Determinants of Dividend Policy

Some of the most important determinants of dividend policy are: (i) Type of
Industry (ii) Age of Corporation (iii) Extent of share distribution (iv) Need for
additional Capital (v) Business Cycles (vi) Changes in Government Policies
(vii) Trends of profits (vii) Trends of profits (viii) Taxation policy (ix) Future
Requirements and (x) Cash Balance.

The declaration of dividends involves some legal as well as financial

considerations. From the point of legal considerations, the basic rule is that
dividend can only be paid out profits without the impairment of capital in any
way. But the various financial considerations present a difficult situation to the
management for coming to a decision regarding dividend distribution.

These considerations are discussed below:

(i) Type of Industry:

Industries that are characterised by stability of earnings may formulate a more
consistent policy as to dividends than those having an uneven flow of income.
For example, public utilities concerns are in a much better position to adopt a
relatively fixed dividend rate than the industrial concerns.

(ii) Age of Corporation:

Newly established enterprises require most of their earning for plant
improvement and expansion, while old companies which have attained a
longer earning experience, can formulate clear cut dividend policies and may
even be liberal in the distribution of dividends.

(iii) Extent of share distribution:

A closely held company is likely to get consent of the shareholders for the
suspension of dividends or for following a conservative dividend policy. But a
company with a large number of shareholders widely scattered would face a
great difficulty in securing such assent. Reduction in dividends can be affected
but not without the co-operation of shareholders.

(iv) Need for additional Capital:

The extent to which the profits are ploughed back into the business has got a
considerable influence on the dividend policy. The income may be conserved
for meeting the increased requirements of working capital or future expansion.

(v) Business Cycles:

During the boom, prudent corporate management creates good reserves for
facing the crisis which follows the inflationary period. Higher rates of dividend
are used as a tool for marketing the securities in an otherwise depressed
market.

(vi) Changes in Government Policies:

Sometimes government limits the rate of dividend declared by companies in a
particular industry or in all spheres of business activity. The Government put
temporary restrictions on payment of dividends by companies in July 1974 by
making amendment in the Indian Companies Act, 1956. The restrictions were
removed in 1975.

(vii) Trends of profits:

The past trend of the company’s profit should be thoroughly examined to find
out the average earning position of the company. The average earnings
should be subjected to the trends of general economic conditions. If
depression is approaching, only a conservative dividend policy can be
regarded as prudent.

(viii) Taxation policy:

Corporate taxes affect dividends directly and indirectly— directly, in as much
as they reduce the residual profits after tax available for shareholders and
indirectly, as the distribution of dividends beyond a certain limit is itself subject
to tax. At present, the amount of dividend declared is tax free in the hands of
shareholders.

(ix) Future Requirements:

Accumulation of profits becomes necessary to provide against contingencies
(or hazards) of the business, to finance future- expansion of the business and
to modernise or replace equipments of the enterprise. The conflicting claims
of dividends and accumulations should be equitably settled by the
management.

(x) Cash Balance:

If the working capital of the company is small liberal policy of cash dividend
cannot be adopted. Dividend has to take the form of bonus shares issued to
the members in lieu of cash payment

Stability of Dividend:
Usually shareholders prefer a stable dividend policy which means they require
a certain minimum percentage of dividends to be paid regularly to them.
Therefore, dividend policy should be devised taking into account this
aspiration of the shareholders.

iii. Liquidity:
The liquidity position of a company affects the dividend policy. Payment of
dividend requires availability of cash resources. Future investment
opportunities should also be taken into consideration.

v. Legal Constraints:
All requirements of The Company’s Act and SEBI guidelines must be kept in
mind before declaring dividend.

vi. Owner’s Consideration:

Tax statuses of shareholders, availability of investment opportunities, own-
ership dilutions, etc., are the different factors that affect shareholders. These
factors should be taken into consideration while devising a dividend policy.

vii. Capital Market Conditions and Inflation:

Capital market conditions and inflation play a dominant role in developing the
dividend policy. A company having an easy access to the capital market will
follow a liberal dividend policy in comparison to others. During times of
inflation a good company tries to satisfy its shareholders by paying higher
dividends.

The main objectives of a dividend policy are:

i. Wealth Maximization:
According to some schools of thought dividend policy has significant impact
on the value of the firm. Therefore the dividend policy should be developed
keeping in mind the wealth maximization objective of the firm.

ii. Future Prospects:

Dividend policy is a financing decision and leads to cash outflows and also
leads to decrease in availability of cash for financing of profitable projects. If
sufficient funds are not available, a firm has to depend on external financing.
Therefore the dividend policy needs to be devised in such a manner that
prospective projects may be financed through retained earnings.

iii. Stable Rate of Dividend:

Fluctuation in the rate of return adversely affects the market price of shares. In
order to have a stable rate of dividend, a firm should retain a high proportion
of earnings so that the firm can keep sufficient funds for payment of dividend
when it faces loss.

iv. Degree of Control:

Issue of new shares or dependence on external financing will dilute the
degree of control of the existing shareholders. Therefore, a more conservative
dividend policy should be followed in order that the interest of existing
shareholders is not hampered.

ome of the major different theories of dividend in financial management are as

follows: 1. Walter’s model 2. Gordon’s model 3. Modigliani and Miller’s
hypothesis.

On the relationship between dividend and the value of the firm different
theories have been advanced.

They are as follows:

1. Walter’s model

2. Gordon’s model

3. Modigliani and Miller’s hypothesis

1. Walter’s model:
Professor James E. Walterargues that the choice of dividend policies almost
always affects the value of the enterprise. His model shows clearly the
importance of the relationship between the firm’s internal rate of return (r) and
its cost of capital (k) in determining the dividend policy that will maximise the
wealth of shareholders.

Walter’s model is based on the following assumptions:

1. The firm finances all investment through retained earnings; that is debt or
new equity is not issued;

2. The firm’s internal rate of return (r), and its cost of capital (k) are constant;

3. All earnings are either distributed as dividend or reinvested internally

immediately.

4. Beginning earnings and dividends never change. The values of the

earnings pershare (E), and the divided per share (D) may be changed in the
model to determine results, but any given values of E and D are assumed to
remain constant forever in determining a given value.

5. The firm has a very long or infinite life.

Walter’s formula to determine the market price per share (P) is as

follows:
P = D/K +r(E-D)/K/K

The above equation clearly reveals that the market price per share is the
sum of the present value of two sources of income:
i) The present value of an infinite stream of constant dividends, (D/K) and
ii) The present value of the infinite stream of stream gains.

[r (E-D)/K/K]

Criticism:
Walter’s model is quite useful to show the effects of dividend policy on an all
equity firm under different assumptions about the rate of return. However, the
simplified nature of the model can lead to conclusions which are net true in
general, though true for Walter’s model.

The criticisms on the model are as follows:

1. Walter’s model of share valuation mixes dividend policy with investment
policy of the firm. The model assumes that the investment opportunities of the
firm are financed by retained earnings only and no external financing debt or
equity is used for the purpose when such a situation exists either the firm’s
investment or its dividend policy or both will be sub-optimum. The wealth of
the owners will maximise only when this optimum investment in made.

2. Walter’s model is based on the assumption that r is constant. In fact

decreases as more investment occurs. This reflects the assumption that the
most profitable investments are made first and then the poorer investments
are made.

The firm should step at a point where r = k. This is clearly an erroneous policy
and fall to optimise the wealth of the owners.

3. A firm’s cost of capital or discount rate, K, does not remain constant; it

changes directly with the firm’s risk. Thus, the present value of the firm’s
income moves inversely with the cost of capital. By assuming that the
discount rate, K is constant, Walter’s model abstracts from the effect of risk on
the value of the firm.

2. Gordon’s Model:
One very popular model explicitly relating the market value of the firm to
dividend policy is developed by Myron Gordon.

Assumptions:
Gordon’s model is based on the following assumptions.

1. The firm is an all Equity firm

2. No external financing is available

3. The internal rate of return (r) of the firm is constant.

4. The appropriate discount rate (K) of the firm remains constant.

5. The firm and its stream of earnings are perpetual

6. The corporate taxes do not exist.

7. The retention ratio (b), once decided upon, is constant. Thus, the growth
rate (g) = br is constant forever.

8. K > br = g if this condition is not fulfilled, we cannot get a meaningful value

for the share.

According to Gordon’s dividend capitalisation model, the market value of a

share (Pq) is equal to the present value of an infinite stream of dividends to be
received by the share. Thus:
The above equation explicitly shows the relationship of current earnings (E,),
dividend policy, (b), internal profitability (r) and the all-equity firm’s cost of
capital (k), in the determination of the value of the share (P0).
3. Modigliani and Miller’s hypothesis:
According to Modigliani and Miller (M-M), dividend policy of a firm is irrelevant
as it does not affect the wealth of the shareholders. They argue that the value
of the firm depends on the firm’s earnings which result from its investment
policy.

Thus, when investment decision of the firm is given, dividend decision the split
of earnings between dividends and retained earnings is of no significance in
determining the value of the firm. M – M’s hypothesis of irrelevance is based
on the following assumptions.

1. The firm operates in perfect capital market

2. Taxes do not exist

3. The firm has a fixed investment policy

4. Risk of uncertainty does not exist. That is, investors are able to forecast
future prices and dividends with certainty and one discount rate is appropriate
for all securities and all time periods. Thus, r = K = Kt for all t.
Under M – M assumptions, r will be equal to the discount rate and identical for
all shares. As a result, the price of each share must adjust so that the rate of
return, which is composed of the rate of dividends and capital gains, on every
share will be equal to the discount rate and be identical for all shares.
Thus, the rate of return for a share held for one year may be calculated
as follows:

Where P^ is the market or purchase price per share at time 0, P, is the market
price per share at time 1 and D is dividend per share at time 1. As
hypothesised by M – M, r should be equal for all shares. If it is not so, the low-
return yielding shares will be sold by investors who will purchase the high-
return yielding shares.

This process will tend to reduce the price of the low-return shares and to
increase the prices of the high-return shares. This switching will continue until
the differentials in rates of return are eliminated. This discount rate will also be
equal for all firms under the M-M assumption since there are no risk
differences.

From the above M-M fundamental principle we can derive their valuation
model as follows:

Multiplying both sides of equation by the number of shares outstanding (n), we

obtain the value of the firm if no new financing exists.

If the firm sells m number of new shares at time 1 at a price of P^, the value of
the firm at time 0 will be
The above equation of M – M valuation allows for the issuance of new shares,
unlike Walter’s and Gordon’s models. Consequently, a firm can pay dividends
and raise funds to undertake the optimum investment policy. Thus, dividend
and investment policies are not confounded in M – M model, like waiter’s and
Gordon’s models.

Criticism:
Because of the unrealistic nature of the assumption, M-M’s hypothesis lacks
practical relevance in the real world situation. Thus, it is being criticised on the
following grounds.

1. The assumption that taxes do not exist is far from reality.

2. M-M argue that the internal and external financing are equivalent. This
cannot be true if the costs of floating new issues exist.

3. According to M-M’s hypothesis the wealth of a shareholder will be same

whether the firm pays dividends or not. But, because of the transactions costs
and inconvenience associated with the sale of shares to realise capital gains,
shareholders prefer dividends to capital gains.

4. Even under the condition of certainty it is not correct to assume that the
discount rate (k) should be same whether firm uses the external or internal
financing.

If investors have desire to diversify their port folios, the discount rate for
external and internal financing will be different.
5. M-M argues that, even if the assumption of perfect certainty is dropped and
uncertainty is considered, dividend policy continues to be irrelevant. But
according to number of writers, dividends are relevant under conditions of
uncertainty.