Dividend Policy

Dividend Policy - Contents

✓ Introduction
✓ Influencing factors
✓ Dividend Distribution Theories –
✓ Walter Model
✓ Gordon Model
✓ Modigliani Miller Model

✓ Stability of Dividends
 Dividend Policy : Significance
 Outflow of cash, pressure on liquidity of the company
 Opportunity cost of the funds distributed
 Dividend payment maximizes shareholders’ current
wealth while retention facilitates future wealth generation.
 Dividend payment is a sign of goodwill, and a positive
impact on investors, and in turn the market price / share.
 Retention leads to faster growth resulting in higher
profitability and increase in shareholders’ wealth.
 Harmony between payout & retention – key mgt. decision
Factors influencing Dividend Policy

External Factors Internal Factors

General state of Economy Desire of Shareholders

Capital Markets Financial needs of Company

Legal Restrictions Nature of Earnings

Contractual Restrictions Desire of Control

Taxation Policy Liquidity Position

Dividend Dividend
Policy Policy
External Factors – Dividend Policy
 General state of Economy – in cases of uncertainty, depression
in the economy, the mgt. may like to retain the earnings and build up
reserves to absorb shocks in the future and preserve liquidity.

 Capital Markets – if a firm has easy access to capital markets to

raise funds, it may follow liberal dividend policy and vice versa.

 Legal Restrictions – the mgt. must comply to all legal restrictions

such as transfer to reserves etc.

 Contractual Restrictions – lending financial institutions may put

restrictions on dividend payments to protect their interests.

 Taxation Policy – consideration of corporate taxes and dividend

distribution tax to be paid by the companies.
Internal Factors – Dividend Policy
 Desire of Shareholders – the shareholders, being the owners of
the company influence the dividend payout. Their expectation for
dividend depicts companies strength, certainty and liquidity.

 Financial needs of Company – financial needs of the company

may directly conflict with shareholders’ desire. Company’s vision for
future growth and profitability may bypass the dividend expectation.

 Nature of Earnings – a firm with a stable income can afford to

have higher dividend payout and vice versa

 Desire of Control – higher dividend implies liquidity crunch that

can be met by new equity issue. New equity dilutes mgt. control.

 Liquidity Position – prime importance for dividend payments.

Dividend Distribution
Theories
Dividend Distribution Theories

❖ Economists & thinkers

studied the outcome of WALTER
dividend on the value of MODEL

the firm.
❖ Establish a relationship
between dividend pay
and value of the firm.
Dividend
❖ The theories put forward distribution
provided extreme views.
MODIGLIANI
❖ Dividend and value of GORDON
MILLER (MM)
MODEL
firm are related as well MODEL
as totally unrelated etc.
❖ Main theories are –
Dividend Distribution Theories
A. Walter’s Model –
 According to Prof. James Walter, the choice of dividend policy
always affects the value of the firm.
 The Walter model exhibits a clear relationship between the
firm’s rate of return (r), cost of capital (k), and dividend policy.
 Assumptions –
• There is only internal financing of investments, i.e. no debts, no equity
• Rate of return (r) and cost of equity (k) are always constant
• Firm has a very long life
 As per the theory, Walter has classified firms into 3 categories,
viz. growth firms (where r > k), normal firms (where r = k), and
declining firms (where r < k)
Dividend Distribution Theories
A. Walter’s Model –
 According to Walter model –
➢ Growth firms earn higher return on their investments (r > k) and
hence, the firm should retain its earnings. These firms maximize
value of shareholders since their earnings (r) are greater than
shareholders’ expectations (k), i.e. market price will increase.
➢ Normal firms earn a return on their investments equal to its cost
of capital (r = k). In such cases, the dividend policy has no effect
on the value of the firm, i.e. market price per share is constant.
➢ Declining firms earn lower return on their investments (r < k).
Value of firm is highest when all its earnings are distributed as
dividend, the market price per share being maximum. Investors
of such firms like its earnings to be distributed to them, so that
they may spend it or earn a higher return elsewhere.
Dividend Distribution Theories
A. Walter’s Model –
 According to Walter model, mathematical formula for
calculation of expected market price per share –
MP = D + (r / k) * (E – D)
k
Where,
• MP = Market price per share
• D = Dividend per share
• E = Earnings per share
• r = Firm’s rate of return
• k = Cost of capital
 Criticisms ~ assumptions of the theory.
Dividend Distribution Theories
B. Gordon’s Model –
 Myron Gordon used the dividend capitalization approach to
prove the effect of dividend policy on stock price (value of firm)
 Gordon model verifies the relation between a firm’s dividend
policy with the expectation of the shareholders.
 Assumptions –
• The firm is an all equity firm, i.e. it has no debt in its capital structure
• There is only internal financing of investments, i.e. no new equity
• Rate of return (r) and cost of equity (k) are always constant
• Retention ratio (b) remains constant, (retention = 1 – dividend ratio)
• Cost of capital (k) is always greater than growth rate (g = b*r)
• Firm has a very long life and perpetual earnings
• Corporate taxes does not exist
Dividend Distribution Theories
B. Gordon’s Model –
 As per Gordon’s model, ‘the market value of a share is equal
to the present value of an infinite dividend stream to be recd.
by the shareholders in the future’.
 Gordon’s model assumes that investors are rational and risk-
averse. They prefer current dividends and avoid risk in future.
 Also known as “bird-in-hand” argument. Where a bird in hand
is better than two in the bush, current dividend better than
future earnings (which are uncertain)
 Thus, for two firms with same earning power and r = k, the firm
paying larger dividend will sell at higher price (bird-in-hand)
 Dividend policy for (r > k) & (r < k) are similar to Walter model.
Dividend Distribution Theories
B. Gordon’s Model –
 According to Gordon model, mathematical formula for
calculation of expected market price per share –
MP = E (1 – b)
ke – br
• MP = Market price per share
• b = retention ratio
• E = Earnings per share
• ke = cost of equity capital
• r = rate of return
• br = Growth rate of the firm (g)
Dividend Distribution Theories
C. Modigliani Miller (MM) Approach –
 According to Modigliani and Miller, under a perfect market
situation, the dividend policy of a firm is irrelevant and it does
not affect the value of the firm.
 As per MM approach, value of a firm entirely depends on its
earnings, which are a result of its investment policy.
 Assumptions –
• Capital markets are perfect, ease of raising funds
• Investors are rational, information freely available
• Transaction and floatation costs does not exist
• No individual taxes
• The firm has fixed in investment policy
• No risk of uncertainty, hence, ‘r = k’
 Stability of Dividends
 Stability of dividends means a ‘consistency’ or ‘regularity’ in
the stream of dividend payment
 A stable dividend policy may have a positive impact on the
market price of the share.
 There are 3 distinct forms of stability –
Constant dividend rate
Constant percentage (i.e. constant payout ratio)
Constant dividend rate + extra dividend in high profits
Numerical Problem: Walter’s model

The earnings per share of a company is Rs. 20 and the rate of

capitalization (cost of capital) applicable to the company is 20%.
The company has the option of adopting a payment ratio of 40%
or 60%.
Compute the market value of the company’s share if the return
on retained earnings is: a) 25%, b) 20% and c) 15%.

MP = ?? D = DPS (40% or 60% of EPS)

E = EPS (Rs. 20) r = ROR (25, 20, 15 %)
k = COC (20%)