S- Final Divident Policy1

D iv id e n d P o licy

1

Learning Points • Dividend • Classification • Distribution Procedure • Some Dividend Policies • Formulating A Dividend Policy : Factors • Dividend Theories •

D IV ID E N D S ?

Retained

Profits

Paid out

Classification 3 Bases





S o u rce s

M e d iu m

R e g u la rity

Dividends to be paid out of Profits



– For the year – Of any previous years – Out of both – Out of money provided by the Govt.

Dividend Distribution Procedure BO D R e so lu tio n H o ld e r o f re co rd d a te R a te o f a m o u n t to b e p a id D a te o f P a y m e n t M e d iu m o f P a y m e n t

Some Dividend Policies

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1. Constant Percentage of Earnings

Some Dividend Policies… 2 . C o n sta n t D iv id e n d R a te

Some Dividend Policies… 3. Steadily Changing Dividends

KEY CONSIDERATIONS IN FORMULATING THE DIVIDEND POLICY Ownership Factors •Current Income Requirement •Alternative use of Funds •Tax Consideration Firm Oriented Factors •Legal •Liquidity •Expansion Scheme •Business Cycle •Inflation

Dividend Theories

Walter Model 

Dividend Policy must be evaluated in the light of objective of the firm – to maximize share price

Assumptions 1.All financed through retained earnings. 2.The firm's internal rate of return, r, and the cost of capital, k, are constant so that business risk is not changed with additional investment proposals. 3.All earnings are either reinvested internally or distributed as dividends. 4.There is no change in the key factors, namely, the earnings per share, E, and the dividends per share, D. 5.The firm has a very long or perpetual life.

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WALTER MODEL

P = where :

D + (E – D) r/k k

P = price per equity share E = earnings per share D = dividend per share r = rate of return on investments k = cost of equity capital

IMPLICATIONS OF THE WALTER MODEL

optimal payout ratio for a growth firm ( r > k ) is nil

e optimal payout ratio for a normal firm ( r = k ) is

rrelevant

e optimal payout ratio for a declining firm ( r < k )

00 percent

Criticism • it is assumed that all investments are financed by the firm through retained earnings. Thus, the model ignores the benefits of an optimum capital structure

• • it is assumed in Walter's model that the internal rate of return, r, will remain constant. This stands against real world situations as r generally declines when more and more investment proposals are taken up by the firm. The internal productivity of the retained earnings, r, is also not precisely quantifiable.

• • the assumption that cost of capital also remains constant may not hold good in practice. If the risk complexion of the firm changes, the cost of capital also changes.

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GORDON MODEL 

As in the case of Walter, Gordon too contends that dividends are relevant and that dividend policy affects the value of the firm. Gordon's model is based on the following assumptions:

• earnings

are used for financing acceptable investment opportu f capital, or the capitalization rate, k, are constant.

GORDON MODEL P0 =

E (1 – b) k – br

P 0 = price per share E = earnings per share ( 1 – b ) = dividend payout ratio b = ploughback ratio shareholders ’ required rate of return ( Cost kof = Capital ) r =by rate of return earned on investments made the firm where

IMPLICATIONS The optimal payout ratio for a growth firm ( r > k ) is nil •

• The payout ratio for a normal firm is irrelevant • The optimal payout ratio for a declining firm ( r < k ) is 100 percent

MILLER AND MODIGLIANI ( MM ) POSITION

MM have argued that the value of a firm depends solely on its earning power and is not influenced by the manner in which earnings are split between dividends and retained earnings

Dividends

Current Income

Retained Earnings

Capital

Earnings

Apprec’n

Cond… 

The crux of Modigliani and Miller's argument is that the effect of dividends on the wealth of the shareholders is exactly offset by the effect of other means of financing.

MM ASSUMPTIONS • • •The firm operates in perfect capital markets. •All investors are rational. •Taxes do not exist or there is no tax advantage or disadvantage associated with dividends. •The investment policy of the firm is fixed. Investment and dividend decisions are independent. •All investors are perfectly certain about the future investment programmes and future profits of all firms • Firms can issue stock without incurring any floatation or transaction costs.

CRITICISMS OF MM POSITION Modigliani and Miller assumed a perfect capital market. But this assumption does not usually hold good in many countries. This is more so in developing countries like India. Transaction costs such as commission, brokerage, stamp duty, etc. can be quite substantial for small transactions. The assumption with regard to taxation is also unrealistic. In fact, taxes do exist and there is tax differential between dividends and retained earnings or between dividends and capital gains. Thus, the presence of a tax differential which has a favourable bias on capital gains vis-a-vis dividends vitiates the validity of the M-M hypothesis.

Residual Theory of Dividend Dividend, investment and financing decisions are interdependent and, in the long run, a trade­off must be made, because a firm cannot afford to: 1.forego profitable investments; 2.operate with a non-optimal capital structure; and 3.finance dividends by issuing new shares. 4.The only policy that avoids one of the choices is to treat dividends as a residual. 

Contd.. • The residual theory of dividend assumes that if the firm has retained earnings 'left over‘ after financing all acceptable investment opportunities, these earnings would then be distributed to shareholders in the form of cash dividends. • • If no fund is left, no dividend will be paid. • • In such a case, the dividend policy is strictly a financing decision. When the dividend policy is treated as a financing decision, the payment of cash dividends is a passive residual. The treatment of dividend policy as a passive residual determined strictly by the availability of acceptable investment proposals implies that dividends are irrelevant; the shareholders are

Question – using Walter Model 

A company has 100,000 equity shares of Rs. 10 each. The company expects its earnings at Rs. 750,000 and cost of capital at 10% for the next financial year. Using Walter's model, what dividend policy will you recommend when the rate of return on investment of the company is estimated at 8% and 12%, respectively? What will be the price of equity share if your

Question - using Gordon's Model 

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A company's total investment in assets is Rs. 100,000. It has 100,000 shares of Rs. 100 each. Its expected rate of return on investment is 30% and the cost of capital is 18%. The company has a policy of retaining 25% of its profits. Determine the value of the firm using Gordon's Model.

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