DIVIDEND AND RETENTION

POLICY

By :

Shafqat AliMBA iv:

University of Azad Jammu and

Kashmir Muzaffarabad.

Dated: 25-02-2013

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 On the basis of Types of Share

Equity Dividend

Preference Dividend

On the basis of Mode of Payment

Cash Dividend

Stock Dividend

Bond Dividend

Property Dividend

Composite Dividend

On the basis of Time of

Payment

Interim Dividend

Regular Dividend

Special Dividend

Cont

d.

What is Dividend

Policy :

“ Dividend policy determines the division of

earnings between payments to shareholders

and retained earnings”.

- Weston and Bringham

Dividend Policies involve the decisions, whether-

To retain earnings for capital investment and

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.

Cont

d.

Factors Affecting Dividend

Policy Legal Restrictions

Magnitude and trend of earnings

Desire and type of Shareholders

Nature of Industry

Age of the company

Future Financial Requirements

Taxation Policy

Stage of Business cycle

Regularity

Requirements of Institutional Investors

Cont

d.

Dimensions of Dividend

Policy

Pay-out Ratio

Funds requirement

Liquidity

Access to external sources of financing

Shareholder preference

Difference in the cost of External Equity and

Retained Earnings

Control

Taxes

Stability

Stable dividend payout Ratio

Stable Dividends or Steadily changing

Dividends

Cont

d.

Types of Dividend

Policy

Regular Dividend Policy

Stable Dividend Policy

Constant dividend per share

Constant pay out ratio

Stable rupee dividend + extra

dividend

Irregular Dividend Policy

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

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.

Walter’s Model

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

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

P

D + r (E-D)

k

k=

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

Illustration

:

Effect of Dividend Policy on Value of

Share

Case If Dividend Payout

ratio Increases

If Dividend Payout

Ration 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. HeShowed how dividend policy can be used tomaximize the wealth of the shareholders.

The main proposition of the model is that thevalue of a share reflects the value of the futuredividends accruing to that share. Hence, thedividend payment and its growth are relevant invaluation of shares.

The model holds that the share’s market price isequal to the sum of share’s discounted futuredividend 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

Where,

P = Price

E = Earning per Share

b = Retention Ratio

k = Cost of Capital

br = g = Growth Rate

P =E (1 – b)

K - br

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)

Illustration

:

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.

Modigliani & Miller’s Irrelevance

Model

Value of Firm (i.e. Wealth of Shareholders)

Firm’s Earnings

Firm’s Investment Policy and not on dividend policy

Depends on

Depends on

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

The expression of the outstanding equity

shares of the firm at time 0 is obtained as:

nPo =1 {nD1+(n + m)P1- mP1}

(1 + p)

nPo =1 (nD1+nP1)

(1 + p)

nPo =1 [nD1+ (n + m)P1– {I – (X –

nD1)}]

(1 + p)

mP1 = I – (X – nD1)

Where,

X = Total net profit of the firm for year 1

nPo =1 nD1+ (n + m)P1– I +X – nD1

(1 + p)

nPo =1 (n + m)P1– I +X

(1 + p)

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

Traditional Approach

This theory regards dividend decision merely

as a part of financing decision because

The earnings available may be retained in the

business for re-investment

Or if the funds are not required in the business

they may be distributed as dividends.

Thus the decision to pay the dividends or

retain the earnings may be taken as a residual

decision

This theory assumes that the investors do

not differentiate between dividends and

retentions by the firm

Thus, a firm should retain the earnings if it

has profitable investment opportunities

otherwise it should pay than as dividends.

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 Traditional Approach and MM’s

Approach says that Value of the Firm is

irrelevant to Dividend we pay.

Bibliograph

y

Google

Financial management by prasanna

chandra.