Chapter Two

Dividend Policy and Theory

Meaning of Dividend
 Dividend refers to the business concerns net profits distributed among the shareholders.
 Dividend is payment made from the earning of the company to owner either in the form
cash or shares.

Dividend Classifications
 Cash dividend
 Stock dividend
 Bond dividend
 Property dividend

Cash Dividend:
The dividend is paid in the form of cash to the shareholders. And result in decrease in cash and
retained earnings.
Stock Dividend:
 Cash is retained by the business concern and stockholders are given additional shares of
stock as dividend.
 It is not a true dividend because no cash leaves the firm.
 It increases the number of shares outstanding, thereby reducing the value of each share.

Advantages of stock dividends

 They can preserve a company's cash position if a substantial number of shareholders take up
the share option.
 Investors may be able to obtain tax advantages if dividends are in the form of shares.
 Investors looking to expand their holding can do so without incurring the transaction costs of
buying more shares.

Property Dividend:
 Property dividends are paid in the form of some assets other than cash.

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 This form of dividend is sometimes used by a business to deliberately issue property
dividends in order to alter their taxable and/or reported income.

Dividend policy
The dividend policy of the firm is systematic way for appropriate allocation of profits between
dividend payments and additions to the firm’s retained earnings. Dividend policy is an integral
part of the firm’s financing decision. When deciding how much cash to distribute to
shareholders, financial managers must keep in mind that the firm’s objective is to maximize
shareholder value.
Increase in dividend would cause the stock price to rise. However, if dividend is raised, then less
money will be available for reinvestment which will cause the firm’s expected growth rate to
decline, and that will tend to lower the stock’s price.

Types of Dividend Policy

The dividend policy may be classified under the following types:
 Regular dividend policy
 Stable dividend policy
 Irregular dividend policy
 No dividend policy.

Regular dividend policy

Dividend payable at the usual rate is regarded as regular dividend policy. Though the rate is
usual, the dividends vary per income earned. This type of policy is suitable to the small
investors, retired persons and companies which get regular earning. Regular dividend policy
has several advantages, including:
⚫ Creating confidence among shareholders.
⚫ Stabilizing market value of shares
⚫ giving regular income to shareholders, etc.
Stable Dividend Policy
Stable dividend policy means payment of certain minimum amount of dividend regularly. This
dividend policy consists of the following three important forms: Constant dividend per share-

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irrespective of the level of earning year after year and fixed dividend is paid to owners. This is
suitable for companies having stable earning for a number of years.
⦿ Constant payout ratio- this is a fixed percentage of net income to be paid as cash dividend
every year.
⦿ In this case, the amount of dividend fluctuates in a direct proportion to the earnings of the
company.
⦿ Stable Birr dividend plus extra dividend: firms pay low- regular dividends supplemented by
an additional dividends when earnings are higher than normal.
Irregular Dividend Policy:
When companies are facing constraints of earnings and unsuccessful business operation, they
may follow irregular dividend policy. It is one of the temporary arrangements to meet the
financial problems. Companies follow this type of policy due to uncertain earnings of the
company, lack of liquid resources, and afraid of regular dividend.
Factors Influencing Dividend Policy

 Profitability Position of the Firm: When the firm earns more profit, they can distribute
more dividends to the shareholders.
 Uncertainty of Future Income: When the shareholder needs regular income, the firm
should maintain regular dividend policy.
 Legal Constrains: in certain situations companies may be prohibited from paying their
legal capital as dividend.
 The restriction is to provide sufficient equity base to protect creditors’ claims.
 Contractual constraints: often the firm’s ability to pay cash dividends is constrained by
restrictive provisions in a loan agreement.
 Liquidity Position:
 Growth Rate of the Firm: fast growing companies may choose to reinvest their earnings
for further growth and expansion.
 Tax Policy: When the government gives tax incentives, the company pays more
dividends.
 Capital Market Conditions: If the capital market is prefect, it leads to improve the higher
dividend.

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Dividend Theories
There are two types of dividend theory
⦿ Irrelevance theory and
⦿ Relevance theory
Dividend Irrelevance Theories
 Modigliani and Miller’s (MM) Approach
 Residual Theory
 Dividend Clientele effect
 Expectation theory

Modigliani and Miller’s (MM) Approach

According MM theory, dividend policy has no effect on firm value or its stock price.MM argue
that the value of the firm is determined solely by the earning power of the firm’s assets or its
investment policy and risk associated to the return.
MM approach is based on the following assumptions:
 Perfect capital market.
 Investors are rational.
 There are no taxes.
 The firm has fixed investment policy.
 No risk or uncertainty.

MM hypothesis is primarily based on the Arbitrage argument. Through the arbitrage process,
MM hypothesis discusses how the value of the firm remains same whether the firm pays
dividend or not.
Residual Theory
Residual Theory suggests the dividend paid by a firm be viewed as a residual, According to this
theory; new equity capital is more expensive than capital rose through retained earnings. Hence,
financing investments internally (through earning) may be favored.
Using this approach, the dividend decision is done in three steps:
 Determine the optimal level of capital expenditures;
 Estimate the total amount of equity financing needed to support the expenditures;

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  Use reinvested profits to meet the equity requirement.

If the available reinvested profits are in excess of the equity need, then the surplus, the residual,
is distributed to shareholders as dividends. Therefore, according to residual theory, since
dividend is paid only when all profitable investments are undertaken, the dividend paid will have
no effect on the firm’s value. That means that dividend amounts for shareholders vary depending
on the company's earnings and expenditures
Expectation theory:
As the time approaches for management to announce the amount of next dividend, investors
form expectations as to how much the dividend will be.
If the actual dividend is as expected, the market prices will remain unchanged; otherwise higher
or lower than expected amounts will force investors to reassess their perception about the firm,
and the value of its shares.It is the investors expectation as compared to actual dividend declared
that affects the stock price, not the dividend policy itself.
Dividend Relevance Theories
According to this concept, dividend policy is considered to affect the value of the firm.Dividend
relevance implies that shareholders prefer current dividend and hence there is direct relationship
between dividend policy and value of the firm.Relevance of dividend concept is supported by
two prominent persons:
 Walter and
 Gordon.

Walter’s Model
 Walter argues that the dividend policy almost always affects the value of the firm.
 Walter’s model is based on the relationship between the following important factors:
Internal rate of return, (r) and Cost of capital, (k) to analyze the effect of dividend policy on
firms value.
 According to Walter, stock price is the Present value of dividend payment over life time
plus Present value of capital gain

Walter has developed a mathematical formula for determining the value of market share.

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Where,
P = Market price of an equity share, D = Dividend per share,
E = Earnings per share,
Ke = Cost of equity capital and r = Internal rate of return
Walter’s model argues that:
o if r > k, the firm is able to earn more than what the shareholders could by reinvesting, if the
earnings are paid to them,
o if r < k, the shareholders can earn a higher return by investing elsewhere,
o If the firm has r = k, it is a matter of indifference whether earnings are retained or distributed.
o When r > k (growing firms), the dividend payout ratio and the firm value have inverse
relationship. Dividend Policy should be 100% retention
o When r < k (declining firms), the dividend payout ratio and the firm value have direct
relationship. Dividend Policy should be 100% payment of dividend
o When r = k (Normal firms), the dividend payment will not affect firms value. Here, dividend
policy is irrelevant

Example 1
XYZ Ltd earns Birr 10/share. Capitalization rate and return on investment are 10% and 12%
respectively. Determine the optimum pay out ratio and the price of the share at the pay out and
Compute stock price under the following dividend payment ratio: a) 25% b) 50% c)75% d)
100%
Solution
⦿ since r> ke, the optimum dividend pay out ratio would be zero, i.e. D= 0
⦿ accordingly, value of a share;
P = D + r (E-D)
Ke
Ke

P = 0 + 0.12 (10-0) = 120

0.1

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 0.1

⦿ At 25% pay-out ratio

P = 2.5 + 0.12 (10-2.5) = 115
0.1
0.1
⦿ At 50% pay-out ratio
P = 5 + 0.12 (10-5) = 110
0.1
0.1
⦿ At 75% pay-out ratio
P = 7.5 + 0.12 (10-7.5) = 105
0.1
0.1
⦿ At 100% pay-out ratio
P = 10 + 0.12 (10-10) = 100
0.1
0.1
Gordon’s model
Under this model;
o If r > k(growing firms), the dividend payment decrease firm value. Dividend Policy
should be high retention ratio and low payout ratio
o If r < k(declining firms), the dividend payment increase firm value. Dividend Policy
should be pay more and retain less
o If r =k, dividend policy will not affect value of the share. Dividend Policy: any dividend
payout ratio

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