s- dividend policy

8/7/2019 S- Dividend Policy

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Dividend Policy


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C oncept of DividendC oncept of Dividend

Dividend is one of the important areas of financial decisions and promotes two other

decisionsinvestment and financing.A firm has to choose between distributing

profits or retaining them in the business.

The ultimate choice would depend on theeffect of the decision on maximization of thevalue of the firm or that of its shares.


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Dividend: Legal ProvisionsDividend: Legal ProvisionsI n I ndia, Section 205 of the Companies Act, 1956stipulates that no dividend shall be declared or paidexcept out of profit:

1. for that year, or 2. of any previous years, or 3. out of both, or 4. out of moneys provided by the Government for

the payment of dividend in accordance with anyguarantee given.


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Dividend: C lassificationDividend: C lassification

1. S ources from which they are paid:(a) retained earnings(b) current profit

2. Medium in which they are paid:(a) cash dividend(b) share dividend or bonus issue

3 Regularity with which they are paid:(a) interim dividend(b) annual dividend


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Dividend: PoliciesDividend: PoliciesC onstant percentage of earnings

C onstant dividend rate

E arnings Dividend

Time Time

Rs.Rs.


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Dividend Policy Formulation:Dividend Policy Formulation:

DeterminantsDeterminants1. Ownership factors:

(a) Current income requirements of shareholders(b) Alternative uses for funds by the shareholders(c) Tax considerations for the shareholders

2 . Firm-oriented factors:(a) Legal constraints(b) Liquidity, credit standing and working capital

considerations

(c) Need for expansion(d) Business cycle considerations(e) Dividend policies and shareholders relationship(f) Factors relating to future financing(g) I nflation


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Dividend Theory : WalterDividend Theory : WalterDividend policy must be evaluated in the light of theobjective of the firm, i.e. to maximize the price of theshare.Choice of dividend policies affects the value of the firm.

Dividend policy should be determined solely by the profitability of investments.I f the firm has an abundance of profitable investmentopportunities, there should be no cash dividends.I n the reverse case, all earnings should be distributed toshareholders in the form of dividends.


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Walters Theory : AssumptionsWalters Theory : Assumptions

1. All investments are financed by the firm throughretained earnings; debt or share capital is not issued.

2. The firms internal rate of return, r , and the cost of capital, k , are constant so that the business risk is notchanged with additional investment proposals.

3. All earnings are either re-invested internally or distributed as dividends.

4. There is no change in the key factors, namely, theEP S, and the D P S.

5. The firm has a perpetual life.


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Walters Theory : FormulaWalters Theory : Formula

P = Market price per equity share

D = DP S E = EP Sr = Return in

investmentk = Cost of capital or marketmapitalizationrate

r > k :G rowth firmsHave profitable investment opportunities P will be maximum when D = 0

r < k :Declining firms

No profitable investment opportunities P will be maximum when E = D

r = k :N ormal firms

No unlimited profitable investmentsM arket price per share becomesinsensitive to the pay-out ratio.

D + (r /k )( E D ) P

k !


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Dividend Theory : G ordonDividend Theory : G ordonThe market value of a share is equal to the presentvalue of an infinite future stream of dividends.

The dividend policy of the firm is dependent on theavailability of profitable investment opportunities andthe relationship between the firms cost of capital, k ,and the internal rate of return, r .

gg

g

1 21 2

1

.. .

(1 ) (1 ) (1 )

(1 )t

t t

D D D P

k k k

D

k


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G ordons Theory : AssumptionsG ordons Theory : Assumptions

1. The firm is an all-equity firm.2. Only retained earnings are used for financing.

3. The internal rate of return ( r ) and cost of capital or the capitalization rate ( k ) are constant.4. The firm has perpetual life.5. Corporate tax does not exist.6. The retention ratio, b, is constant. Thus, the growth

rate, g = b X r , is also constant.7. k > g .


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Gordons Theory : Formula

Gordons Theory : Formula

r > k:G rowth firmsHave profitable investment opportunities P

will be maximum when D =

0r < k :Declining firms

No profitable investment opportunities P will be maximum when E = D

r = k

:N ormal firms No unlimited profitable investmentsM arket price per share becomesinsensitive to the pay-out ratio.

E b

k br P =

P = P rice of shares E = EP Sb = Retention ratiok = Cost of capital or

capitalization ratebr = g = Growth rate in r r = Rate of return on

investment


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Residual Theory of DividendDividend, investment and financing decisions areinterdependent and in the long run, a trade-off must be made,

because a firm cannot afford to (a) forego profitableinvestments; (b) operate with a non-optimal capitalstructure; and (c) finance dividends by issuing newshares.The only policy that avoids one of the choices is to treatdividends as a residual.The residual theory of dividend assumes that if the firm hasretained earnings left over after financing all acceptable

investment opportunities, these earnings would then bedistributed to shareholders in the form of cash dividends.There may be fluctuations in dividend payout from period to

period in keeping with fluctuations in availability of investment opportunities.


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ModiglianiModigliani Miller (MMiller (M M) HypothesisM) HypothesisThe dividend policy of the firm is irrelevant; it does not affectthe wealth of shareholders.Value of the firm is determined by the earning power of thefirm or its investment policy.

Assumptions:1. The firm operates in perfect capital markets. This implies

availability of information to all, absence of transaction costs;and inability of an individual investors to affect the market

price of share.2. All investors are rational.3. Taxes do not exist.4. I nvestment policy of the firm is fixed.5. All investors are perfectly certain about the future investment

programmes and future profits of all firms.


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MM M HypothesisM Hypothesis : Working Formulae: Working Formulae

P 0 = M arket price per share at time 0k = Cost of capital or capitalization rate ( = r )D 1 = Dividend per share at time 1P 1 = M arket price per share at time 1

When there is no external financing, the value of the firm, V ,would be the number of shares n times the price of eachshare, P 0.

0 P P k !

1 10

( )

1

n D P V nP

k ! !

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