Dividend Policy

Dividend Policy
Dr. Manish Dadhich

Assistant Professor
Sir Padampat Singhania University, Udaipur
Contents
 What is Dividend?
 Forms/Types of Dividend
 Theories of Dividend Policy
◦ Relevant Theory
 Walter’s Model
 Gordon’s Model
◦ Irrelevant Theory
 M-M’s Model/ Approach
What is Dividend?
 Dividend is a part of the profit that the company
shares with its shareholders.
 Dividends are a portion of a company's earnings
which it returns to investors, usually as a cash

payment.
 Choice of returning some portion of its earnings to
investors as dividends, or of retaining the cash to

fund internal development projects.
Forms/Types of Dividend
 On the basis of Types of Share
◦ Equity Dividend
◦ Preference Dividend
 On the basis of Mode of Payment
◦ Cash Dividend
◦ Stock or Bonus Dividend
◦ Scrip Dividend - promissory note
◦ Composite Dividend
Forms/Types of Dividend (Cont’d)
 On the basis of Time of Payment
◦ Interim Dividend
◦ Regular Dividend
◦ Special Dividend
◦ Liquidity Dividend
What is Dividend Policy
 Dividend policy determines the division of earnings
between payments to shareholders and retained
earnings. - Weston and Bringham
 Dividend Policies involve the decisions, whether-
1. To retain earnings for capital investment and other

purposes; or
2. To distribute earnings in the form of dividend among
shareholders; or
3. To retain some earning and to distribute remaining
earnings to shareholders.
Types of Dividend Policy
1. Regular or Stable Dividend Policy

a. Constant dividend per share
b. Constant percent of Net earnings
c. Stable rupee dividend + extra dividend
2. Irregular Dividend Policy
3. Regular Bonus dividend
4. Policy of no Immediate Dividend
Relevance Theories
Walter’s Model
 Prof. James E. Walter, the dividends are relevant and have a
bearing on the firm’s share prices. Investment policy cannot be
separated from the dividend policy since both are interlinked.
 Walter used the dividend to optimize the wealth of the equity
shareholders.
 Assumptions of Walter’s Model:
 Internal Financing
 Constant return in Cost of Capital
 100% payout or Retention
 Constant EPS and DPS
 Infinite time
 r & K remain constant
Walter’s Model (Cont’d)
 Walter’s Model shows the clear relationship between the
return on investments or internal rate of return (r) and the
cost of capital (K). The efficiency of dividend policy can be
shown through a relationship between returns and the
cost.
 If r > K, the firm should retain the earnings.
 If r < K, the firm should pay all its earnings to the
shareholders.
 If r = K, the firm’s dividend policy has no effect on the
firm’s value & payout ratio can vary from zero to 100%.
Formula of Walter’s Model
P = D + r/ke (E - D)/ ke
Where,
P = Current Market Price of equity share
E = Earning per share
D = Dividend per share
r = Rate of Return on investment or Internal Rate of
Return
k = Cost of Equity Capital
Example
A company has the following facts:
Cost of capital (ke) = 0.10 ; Earnings per share (E) = 10
Rate of return on investments ( r) = 8%
Dividend payout ratio: Case A: 50% Case B: 25%
Show the effect of the dividend policy on the market price of the
shares.
Case A:
D/P ratio = 50%
When EPS = 10 and D/P ratio is 50%, D = 10 x 50% = 5
Answer: P = 5 + [0.08 / 0.10] [10 - 5] / 0.10 = 90
Case B:
D/P ratio = 25%
When EPS = 10 and D/P ratio is 25%, D = 10 x 25% = 2.5
Answer: P =2.5 + [0.08 / 0.10] [10 - 2.5] / 0.10 = 85
Criticisms of Walter’s Model
 No external financing.
 Firm’s internal rate of return does not always remain
constant.
 Cost of Capital remain constant.
2. Gordon’s Model
• Myron Gordon, also supports the doctrine that dividends are
relevant to the share prices of a firm.
• Dividend affects the value of the firm and explained how
dividend policy can be used to maximize the wealth of the
shareholders.
• The main proposition of the model is that the value of a
share reflects the value of the future dividends accruing to
that share.
• Hence, the dividend payment and its growth are relevant
in valuation of shares.
 Assumptions:
◦ All equity firm

◦ r & K remain constant
◦ Indefinite life
◦ Constant Returns
◦ Constant Retention ratio
◦ Cost of Capital is greater then growth rate (k>br=g)
Formula of Gordon’s Model
• Market value of the share is equal to the present value
of future dividends.
E (1 – b)
P =
K - br
 Where,
P = Price
E = Earning per Share
b = Retention Ratio (1-d/p ratio)
k = Cost of Capital
br = g = Growth Rate
Example: Determination of value of shares, given the
following data:
Particular Case A Case B
D/P Ratio 40 30
Retention Ratio 60 70
Cost of capital 17% 18%
r 12% 12%
EPS 20 20
E (1 – b)
P = K - br
20 (1 - 0.60)
P = = 81.63 (Case A)
0.17 - (0.60 x 0.12)
20 (1 - 0.70)
P = = 62.50 (Case B)
0.18 - (0.70 x 0.12)
3. Modigliani & Miller’s Irrelevance Model
Dividend policy has no effect on the price of the shares of
the firm and believes that it is the investment policy that
increases the firm’s share value.
Value of Firm (i.e. Wealth of Shareholders)
Firm’s Earnings
Firm’s Investment Policy and not on dividend policy

Modigliani and Miller’s Approach
 Assumption
◦ Perfect capital market.

◦ No taxes.
◦ Constant investment policy.
◦ No uncertainty about the future profits.
◦ Investment and dividend decisions are independent
◦ No floatation cost.
Criticism of M-M Model
 No perfect Capital Market

 Existence of transaction cost
 Existence of floatation cost
 Lack of relevant information
 No fixed investment Policy
 Investor’s desire to obtain current income
Formula: M M Model
 In order to satisfy their model, MM has started with the
following valuation model:
 P0 = (D1+P1) / (1+ke)
 Where,
 P0 = Present market price of the share
 Ke = Cost of equity share capital
 D1 = Expected dividend at the end of year 1
 P1 = Expected market price at the end of year 1
 A firm has 1,00,000 shares outstanding and is planning
to declare a dividend of Rs. 5 at the end of current
financial year. The present market price of the share is
Rs.100. The cost of equity capital is 10%. The expected
market price at the end of the year 1 may be found
under two options: (a) If dividend of Rs. 5 is paid (b) If
dividend is not paid
 When Dividend of Rs. 5 is paid (the value of D 1 is 5) :
 P0 = (D1 + P1)/ (1+ ke)
 P0 (1+ ke) = D1 + P1
 P1 = P0 (1+ ke) – D1
 = 100 (1.10) – 5
 = 105
Cont’d
 So, the market price is expected to be Rs.105, if the firm
pays dividend of Rs. 5
 When, Dividend of Rs.5 is not paid (the value of D1 is 0):
 P0 = (D1 + P1) / (1+ ke)
 P0 (1+ ke) = D1 + P1
 P1 = P0 (1+ ke) – D1
 = 100 (1.1)
 = 110
 So, the market price of the share is expected to be Rs.
110, if the firm does not pay any dividend.

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Dr. Manish Dadhich

which it returns to investors, usually as a cash

investors as dividends, or of retaining the cash to

1. To retain earnings for capital investment and other

1. Regular or Stable Dividend Policy

◦ All equity firm

Value of Firm (i.e. Wealth of Shareholders)

Firm’s Investment Policy and not on dividend policy

◦ Perfect capital market.

 No perfect Capital Market

110, if the firm does not pay any dividend.

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