Dividend Policy

• Dividend Decisions of a Firm – Relevance/Irrelevance• Models explaining the Relevance/Irrelevance of the Dividend Policy

What is Dividend Policy?

Introduction to Dividend Decisions

• Once a company makes a profit, they must decide on what to do with those profits.

• They could continue to retain the profits within the company, or they could pay out the profits to the owners of the firm in the form of dividends.

• Once the company decides on whether to pay dividends, they may establish a somewhat permanent dividend policy, which may in turn impact on investors and perceptions of the company in the financial markets.

• What they decide depends on the situation of the company now and in the future.

• It also depends on the preferences of investors and potential investors.

Dividend

• Dividends are payments made to stockholders from a firm's earnings, whether those earnings were generated in the current period or in previous periods.

• Dividends may affect capital structure.• Retaining earnings increases common equity relative to debt.• Financing with retained earnings is cheaper than issuing new common equity.

Two options• There are basically two options which a

firm has while utilizing its profits after tax.– Ploughing back the earnings by retaining them– Distribute the same to the shareholders.

• Option I is suitable for firms which need funds to finance their long term projects, which have growth potential and sufficient profitability.

• Option II is suitable for those firm whose objective is to maximize the shareholders wealth.

Dividend Policy and Stock Value

• There are various theories that try to explain the relationship of a firm's dividend policy and common stock value.

Dividend Irrelevance TheoryThis theory purports that a firm's dividend policy has

no effect on either its value or its cost of capital. Investors value dividends and capital gains equally.

Optimal Dividend PolicyProponents believe that there is a dividend policy

that strikes a balance between current dividends and future growth that maximizes the firm's stock price.

Dividend Relevance TheoryThe value of a firm is affected by its dividend policy.

The optimal dividend policy is the one that maximizes the firm's value.

Dividend Models

Dividend Relevance Model• Traditional Model• Walter Model• Gordon ModelDividend Irrelevance Model• Miller & Modigliani Position

Traditional Model• It is given by B Graham and DL Dodd.• This model lays down a clear emphasis on the

relationship between the dividends and the stock market.

• Acc to this model, the stock value responds positively to higher dividends and negatively when there are low dividends.

• This model establishes the relationship between market price and dividends using a multiplier.

• P/E ratios are directly related to the dividend payout ratios i.e a higher dividend payout ratio will increase the P/E ratio and vice-versa.

• P = m(D+E/3)• Where;

P = market priceM = multiplierD = Dividend per shareE = Earnings per share

Limitation of the Traditional Approach

• P/E ratios are directly related to the dividend payout ratios is not true for a firm’s whose payout is low but its earnings are increasing.

• This approach does not hold good for those firm whose payout is high but have slow growth rate.

• There may be few investors who would prefer the dividends to the uncertain capital gains and a few who would prefer low taxed capital gains.

• These conflicting factors have not been properly explained by traditional approach.

Walter Model• The dividend policy given by James E Walter considers

that dividends are relevant and they do affect the share price.

• In this model , he studied the relationship between the internal rate of return (r) and the cost of capital of the firm(K), to give a dividend policy that maximizes the shareholders’ wealth.

• The model studies the relevance of the dividend policy in three situations;r > Ker < Ker = Ke

• Acc to WalterWhen r > Ke the firm has to adopt Zero% payout policy.

r < ke the firm has to adopt 100% payout policy. r = ke any policy between 0 to 100% payout.

Assumptions of Walter Model

1.

4.

2.

3.

Acc to Walter Market Price Per share is given by

Ke

Impact of Dividend Policy on Market Price

EPS = Rs. 8Dividend Payout

r > ke r < ke r = ke

15% > 12% 10% < 12% 12% = 12%

Market Price (P) Market Price (P) Market Price (P)

0% 83 56 67

25% 79 58 67

50% 75 61 67

75% 71 64 67

100% 67 67 67

 Dividend Policy Zero Payout  100% Payout  Payout 0% to 100%

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

Ke

Limitation

Gordon Model• Myron Gordon uses the dividend capitalization

approach to study the effect of the firms dividend policy on the stock price.

• Gordon model assumes that the investors are rational and risk averse.

• They prefer certain returns to uncertain returns and thus put a premium to the certain returns and discount the uncertain returns.

• Investor would prefer to pay a higher price for the stocks, which earn them current dividends income and would discount those stocks, which either postpones/ reduce the current income.

• The discounting will differ depending on the retention rate and the time.

Assumptions

Acc to Gordon Market Price Per share is given by

• P = E ( 1-b)Ke - br

• Acc to Gordon;– The firms with rate of return greater

than the cost of capital should have a higher retention ratio.

– Firms which have rate of return less than the cost of capital, should have a lower retention ratio.

– The firms which have a rate of return equal to the cost of capital will however not have any impact on its share value, it can adopt any retention policy.

Impact of Dividend Policy on Market Price

EPS = 15

Dividend Payout (1-b)

Retention Ratio = b

r > ke r < ke r = ke

12% > 11% 10% < 11% 11% = 11%

Market Price (P) Market Price (P) Market Price (P)

10% 90% 750 75 136.36

20% 80% 214.28 100 136.36

30% 70% 173.08 112.5 136.36

40% 60% 158 120 136.36

50% 50% 150 125 136.36

  Dividend Policy

Retain More Pay less

Retain less Pay more

Any combination

Formula 

E(1-b)Ke - br 

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