Dividend

Prof. Bagesree Behani

Topics to be covered
➢ Concept & Meaning

➢ Types of Dividends

➢ Different models for analyzing Dividend

➢ Determinants & Constraints

➢ Various ratios related to Dividend

➢ Dividend payment chronology

➢ Bonus Shares
 Financing Decision
Financial
Decision Investment Decision

Dividend Decision
As per ICAI, Dividend is that part of
Profit After Tax (PAT) which is
distributed to the shareholders of
the company.

Distributed Dividend

PAT
Retained
Retained
Earnings
Objective of Dividend Decision
1. Maximizing owners' wealth
2. Providing sufficient financing
The dividend policy decision is a trade-off between retaining earnings v/s
paying out cash dividends.

The dividend policy decision involves two questions:

1) What fraction of earnings should be paid out, on average, over time? And,
2) What type of dividend policy should the firm follow? i.e. issues such as
whether it should maintain steady dividend policy or a policy increasing
dividend growth rate etc.
Alternative Forms of Dividend
❑ Bonus Shares
Involves payment of dividend to existing shareholders
in the form of shares A bonus share is a free share of
stock given to current/existing shareholders in a
company, based upon the number of shares owned at
the time of announcement Issue of bonus shares is a way
of capitalizing reserves into shares.
Advantages:
(a) Attract shareholders (b) Positive signal about firm’s
future (c) No outflow for firm (d) Get share price in
popular trading range
Alternative Forms of Dividend
❑ Stock Splits
It is a method commonly used to lower the market price of
shares by increasing the number of shares belonging to each
shareholder
Bonus & stock splits are wealth neutral accounting adj that
may lead to some transitory immediate gains
Effect of Bonus share & Share Splits Eg:
Particulars INR
(i) Equity portion before the bonus issue :
Equity shares capital (30,000 shares of INR 100 each) 30,00,000
Share premium (@ INR 25 per share) 7,50,000
Retained earnings 62,50,000
Total Equity 1,00,00,000
(ii) Equity portion after the bonus issue (1:2 ratio) :
Equity share capital (45,000 shares of INR 100 each) 45,00,000
Share premium (@ INR 25 per share) 11,25,000
Retained earnings ( INR 62,50,000-15,000 shares * INR 125) 43,75,000
Total Equity 1,00,00,000
(iii) Equity portion after the share splits ( 10 : 1 ratio):
Equity share capital (3,00,000 shares of INR 10 each) 30,00,000
Share premium 7,50,000
Retained earnings 62,50,000
Total Equity 1,00,00,000
Stock Dividend Eg-1:
Hemant owns 100 shares of ABC ltd. at current price of INR
30 per share. ABC Ltd. has 10,00,000 shares of stock
outstanding, and its earnings per share (EPS) for the last
year was INR 1.50. ABC Ltd. declare a 20% stock dividend
to all shareholders of record as of June 30.

What is the effect of the stock dividend on the market price

of the stock, and what is the impact of the dividend on
Hemant’s ownership position in the company?
Dividend payment chronology
Dividend Payment Chronology :

Declaration Ex-dividend Holder of Payment date

date date record date

August 25 September 15 September 17 September 30

Declaration Date --- BOD approves dividend payment.Issue press release/publish on

website
Ex- Dividend Date --- Cut-off date for receiving dividend
Holder of record Date --- Shareholders of record are designated to receive dividend
Payment Date --- Dividend is transferred to shareholders account
Dividend
Models
Different models for analyzing Dividend

1. Irrelevance Theory : According to irrelevance theory

dividend policy do not affect value of firm, thus it is called
irrelevance theory.

2. Relevance Theory : According to relevance theory

dividend policy affects value of firm, thus it is called
relevance theory.
Modigliani and Miller (MM) Approach
Modigliani – Miller theory was proposed by Franco Modigliani and
Merton Miller in 1961. MM approach is in support of the irrelevance
of dividends i.e. firm’s dividend policy has no effect on the value of a
firm’s stock.

According to this approach, the market value of a share is dependent

on the earnings potentiality, investment pattern & not on dividend
distribution. Dividend policy is a residual decision
Assumption in MM Approach
❑ Perfect Capital Markets

❑ No floatation & transaction costs, securities are fully divisible

❑ No Taxes

❑ Fixed Investment Policy i.e investment financed through eq

❑ Investor is indifferent between dividend and capital gain

❑ Info is available free of cost to all & no investor is large

enough to impact share prices
Advantages of MM Hypothesis:
1. This model is logically consistent.
2. It provides a satisfactory framework on dividend policy
with the concept of Arbitrage process.
Limitations of MM Hypothesis :
1. Validity of various assumptions is questionable.
2. This model may not be valid under uncertainty.
Situations under MM Hypothesis :
1) Firm pays cash dividend from Reserves & surplus
2) Firm pays cash dividend from new issue
MM Model Eg (3):
Wisdom Ltd has 50k shares o/s. Current MP is INR 20 each. The BOD has recommended INR 3
per share as dividend. The rate of capitalisation appropriate to the risk class to which co. belongs
is 20%.

i)Based on MM approach, calculate the MP of the share of the co. when the recommended
dividend is (a) distributed & (b) not declared

ii)How many new shares to be issued by the co. at the end of the accounting year on the
assumption that NI of the co. is INR 2,50,000 & investment budget is INR 5.2 lacs when
(a) dividend are declared & (b) dividend not declared

iii)Show that the Market value of the shares at the end of the accounting year will remain the
same whether dividend are declared or not
MM Model Eg (4) :
A company belongs to a risk class for which the approximate capitalization rate
is 10%. It currently has outstanding 25,000 shares selling at INR 100 each. The
firm is contemplating the declaration of a dividend of INR 5 per share at the end
of the current financial year.

It expects to have a net income of INR 2,50,000 and has a proposal for making
new investments of INR 5,00,000. Show that the under the MM assumptions, the
payment of dividend does not affect the value of the firm.
Relevance Theories--- Walter’s Model
Value of the firm depends upon firm’s earning level, dividend payout, constant reinvestment rate
and the shareholder’s expected rate of return.

The model suggests that dividend policy of the company depends upon the fact that whether firm
has got good investment opportunities or not. If the firm does not have enough investment
opportunities, then it will pay the dividend otherwise it will retain the money.

Company Condition of r vs Ke Optimum dividend

Cost of capital ( Ke) payout ratio
Expected rate of return on reinvestment of retained earning (r)
Growth r > Ke Zero
Constant r = Ke Every payout ratio is
optimum
Decline r < Ke 100%
Assumption in Walter’s Model Approach

❑ Internal Financing

❑ Constant IRR and Cost of Capital

❑ Constant EPS and DPS at any given value

❑ Going concern & Perpetual Life

Advantages of Walter’s Model
1. The formula is simple to understand and easy to compute.
2. It can envisage different possible market prices in different situations and
considers internal rate of return, market capitalisation rate and dividend
payout ratio in the determination of market value of shares.

Limitations of Walter’s Model

1. The formula does not consider all the factors affecting dividend policy and
share prices. Moreover, determination of Ke is difficult.
2. Further, the formula ignores such factors as taxation, various legal and
contractual obligations, management policy and attitude towards dividend
policy and so on.
Walter’s Model Eg (A):
The following information is available in respect of a firm:
Capitalisation rate (Ke) = 0.10
Earning per share (E) = INR 10
Assumed rate of return on investment (r) : (i) 15 (ii) 8 and
(iii) 10.
Show the effect of dividend policy on the market price of
shares, using Walter's model.
Walter’s Model Eg (B):
The following figures are collected from the annual report of XYZ
Ltd.:
• Net Profit---INR 30 lakhs
• Outstanding 12% preference shares--- INR 100 lakhs
• No. of equity shares---3 lakhs
• Return on Investment---20%
• Cost of capital i.e. (Ke)---16%
Compute div payout ratio to keep share price at INR 42 by using
Walter’s model.
DETERMINANTS OF DIVIDEND DECISIONS

A)Legal requirements- Do not require dividend declaration, but specify

conditions for payments i)Capital impairment rules ii) Net profits iii)
Insolvency

B) Contractual requirements

C)Internal constraints (i) Liquidity [shortage of finds for growing companies

,loans due, preference share due for redemption] (ii) Investment opportunities
(iii) Access to finance (iv) Floatation costs (v) Corporate control (vi)Taxes (vii)
Dividend stability
Gordon’s
Model
Relevance Theories--- Gordon’s Model
Dividend policy of a firm is relevant and can affect the value of a firm. Like
Walter’s Model value of the firm under this method also depends upon
reinvestment rate (r) and shareholder’s expectations ( Ke).

This is based on the premise that the investors are generally risk-averse
and prefer to have current income i.e. dividend. Hence there is a direct
relationship between dividend policy and the value of a firm.
Assumption in Gordon’s Model Approach
❑ No Debt
❑ No External Financing
❑ Constant IRR & cost of capital
❑ Constant Retention Ratio i.e retention ratio once decided is
constant
❑ Growth rate (g=br)is constant
❑ Going concern & Perpetual Life
❑ Cost of capital (k) > growth rate (g)
Advantages of Gordon’s Model
1. The model is a useful model that relates the present stock price to
the present value of its future cash flows.
2. This Model is easy to understand.

Limitations of Gordon’s Model

1. The model depends on projections about company growth rate and
future capitalization rates of the remaining cash flows, which may be
difficult to calculate accurately.
2. The true intrinsic value of a stock is difficult to determine
realistically.
Gordon’s Model Eg (A):
The following information is available in respect of the rate of return on
investment (r), the capitalisation rate (Ke) and earning per share (E) of ABC Ltd.
r= 12% and E= INR 20. Determine the value of its shares, assuming the
following:
D/P ratio (1-b) Retention ratio (b) Ke (%)
(a) 10 90 20
(b) 20 80 19
(c) 30 70 18
(d) 40 60 17
(e) 50 50 16
(f) 60 40 15
(g) 70 30 14
Gordon’s Model Eg (B):
The annual report of XYZ Ltd. provides the following information:
Particulars Amount (INR)
Net Profit 30 Lakhs
Outstanding 15% preference shares 100 Lakhs
No. of equity shares 3 Lakhs
Return on Investment 20%
Cost of capital i.e. (Ke) 16%

Calculate price per share using Gordon’s Model when dividend pay-out is:
(i) 25%;
(ii) 50%;
(iii) 100%.
“Bird-in-hand theory”---- Gordon’s revised Model
The Bird in Hand theory states that investors prefer dividends earned from equity instead of capital
gains owing to the latter's inherent uncertainty. This argument states that investors prefer current
dividends over future capital gains. It's based on the idea that investors are risk-averse and want to
receive div

The Bird-in-hand theory of Gordon has two arguments:

(i) Investors are risk averse and

(ii) Investors put a premium on certain return and discount on uncertain return.

Gordon argues that what is available at present is preferable to what may be available in the future. As
investors are rational, they want to avoid risk and uncertainty. They would prefer to pay a higher
price for shares on which current dividends are paid. Conversely, they would discount the value of
shares of a firm which postpones dividends. The discount rate would vary with the retention rate.
PRACTICAL CONSIDERATIONS IN DIVIDEND POLICY
The formulation of dividend policy depends upon answers to the following questions:
• Whether there should be a stable pattern of dividends over the years? or
• Whether the company should treat each dividend decision completely independent?

Mature Companies Growth Companies

1. Mature companies having few 1. Growth companies have low payout ratios. They are
investment opportunities will show high in need of funds to finance fast growing fixed assets.
payout ratios;
2. Share prices of such companies are 2. Distribution of earnings reduces the funds of the
sensitive to any changes in dividend company. They retain all the earnings and declare
payout. bonus shares to offset the dividend requirements of the
shareholders.
3. A small portion of the earnings is kept to 3. These companies increase the amount of dividends
meet emergent and occasional financial gradually as the profitable investment opportunities
needs. start falling.
Agency Costs:
“Clientele Effect”
Different group of investors desire different levels of dividend payment.
Investor Type Preference

Wealthy/Young Low or Zero dividend payout

Widows/Pensioners/retired Higher and regular dividend payout

individuals
Dividend Payout policies:
Payout policies can be maintained by fixing the amount or rate of dividend
irrespective of the earnings of the company. The policies may include

Constant Dividend Policy: Shareholders are given fixed amount of dividend

irrespective of actual earnings. Co. follows a practice of paying a certain fixed amt
per share as dividend.

For instance of a share of INR 100, a Co. pays INR 15 as dividend. This amt would be
paid YoY. The amount of dividend may increase or decrease later on depending
upon the financial health of the company but it is generally maintained for a
considerable period of time.
Dividend Payout policies:

Co pays a Steady dividend with a consistency for a no of years. Co increases steady dividends if earnings have
increased to a higher permanent level & vice versa.
Stable Dividend Policy:
The ratio of dividend to earnings is known as Payout ratio. Some companies follow a
policy of constant Payout ratio i.e. paying fixed percentage on net earnings every
year. Under the stable dividend policy, the percentage of profits paid out as
dividends is fixed.

For example, if a company sets the payout rate at 6%, it is the percentage of profits
that will be paid out regardless of the amount of profits earned for the financial year.
To quote from Page 74 of the annual report 2011 of Infosys Technologies Limited.

“The Dividend Policy is to distribute up to 30% of the Consolidated Profit after Tax
(PAT) of the Infosys Group as Dividend.”
Residual Dividend Policy:
Policy suggests that dividend should be viewed as a residual i.e amount left over
after meeting the financing req of all acceptable/profitable projects.

The residual theory suggests that dividends paid by a corporate should be viewed as
a residual, that is, the amt left over after meeting the financing requirement of all
acceptable/profitable investment projects.

Div can be paid only out of the left over amt after financing all new projects with
positive NPV. The treatment of div payment as a passive residual implies that div
decisions are irrelevant. The approach is guided by the availability of acceptable
invest opportunities but is also concerned with maintaining a desirable/target
capital structure in deciding about cash dividends .
Four steps involved in Residual Dividend Policy:
1) Prepare capital budget to disclose capital exp of profitable investment opportunities
2) Decide on equity requirements, based on desired D/E ratio to support capex in Step 1
3) Use RE to the max to meet fund req decided in Step 2
4) Pay cash div only if available earnings>Eq funds needed in terms of the desired D/E
ratio
Example:
Assume a company has :
i) Earnings after taxes (available for equity holders) of INR 90 lakhs
ii) Target debt- equity ratio of 1:2 and
iii) New profitable investment projects in the size range of (1) INR 150 lakhs (2) INR 120
Lakhs (3) INR 75 lakhs (4) INR 60 lakhs and (5) Zero.
Determine the amount of dividends paid and dividend payout ratio at varying levels of
investment requirements as per residual theory of dividends.
• BOD & Management having more information than outside investors, may use dividend to signal
to investors about the companies prospects.
• A company that does not expects its cash flow to increase will not be able to maintain dividends
at increasing high levels in the long run.
• Dividend initiation/increase convey positive information
“Dividend Payout (D/P) Ratio”

The dividend payout ratio is a financial ratio that shows the percentage of a
company's earnings that are paid out to shareholders as dividends.

D/P ratio objective --- (i) Maximizing owner’s wealth (ii) Provide funds to
finance growth

Dividend payout ratio = Total annual dividend payments ÷ Net income after tax

OR Annual dividend paid per share/ EPS

OR 1- Retention Ratio (Where retention ratio = Retained Earnings/ Net income )

“Dividend Payout (D/P) Ratio”
• A company's dividend payout ratio can be used to assess the company's financial health and
management.

• A low payout ratio could indicate that the company is reinvesting most of its earnings into
expanding operations

• A low D/P ratio may cause a decline in share prices while the high ratio may lead to rise in
market prices

• Eg: Net Profit -----INR30 lakhs

Outstanding 12% preference shares ------INR 100 lakhs
No. of equity shares -----3 lakhs
Dividend per share ------ INR 3.12
“Dividend Yield Ratio”

Dividend yield is a financial ratio that

shows the percentage of a company's
annual dividend payments relative to its
stock price.

Used by investors to gauge how much

income they can expect to receive from
owning a stock, expressed as a
percentage.

Dividend Rate
“Dividend Rate”
The dividend rate, also known as the
dividend, is the amount of money that
investors receive per share from a company
that pays dividends. Dividend is calculated
on face value of the share.

If company pays dividend INR. 5 per share,

if face value of a share is INR. 100.

Rate of dividend = 5/100 = 5%

 Aversion to Regret Theory:
The Aversion to Regret Theory of dividends is grounded in behavioral finance and
psychology, explaining why investors and managers behave in ways that might
deviate from strictly rational economic theories when it comes to dividend decisions.
It focuses on the human tendency to avoid regret — a negative emotion felt when
realizing that a different decision could have led to a better outcome.

Investor Perspective:
Investors often prefer receiving regular dividends because they represent a
guaranteed return on their investment, reducing uncertainty. If an investor depends
solely on capital gains (price appreciation of the stock), they might experience regret
if:
• The stock price declines, eroding their investment value.
• The company retains earnings but fails to generate expected returns.
Why dividends minimize regret for investors:

• Tangible returns: Receiving regular dividends provides a sense of security

and satisfaction, as it represents an actualized gain, regardless of market
volatility.

• Emotional buffering: If the stock's price declines, the dividend payments

mitigate the emotional and financial impact of the loss.

• Preference for certainty: Behavioral studies show that investors value

immediate, certain returns over uncertain future gains, even if the latter might
be larger
Alternative Forms of Dividend
❑ Bonus Shares
Involves payment of dividend to existing
shareholders in the form of shares A bonus
share is a free share of stock given to
current/existing shareholders in a company,
based upon the number of shares owned at
the time of announcement Issue of bonus
shares is a way of capitalizing reserves into
shares. Adv a) attract shareholders b)
positive signal about firm’s future c) no
outflow for firm
Conditions of Stock Dividend or Bonus Issue
❑ A Company needs to fulfil all the conditions given by Security
Exchange Board of India (SEBI)
❑ Bonus issue should be authorised by Article of Association (AOA)
❑ Company should not have defaulted in re-payment of loan,
interest and any statutory dues
❑ Issued only from share premium and free reserves and not from
capital reserve
❑ Not to be declared unless all partly paid-up shares have been
converted into fully paid-up shares
Advantages of Stock Dividend or Bonus Issue
❑ To Shareholders:
✓ No tax payable
✓ Higher cash dividend in future
✓ Bring the shares price in popular trading range
✓ Psychological Value- Attract the attention of shareholders
❑ To Company:
✓ Conservation of cash
✓ Suitable in case of cash deficiency and restrictions by lenders
Alternative Forms of Dividend
❑ Share buyback

When firm buys its own shares

from whoever wants to sell his
holding at a specified price
during a specified period
Taxation of Dividend Income: Individual investors can receive
dividend income up to Rs. 5,000 without any tax liability. Any
amount above this threshold is taxed according to the recipient's
applicable income tax slab rates.

Under Section 194 of the Income-tax Act of 1961, the firm declaring
the dividend must deduct TDS. If the dividend income exceeds Rs.
5000 for an individual, TDS is 10%. If the beneficiary does not submit
a PAN, the TDS rate increases to 20%.
Practice problems (1):
(a)X company earns INR 5 per share, is capitalized at a rate of 10% and has a rate
of return on investment of 18%. According to Walter’s model, what should be
price per share at 25% dividend payout ratio? Is this the optimum payout ratio
according to Walter?

(b)Omega company has a cost of equity capital of 10%, the current market value
of the firm (v) is INR 20,00,000 (@ INR 20 per share). Assume value for I (new
investment), Y (earnings) and D (dividends) at the end of the year as I= INR
6,80,000, Y= INR 1,50,000 and D= INR 1 per share. Show that under the MM
assumptions, the payment of dividend does not affect the value of the firm.
Practice problems (2):
The apex company which earns INR 5 per share, is capitalized @ 10% and has
return on investment of 12%. Using Walter’s dividend policy model, determine
optimum dividend pay out ratio and the price of the share at this pay out. It
currently has 1,00,000 share selling at INR 100 each.

The firm is contemplating the declaration of INR 5 as dividend at the end of the
current financial year, which has just begun. What will be the price of the share at
the end of the year, if a dividend is not declared? What will it be if it is paid?
Answer these on the basis of MM model and assume no taxes.
Practice problems (3):
The following information pertains to M/s XY Ltd.
Earnings of the Company INR 5,00,000
Dividend Payout ratio 60%
No. of shares outstanding 1,00,000
Equity capitalization rate 12%
Rate of return on investment 15%

Calculate:

(i) Market value per share as per Walter’s model.

(ii) Optimum dividend payout ratio according to Walter’s model and the market value of Company’s share
at that payout ratio.
Practice problems (4):
Taking an example of three different firms i.e. growth, normal and declining, Calculate the share price using
Gordon’s model.

Factors Growth Firm Normal Firm Declining Firm

r > Ke r = Ke r < Ke
r (rate of return on retained earnings) 15% 10% 8%
Ke (Cost of Capital) 10% 10% 10%
E (Earning Per Share) INR 10 INR 10 INR 10
b (Retained Earnings) 0.6 0.6 0.6
1- b (Dividend Payout) 0.4 0.4 0.4
Practice problems (5):
The following information is supplied to you:
Particulars INR
Total Earnings 2,00,000
No. of equity shares (of INR 100 each) 20,000
Dividend Paid 1,50,000
Price/Earnings Ratio 12.5

Applying Walter’s Model:

(i) ANALYSE whether the company is following an optimal dividend policy.
(ii) COMPUTE P/E ratio at which the dividend policy will have no effect on the
value of the share.
(iii) Will your decision change, if the P/E ratio is 8 instead of 12.5?
Practice problems (6):
RST Ltd. has a capital of INR 10,00,000 in equity shares of INR 100 each. The shares are currently
quoted at par. The company proposes to declare a dividend of INR 10 per share at the end of the
current financial year. The capitalization rate for the risk class of which the company belongs is
12%. COMPUTE market price of the share at the end of the year, if

(i) dividend is not declared

(ii) dividend is declared

Assuming that the company pays the dividend and has net profits of INR 5,00,000 and makes
new investments of INR 10,00,000 during the period, Calculate number of new shares to be
issued? Use the MM model.