DIVIDEND POLICYFINANCIAL MANAGEMENT-IISECOND SEMESTER, 2014

Prof. Ajit Kumar Ray

What is dividend?

•Dividend is the return on the investment made in the shares (equity or preference) and is paid out of the profits of the company.

•The shareholders being the owners of the company are entitled to get their share of profit and the part of profit which is distributed among the shareholders is known as dividend.

•While the rate of dividend in case of preference shares is fixed, the dividend on equity shares varies from year to year depending upon the profit for the year and few other determinants.

•Dividend rate is used for valuation of share and is an indicator of performance of the company.

Legal Provisions Regarding Dividend Under Indian Acts

Section 205 of the Indian Companies Act, 1956 regulates the declaration and distribution of dividend.

All the companies which have share capital other than section 25 companies and make profit are bound by law to declare and distribute dividends.

As per the Section 205, a dividend (including interim dividend) can be paid out of current profits or profits accumulated of earlier years out of the profits of the company for that year arrived at after providing for depreciation .

Before declaring the dividend, the some part of the profit has to be compulsorily transferred to the Reserves of the Company.

This amount is based on the proposed rate of dividend.

However voluntary transfer of higher percentage to reserves is permitted subject to the conditions stipulated in the Act.

TAX PROVISION: In addition to the income tax chargeable in respect of the total income of a company for any assessment year, any amount declared, distributed or paid by such company by way of dividends (whether interim or otherwise) and also whether paid out of current or accumulated profits is charged with additional tax at the rate of 15 %.

Legal Provisions Regarding Dividend Under Indian Acts

What implies Dividend Policy :

Dividend Policies thus involve the following decisions,

1. Whether to retain earnings for capital investment and other purposes;

or

2. To distribute earnings in the form of dividend among shareholders;

or

3. To retain some earning and to distribute remaining earnings to shareholders.

Dividend Policy thus resolves two questions:

• Question 1:– Does dividend policy affect firm value?

• Question 2:– If so

• What is the optimal level of distribution ratio i.e., % Net Income to be distributed as dividend (Payout ratio)

• What is the optimal form of dividend i.e., cash dividend or stock dividend or both.

What is Dividend Policy :

Dividend Theories Two Groups of Theories:

A. Irrelevance Theories which consider dividend decision to be irrelevant as

it does not affects the value of the firm.

Modigliani and Miller’s Model

B. Relevance Theories which consider dividend decision to be relevant

as it affects the value of the firm

a) Traditional View b) Walter’s Model c) Gordon’s Model

Irrelevance Theory: Modigliani & Miller (1961)

Assumptions of the Model:

1. Capital Market is perfect

2. Investors are rational

3. There is no discrimination of tax between dividend income and income from capital gains.

4. There is no transaction cost

Under such conditions M-M model believes that the price of equity shares of a firm in the market depends solely on competency & capability of its earning ability and not influenced by the split of earnings between dividends and retained earnings

M-M Model

Let,

P0 = Market Price of share in the beginning of the year = PV of sum of [dividend (D1) + Market Price of the

share(P1)] at the beginning of the next period I = Amount to be invested in the beginning of the next

period

n = Number of shares at the initial period

E = Earnings of the period

I + D1 – E = Amount to be raised from the market by issuing m shares at the price P1

M-M Model

Then,

1 10

e

D +PP =

1+k

ekWhere

= cost of equity shares

M-M showed that value of n shares at the beginning of the year

10

(n+m)P I+EV= nP =

1 + Ke

Example 1

A company belongs to a risk class of which appropriate capitalization rate is 10 percent. It currently has 1000 shares of Rs. 10 each. The firm is contemplating the declaration of a dividend of Rs. 0.6 per share at the beginning of the next fiscal year, which has just begun. On the basis of M-M model, answer the following:

(1)What will be the price of the share at the beginning of the next year if dividend is not declared?

(2) Assuming that the firm pays dividend, has net income of Rs. 10,000 and makes new investment of Rs. 20,000, how many new shares must be issued?

Example 2

A company has 5000 outstanding shares. The current market price per share is Rs. 10 each. Estimated net income at the end of the current year is Rs. 5000.Board is considering a dividend of Re. 0.5 per share at the end of the current financial year. The firm needs Rs. 10,000 for an approved investment expenditure. Capitalization rate is 10 percent. Show how does the M-M approach affect the market value of the firm if dividends are (a) paid and (b) not paid.

Relevance Theory

a)Traditional View b) Walter’s Model c) Gordon’s Model

Relevance Theory

Traditional View:

• Bird in hand view: A bird in hand is better than two in the bushes

• Graham & Dodd observed: “ The stock market is overwhelmingly in favour of liberal dividend.”

• Accordingly, traditional theorists believe that value of share is directly proportional to the size of the dividend and earning per share with lesser weightage.

Accordingly, Graham & Dodd proposed that the market price (P) of a share is to be obtained by

P = m(D + E/3)= m(D + (D+R)/3)= m(4D+R)/3)

Where, Dividend per share = D and Earnings per Share = ERetained earnings = R and ‘m’ is a constant proportional (called multiplier)

The weight given by Graham and Dodd is completely subjective consideration of them and is not based on any empirical or theoretical analysis.

Walter’s Valuation 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.

Assumptions of Walter’s Model

1. External sources of funds like debt or new equity capital are not used.2. Retained earnings represents the only source of funds.3. All investment is done through retained earnings. 4. With additional investment undertaken, the firm’s business risk does not

change. (It implies that firm’s IRR and cost of capital are constant.)5. The return on investment remains constant.6. The firm has an infinite life and is a going concern. 7. All earnings are either distributed as dividends or invested internally

immediately. 8. There is no change in the key variables such as EPS .

Walter’s Model

Walter identified two factors that influence the market price of a share:

i)Dividend pay-out ratio (P/O ratio)

ii) The relationship between Internal Return on retained earnings (r) and cost of equity capital (ke).

Walter classified all firms into three categories:a)Growth firmb)Constant or Normal firm and c)Declining firmGiven r and ke,

(i) Growth firm, if r > ke

(ii) Constant or Normal firm, if r = ke

(iii) Declining firm, if r < ke

Walter concluded the following:

(i) The optimum pay-out ratio is nil in case of growth firm

(ii) the payout ratio of a constant firm is irrelevant or every pay-out ratio is optimum

(iii) the optimum pay-out ratio for a declining firm is 100 per cent

Walter’s Model

Category of firm

relation between r and ke

Correlation between dividend and market price of the share

Optimum P/O ratio

Growth r > ke Negative nil

Constant r = ke No correlation Any P/O ratio is optimum

Declining r < ke Positive 100%

Walter’s Model

Walter’s Valuation Model:

e

e

rD+(E-D)

kp

k

Walter proposed the following to compute the valuation of firm:

E = Earning per share, r = rate of return on retained earningsD = Dividend per share ke = cost of equity capitalP = Market price per share

ProblemsWalter’s Model

1

EPS is given as Rs. 16.00. The market rate of discount applicable to the company is 12.5 percent. Retained earnings can be employed to yeild a return of 10 percent. The company is considering a pay-out of 25 percent, 50 percent and 75 percent. Which of these would maximize the wealth of shareholders?

2

Cost of equity is 20 percent and EPS is Rs 5. dividend per share Rs. 4. rate of return on investment 20 percent. Find market price of the share after dividend announcement using Walter model.

3

A company earns Rs 6 per share having capitalization rate of 10 percent and has a return on investment at the rate of 20 percent. According to Walter’s model, what should be the price per share at 30 percent dividend pay-out ratio? Is this the optimum pay-out ratio as per Walter?

4Consider the following information of a company:Net Profit 3.0 millionOutstanding 12 percent preference share 10.0 millionNo of equity shares 0.3 millionReturn on investment 20 percentCost of equity 16 percentWhat should be the appropriate P/O ratio so as to keep the price at Rs 40 per share by using Walter’s model?

GORDON’S MODEL OF DIVIDEND POLICY

GORDON’S MODEL OF DIVIDEND POLICY

Gordon’s Model which is termed as ‘Growth Valuation Model’ based on the following assumptions:

1. The firm is an all equity firm and external financing is not used and thus has no debt.

2. Retained earnings represent the only source of financing. 3. The internal rate of return is the firm’s cost of capital ’k’ which

remains constant and is taken as the appropriate discount rate. 4. Future annual growth rate of dividend is expected to be constant. 5. Growth rate of the firm is the product of retention ratio and its rate of

return. 6. Cost of Capital is always greater than the growth rate. 7. The company has perpetual life and the stream of earnings are

perpetual. 8. Corporate taxes does not exist. 9. The retention ratio ‘b’ once decided upon, remain constant. Therefore,

the growth rate g=br, is also constant forever.

•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 present market price (P0) is equal to the sum of share’s discounted future dividend payment.

GORDON’S MODEL OF DIVIDEND POLICY

GORDON’S MODEL OF DIVIDEND POLICY

The growth of dividend of a normal firm is expected to continue in the foreseeable future at a constant rate ‘g’.

Thus if such a company’s dividend which has already been paid at time t=0 is d0 , its dividend in the next period t=1 would be d1=d0(1+g)Similarly, at time t=2 dividend would be d2=d1(1+g) = d0(1+g)^2Thus, present market price P0 is sum of PV of stream of dividends for infinte times

α

1tt

e

t0

3e

32

e

2

e

10

)k(1

g)(1d

.......)k(1

d

)k(1

d

)k(1

dP

GORDON’S MODEL OF DIVIDEND POLICY

Since ‘g’ is assumed to be constant, the above expression may be simplified to

.k

dP

e

10 g

Where,P0 = Price of sharesb = Retention Ratioke = Cost of equity capitalg = growth rate of dividend= br ; r =rate of return on investment of an all-equity firmd1 = Dividend per share at the end of first year

The implications of Gordon’s basic valuation model is identical to Walter’s model and may be summarized as follows:

1.When the rate of return of firm’s investment is greater than the required rate of return, i.e. when r > k, the price per share increases as the dividend payout ratio decreases. Thus, growth firm should distribute smaller dividends and should retain maximum earnings.

2.When the rate of return is equal to the required rate of return, when r = k, the price per share remains unchanged and is not affected by dividend policy. Thus, for a normal firm there is no optimum dividend payout.

3.When the rate of return is less than the required rate of return, i.e., when r<k, the price per share increases as the dividend payout ratio increases. Thus, the shareholders of declining firm stand to gain if the firm distributes its earnings. For such firms, the optimum pay out would be 100%.

GORDON’S MODEL OF DIVIDEND POLICY

A Ltd Co’s registered earnings is Rs. 800,000 for the year ended 31st March. They finance all investments from out of retained earnings. The opportunities for investments are many. If such opportunities are not availed their earnings will stay perpetually at Rs. 800,000. Following figures are relevant.

The returns to shareholders are expected to rise if the earnings are retained because of the risk attached to new investments. As for the current year, dividend payments will be made with or without retained earnings. What according to you, should be retained ?

GORDON’S MODEL OF DIVIDEND POLICYAn Example

Policy Retention (%) Growth (%) Cost of equity on all investments

A 0 0 14

B 25 5 15

C 40 7 16

Determinants or Factors affecting Dividend Policy :

1. Availability of Distributable Profits

2. Availability of Profitable Reinvestment Opportunities

3. Availability of Liquidity

4. Inflation Effect on Market Prices

5. Composition of Shareholding

6. Company’s own policy regarding stability of dividend

7. Extent of access to external sources

8. Attitude and Objectives of Management

Thank You