Dividend Policy 6

8/7/2019 Dividend Policy 6

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DIVIDEND POLICY


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What do you mean by

dividend????


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` Cash Dividend

` Stock Dividend/Bonus Shares

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` Legal restrictions

` Liquidity.

` Financial condition.` Access to the capital market.

` Restriction in loan agreements.

`

Desire of the Shareholders.

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` The Relevance Concept of Dividend or the

Theory of Relevance.

` The Irrelevance Concept of Dividend or the

Theory of Irrelevance

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` RELEVANCE CONCEPT:-

Walters Model

Gordons Model Lintners Model

` IRRELEVANCE CONCEPT:-

Miller & Modigliani Model

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WALTER MODEL

Developed by James E Walter

Based on notion that dividend affects the

share price

Model studies relationship between

internal rate of return (r) and the cost of

capital of the firm (k) in order to maximizethe shareholders wealth


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` The firm finance its entire investments bymeans of retained earnings. New equity stock

or debentures are not issued to raise funds.

` Internal rate of return (r) and cost of capital(Ke) of the firm remain constant.

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` The firms earnings are either distributed as

dividends or reinvested internally.

` Firm has infinite life.

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Model studies dividend in three situations:-

(a) r k

e

(b) r ke

(c) r = ke


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When Return is morethanthe Cost of

Equity.

Such firms are high growth firms.

Such firms must reinvest retained earnings sinceexisting alternative investments offer a lower return

than the firm is able to secure.

Zero pay-out ratio is the most beneficial strategy.


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When Return is less thanthe Cost of

Equity

Such firms are declining firms.

Such firms earn less than the minimum rate

required by Investors on their investments.

100% pay-out ratio is the most beneficial

strategy.


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When Return is equal to the Cost of

Equity..

Such firms are Normal or matured firms.

Dividend policy will have no effect on the market

value per share.

Such are firms that have matured Dividend pay-out ratio which could be between zero to 100%


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LIMITATIONS OF WALTERS MODEL

Suitable only for all equity firms.

ROI and Ke is not constant as assumed.

Ignores changes in risk that has a direct

impact on the value of the firm.


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

Ke

Where

P = Current Market price per share

D = Dividend per share

r = Rate of returnKe = Cost of equity i.e.,10%or 0.10

E = Earnings per share i.e., Rs. 8

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The EPS of a company is Rs 8 & the applicable

capitalization rate is 10%.The Co. is evaluating

dividend payout ratio & is considering a) 50% b)

25% & c) 100%.C

ompute the share price underWalter model assuming that the company can

earn a return of a) 15% b) 10% & c) 5% on its

retained earnings for each of the three

alternative payout choices.

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when r = 15% & Ke =10%

` a) 100 b) 110 c) 80

when r = 10% & Ke =10%

` a) 80 b) 80 c) 80

when r = 10% & Ke =10%` a) 60 b) 50 c) 80

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GORDONS DIVIDEND CAPITALIZATIONMODEL

1. Developed by Myron Gordon.

2. Studies the effect of dividend policy on the

stock price.

3. Dividend decision of the firm affects its value.


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GORDONS ASSUMPTIONS

a) The firm is an all equity firm.

b) No external financing is available or used.

c) Retained earnings represent the only source

of financing.

d) The rate of return on the firms investment r, isconstant.


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e) Dividends are assumed to grow at a uniform rate

forever.

f ) The cost of capital for the firm remains constant

and it is greater than the growth rate, i.e. k > br.

g) The firm has perpetual life.

h) Corporate taxes do not exist.

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P = E (1- b) Or P = D/ K -g

K br

Where,

P = Price of shares ; E = Earnings per share

b = Retention Ratio; k = Rate of discount orCost of capital

br = g = growth rate in r, i.e., rate of return on investment of

an all-equity firm

D = Dividend per share

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The EPS of a company is Rs 10 andretention ratio is 40%.Find the Price of the

share under Gordons model when:

i) r = 30% & K = 20%

ii) r = 30% & K = 30%

iii) r = 20% & K = 30%

Also find the share Prices when b is changed to 60%.

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PS Ltds share has an EPS of Rs.20.67 & rate of

return (r) is 15% & it follows a policy of retaining

60% of its earnings. If the cost of capital is 18%

what is the price of the share today. Use Gordon'smodel.

Ans: Rs.91.87

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1.When the rate of return of firms investment is

greater than the required rate of return,i.e. when

r > k,The price per share increases as thedividend payout ratio decreases. Thus, growth

firm should distribute smaller dividends and

should retain maximum earnings.

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2.When the rate of return is equal to the required

rate of return, i.e, when r = k, the price per share

remains unchanged and is not affected bydividend policy. Thus, for a normal firm there is

no optimum dividend payout.

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3.When the rate of return is less than the required

rate of return, i.e., when r


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` Firms set long run target payout ratios.

` Managers are reluctant to effect dividend

changes that may have to be reversed.

` Adjustment factor is an arbitrary number.

` Lintners model does not offer a market price forthe share.

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` D1= D0 + [(EPS X Target Payout)- D0 ] x AF

` Where:

D1= Dividend in year 1

D0 = Dividend in current year

EPS = Earning per share

AF = Adjustment factor

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PS Ltd has earnings of Rs 4 per share this year.

DPS last year was Rs.1.5. Suppose the target

payout ratio & the adjustment factor for the firm

are 0.6 & 0.5 respectively. What would be the

dividend per share underLintners model?

Ans: Rs.1.95

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This theory is propounded by Modigliani & Miller.

This theory is also called as irrelevance theory.

It argues that the declaration of dividends does

not effect the value of the firm

Value of the firm depends on the earning

capacity of the firm.

Millerand Modigliani Model


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Existence of perfect market.

MM MODEL ASSUMPTIONS

No differential tax rate for dividend income

and capital gains.

The firm has a fixed investment policy.

All investments are funded either by equity or by

retained earnings.


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LIMITATIONS OF MM MODEL

Firms valuation and cost of capital may change

with changes in its capital structure.

Taxes can have implications on the capital

structure.

Existence of perfect market.


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Stable Dividend Policy

Constant dividend per share

Constant pay out ratio

Stable rupee dividend plus extra dividend

Irregular Dividend Policy

No Dividend Policy

Residual Dividend Policy

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` Constant dividend per share

:-

Policy of paying fixed dividend per share.

` Constant pay out ratio:-

Payment of a fixed percentage of net earnings asdividends every year.

` Stable rupee dividend plus extra dividend:-

policy of paying constant low dividend per shareplus an extra dividend in the years of high profits.

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` It is sign of continued normal operations of the

company.

`

It stabilizes the market value of shares.` It creates confidence among the investors.

` It provides a source of livelihood to those

investors who view dividends as a source of

funds to meet day-to-day expenses.

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` It meets the requirements of institutional

investors who prefer companies with stable

dividends.

` It improves the credit standing and makes

financing easier.

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` Board Resolution

` Shareholder Approval` Record Date

` Dividend Payment

` Unpaid Dividend

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THANK YOU

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Dividend Policy 6

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