Presented By:- Anju PalAshish KanyalGaurav Verma

Sunny Mervyne Baa

DIFFERENT MODELS OF DIVIDEND POLICY

Dividend Policy

Once a company makes a profit, management must decide on what to do with those profits.

They could continue to retain the profits within the company, or they could pay out the profits to the owners of the firm in the form of

dividends.

Once the company decides on whether to pay dividends they may establish a somewhat permanent dividend policy, which may in turn impact on investors and perceptions of the company in the financial

markets.

What they decide depends on the situation of the company now and in the future.

It also depends on the preferences of investors and potential investors.

TYPES OF DIVIDEND/FORM OF DIVIDEND

Dividend may be distributed among the shareholders in the form of cash or stock. Hence, Dividends are classified into:

A. Cash dividend

B. Stock dividend

C. Bond dividend

D. Property dividend

Cash Dividend

• If the dividend is paid in the form of cash to the shareholders, it is called cash dividend.

• It is paid periodically out the business concerns EAIT (Earnings after interest and tax).

• Cash dividends are common and popular types followed by majority of the business concerns.

Stock Dividend

• Stock dividend is paid in the form of the company stock due to raising of more finance.

• Under this type, cash is retained by the business concern. Stock dividend may be bonus issue.

• This issue is given only to the existing shareholders of the business concern.

Bond Dividend

• Bond dividend is also known as script dividend.

• If the company does not have sufficient funds to pay cash dividend, the company promises to pay the shareholder at a future specific date with the help of issue of bond or notes.

Property Dividend

• Property dividends are paid in the form of some assets other than cash. I

• t will distributed under the exceptional circumstance.

• This type of dividend is not published in India.

FACTORS DETERMINING DIVIDEND POLICYProfitable Position of the Firm

Dividend decision depends on the profitable position of the business concern. When the firm earns more profit, they can distribute more dividends to the shareholders.

Uncertainty of Future Income

Future income is a very important factor, which affects the dividend policy. When the shareholder needs regular income, the firm should maintain regular dividend policy.

Legal Constrains

The Companies Act 1956 has put several restrictions regarding payments and declaration of dividends. Similarly, Income Tax Act, 1961 also lays down certain restrictions on payment of dividends.

Liquidity PositionLiquidity position of the firms leads to easy payments of dividend. If the firms have high liquidity, the firms can provide cash dividend otherwise, they have to pay stock dividend.

Sources of

FinanceIf the

firm has finance sources, it will be easy to

mobilise large

finance. The firm shall not

go for retained earnings.

Growth Rate of

the FirmHigh

growth rate

implies that the firm can distribute more

dividend to its

shareholders.

Tax Policy

Tax policy of

the government also affects

the dividend policy of the firm.

When the

government gives

tax incentive

s, the company

pays more

dividend.

Capital Market Conditi

onsDue to

the capital market

conditions,

dividend policy

may be affected.

If the capital

market is prefect, it leads

to improve

the higher

dividend.

• Regular dividend policy • Stable dividend policy

• Irregular dividend policy

• No dividend policy.

Dividend policy depends upon the nature of the

firm, type of shareholder and profitable position.

On the basis of the dividend declaration by the firm, the dividend

policy may be classified under the following types:

Regular Dividend

Policy

• Dividend payable at the usual rate is called as regular dividend policy. This type of policy is suitable to the small investors, retired persons and others.

Stable Dividend

Policy

• Stable dividend policy means payment of certain minimum amount of dividend regularly.This dividend policy consists of the following three important forms: Constant dividend per shareConstant payout ratioStable rupee dividend plus extra dividend.

Irregular Dividend

Policy

• When the companies are facing constraints of earnings and unsuccessful business operation,they may follow irregular dividend policy. It is one of the temporary arrangements to meet the financial problems. These types are having adequate profit. For others no dividend is distributed.

No Dividend Policy

• Sometimes the company may follow no dividend policy because of its unfavourable working capital position of the amount required for future growth of the concerns

WALTER’S THEORY ON DIVIDEND POLICY

Walter’s theory on dividend policy believes in the relevance concept of a dividend.

According to this concept, a dividend decision of the company affects its valuation. The companies paying higher dividends have more value as compared to the companies that pay lower dividends or do not pay at all.

Walter’s theory further explains this concept in a mathematical model.

Crux of Walter’s Model

Prof. James E Walter formed a model for share valuation that

states that the dividend policy of a company has

an effect on its valuation.

He categorized two factors that influence the price of the share viz. dividend payout ratio of the company and the relationship between the internal rate of return of the

company and the cost of capital.

RELATION OF DIVIDEND DECISION AND VALUE OF A FIRM

According to Walter’s theory, the dividend payout in relation to (Internal Rate of Return) ‘r’ and (Cost of Capital) ‘k’ will impact the value of the firm in the following ways:• Relationship between r and k Increase in Dividend

Payout Decrease in Dividend Payout • r>k• Value of the firm decreases Value of the firm

increases • r<k• Value of the firm increases Value of the firm

decreases • r=k• No change in the value of the firm No change in

the value of the firm

◾Infinite Life:The company has an infinite or a very long life

◾100% Retention/ Payout:All the earnings of the company are either reinvested internally or distributed as dividends.

◾Constant EPS and DPS:Beginning earnings and dividends of the firm never change. Though different values of EPS and DPS may be used in the model, but they are assumed to remain constant

while determining a value.

◾Constant IRR and Cost of Capital:The internal rate of return (r) and the cost of capital (k) of the firm are constant. The business risks remain same for all the investment decisions.

◾Internal Financing:All the investments are financed by the firm through retained earnings. No new equity or debt is issued for the same.

Assumptions of the Model:Walter’s model is based on the following assumptions:

P = D/k + {r*(E-D)/k}/k, • P = market price per share• D = dividend per share• E = earnings per share• r = internal rate of return of the firm• k = cost of capital of the firmValuation Formula and its

Denotations: Walter’s formula to calculate the

market price per share (P) is:

The mathematical equation indicates

that the market price of the

company’s share is the total of the

present values of:

◾An infinite flow of dividends, and

◾An infinite flow of gains on investments

from retained earnings.

The formula can be used to calculate the price of the share if the values of other

variables are available.

• Growth firms are characterized by an internal rate of return > cost of the capital i.e. r > k.

• These firms will have surplus profitable opportunities to invest.

• Because of this, the firms in growth phase can earn more return for their shareholders in comparison to what the shareholders can earn if they reinvested the dividends.

• Hence, for growth firms, the optimum payout ratio is 0%.

◾Growth Firm:

• Normal firms have an internal rate of return = cost of the capital i.e. r = k.

• The firms in normal phase will make returns equal to that of a shareholder.

• Hence, the dividend policy is of no relevance in such a scenario.

• It will have no influence on the market price of the share.• So, there is no optimum payout ratio for firms in the

normal phase. Any payout is optimum.

◾Normal Firm:

• Declining firms have an internal rate of return < cost of the capital i.e. r < k.

• Declining firms make returns that are less than what shareholders can make on their investments.

• So, it is illogical to retain the company’s earnings. • In fact, the best scenario to maximize the price of the

share is to distribute entire earnings to their shareholders. • The optimum dividend payout ratio, in such situations, is

100%.

◾Declining Firm:

Criticism of Walter’s Model

Walter’s theory is critiqued for the following unrealistic assumptions in the model:

◾No External Financing:• Walter’s assumption of complete internal financing by the firm

through retained earnings is difficult to follow in the real world. • The firms do require external financing for new investments.

◾Constant r and k:• It is very rare to find the internal rate of return and the cost of capital

to be constant. • The business risks will definitely change with more investments which

are not reflected in this assumption.

Summary• Though Walter’s theory has some unrealistic

assumptions,• it follows the concept that the dividend policy

of a company has an effect on the market price of its share.

• It explains the impact in the mathematical terms and finds the value of the share.

Gordon’s Theory on Dividend Policy

• Gordon’s theory on dividend policy is one of the theories believing in the ‘relevance of dividends’ concept.

• It is also called as ‘Bird-in-the-hand’ theory that states that the current dividends are important in determining the value of the firm.

• Gordon’s model is one of the most popular mathematical models to calculate the market value of the company using its dividend policy.

Crux of Gordon’s Model

Myron Gordon’s model explicitly

relates the market value of the

company to its dividend policy.

The determinants of the market

value of the share are the perpetual stream of future dividends to be paid, the cost of capital and the

expected annual growth rate of the

company.

Relation of Dividend Decision and Value of a

Firm

The Gordon’s theory on dividend policy states that

the company’s dividend payout policy and the

relationship between its rate of return (r) and the

cost of capital (k) influence the market price per share

of the company

• No change in the price per share

• Price per share increases

• Price per share decreases

Relationship between

r and k Increase in Dividend Payout

r>k

r<k

r=k

• The model assumes that the company is an all equity company, with no proportion of debt in the capital structure.

No Debt:

• The model assumes that all investment of the company is financed by retained earnings and no external financing is required.

◾No External Financing:

• The model assumes a constant Internal Rate of Return (r), ignoring the diminishing marginal efficiency of the investment.◾Constant

IRR:

• The model is based on the assumption of a constant cost of capital (k), implying the business risk of all the investments to be the same.

◾ Constant Cost of Capital:

• Gordon’s model believes in the theory of perpetual earnings for the company.

◾Perpetual Earnings:

• Corporate taxes are not accounted for in this model.

◾Corporate Taxes:

• The model assumes a constant retention ratio (b) once it is decided by the company. Since the growth rate (g) = b*r, the growth rate is also constant by this logic.

◾Constant Retention Ratio:

• Gordon’s model assumes that the cost of capital (k) > growth rate (g). This is important for obtaining the meaningful value of the company’s share.◾K>g:

ASSUMPTIONS OF THE MODELGORDON’S MODEL IS BASED ON THE FOLLOWING ASSUMPTIONS:

Gordon’s formula to calculate the market price per share (P) is P = {EPS * (1-b)} / (k-g)

Where,

P = market price per share

EPS = earnings per share

b= retention ratio of the firm

(1-b) = payout ratio of the firm

k = cost of capital of the firm

g = growth rate of the firm = b*r

VALUATION FORMULA AND ITS DENOTATIONS

The above model indicates that the market value of the company’s share is the sum total of the present values of

infinite future dividends to be declared. The Gordon’s model can also be used to calculate the cost of equity, if the

market value is known and the future dividends can be forecasted.

EXPLANATION

Implications• Gordon’s model believes that the dividend policy impacts the

company in various scenarios as follows:

◾Growth Firm:• A growth firm’s internal rate of return (r) > cost of capital (k). It

benefits the shareholders more if the company reinvests the dividends rather than distributing it. So, the optimum payout ratio for growth firms is zero.◾Normal Firm:

• A normal firm’s internal rate of return (r) = cost of the capital (k). So, it does not make any difference if the company reinvested the dividends or distributed to its shareholders. So, there is no optimum dividend payout ratio for normal firms.

• However, Gordon revised this theory later and stated that the dividend policy of the firm impacts the market value even when r=k. Investors will always prefer a share where more current dividends are paid.◾Declining Firm:

• The internal rate of return (r) < cost of the capital (k) in the declining firms. The shareholders are benefitted more if the dividends are distributed rather than reinvested. So, the optimum dividend payout ratio for declining firms is 100%.

Gordon’s theory on dividend policy is criticised mainly for the unrealistic assumptions made in the model.

◾Constant Internal Rate of Return and Cost of Capital: The model is inaccurate in assuming that r and k always remain

constant. A constant r means that the wealth of the shareholders is not optimized. A constant k means the

business risks are not accounted for while valuing the firm.

◾No External Financing: Gordon’s belief of all investments being financed by retained earnings is faulty. This reflects

sub-optimum investment and dividend policies.

CRITICISM OF GORDON’S MODEL

Gordon’s theory of dividend policy is one of the prominent theories in the valuation of the company. Though it comes with its own limitations, it is a widely accepted model to

determine the market price of the share using the forecasted dividends.

SUMMARY

MODIGLIANI- MILLER THEORY ON DIVIDEND POLICY

Modigliani – Miller theory is a major proponent of ‘Dividend Irrelevance’ notion. According to this concept, investors do not pay any importance to

the dividend history of a company and thus, dividends are irrelevant in calculating the

valuation of a company. This theory is in direct contrast to the ‘Dividend Relevance’ theory which deems dividends to be important in the valuation

of a company.

MODIGLIANI – MILLER THEORY

Modigliani – Miller theory was proposed by Franco Modigliani and Merton Miller in 1961. They were the pioneers in suggesting that dividends and capital gains are equivalent when an investor considers returns on investment. The only thing that impacts the

valuation of a company is its earnings, which is a direct result of the company’s investment policy and the future prospects. So, according to this theory, once the

investment policy is known to the investor, he will not need any additional input on the dividend history of the company. The investment decision is, thus, dependent on the

investment policy of the company and not on the dividend policy. Modigliani – Miller theory goes a step further and illustrates the practical situations

where dividends are not relevant to investors. Irrespective of whether a company pays a dividend or not, the investors are capable enough to make their own cash flows from the stocks depending on their need for the cash. If the investor needs more money than the

dividend he received, he can always sell a part of his investments to make up for the difference. Likewise, if an investor has no present cash requirement, he can always

reinvest the received dividend in the stock. Thus, the Modigliani – Miller theory firmly states that the dividend policy of a company has no influence on the investment decisions

of the investors.This theory also believes that dividends are irrelevant by the arbitrage argument. By this logic, the dividends distribution to shareholders is offset by the external financing. Due to

the distribution of dividends, the price of the stock decreases and will nullify the gain made by the investors because of the dividends. This theory also implies that the cost of debt is equal to the cost of equity as the cost of capital is not affected by the leverage.

CRUX OF MODIGLIANI-MILLER MODEL

This theory believes in the existence of ‘perfect capital markets’. It assumes that all the investors are rational, they have access to free information, there are no floatation or transaction costs and no large investor to influence the market price of the share.

◾Perfect Capital Markets:

There is no existence of taxes. Alternatively, both dividends and capital gains are taxed at the same rate.

◾ No Taxes:

The company does not change its existing investment policy. This means that new investments that are financed through retained earnings do not change the risk and the rate of required return of the firm.

◾Fixed Investment Policy:

All the investors are certain about the future market prices and the dividends. This means that the same discount rate is applicable for all types of stocks in all time periods

◾No Risk of Uncertainty:

ASSUMPTIONS OF THE MODEL

Modigliani – Miller’s valuation model is based on the assumption of same discount rate / rate of return applicable to all the stocks.

P1 = P0 * (1 + k) – D

Where,

P1 = market price of the share at the end of a period

P0 = market price of the share at the beginning of a period

k = cost of capital

D = dividends received at the end of a period

VALUATION FORMULA AND ITS DENOTATIONS

◾Perfect capital markets do not exist. Taxes are present in the capital

markets.

◾According to this theory, there is no difference between internal and

external financing. However, if the flotation costs of new issues are considered, it is false.

◾This theory believes that the shareholder’s wealth is

not affected by the dividends. However, there

are transaction costs associated with the selling

of shares to make cash inflows. This makes the

investors prefer dividends.

◾The assumption of no uncertainty is unrealistic. The dividends are relevant

under the certain conditions as well.

CRITICISM OF MODIGLIANI MILLER’S MODEL

Modigliani – Miller theory of dividend policy is an interesting and a different approach to the valuation of

shares. It is a popular model which believes in the irrelevance of the dividends. However, the policy suffers from various important limitations and thus, is critiqued

regarding its assumptions.

SUMMARY