DIVIDEND POLICY

Introduction
The important aspect of dividend policy is to determine the amount of earnings to be
distributed to shareholders and the amount to be retained in the firm. Retained earnings are the
most significant internal sources of financing the growth of the firm. On the other hand,
dividends may be considered desirable from the shareholders’ point of view as they tend to
increase their current return. Dividends, however, constitute the use of the firm’s funds.
Dividend policy involves the balancing of the shareholders’ desire for current dividends and
the firms’ needs for funds for growth.
Meaning of Dividend Policy:
According to Weston and Brigham, “Dividend policy determines the division of earnings
between payments to shareholders and retained earnings”
Objective of dividend policy
A firms’ dividend policy has the effect of dividing its net earnings into two parts:
retained earnings and dividends. The retained earnings provide funds to finance the firm’s long
– term growth. It is the most significant source of financing a firm’s investment in practice.
Dividends are paid in cash. Thus, the distribution of earnings uses the available cash of the
firm. A firm which intends to pay dividends and also needs funds to finance its investment
opportunities will have to use external sources of financing, such as the issue of debt or equity.

6.1 TYPES OF DIVIDENDS:

Dividends can be classified in various form. Dividends paid in ordinary course of business are
known as Profit dividends, while dividends paid out of capital are known as Liquidation
dividends, Dividends may also be classified based on medium in which they are paid.

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Dividends classification based on medium is discussed here.
6.1.1 Cash Dividends
Cash dividend is, by far, the most important form of dividend. In cash dividends stockholders
receive cheques for the amounts due to them. Cash generated by business earnings is used to
pay cash dividends. Sometimes the firm may issue additional stock to use proceeds so derived
to pay cash dividends or approach bank for the purpose. Generally, stockholders have strong
preference for cash dividends.
6.1.2 Stock Dividends
Stock dividends rank next to cash dividends in respect of their popularity. In this form of
dividends, the firm issues additional shares of its own stock to the stockholders in proportion
to the number of shares held in lieu of cash dividends. The payment of stock dividends neither
affects cash and earnings position of the firm nor is ownership of stockholders changed. Indeed
there will be transfer of the amount of dividend from surplus account to the capital stock
account which amount to capitalization of retained earnings. The net effect of this would be an
increase in number of shares of the current stockholders. But there will be no change in their
equity. With payment of stock dividends, the stockholders have simply more shares of stock to
represent the same interest as it was before issuing stock dividends. Thus, there will be merely
an adjustment in the firm’s capital structure in terms of both book value and market price of
the common stock.
[Link] Stock Splits
Closely related to a stock dividend is a stock split. From a purely economic point of view a
stock split is nothing but a giant stock dividend. A stock split is a change in the number of
outstanding shares of stock achieved through a proportional reduction of increase in the par
value of the stock. The management employs this device to make a major adjustment in the
market price of the firm’s stock and consequently in its earnings and dividends per share. In
stock split only the par value and number of outstanding shares are affected. The amounts in
the common stock, premium and retained earnings remain unchanged.
6.1.3 Scrip Dividend
Scrip dividend means payment of dividend in scrip of promissory notes. Sometimes company
needs cash generated by business earnings to meet business requirements because of temporary
shortage of cash. In such cases the company may issue scrip or notes promising to pay dividend
at a future date. The scrip usually bears a definite date of maturity or sometimes maturity date
is not stipulated, and its payment is left to the discretion of the Board of Directors. Scrips may
be interest-bearing or non-interest bearing. Such dividends are relatively scarce.
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[Link]. Bond Dividend
As in scrip dividends, dividends are not paid immediately in bond dividends. Instead the
company promises to pay dividends at a future date and to that effect bonds are issued to stock
holders in place of cash. The purpose of both the bond and scrip dividends is alike, i.e.,
postponement of dividend payments. Difference between the two is in respect of the date of
payment and their effect are the same. Both result in lessening of surplus and addition to the
liability of the firm. The only difference between bond and scrip dividends is that the former
carries longer maturity than the latter. Bond dividends are not popular in India.
6.1.4 Property Dividend:
In property dividend the company pays dividends in the form of assets other than cash.
Generally, assets which are superfluous for the company are distributed as dividends to the
stockholders. Sometimes the company may use its products to pay dividends. Securities of the
subsidiary companies owned by the company may also take the form of property dividends.
This kind of dividend payment is not in vogue in India.
6.1.5 Composite Dividend:
When dividend is paid partly in the form of cash and partly in other form, it is called as
composite dividend. It is only combination of earlier method.

6.2 Standard Method of Cash Dividend Payment

The decision to pay a dividend rests in the hands of the board of directors of the
corporation. When a dividend has been declared, it becomes a debt of the firm and cannot be
rescinded easily. Sometime after it has been declared, a dividend is distributed to all
shareholders as of some specific date. Commonly, the amount of the cash dividend is expressed
in terms of dollars per share (dividends per share). As we have seen in other chapters, it is also
expressed as a percentage of the market price (the dividend yield) or as a percentage of net
income or earnings per share (the dividend payout).

Example of procedure for dividend payment

January 15 January 28 January 30 February 16

(Declaration date) (Ex-Dividend date) (Record date) (Payment date)

6.3 Establishing Dividend policies and Decisions

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 How do firms determine the level of dividends they will pay at a particular time? As
we have seen, there are good reasons for firms to pay high dividends and there are good reasons
to pay low dividends. There are three approaches for establishing dividend policy, such as
residual dividend approach, dividend stability and a compromise dividend policy.
6.3.1 Residual Dividend Approach
❖ Firms with higher dividend payouts will have to sell stock more often. Such sales are not
very common, and they can be very expensive.
❖ Consistent with this, we will assume that the firm wishes to minimize the need to sell new
equity. We will also assume that the firm wishes to maintain its current capital structure.
❖ If a firm wishes to avoid new equity sales, then it will have to rely on internally generated
equity to finance new positive NPV projects. Dividends can only be paid out of what is
left over. This leftover is called the residual, and such a dividend policy is called a residual
dividend approach.
❖ With a residual dividend policy, the firm’s objective is to meet its investment needs and
maintain its desired debt-equity ratio before paying dividends.
Illustrate, imagine that a firm has $1,000 in earnings and a debt-equity ratio of 0.50. Notice
that, because the debt-equity ratio is 0.50, the firm has 50 cents in debt for every $1.50 in total
value. The firm’s capital structure is thus debt and equity.
The first step in implementing a residual dividend policy is to determine the amount of
funds that can be generated without selling new equity. If the firm reinvests the entire $1,000
and pays no dividend, then equity will increase by $1,000. To keep the debt-equity ratio of
0.50, the firm must borrow an additional $500. The total amount of funds that can be generated
without selling new equity is thus $1,000 + 500 = $1,500.
The second step is to decide whether or not a dividend will be paid. To do this, we
compare the total amount that can be generated without selling new equity ($1,500 in this case)
to planned capital spending.
➢ If funds needed exceed funds available, then no dividend will be paid. In addition, the firm
will have to sell new equity to raise the needed financing or else postpone some planned
capital spending.
➢ If funds needed are less than funds generated, then a dividend will be paid. The amount of
the dividend will be the residual, that is, that portion of the earnings that is not needed to
finance new projects.
For example,

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 Suppose we have $900 in planning capital spending. To maintain the firm’s capital
structure, this $900 must be financed by 2⁄3 equity and 1⁄3debt. So, the firm will actually
borrow 1⁄3 X $900 = $300. The firm will spend 2⁄3 X $900 = $600 of the $1,000 in equity
available. There is a $1,000 - 600 = $400 residual, so the dividend will be $400.
In sum, the firm has after tax earnings of $1,000. Dividends paid are $400. Retained
earnings are $600, and new borrowing totals $300. The firm’s debt-equity ratio is unchanged
at 0.50.
6.3.2 Stability of Dividend
It is considered a desirable policy by the management of most companies in practices.
Many surveys have shown that shareholders also seem generally to favor this policy and value
stable dividends higher than the fluctuating ones. All other things being the same, the stable
dividend policy may have a positive impact on the market price of the share.
It is also meant regularity in paying some dividend annually, even though the amount
of the dividend may fluctuate over the years and may not relate to earnings. There are a number
of companies, which have records of paying dividend for a long, unbroken period. More
precisely, stability of dividend refers to the amounts paid out regularly. Three forms of such
stability may be distinguished:
a) Constant dividend per share or dividend rate
b) Constant pay out.
c) Constant dividend per share plus extra dividend.
a) Constant dividend per share or dividend rate
The companies announce dividend as per cent of the paid-up capital per share. A
company follows the policy of paying a fixed rate on paid-up capital as dividend every year,
irrespective of fluctuations in the earnings. This policy does not imply that the dividend per
share or dividend rate will never be increased. When the company reaches new levels of
earnings and expects to maintain them, the annual dividend per share may be increased. The
relationship between earnings per shares and the dividend per share under this policy is shown
below figure
EPS

EPS and DPS (Birr)

DPS

Constant dividend per share policy Time (Years)

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 A constant dividend per share policy puts ordinary shareholders at par with preferred
shareholders irrespective of the firm’s investment opportunities or the preference shareholders.
Those investors who have dividends as they only sources of their income may prefer the
constant dividend policy. They do not accord much importance to the changes in share prices.
In the long run, this may help to stabilize the market price of the share.
b) Constant Payout
The ratio of dividend to earnings is known as payout ratio. Some companies may
follow a policy of constant payout ratio ie., paying a fixed percentage of net earnings every
year. With this policy of the amount of the dividend will fluctuate in direct proportion to
earnings. If a company adopts a 40 percent payout ratio, then 40 percent of every Birr of net
earnings will be paid out.
For example, if the company earns, 2 Birr per share, the dividend per share will be 0.80
Birr and if it earns 1.5 Birr per share the dividend per share will be 0.60 Birr. The relation
between the earnings per share and the dividend per share under the policy is exhibited in the
below figure.
EPS

EPS and DPS (Birr) DPS

Dividend policy of constant payout ratio

This policy is related to a company’s ability to pay dividends. If the company incurs
losses, no dividend shall be paid regardless of the desires of shareholders. Internal financing
with retained earnings is automatic when this policy is followed. At any given payout ratio, the
number of dividends and the additions to retained earnings increase with increasing earnings
and decrease with decrease earnings. This policy does not put any pressure on a company’s
liquidity since dividends are distributed only when the company has profited.
c) Constant dividend per share plus Extra dividend
The smallest amount of dividend per share is fixed to reduce the possibility of every
missing a dividend payment. By paying extra dividend in periods of prosperity, an attempt is
made to prevent investors from expecting that the dividend represents an increase in the
established dividend amount. This type of policy enables a company to pay a constant amount
of dividend regularly without a default and allows a great deal of flexibility for supplementing

6
the income of shareholders only when the company earnings are higher than the usual, without
committing itself to make a larger payments as part of the future fixed dividend.
6.3.3 A Compromise Dividend Policy
In practice, many firms appear to follow a compromise dividend policy. Such a policy
is based on five main goals:
1. Avoid cutting back on positive NPV projects to pay a dividend.
2. Avoid dividend cuts.
3. Avoid the need to sell equity.
4. Maintain a target debt-equity ratio.
5. Maintain a target dividend payout ratio.
These goals are ranked more or less in order of their importance. In our strict residual
approach, we assume that the firm maintains a fixed debt-equity ratio. Under the compromise
approach, the debt-equity ratio is viewed as a long-range goal. It is allowed to vary in the short
run if necessary, to avoid a dividend cut or the need to sell new equity.
In addition to having a strong reluctance to cut dividends, financial managers tend to
think of dividend payments in terms of a proportion of income, and they also tend to think
investors are entitled to a “fair” share of corporate income. This share is the long-run target
payout ratio, and it is the fraction of the earnings the firm expects to pay as dividends under
ordinary circumstances. Again, this ratio is viewed as a long-range goal, so it might vary in the
short run if this is necessary. As a result, in the long run, earnings growth is followed by
dividend increases, but only with a lag.

6.4 FACTORS AFFECTING DIVIDEND POLICY:

There is a controversy amongst financial analysts regarding impact of dividends on market
price of a company’s shares. Some argue that dividends do not have any impact on such price
while others hold a different opinion. However, preponderance of evidence suggests that
dividend policies do have a significant effect on the value of the firm’s equity shares in the
stock exchange. Having accepted this premise, it will now be appropriate to consider those
factors which affect the dividend policy of a firm. The factors affecting the dividend policy are
both external as well as internal.
6.4.1 External factors:
[Link] state of economy - The general state of economy affects to a great extent the
management’s decision to retain or distribute earnings of the firm. In case of uncertain
economic and business conditions, the management may like to retain the whole or a part of
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the firm’s earnings to build up reserves to absorb shocks in the future. Similarly, in periods of
depression, the management may also withhold-dividends payment to retain a large part of its
earnings to preserve the firm’s liquidity position. In periods of prosperity the management may
not be liberal in dividend payments though the earning power of a company warrants it because
of availability of larger profitable investment opportunities similarly in periods of inflation, the
management may withhold dividend payments in order to retain larger proportion of the
earnings for replacement of worn-out assets.
2. Legal restrictions - A firm may also be legally restricted from declaring and paying
dividends. For example, in India, the companies Act, 1956 has put several restrictions regarding
payments and declaration of dividends. Some of these restrictions are as follows:
(i) Dividends can only be paid out of (a) the current profits of the company, (b) the past
accumulated profits or (c) money provided by the Central or State Governments for the
payment of dividends in pursuance of the guarantee given by the Government. Payment of
dividend out of capital is illegal.
(ii) A company is not entitled to pay dividends unless (a) it has provided for present as well as
all arrears of depreciation, (b) a certain percentage of net profits of that year as prescribed by
the central Government not exceeding 10%, has been transferred to the reserves of the
company.
(iii) Past accumulated profits can be used for declaration of dividends only as per the rules
framed by the Central Government in this behalf.
Similarly, the Indian Income Tax Act also lays down certain restrictions on payment of
dividends. The management has to take into consideration all the legal restrictions before
taking the dividend decision otherwise it may be declared as ultra vires.
6.4.2 Internal factors
The following are the internal factors which affect the dividend policy of a firm:
[Link] of the shareholders - Of course, the directors have considerable liberty regarding the
disposal of the firm’s earnings, but the shareholders are technically the owners of the company
and, therefore, their desire cannot be overlooked by the directors while deciding about the
dividend policy.
Shareholders of a firm expect two forms of return from their investment in a firm:
(i) Capital gains - The shareholders expect an increase in the market value of the equity shares
held by them over a period of time. Capital gain refers to the profit resulting from the sale of
capital investment i.e., the equity shares in case of shareholders. For example, if a shareholder
purchases a share for 40 and later on sells it for 60 the amount of capital gain is a sum of 20.
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(ii) Dividends - The shareholders also expect a regular return on their investment from the
firm. In most cases the shareholders’ desire to get dividends takes priority over the desire to
earn capital gains because of the following reasons:
(a) Reduction of uncertainty - Capital gains or a future distribution of earnings involves more
uncertainty than a distribution of current earnings.
(b) Indication of strength - The declaration and payment of cash dividend carries an
information content that the firm is reasonably strong and healthy.
(c) Need for current income - Many shareholders require income from the investment to pay
for their current living expenses. Such shareholders are generally reluctant to sell their shares
to earn capital gain.
2. Financial needs of the company - The financial needs of the company are to be considered
by the management while taking the dividend decision. Of course, the financial needs of the
company may be in direct conflict with the desire of the shareholders to receive large dividends.
However, a prudent management should give more weightage to the financial needs of the
company rather than the desire of the shareholders. In order to maximize the shareholders’
wealth, it is advisable to retain earnings in the business only when company has better
profitable investment opportunities as compared to the shareholders. However, the directors
must retain some earnings, whether profitable investment opportunity exists, to maintain the
company as a sound and solvent enterprise.
3. Desire of control - Dividend policy is also influenced by the desire of shareholders or the
management to retain control over the company. The issue of additional equity shares for
procuring funds dilutes control to the detriment of the existing equity shareholders who have a
dominating voice in the company. At the same time, recourse to long-term loans may entail
financial risks and may prove disastrous to the interests of the shareholders in times of financial
difficulties.
In case of a strong desire for control, the management may be reluctant to pay substantial
dividends and prefer a smaller dividend pay-out ratio. This is particularly true in case of
companies which need funds for financing profitable investment opportunities and an outside
group is seeking to gain control over the company.
However, where the management is strongly in control of the company either because of
substantial shareholdings or because of the shares being widely held, the firm can afford to
have a high dividend pay-out ratio.
4. Liquidity position - The payment of dividends results in cash outflow from the firm. A firm
may have adequate earnings, but it may not have sufficient cash to pay dividends. It is,
9
therefore, important for the management to take into account the cash position and the overall
liquidity position of the firm before and after payment of dividends while taking the dividend
decision. A firm may not, therefore, be in a position to pay dividends in cash or at a higher rate
because of insufficient cash resources. Such a problem is generally faced by growing firms
which need constant funds for financing their expansion activities.

6.5. TYPES OF DIVIDEND POLICY:

The various types of dividend policies are discussed as follows:
1. Regular Dividend Policy
Payment of dividend at the usual rate is termed as regular dividend. The investors such as
retired persons, widows and other economically weaker persons prefer to get regular dividends.
A regular dividend policy offers the following advantages.
a. It establishes a profitable record of the company.
b. It creates confidence amongst the shareholders.
c. It aids in long-term financing and renders financing easier.
d. It stabilizes the market value of shares.
e. The ordinary shareholders view dividends as a source of funds to meet their day-today living
expenses.
f. If profits are not distributed regularly and are retained, the shareholders may have to pay a
higher rate of tax in the year when accumulated profits are distributed.
However, it must be remembered that regular dividends can be maintained only by companies
of long standing and stable earnings. A company should establish the regular dividend at a
lower rate as compared to the average earnings of the company.
2. Stable Dividend Policy
The term ‘stability of dividends’ means consistency or lack of variability in the stream of
dividend payments. In more precise terms, it means payment of certain minimum amount of
dividend regularly. A stable dividend policy may be established in any of the following three
forms.
Constant dividend per share: Some companies follow a policy of paying fixed dividend per
share irrespective of the level of earnings year after year. Such firms, usually, create a ‘Reserve
for Dividend Equalisation’ to enable them to pay the fixed dividend even in the year when the
earnings are not sufficient or when there are losses. A policy of constant dividend per share is
most suitable to concerns whose earnings are expected to remain stable over a number of years.
3. Irregular Dividend Policy

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Some companies follow irregular dividend payments on account of the following:
a. Uncertainty of earnings.
b. Unsuccessful business operations.
c. Lack of liquid resources.
d. Fear of adverse effects of regular dividends on the financial standing of the company.
4. No Dividend Policy
A company may follow a policy of paying no dividends presently because of its unfavourable
working capital position or on account of requirements of funds for future expansion and
growth.
5. Residual Dividend Policy
When new equity is raised floatation, costs are involved. This makes new equity costlier than
retained earnings. Under the Residual approach, dividends are paid out of profits after making
provision for money required to meet upcoming capital expenditure commitments.

6.6 Dividend Theories and Behavior

6.6.1 Irrelevance of Dividend
MM Approach
6.6.2 Relevance of Dividend
Walter’s Model
Gordon’s Model
6.6.1 Irrelevance of Dividend
The dividend policy has no effect on the share price of the company. There is no relation
between the dividend rate and value of the firm. Dividend decision is irrelevant of the value of
the firm. Modigliani and Miller contributed a major approach to prove the irrelevance dividend
concept.
Modigliani and Miller’s Approach
According to MM, under a perfect market condition, the dividend policy of the
company is irrelevant, and it does not affect the value of the firm. “Under conditions of perfect
markets, rational investors, absence of tax discrimination between dividend income and capital
appreciation, given the firm’s investment policy, its dividend policy may have no influence on
the market price of shares”.
Assumptions
MM approach is based on the following important assumptions:

11
 ❖ Perfect capital market.
❖ Investors are rational.
❖ There is no tax.
❖ The firm has a fixed investment policy.
❖ No risk or uncertainty.
Proof for MM approach
The MM approach can be proved with the help of the following formula:
Po = D1 + P1 / (1 + Ke)
Where,
Po = Prevailing market price of a share; Ke = Cost of equity capital.
D1 = Dividend to be received at the end of period one.
P1 = Market price of the share at the end of period one.
P1 can be calculated with the help of the following formula.
P1 = Po (1+Ke) – D1
The number of new shares to be issued can be determined by the following formula:
M × P1 = I – (X – nD1)
Further, the value of the firm can be ascertained with the help of the following formula:
n Po = [(n + M) P1 - (I - X)] / (1+ Ke)
Where,
M = Number of new shares to be issued.
P1 = Price at which new issue is to be made.
I = Amount of investment required.
X = Total net profit of the firm during the period.
D1= Dividend to be paid at the end of the period.
n = No. of shares outstanding at the beginning of the period.
nPo =Value of the firm
Exercise 1
X Company Ltd. has 100,000 shares outstanding the current market price of the shares
Birr. 15 each. The company expects the net profit of Birr. 200,000 during the year and it
belongs to a rich class for which the appropriate capitalization rate has been estimated to be
20%. The company is considering dividend of Birr. 2.50 per share for the current year. What
will be the price of the share at the end of the year (i) if the dividend is paid and (ii) if the
dividend is not paid.
Solution
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 Po = D1 + P1 / (1 + Ke)
(i) If the dividend is paid
Po = Birr.15; Ke = 20%; D1 = Birr. 2.50; P1 =?
15 = 2.50 + P1 / 1 + 20%
15 = 2.50 + P1 / 1.2
2.50 + P1 =15 x 1.2
P1 = 18 – 2.50 P1 = Birr. 15.50
(ii) If the dividend is not paid
Po = 15; Ke = 20%; D1 = 0; P1 = ?
15 = 0 + P1 / 1 + 20%
15 = 0 + P1 / 1.2
0 + P1 =15 x 1.2
P1 = Birr.18

Criticism of MM approach
❖ The MM approach consists of certain criticisms also. The following are the major
criticisms of MM approach.
❖ The MM approach assumes that tax does not exist. It is not applicable in the practical
life of the firm.
❖ The MM approach assumes that, there is no risk and uncertain of the investment. It is
also not applicable in present day business life.
❖ The MM approach does not consider floatation cost and transaction cost. It leads to
affect the value of the firm.
❖ The MM approach considers only single decrement rate, it does not exist in real
practice.
❖ The MM approach assumes that, investor behaves rationally. But we cannot give
assurance that all the investors will behave rationally.

6.6.2. RELEVANCE OF DIVIDEND

According to this concept, dividend policy is considered to affect the value of the firm.
Dividend relevance implies that shareholders prefer current dividend and there is no direct
relationship between dividend policy and the value of the firm. Relevance of dividend concept
is supported by two eminent persons like Walter and Gordon.
i) Walter’s Model
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 Prof. James E. Walter argues that the dividend policy almost always affects the value
of the firm. Walter model is based on the relationship between the following important factors:
❖ Rate of return I
❖ Cost of capital (k)
According to the Walter’s model, if r > k, the firm is able to earn more than what the
shareholders could by reinvesting, if the earnings are paid to them. The implication of r > k is
that the shareholders can earn a higher return by investing elsewhere. If the firm has r = k, it is
a matter of indifference whether earnings are retained or distributed.
Assumptions
Walters model is based on the following important assumptions:
❖ The firm uses only internal finance.
❖ The firm does not use debt or equity finance.
❖ The firm has constant return and cost of capital.
❖ The firm has 100 recent payout.
❖ The firm has constant EPS and DPS.
❖ The firm has a very long life.
Walter has evolved a mathematical formula for determining the value of market share.
P = (D + (r /Ke) (E-D)) / Ke
OR
P =D/Ke + (r(E-D)/Ke)/Ke
Where,
P = Market price of an equity share; D = Dividend per share; r = Internal rate of return
E = Earnings per share; Ke = Cost of equity capital
Exercise 2
From the following information supplied to you, ascertain whether the firm is following
an optional dividend policy as per Walter’s Model?
Total Earnings Birr. 2,00,000
No. of equity shares (of Birr. 100 each 20,000)
Dividend paid Birr. 1,00,000
P/E Ratio 10
Return Investment 15%
The firm is expected to maintain its rate of return on fresh investments. Also find out
what should be the E/P ratio at which the dividend policy will have no effect on the value of
the share? Will your decision change if the P/E ratio is 7.25 and interest of 10%?
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Solution
EPS = Earnings / [Link] shares
= 200,000 / 20,000= Birr 10.
PE ratio = 10
Ke = 1 / PE ratio = 1 / 10= 0.10
DPS = Total dividend paid / no of shares
= 100,000 / 20,000 = Birr 5.
The value of the share as per Walter’s Model is
P = (D + (r /Ke) (E-D)) / Ke
= (5 + 0.15 / 0.10 (10 – 5)) / 0.10
= 5 + 7.5 / 0.10 = Birr 12.5
Dividend payout = DPS / EPS x 100
= 5 / 10 x 100 = 60%
r > Ke therefore by distributing 60% of earnings, the firm is not following an optional dividend
policy. In this case, the optional dividend policy for the firm would be to pay a zero dividend
and the Market Price would be:
P = (5 + 0.15 / 0.10 (10 – 0)) / 0.10
= (5 + 15) / 0.10
P = Birr. 200
So, the MP of the share can be increased by following a zero payout, of the P/E is 7.25 instead
of 10 then the Ke =1=0.138 and in this case Ke > r and the MP of the share is 7.25.
P = (5 + 0.15 / 0.138 (10 – 5)) / 0.138
= 5 + 5.435 / 0.138
P = Birr 75.62
Criticism of Walter’s Model
The following are some of the important criticisms against Walter model:
❖ Walter model assumes that there is no extracted finance used by the firm. It is not
practically applicable.
❖ There is no possibility of constant return. Return may increase or decrease, depending
upon the business situation. Hence, it is applicable.
❖ According to Walter model, it is based on constant cost of capital. But it is not
applicable in the real life of the business.

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ii) Gordon’s Model
Myron Gordon suggests one of the popular models which assume that dividend policy
of a firm affects its value, and it is based on the following important assumptions:
❖ The firm is an all equity firm.
❖ The firm has no external finance.
❖ Cost of capital and return are constant.
❖ The firm has perpetual life.
❖ There are no taxes.
❖ Constant relation ratio (g = br).
❖ Cost of capital is greater than the growth rate (Ke > br).
Gordon’s model can be proved with the help of the following formula:
P = E (1 – b) /( Ke – br)
Where,
P = Price of a share; E = Earnings per share
1 – b = D/p ratio (i.e., percentage of earnings distributed as dividends)
Ke = Capitalization rate; br = Growth rate = rate of return on investment of an all equity firm.

Exercise 3
ABC company earns a rate of 12% of its total investment of Birr. 600,000 in assets. It
has 600,000 outstanding common shares at Birr. 10 per share. The discount rate of the firm is
10% and it has a policy of retaining 40% of the earnings. Determine the price of its share using
Gordon’s Model. What shall happen to the price of the share if the company has a payout of
60% (or) 20%?
Solution
According to Gordon’s Model, the price of a share is
P = E (1 – b) / (Ke – br)
Given: E = 12% of Birr. 10 = Birr. 1.20
r = 12% = 0.12
K = 10% = 0.10
t = 10% = 0.10
b = 40% = 0.40
Put the values into the formula
P = 1.20 (1 – 0.40) / 10 – (0.40 x 0.12)
= 1.20 x (0.60) / 0.10 – 0.048
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 = 0.72 / 0.052
= Birr. 13.85
If the firm follows a policy of 60% payout then b = 20% = 0.20
The price is P = 1.20 (1 x 0.20) / 0.1 – (0.20 x 0.12)
= 0.05
r = 4% = 0.04; D =25% of 10 = 2.50
= 2.50 + (0.04 / 0.12 (10 – 2.50)) / 0.12
= 5 / 0.12
= Birr. 41.67
If the payout ratio is 50%, D = 50% of 10 = Birr. 5
r = 12% = 0.12; D = 50% of 10 = Birr. 5
= 5 + (0.12 / 0.12 (10 – 5)) / 0.12
= 5 + 5 / 0.12 = 10 / 0.12
= Birr. 83.33
r = 8% = 0.08; D = 50% of 10 = 5
= 5 + (0.08 / 0.12 (10 – 5)) / 0.12
= 5 + 3.33 / 0.12 = 8.33 / 0.12
= Birr. 69.42
r = 4% = 0.04; D = 50% of 10 = 5
= 5 + (0.04 /0.12 (10 – 5)) / 0.12
= 5 + 1.67 / 0.12 = 6.67 / 0.12
= Birr. 55.58
Criticism of Gordon’s Model
Gordon’s model consists of the following important criticisms:
❖ Gordon model assumes that there is no debt and equity finance used by the firm. It is
not applicable to present day business.
❖ Ke and r cannot be constant in the real practice.
❖ According to Gordon’s model, there is no tax paid by the firm. It is not practically
applicable.

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