Dividend policy

DIVIDEND AND
RETENTION POLICY
 Bidyadhar Nayak
(04)
 Navjot Panesar (07)
 Prachi Jadhav (06)
 Rashmi Vaishya
(14)
 Sunil Shinde (15)

Introduction :
 What is Dividend?
 What is dividend policy?
 Theories of Dividend Policy
 Relevant Theory
 Walter’s Model
 Gordon’s Model
 Irrelevant Theory
M-M’s Approach
 Traditional Approach

What is Dividend ???
“A dividend is a distribution to shareholders
out of profit or reserve available for this
purpose.”
- Institute of Chartered Accountants of India

Forms/Types of Dividend
EQUITY
PREFERENCE
On The Basis Of
CASH
STOCK
BOND
PROPERTY
COMPOSITE
INTERIM
REGULAR
SPECIAL
Type Of
Share
Modes Of
Payment
Time Of
Payment

What is Dividend Policy???
“ Dividend policy determines the division
of earnings between payments to
shareholders and retained earnings.”
- Weston and Bringham

Contd…
Dividend Policies involve the decisions,
whether
 To retain earnings for capital investment &
other purposes; or
 To distribute earnings in the form of dividend
among shareholders; or
 To retain some earning and to distribute
remaining earnings to shareholders.

Factors Affecting Dividend Policy
INTERNAL EXTERNAL
Stability of Earnings Legal Requirements
Age of corporation Government Policies
Liquidity of Funds Taxation Policy
Extent of share Distribution
Needs for Additional Capital
Trade Cycles
Past dividend Rates
Ability to Borrow
Policy of Control
Repayments of Loan
Time for Payment of Dividend
Regularity and stability in Dividend
Payment

Bonus Shares
 Stock Dividend
 Capitalizing the Reserves
 Given as a ratio 1:2
 Conserves Cash
 For the Shareholder, tax liability is less as
stock dividend is not treated as income

Benefits of Bonus Shares to
the Company
 No cash Outflow
 Higher Liquidity
 Good Image
 Higher Market Capitalisation
 Reduction in Rate of Dividend
 No Dividend Tax
 Undercapitalisation

Benefits of Bonus Shares to
the Shareholders
 Higher Holding
 Partial Liquidation
 Taxability
 Higher Liquidity
 Higher Future Dividend

Dividend Theories
Relevance Theories
(i.e. which consider dividend
decision to be relevant as it
affects the value of the firm)
Walter’s
Model
Gordon’s
Model
Irrelevance Theories
(i.e. which consider dividend
decision to be irrelevant as it
does not affects the value of the
firm)
Modigliani and
Miller’s Model
Traditional
Approach

Relevance Theory
 According to relevant theory payment of
dividend affect the firm's stock and its
cost of capital.
 This theory is based on rate of interest and
cost of capital.

Walter’s Model
 Prof. James E Walter argued that in the
long-run the share prices reflect only the
present value of expected dividends.
 Retentions influence stock price only
through their effect on future dividends.
 Walter has formulated this and 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

Formula of Walter’s Model
P
D + r (E-D)
k
k
=
 Where,
P = Current Market Price of equity share
E = Earning per share
D = Dividend per share
(E-D) = Retained earning per share
r = Rate of Return on firm’s investment or Internal
Rate of Return
k = Cost of Equity Capital

Illustration :
 Growth Firm (r > k):
r = 20% k = 15% E = Rs. 4
If D = Rs. 4
P = 4+(0) 0.20 /0 .15 = Rs. 26.67
0.15
If D = Rs. 2
P = 2+(2) 0.20 / 0.15 = Rs. 31.11
0.15

Illustration :
 Normal Firm (r = k):
r = 15% k = 15% E = Rs. 4
If D = Rs. 4
P = 4+(0) 0.15 / 0.15 = Rs. 26.67
0.15
If D = Rs. 2
P = 2+(2) 0.15 / 0.15 = Rs. 26.67
0.15

Illustration :
 Declining Firm (r < k):
r = 10% k = 15% E = Rs. 4
If D = Rs. 4
P = 4+(0) 0.10 / 0.15 = Rs. 26.67
0.15
If D = Rs. 2
P = 2+(2) 0.10 / 0.15 = Rs. 22.22
0.15

Example :
The following information is available for
Avanti Corporation:
 Earning per share(EPS) Rs. 40
 Rate of return on investment
or internal earning 18%
 Rate of return required by shareholder 15%
What will be the price per share as per the
Walter model if the pay out ratio is
 40%??
 50%??
 60%??

Given: E=4 rs, r=18%=0.18, k=15%=0.15
To Find: Price per equity share=P @ 40%,50% &
60%
Solution: According to Walter Model,
P
D + r (E-D)
k
k =
Payout ratio Price per share (P) P
40% 1.60+0.18(2.40)/0.15
0.15
Rs. 29.87
50% 2+0.18(2)/0.15
0.15
Rs. 29.33
60% 2.40+0.18(1.60)/0.15
0.15
Rs. 28.80

Effect of Dividend Policy on Value of Share
Case
If Dividend Payout
Ratio Increases
If Dividend Payout
Ratio Decreases
1. In case of Growing
firm
i.e. where r > k
Market Value of Share
decreases
Market Value of a share
increases
2. In case of Declining
firm i.e. where r < k
Market Value of Share
increases
Market Value of share
decreases
3. In case of normal firm
i.e. where r = k
No change in value of
Share
No change in value of
Share

Criticisms of Walter’s Model
 No External Financing
 Firm’s internal rate of return does not
always remain constant. In fact, r decreases
as more and more investment in made.
 Firm’s cost of capital does not always remain
constant. In fact, k changes directly with
the firm’s risk.

Gordon’s Model
 According to Prof. Gordon, Dividend Policy
almost always affects the value of the firm. He
Showed 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.
 The model holds that the share’s market price
is equal to the sum of share’s discounted
future dividend payment.

 Assumptions:
 All equity firm
 No external Financing
 Constant Returns
 Constant Cost of Capital
 Perpetual Earnings
 No taxes
 Constant Retention
 Cost of Capital is greater then growth rate
(k>br=g)

Formula of Gordon’s Model
P =
E (1 – b)
K - br
 Where,
P = Price
E = Earning per Share
b = Retention Ratio
k = Cost of Capital
br = g = Growth Rate

Illustration :
 Growth Firm (r > k):
r = 20% k = 15% E = Rs. 4
If b = 0.25
P0 = (0.75) 4 = Rs. 30
0.15- (0.25)(0.20)
If b = 0.50
P0 = (0.50) 4 = Rs. 40
0.15- (0.5)(0.20)

Illustration :
 Normal Firm (r = k):
r = 15% k = 15% E = Rs. 4
If b = 0.25
P0 = (0.75) 4 = Rs. 26.67
0.15- (0.25)(0.15)
If b = 0.50
P0 = (0.50) 4 = Rs. 26.67
0.15- (0.5)(0.15)

Illustration :
 Declining Firm (r < k):
r = 10% k = 15% E = Rs. 4
If b = 0.25
P0 = (0.75) 4 = Rs. 24
0.15- (0.25)(0.10)
If b = 0.50
P0 = (0.50) 4 = Rs. 20
0.15- (0.5)(0.10)

Example :
The following information is available for
Kavita Musicals:
 Earning per share(EPS) Rs. 5
 Rate of return required by shareholder 16%
Assuming that the Gordon valuation model
holds, what rate of return should be earned
on investment to ensure that the market
price is Rs.50 when the dividend payout is
40%?

Given:
Dividend payout = 40% = 0.4 So, b= 100-40=60%=0.6
b = Retention Ratio = 0.6
P = Price = Rs 50 E = Earning per Share = 5
k = Cost of Capital=16% = 0.16 br = g = Growth Rate
Solution: According to Gordon Model;
P = E (1-b)
k-br
50 = 5 (1 - 0.6)
0.16-0.6r
50(0.16-0.6r) = 5(1-
0.6)
50(0.16-0.6r) = 2
8-30r = 2
30r = 8-2 = 6
r = 0.20 = 20%

Criticisms of Gordon’s model
As the assumptions of Walter’s Model and
Gordon’s Model are same so the
Gordon’s model suffers from the same
limitations as the Walter’s Model.

Irrelevance Theory
 Dividend irrelevance theory is one of the
major theories concerning dividend policy
in an enterprise. It was first developed by
Franco Modigliani and Merton Miller in a
famous seminal paper in1961.
 The authors claimed that neither the
price of firm's stock nor its cost of
capital are affected by its dividend policy.

Modigliani & Miller’s Irrelevance Model
Value of Firm (i.e. Wealth of Shareholders)
Depends on
Firm’s Earnings
Depends on
Firm’s Investment Policy and not on dividend policy

Modigliani and Miller’s Approach
Assumption
 Capital Markets are Perfect and people are
Rational
 No taxes
 Floating Costs are nil
 Investment opportunities and future profits
of firms are known with certainty (This
assumption was dropped later)
 Investment and Dividend Decisions are
independent

M-M’s Argument
 If a company retains earnings instead of
giving it out as dividends, the shareholder
enjoy capital appreciation equal to the
amount of earnings retained.
 If it distributes earnings by the way of
dividends instead of retaining it, shareholder
enjoys dividends equal in value to the amount
by which his capital would have appreciated
had the company chosen to retain its
earning.
 Hence,
the division of earnings between dividends and
retained earnings is IRRELEVANT from the
point of view of shareholders.

Formula of M-M’s Approach
P
o
=
1 ( D1+P1 )
(1 + p)
Where,
Po = Market price per share at time 0,
D1 = Dividend per share at time 1,
P1 = Market price of share at time 1

Criticism of M-M Model
 No perfect Capital Market
 Existence of Transaction Cost
 Existence of Floatation Cost
 Lack of Relevant Information
 Differential rates of Taxes
 No fixed investment Policy
 Investor’s desire to obtain current
income

Synopsis
 Dividend is the part of profit paid to
Shareholders.
 Firm decide, depending on the profit, the
percentage of paying dividend.
 Walter and Gordon says that a Dividend
Decision affects the valuation of the
firm.
 While the MM’s Approach says that Value
of the Firm is irrelevant to Dividend we
pay.

Bibliography
 Google
 Financial management by
PRASANNA CHANDRA.

Dividend policy

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Dividend policy