dividend policy
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Dividend Policy
• Dividend Decisions of a Firm – Relevance/Irrelevance• Models explaining the Relevance/Irrelevance of the Dividend Policy
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What is Dividend Policy?
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Introduction to Dividend Decisions
• Once a company makes a profit, they 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.
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Dividend
• Dividends are payments made to stockholders from a firm's earnings, whether those earnings were generated in the current period or in previous periods.
• Dividends may affect capital structure.• Retaining earnings increases common equity relative to debt.• Financing with retained earnings is cheaper than issuing new common equity.
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Two options• There are basically two options which a
firm has while utilizing its profits after tax.– Ploughing back the earnings by retaining them– Distribute the same to the shareholders.
• Option I is suitable for firms which need funds to finance their long term projects, which have growth potential and sufficient profitability.
• Option II is suitable for those firm whose objective is to maximize the shareholders wealth.
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Dividend Policy and Stock Value
• There are various theories that try to explain the relationship of a firm's dividend policy and common stock value.
Dividend Irrelevance TheoryThis theory purports that a firm's dividend policy has
no effect on either its value or its cost of capital. Investors value dividends and capital gains equally.
Optimal Dividend PolicyProponents believe that there is a dividend policy
that strikes a balance between current dividends and future growth that maximizes the firm's stock price.
Dividend Relevance TheoryThe value of a firm is affected by its dividend policy.
The optimal dividend policy is the one that maximizes the firm's value.
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Dividend Models
Dividend Relevance Model• Traditional Model• Walter Model• Gordon ModelDividend Irrelevance Model• Miller & Modigliani Position
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Traditional Model• It is given by B Graham and DL Dodd.• This model lays down a clear emphasis on the
relationship between the dividends and the stock market.
• Acc to this model, the stock value responds positively to higher dividends and negatively when there are low dividends.
• This model establishes the relationship between market price and dividends using a multiplier.
• P/E ratios are directly related to the dividend payout ratios i.e a higher dividend payout ratio will increase the P/E ratio and vice-versa.
• P = m(D+E/3)• Where;
P = market priceM = multiplierD = Dividend per shareE = Earnings per share
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Limitation of the Traditional Approach
• P/E ratios are directly related to the dividend payout ratios is not true for a firm’s whose payout is low but its earnings are increasing.
• This approach does not hold good for those firm whose payout is high but have slow growth rate.
• There may be few investors who would prefer the dividends to the uncertain capital gains and a few who would prefer low taxed capital gains.
• These conflicting factors have not been properly explained by traditional approach.
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Walter Model• The dividend policy given by James E Walter considers
that dividends are relevant and they do affect the share price.
• In this model , he studied the relationship between the internal rate of return (r) and the cost of capital of the firm(K), to give a dividend policy that maximizes the shareholders’ wealth.
• The model studies the relevance of the dividend policy in three situations;r > Ker < Ker = Ke
• Acc to WalterWhen r > Ke the firm has to adopt Zero% payout policy.
r < ke the firm has to adopt 100% payout policy. r = ke any policy between 0 to 100% payout.
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Assumptions of Walter Model
1.
4.
2.
3.
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Acc to Walter Market Price Per share is given by
Ke
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Impact of Dividend Policy on Market Price
EPS = Rs. 8Dividend Payout
r > ke r < ke r = ke
15% > 12% 10% < 12% 12% = 12%
Market Price (P) Market Price (P) Market Price (P)
0% 83 56 67
25% 79 58 67
50% 75 61 67
75% 71 64 67
100% 67 67 67
Dividend Policy Zero Payout 100% Payout Payout 0% to 100%
FormulaP = D + r/ke (E-D)
Ke
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Limitation
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Gordon Model• Myron Gordon uses the dividend capitalization
approach to study the effect of the firms dividend policy on the stock price.
• Gordon model assumes that the investors are rational and risk averse.
• They prefer certain returns to uncertain returns and thus put a premium to the certain returns and discount the uncertain returns.
• Investor would prefer to pay a higher price for the stocks, which earn them current dividends income and would discount those stocks, which either postpones/ reduce the current income.
• The discounting will differ depending on the retention rate and the time.
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Assumptions
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Acc to Gordon Market Price Per share is given by
• P = E ( 1-b)Ke - br
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• Acc to Gordon;– The firms with rate of return greater
than the cost of capital should have a higher retention ratio.
– Firms which have rate of return less than the cost of capital, should have a lower retention ratio.
– The firms which have a rate of return equal to the cost of capital will however not have any impact on its share value, it can adopt any retention policy.
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Impact of Dividend Policy on Market Price
EPS = 15
Dividend Payout (1-b)
Retention Ratio = b
r > ke r < ke r = ke
12% > 11% 10% < 11% 11% = 11%
Market Price (P) Market Price (P) Market Price (P)
10% 90% 750 75 136.36
20% 80% 214.28 100 136.36
30% 70% 173.08 112.5 136.36
40% 60% 158 120 136.36
50% 50% 150 125 136.36
Dividend Policy
Retain More Pay less
Retain less Pay more
Any combination
Formula
E(1-b)Ke - br
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Thank you