMCC).

Step 2: Using the optimal capital structure proportions, estimate the total amount of equity financing needed to support the expenditures estimated in Step 1.

## Step 3: Because the cost of retained earnings is less than

new equity, use retained earnings to meet the equity requirement in Step 2. If inadequate, sell new stock. If

## there is an excess of retained earnings, distribute the

surplus amountthe residualas dividends.

## Modigliani & Millers Irrelevance Model

Value of Firm (i.e. Wealth of Shareholders)

Depends on

Firms Earnings
Depends on

## Firms Investment Policy and not on dividend policy

Assumption
Capital Markets are Perfect and people are Rational No taxes Floating Costs are nil Investment opportunities and future profits of firms are known with certainty (This assumption was dropped later) Investment and Dividend Decisions are independent

Arbitrage Process
Payment of dividend. Raising the new(fresh) capital.

Proof: MM provide the proof in support of their argument in the following manner.

Step 1: The market price of a share in the beginning of the period is equal to the present value of dividends paid at the end of the period plus the market price of share at the end of the period. Symbolically,

Step 2: Assuming no external financing, the total capitalized value of the firm would be simply the number of shares (n) times the price of each share (P0). Thus,

Step 3: If the firms internal sources of financing its investment opportunities fall short of the funds required, and n is the number of new shares issued at the end of year 1 at price of P1, Eq. 2 can be written as:

where

n = Number of shares outstanding at the beginning of the period n= Change in the number of shares outstanding during the period/Additional shares issued

Step 4: If the firm were to finance all investment proposals, the total amount raised through new shares issued would be given in Eq. 4. or
where nP1 I E nD1

## nP1 = I (E nD1) nP1 = I E + nD1

= Total amount/requirement of capital budget = Earnings of the firm during the period = Total dividends paid ; (E nD1) = Retained earnings

(4)

= Amount obtained from the sale of new shares of finance capital budget.

## Step 5: If we substitute Eq. 4 into Eq. 3 we derive Eq. 5.

Step 6: Conclusion Since dividends (D) are not found in Eq. 6, Modigliani and Miller conclude that dividends do not count and that dividend policy has no effect on the share price.

Example 1 A company belongs to a risk class for which the approximate capitalisation rate is 10 per cent. It currently has outstanding 25,000 shares selling at Rs 100 each. The firm is contemplating the declaration of a dividend of Rs 5 per share at the end of the current financial year. It expects to have a net income of Rs 2,50,000 and has a proposal for making new investments of Rs 5,00,000. Show that under the MM assumptions, the payment of dividend does not affect the value of the firm.

DIVIDENT DECISION

INTRODUCTION

Dividend payment is an important consideration used by prospective shareholder in valuing the worth of the share.

Dividend policy adopted should be one which helps maximizing its contribution towards increasing the wealth of the shareholders.

## Dividend Payout Ratio

Stability of Dividents

## Dividend Payout Ratio

To decide about the percentage of profit to be distributed by the firm. DP Ratio = Dividend paid to stake holders Net profit after tax

Critical Decision

Liquidity

Growth Plan

Control

Stability of Dividends

How stable, regular or steady should the dividend stream be over time. So, while designing a dividend policy for a firm it is to be considered as to whether the firm will have a consistency in paying dividends or not.

Constant DP ratio

EPS

EPS
and DPS DPS

Years

## Earning and DPS DPS

Earnings

Years

A firm may also adopt a policy of paying a steady dividends together with some extra whenever supported by the earning of the firm.

LINTNER MODEL

## D1 =EPS1 X SA X DP Ratio + (1- SA) Dt-1

Where D1 = Dividend for current year EPS1 = EPS for current year SA = Speed of adjustment DP Ratio = Target payout ratio Dt-1 = Dividend of the previous year

LEGAL

## AND PROCEDURAL CONSIDERATIONS

Important while designing a dividend policy of a firm. Legal factors result from laws, contractual constraints from loan provisions,

PROVISIONS
A company can pay dividends to shareholders only if sufficient provisions have been made for redemption of preference shares. All dividends should be paid in cash. Cash can be paid as: Final Dividend and Interim Dividend. Dividend is payable out of current year revenue profits. The dividends once declared at the general meeting must be paid within 30days of declaration.

## ISSUE OF BONUS SHARES

A method of distribution of earnings among the shareholders. Utilization of profits to reward the shareholders without affecting the current liquidity position of the firm is known as Scrip Dividend or Issue of bonus shares by Capitalization of profits. These are the shares issued by the company free of costs by capitalization of its profits and reserves.

## Increase in no. of shares

Increase in no of shares
Book value and earnings per share Decreases

## Increases the paid up capital of company

REASONS

AND GUIDELINES

SHARES REPURCHASE
A firm uses excess cash to buy stock back from existing shareholders. Substitute for a cash dividend: Three used approaches are: 1. Repurchase tender offer, 2. Open market repurchase, 3. Negotiated Repurchase.

CLIENTELE EFFECT
Clientele effect refers to the tendency of investors to buy shares in companies that have dividend policies that meet their preferences for dividend payout. Implications are: 1. Investors get what it deserves, 2. Firm will have a difficult time in changing its dividend policy.

DIVIDEND PUZZLE

Dividend policy affects the market price of the share. Its stability increases the market price. Dividend policy of a firm determines the amount of the retained earnings which can be reinvested by the firm to result in the growth of the firm.