1

FINANCIAL MANAGEMENT

M O D U L E :- 4

Dividend Decision

2

Syllabus – M O D U L E - 1

• Understanding Dividend Decisions• Theory and Practices• Contemporary Issues and Projects by Students • Various Models of Relevance and Irrelevance

Approaches towards Dividend Theory

3

M O D U L E :- C O N T E N T s

•DIVIDEND MODELS•DIVIDEND DECISION

4

DIVIDEND MODELS

5

C O N T E N Ts• RELEVANCE CONCEPT OF DIVIDEND THEORY–WALTER’S MODEL–GORDER’S GROWTH MODEL

• IRRELEVANCE CONCEPT OF DIVIDEND POLICY–MODIGLIANI AND MILLER APPROACH (MM

MODEL)

6

RELEVANCE CONCEPT OF DIVIDEND THEORY

• Dividend relevance theory proposes that dividend policy affect the share price.

• According to this theory, optimal dividend policy should be determined which will ensure maximization of the wealth of the shareholders.

7

WALTER’S MODEL

• MEANING OF WALTER’S MODEL• ASSUMPTIONS OF WALTER’S MODEL• FORMULA FOR DETERMINING THE VALUE OF A

SHARE OF WALTER’S MODEL• CRITICISMS OF WALTER’S MODEL

8

MEANING OF WALTER’S MODEL• Prof. Walter’s approach supports the doctrine that

dividend decisions are relevant and affect the value of the firm.

• The relationship between the internal rate of return earned by the firm and its cost of capital is very significant in determining the dividend policy to sub serve the ultimate goal of maximizing the wealth of the share holders.

• Prof. Walter model is based on the relationship between the firm’s i) return on investment and ii) the cost of capital.

9

ASSUMPTIONS OF WALTER’S MODEL• Internal Financing • Constant Return and Cost of Capital• 100 percent payout or retention• Constant EPS and DPS• Infinite Time

10

FORMULA FOR DETERMINING THE VALUE OF A SHARE OF WALTER’S MODEL

D + r (E - D) P = Ke Kewhere,

E = Earning P = Market Value of ShareD = Dividendr = return on investmentKe = Cost of equity or capital or

capitalization rate

Growth Company = (r > Ke)

Normal Company = (r = Ke)

Declining Company = (r < Ke)

11

Cost of capitalCost of capital refers to the opportunity cost of making a specific investment. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk. Thus, the cost of capital is the rate of return required to persuade the investor to make a given investment.

12

CRITICISMS OF WALTER’S MODEL• Constant Return • Constant Opportunity Cost of Capital

13

GORDAN’S GROWTH MODEL• MEANING OF GORDAN’S GROWTH MODEL• ASSUMPTIONS OF GORDAN’S GROWTH MODEL• FORMULA FOR DETERMINING THE VALUE OF A

SHARE OF GORDAN’S GROWTH MODEL• CRITICISMS OF GORDAN’S GROWTH MODEL

14

MEANING OF GORDON’S GROWTH MODEL• Myrion Gordon contended that dividends are

relevant.• He proposed a model of stock valuation using the

dividend capitalization approach.• According to Gordon, Dividend policy of a firm is

based on few following assumptions:

15

ASSUMPTIONS OF GORDON’S GROWTH MODEL• All equity firm • No external Financing • Constant Return • Constant Cost of Capital• Perpetual Earning • No Taxes• Constant Retention• Cost of Capital greater than Growth Rate

16

FORMULA FOR DETERMINING THE VALUE OF A SHARE OF GORDON’S GROWTH MODEL

E (1 – b)P =

Ke – br

where, P = Price of ShareE = Earning b = Retention Ratio or % of earning br = g = growth rate

17

CRITICISMS OF GORDON’S GROWTH MODEL• Gordon’s model’s conclusions about dividend policy

are similar to that of walter’s model. • This similarity is due to the similarities of

assumptions which underlines both models.• Thus the Gordon model suffers from the same

limitations as the Walter model.

18

IRRELEVANCE CONCEPT OF DIVIDEND POLICY

• Dividend irrelevance theory suggests that, in a perfect world, dividends are irrelevant and it has no effect on the wealth of the shareholders or the prices of the shares.

• Irrelevance Policy perceive dividend as a signal as,– Increase = Positive Signal and earns in future– Decrease = Negative Signal and decrease in earning

capacity in future

19

• According to this theory, dividend decision has no effect on the wealth of the shareholders or the prices of the shares, and hence it is irrelevant so far as the valuation of the firm is concerned.

• This theory regards dividend decision merely as a part of financing decision because the earning available may be retained in the business for re – investment.

• But if the funds are not required in the business they may be distributed as dividend.

• Thus, a firm should retain the earnings if it has profitable investment opportunities otherwise it should pay them as dividend.

20

MODIGLIANI AND MILLER APPROACH (MM

MODEL)• MEANING OF MM MODEL• ASSUMPTIONS OF MM MODEL• FORMULA FOR DETERMINING THE VALUE OF A

SHARE OF MM MODEL• CRITICISMS OF MM MODEL

21

MEANING OF MM MODEL• MM has expressed in the most comprehensive

manner in support of the theory of irrelevance.• According to this theory dividend policy has no

effect on the market price of the shares and the value of the firm is determined by the earning capacity of the firm or its investment policy.

• As observed by M.M. “Under conditions of perfect capital markets, rational investors, absence of tax discrimination between dividend income and capital appreciation, given the firm’s investment policy, its dividend policy may have no influence on the market price of the shares.”

22

ASSUMPTIONS OF MM MODEL• No Taxes• Investment Policy given • No Risks

23

FORMULA FOR DETERMINING THE VALUE OF A SHARE OF MM MODEL

P0 = (D1 + P1)/(1 + Ke)

nP1 = I – (E – nD1)

Delta n = Delta n*P1 / P1

nP0 = (n + Delta n)P1 – (I-E)/ 1 + Ke

24

CRITICISMS OF MM MODEL• Information about the company is not available to

all the persons.• The firms have to incur floatation costs while issuing

securities.• Taxes do exist and there is normally different tax

treatment for dividends and capital gains.• The firms do not follow a rigid investment policy.• The investors have to pay brokerage, fees, etc. while

doing any transaction.• Shareholders may prefer current income as

compared to further gains.

25

Residual Theory of Dividend

• It suggest that the dividends paid by a corporate should be the amount left over after meeting the financial requirements of all the acceptable / profitable investment projects.

• Dividend will be paid after investing in all new projects.

26

DIVIDEND DECISION

27

C O N T E N Ts

• MEANING AND DEFINITION OF DIVIDEND • TYPES OF DIVIDEND • RELEVANCE OF DIVIDEND DECISION• MEANING OF DIVIDEND POLICY• FORMULATING / FACTORS AFFECTING DIVIDEND

POLICY• CONTEMPORARY ISSUES ON DIVIDEND POLICY• BONUS SHARES AND STOCK SPLITS

28

MEANING AND DEFINITION OF DIVIDEND • According to ICAI, “A dividend is a distribution to

shareholders out of profit or reserves available for this purpose.”

• The term dividend refers to that part of profit of a company which is distributed by the company among its shareholders after execution retained earning.

• It is reward of the shareholders for investments made by them in the shares of the company.

• It is the return that a shareholder gets from the company out of profit on his shareholding.

29

TYPES OF DIVIDEND • On the Basis of Types of Shares– Equity Dividend – Preference Dividend

• On the Basis of Modes of Payment– Cash Dividend– Bonus Shares / Stock Dividend – Scrip or Bond Dividend – Property Dividend – Composite Dividend

• On the Basis of Time of Payment – Interim Dividend – Regular Dividend – Special Dividend

30

RELEVANCE OF DIVIDEND DECISION• The firm has to balance between the growth of the

company and the distribution to the shareholders.• It plays an important role in determining the value of a

firm.• Dividends are important component for calculating the

value of a stock.• A large number of analyst employ dividends to

calculate the intrinsic value of stock.• Dividends can indirectly influence the external

financing plans of financial managers• Retained earning helps the firm to concentrate on the

growth, expansion and modernization.

31

MEANING OF DIVIDEND POLICY• It refers to the policy concerning quantum of profit

to be distributed as dividend.• The concept of dividend policies implies that

companies through their Board of Directors evolve a pattern of dividend payment which has a bearing on future action.

• According to Weston and Brigham, “Dividend policy determines the division of earning between payments to shareholders and retained earning.”

32

FORMULATING / FACTORS AFFECTING DIVIDEND POLICY

• Size of the Earnings• Investment Opportunities and Shareholder’s

Preferences• Liquidity Position• Management’s Attitude towards Control• State of Capital Market and Access to it • Contractual Restrictions• Profit Rate and Stability of Earnings• Inflation

33

CONTEMPORARY ISSUES ON DIVIDEND POLICY

• Dividend follows earning.• The market seems to react positively to the

announcement of dividend increases and penalize the dividend decrease.

• Factors such as ownership structure, management control and other market imperfections seem to make the dividend decisions more complex.

• The challenge to financial economists is therefore to determine the link of such factors with payout policies so that firms maximize shareholders wealth and investors maximize their utility.

34

BONUS SHARES AND STOCK SPLITS• Bonus Shares:– A company very often distributes dividend in cash.

But in certain circumstances where cash is not available or company wants to capitalize its profits, it may distribute dividend in the form of shares known as ‘Bonus Shares’.

– Thus ‘Bonus shares’ represents a distribution of shares in lieu of or in addition to the cash dividend to the existing shareholders. If the articles so permit.

– The shares are issued to the existing ordinary shareholders in proportion to their present holding. Thus it makes no change in ownership equity.

35

BONUS SHARES AND STOCK SPLITS• Stock Split:– It is the process of splitting shares with high face

value into shares of a lower face value.– It’s like getting an Rs. 20 note changed for two Rs.

10–A stock split simply involves a company altering

the number of its shares outstanding and proportionally adjusting the share price to compensate.– In other words it is an increase in the number of

outstanding shares of a company.

36

Bonus Shares v/s Stock SplitBonus Shares

• Meaning – Additional Free share

• Face Value – It is not changed

• Share Capital– It is increased from issue

• Dividend – More dividend are to be

paid• Reserves – Reserved are to be used

Stock Split• Meaning – Process dividing the face

value• Face Value – It is chnaged

• Share Capital – Capital is not changed but

no. of shares changed• Dividend – There is no difference in

dividend • Reserves – No use of Reserve

Thank You