DIVIDEND POLICY
UNIT: D
Meaning and Types of Dividend
The word dividend is derived from the word “dividendum”
which means total divisible sum. It is that share of profit
which is distributed among shareholders. It provides
information about company. As “In an uncertain world in
which verbal statements can be ignored or misinterpreted,
dividend action does provide a clear cut means of ‘making a
statement’ that speaks louder than a thousand words”. —
Solomon
Types:
1. Cash Dividend
2. Stock Dividend
3. Scrip or Bond Dividend
4. Property Dividend
Dividend Policy
Dividend Policy is the policy which concerns quantum of
profits to be distributed by way of dividend.
“Dividend Policy determines the division of earnings
between payments to shareholders and retained
earnings”
Types of Dividend Policy:
1. Conservative or Strict Dividend Policy
2. Liberal Dividend Policy
3. Irregular Dividend Policy
4. Sound or Stable Dividend Policy
Sound or Stable Dividend Policy
Patterns:
1. Constant Dividend per share
2. Constant Pay-out ratio
3. Constant Dividend per share plus extra dividend
Advantages:
1. Sign of continued normal operations of company.
2. Stablise the market value of shares.
3. Creates confidence among shareholders.
4. Improves credit standing of company.
5. Resolutions of investors uncertainty.
6. Institutional Investors’ Requirement.
Limitations:
1. Difficult to make changes in the policy.
2. Difficult to be followed in case of insufficient profits.
Practical Consideration in Paying Dividends or
Factors affecting (determinants) of Dividend
Policy
1. Financial Need of company
2. Magnitude and trend of earning
3. Liquidity position
4. Shareholders Expectations
5. Nature of the industry
6. Cyclical Variation
7. Age of the company
8. Structure of ownership (Closely / Widely Held Company)
9. Legal Restrictions
10. Restriction by lending institutions
11. State of Capital Market
12. Taxation Policy
Issues in Dividend Policy
Earnings to be Distributed – High Vs. Low Payout.
Objective – Maximize Shareholders Return.
Effects – Taxes, Investment and Financing
Decision.
Relevance Vs. Irrelevance
Relevance concept of Dividend: this hold that there
is a direct relationship between dividend policy and
the value in terms of market price of shares. It is
represented by following two theories:
a. Walter's Model
b. Gordon's Model
Irrelevance concept of Dividend: According to this
concept dividend are irrelevant or are a passive
residual. As per this concept, investors are indifferent
between capital; gains and dividend. The ultimate
desire of investor is to earn higher return. It is
explained through Modigliani and Miller approach.
Walters Model
Assumptions:
1. Internal Financing
2. Constant Return and Cost of Capital
3. Fixed Payout or Retention
4. Constant EPS and DIV
5. Infinite Time
Valuation
Market price per share is the sum of the
present value of the infinite stream of
constant dividends and present value of
the infinite stream of capital gains.
If, r=firm’s average rate of return
K=firm’s cost of capital or capitalization rate
(r / k )
P (DIV / k ) (EPS – DIV)
k
Example
r 0.15, 0.10, 0.08
k 0.10
EPS Rs 10
DPS 40%
(0.15 / 0.1)
P (4 / 0.1) (10 4) Rs 130
0.1
(0.10 / 0.1)
P (4 / 0.1) (10 4) Rs 100
0.1
(0.08 / 0.1)
P (4 / 0.1) (10 4) Rs 88
0.1
Cont.
Optimum Payout Ratio:
Growth Firms – Retain all earnings
Normal Firms – Distribute all earnings
Declining Firms – No effect
Criticism:
No external Financing
Constant Rate of Return
Constant opportunity cost of capital
Gordon's Model
Assumptions:
1. All Equity Firm
2. No External Financing
3. Constant Return and Cost of Capital
4. Perpetual Earnings
5. No Taxes
6. Constant Retention
7. Cost of Capital greater than Growth Rate
Valuation:
Market value of a share is equal to the present value
of an infinite stream of dividends to be received by
shareholders
P EPS(1 b) /(k br )
Example
r 0.15, 0.10, 0.08
k 0.10
EPS Rs 10
b 60%
P (1 – 0.6) / 0.10 – (0.15 * 0.6) = Rs 400
P 10(1 – 6) / 0.10 – (0.10 * 0.6) = Rs 100
P 10(1 – 0.6) / 0.10 – (0.08 * 0.6) = Rs 77
Cont.
Optimum Payout Ratio
Growth Firms – Retain all earnings
Normal Firms – Distribute all earnings
Declining Firms – No effect
The Bird in the Hand:
Argument put forward, first of all, by Kirshman
Investors are risk averters. They consider distant
dividends as less certain than near dividends.
Rate at which an investor discounts his dividend
stream from a given firm increases with the
futurity of dividend stream and hence lowering
share prices.
MODIGLIANI AND MILLER
According to M-M, under a perfect market situation, the
dividend policy of a firm is irrelevant as it does not affect
the value of the firm. They argue that the value of the firm
depends on firm earnings which results from its investment
policy. Thus when investment decision of the firm is given,
dividend decision is of no significance.
Market Imperfections
Tax Differential – Low Payout Clientele
Flotation Cost
Transaction and Agency Cost
Information Asymmetry
Diversification
Uncertainty – High Payout Clientele
Desire for Steady Income
No or Low Tax on Dividends
