Cost of Capital - Copy

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DIVIDEND DECISION


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DIVIDENDS

DIVIDEND refers to that portion of a firmsnet earnings which are paid out to the share

holders.

Dividend payout ratio

Retention ratio

Larger retentions, lesser dividends; smallerretention, larger dividends.


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The management has to choose betweendistributing the profit to the share holdersand ploughing back them into thebusiness.


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Dividenddecision

Amountdistributed

amongshareholders

Amount ofearnings to

be retained

Maximization of present value(value of the firm)


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There are conflicting opinions regardingthe impact of dividends on the valuation of

a firm.

According to one school of thought ,dividends are irrelevant .so that the

amount of dividends paid has no effect onthe valuation of a firm.

On the other hand certain theory considerthe dividend decision as relevant to thevalue of the firm measured in terms of the

market price of the shares.


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Relevance of dividend

Irrelevance of dividends


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Relevance of dividend

There are some theories which considerdividend decisions to be an active variablein determining the value o a firm.

The divined decision is therefore relevant.

Walters model

Gordons model


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Walters model supports the doctrine thatdividends are relevant. The investmentpolicy of the firm cannot be separatedfrom its dividend policy and both areaccording to Walter, interlinked. The

choice of an appropriate dividend policyaffect the value of the firm .


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The key argument in support of therelevance proposition of Walter's model isthe relationship between the return on

firms investment or its internal rate ofreturn(r) and its cost of capital or requiredrate of return.


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A firm will have an optimum dividendpolicy which will be determined by the

relationship of r and k.

In other words, if the return on

investment exceeds the cost of capital,the firm should retain the earnings,whereas it should distribute the

earnings to the shareholders in case the

required Rate of return exceeds theexpected return on the firms

investments.


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The rationale is that if r>k the firm isable to earn more than whatshareholders could by reinvesting, Ifthe earnings are paid to them.

The implication of r


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Walters model, thus relates thedistribution of dividends to available

investment opportunities .

If the firm has adequate profitable

investment opportunities it will be ableto earn more than what the investors

expect. Such firms are known andgrowth firms. For the growth firms, theoptimum dividend policy would be given

by a D/P ratio of zero.


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That is to say, they should plough backthe earnings within the firm. the market

value of the shares will be maximized as aresult.

In contrast, if a firm does not haveprofitable investment opportunities (whenr


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In such a case the market price of shareswill be maximized by the distribution of the

entire earnings as dividends. The D/P ratioof 100 would give an optimum dividends

policy.

Finally when r=k (normal firm)it is a mattero indifference where earnings are retained

or distributed. This is so because for all D/Pratio the market price of shares will remain

constant. For such firms thee is no

optimum dividend policy.


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Assumptions

All financing is done through retainedearnings; external sources of funds likedebt or new equity capital are not used.

With additional investments undertaken,the firms business risk does not change.

It implies that r and k are constant.


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There is no change in the key variables,namely, beginning EPS(E) and dividend

per share(D).

E and D will be changed in the model todetermine results.

The firm has perpetual life


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equation

P= D+r/ke(E-D)

ke

P=prevailing market price of a share

D=Dividend per share

E=Earnings per share


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Irrelevance of dividends

The crux of the argument supporting theirrelevance of dividend to the valuation isthat dividend policy of a firm is a part of

financing decision.

As a part of the financing decision, thedividend policy of the firm is a residualdecision and dividends are passiveresidual.


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Modigliani and Miller (MM)Hypothesis

The most comprehensive argument in support of the

irrelevance of dividends is provided by the MM

hypothesis. Modigliani and Miller maintain that

dividend policy has no effect on the share price of

the firm and is, therefore, of no consequence.

Dividend Irrelevance

Dividend irrelevance implies that the value of a firmis unaffected by the distribution of dividends and is

determined solely by the earning power and risk of

its assets.


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Assumptions

The MM hypothesis of irrelevance of dividends is based on the

following critical assumptions:

Perfect capital markets in which all investors are rational.There are no taxes. Alternatively, there are no differences in tax

rates applicable to capital gains and dividends.

A firm has a given investment policy which does not change.

There is a perfect certainty by every investor as to future

investments and profits of the firm.

Crux of the Argument

The crux of the MM position on the irrelevance of dividend is the arbitrage

argument. The arbitrage process involves a switching and balancing

operation. In other words, arbitrage refers to entering simultaneously intotwo transactions which exactly balance or completely offset each other. The

two transactions here are the acts of paying out dividends and raising

external fundseither through the sale of new shares or raising additional

loansto finance investment programmes.


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Proof: MM provide the proof in support of their argument in the following

manner.

Step 1: The market price of a share in the beginning of the period is equal

to the present value of dividends paid at the end of the period plus the

market price of share at the end of the period. Symbolically,P0=(1/1+ke)(D1+P1)

P0=prevailing market price of a share

Ke=cost of equity capital

D1=dividend to be received at the end of period 1

P1=market price of a share at the end o period of 1

Step 2: Assuming no external financing, the total capitalized value of the

firm would be simply the number of shares (n) times the price of eachshare (P0). Thus,

nP0=(1/1+ke)(nD1+nP1)

n=number of shares


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Step 3: If the firms internal sources of financing its investment

opportunities fall short of the funds required, and n is the number of

new shares issued at the end of year 1 at price of P1, Eq. 2 can be written

as:

nP0=(1/1+ke)[(nD1+(n+ n)P- nP1)]

where n =Number of shares outstanding at the beginning of the period

n = Change in the number of shares outstanding during the

period/Additional shares issued

Equation 3 implies that the total value of the firm is the capitalised value of the dividends to be

received during the period plus the value of the number of shares outstanding at the end of the

period, considering new shares, less the value of the new shares. Thus, in effect, Eq. 3 is

equivalent to Eq. 2.


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Step 4: If the firm were to finance all investment proposals, the

total amount raised through new shares issued would be given in

Eq. 4.

nP1 = I (E nD1)or nP1 = I E + nD1 (4)

where nP1 = Amount obtained from the sale of new shares of

finance capital budget.

I = Total amount/requirement of capital budget

E = Earnings of the firm during the period

nD1 = Total dividends paid

(E nD1) = Retained earnings

According to Equation 4, whatever investment needs (I) are not

financed by retained earnings, must be financed through the sale

of additional equity shares.


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Step 5:If we substitute Eq. 4 into Eq. 3 we derive Eq. 5.

nP0=(n+ n)P1-I+E)/(1+ke)

Step 6:Conclusion Since dividends (D) are not found in Eq. 6, Modigliani

and Miller conclude that dividends do not count and that dividend policy

has no effect on the share price.


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Legal aspects of dividend policy

It is necessary for a company to declareand pay dividend only out of profits forthat year arrived at after providing fordepreciation in accordance with the

provisions of section 205(2) of the act.


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A dividend could be declared out of profitsof the company for any previous financialyear or years arrived after providing for

depreciation in accordance with thoseprovisions and remaining undistributed.


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The dividend can also be declared out ofmoneys provided by the central govt. or a

state govt. for the payment of dividend inpursuance of guarantee given by thatgovt.

The company is required to transfer tothe reserves such percentage of its profits

for that year not exceeding 10% inaddition to providing for depreciation asrequired under section 205(2A) of the Act.


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Unpaid dividend to be transferred to special dividendaccount:

Dividends are to be paid within 30 days from the date ofthe declaration

If they are not paid the company is required to transferthe unpaid dividend to unpaid account within 7 days of the

expiry of the period of 30 days.

The company is required to open this account in anyscheduled bank as required under section 205-A of the

Companies Act, 1956


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Dividend is to be paid only to registeredshareholders or to their order or theirbankers

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Cost of Capital - Copy

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