dividend decision (1)

8/2/2019 Dividend Decision (1)

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FINANCIAL MANAGEMENT

MODULE-VI

DIVIDEND DECESIONS

PRIYANKA SAXENA

1


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DIVIDEND DECISIONS

An Introduction

Meaning of dividend- Dividend is a part of retainedearning which is distributed among the shareholders

on equity / Pref. shares ,they hold

Meaning of dividend policy A question in front ofmanagement is either to retain the profit or to

distribute it with an objective to maximizeshareholders wealth. A dividend policy is such whichexplains how much is to be paid and how much is tobe retained


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OBJECTIVESOFDIVIDENDPOLICY

1-Firms need for funds.

2- Shareholders need for income.

3- Firms investment opportunities and financial needs.

4- Shareholders expectations.


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STABILITYOFDIVIDENDS

It is considered a desirable policy . It means regularity in payingsome dividend annually .Three forms of stability may bedistinguished

1. Constant dividend per share

2. Constant Dividend payout ratio

3. Constant dividend per share plus extra dividend


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CONSTANTDIVIDENDPERSHAREPLUSEXTRADIVIDEND

This policy is desirable where earnings are fluctuating .

Merits of stability of dividends -

1. Resolution of investors uncertainty

2. Investors desire for current income

3. Raising additional finance


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FORMSOFDIVIDENDS

Cash dividends

Bonus Shares

Bonus Shares vs. Share split

Buy Back of Shares-


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DIVIDEND THEORIES

On the relationship between dividend policy and value of firm,different theories have been advanced .these theories can begrouped into two categories

1. Theories that consider dividend decisions to be relevant

2. Theories that consider dividend decisions to be irrelevant


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DIVIDEND RELEVANCEWALTERS MODEL

Prof. James. E. Walter argues that the choice of dividend

policy always affects the value of firm. It is based on followingassumptions-

1. Internal Financing

2. Constant return and cost of capital

3. 100% payout or retention4. Constant EPS and DIV

5. Infinite time


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Walters formula to determine the market price per

share is as follows-

p= DIV/k + r(EPS-DIV)/k/kP=Market price per share

DIV= Dividend per share

EPS=Earning per share

r = Firms rate of return

k- Firms cost of capital or capitalization rate


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DIVIDENDPOLICY : APPLICATIONOFWALTERS' MODEL

There are three type of firms as per this model-

Growth Firms -Internal rate more than opportunity cost ofcapital (r>k)

Normal Firms Internal rate equals opportunityCost of capital (r=k)

Declining Firms- Internal rate less than opportunity cost ofcapital ( r


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CRITICISMOF WALTERS' MODEL

No external Financing

Constant return ,r

Constant opportunity cost of capital ,k


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GORDONS MODEL Myron Gordon develops one very popular model explicitly

relating to the market value of the firm to dividend policy.This model is based on following assumptions-

1. All equity firm2. No external financing

3. Constant return

4. Constant cost of capital

5. Perpetual earning6. No taxes

7. Constant Retention

8. Cost of capital greater than growth rate


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According to the Gordons model , the market value ofa share is equal to the present value of an infinitestream of dividend received by the shareholders .

Thus the formula is -

Po= DIV1/k-gor

Po= EPS1(1-b)/ k-br

EPS1= Earning per share

k =cost of capital

r= rate of return

b= retention ratio

g= br = growth rate


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APPLICATION OF GORDONSDIVIDEND MODEL

The implication of the dividend policy as per Gordon'smodel are as follows for normal, growth and decliningfirms -

The market value of share ,Po increases with theretention ratio ,b, for the firms with growthopportunities i.e. r>k

The market value of the share , Po , increases withthe payout ratio, (1-b), for declining firms i.e. r< k

The market value of the share is not affected bydividend policy when r=k


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DIVIDEND IRRELEVANCE MM HYPOTHESISAccording to Modigliani and Miller, under a perfect market

situation, the dividend policy of the firm is irrelevant, as itdoesnt affect the value of the firm .

Thus, when the investment decisions are given , dividenddecisions are of no significance in determining the value ofthe firm .

A firm may face the following 3 situations regarding thepayment of dividends-

The firm has the sufficient cash to pay dividends The firm doesnt have sufficient cash to pay dividends ,therefore it issues new shares to finance the payment s ofdividend

The firm doesnt pay the dividend s, but a shareholderneeds cash .


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In the first situation when the firm pays the dividends,

shareholders get cash in their hands, but the firms assetsreduce. What shareholders gain in the form of cashdividends, they lose in the form of their claims on the assets.There is no net gain or loss. Since it is a fair transactionunder perfect capital market conditions, the value of the firmwill remain unaffected.

In the second situation, when the firm issues new shares tofinance the payment of dividends, two transactions takeplace. First, the existing shareholders get cash in the form of

dividends


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ASSUMPTIONSOFTHISTHEORY

Perfect capital market

No taxes Investment policies

No risk

Under the MM theory , r will be equal to k , and identicalfor all the shares . As a result , the prices of eachshare must adjust so that the rate of return and the

capital gains will be equal to k on each share.


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Thus the minimum rate of return may be calculatedas follows --

r = Dividends+ capital gains /Share price

Or

r= DIV+(P1-Po)/ Po


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RELEVANCEOFTHE DIVIDENDPOLICYUNDERMARKETIMPERFECTIONS-

The MM theory on simplifying assumption. But these assumptionmay not be found valid under in practiced . The following are

the situations where MM hypothesis may go wrong- Uncertainty and shareholders preference

Transaction cost and case against the dividend payments

Tax differentials

Informational content of dividends


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BY:-

PRIYANKA

SAXENA20

dividend decision (1)

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