DIVIDEND DECISIONS

If there are not enough investments that earn the

hurdle rate, return the cash to the owners of the firm
Dividend Policy
Determines the proportion of earnings to be
paid to shareholders by way of dividends
Indicates the proportion ploughed back in the
organisation for reinvestment purposes
Has a bearing on financing
Dividend policy affected by the way of
measuring earnings
Dividend-Share Price relation: Two opinion
Dividend does not affect share prices
Dividend do affect the share prices
Narain
Major theories of Dividend Policy
Many such theories –
1. Traditional Theory
2.
3.
4. MM Model
5. Bird-in-Hand Theory
6. Tax Preference Theory
Only the MM model fully subscribes to
dividend irrelevance hypothesis
Narain
Traditional Theory
Expounded eloquently by Graham & Dodd
Stock market places considerably more weight on
dividends than on retained earnings
According to the model, in the valuation of shares,
the weight attached to dividend is equal to four times
the weight attached to retained earnings
Weights given by Graham & Dodd are based on their
subjective judgements and not derived objectively

 4 D + RE 
P 
 5 
Narain
 Evaluating Graham-Dodd model
Not a flawless theory
1. Empirical tests have suggested that, when earnings
are temporarily depressed, two likely effects
i. The Dividend Payout Ratio (DPR) tends to be
high because firms normally maintain or
reduce the DPS marginally
ii. High P/E ratio because a temporarily decline
in earnings does not have significant impact
on market price per share
2. Risk in organisation’s operations
If high risk (i) low DPR conservative mgt
– (ii) low P/E ratio averse investors
Narain
Walter’s Model
Supports the view that the dividend policy of the company
has a bearing on “share valuation”
Assumptions:
1. RE represents the only source of financing for the firms
2. The cost of capital (k) for the company remains
constant
3. The company has an infinite life
4. The return on the investment (r) remains
constant
D + ( E −kD ).r
P=
k
Share Price = PV of constant dividend + increased Cap.
Gains
Narain
Illustration
Compute the share price of the company where
expected earnings per share is Rs. 8, cost of
equity as 15% and expected dividend to be
Rs. 8 per share, Rs. 4 per share & nil.
Assume return on investment as 20%
What will the share price be if return on
investment is 15%
What will the share price be if return on
investment is 10%

Narain
Implications of Walter’s model
In summary –
The optimal DPR for a growth firm (r>k) is nil
The DPR for a normal firm (r=k) is irrelevant
The optimal DPR for a declining firm (r<k) is
100%
The policy implication lead to very extreme
courses of action which make limited sense in
real world
But a useful tool to show the effects of
dividend policy under varying profitability
assumptions
Narain
Gordon’s Model
Assumptions:
1. RE represents the only source of financing for the
firm
2. Rate of return (r) on the investments is
constant
3. The growth rate of the firm is the product of its
retention ratio (b) & its rate of return (r)
4. Cost of capital (k) for the firm remains constant
and it is greater than the growth rate
5. The company has a perpetual life
6. Taxes does not exist E1 (1 − b )
Share price of the firm is: P0 = k − b.r Narain
Illustration
Compute the share price of the company where
expected earnings per share is Rs. 8, cost of
equity as 15% and dividend payout to be
75%, 50% & 15%. Assume return on
investment as 20%
What will the share price be if return on
investment is 15%
What will the share price be if return on
investment is 10%

Narain
 Implications of Gordon’s Model
Policy implications:
Same as from the Walter’s model
The optimal payout ratio for a growth firm is
nil

The payout ratio for a normal firm is

irrelevant

The optimal payout ratio for a declining firm

is 100% Narain
MM Theory
Dividend Irrelevance Theorem
Value of a firm depends solely on its “earnings
power”
Not influenced by the manner in which the earnings
are split between dividend and RE
Assumptions:
1. Perfect capital market
2. Investors are rational
3. Floatation costs are nil
4. No taxes
5. Investments opportunities and future profits
known with certainty Narain
MM Theory
If a Co. retains earnings instead of giving it out as
dividend, the shareholders enjoys capital appreciation
equal to the amount of earnings retained
If it distributes earning by way of dividend instead of
retaining it, the shareholders enjoy dividend equal in
value to the amount by which their capital would
have appreciated had the Co. chosen to retain its
earnings
Hence the division of earnings between dividend and
RE is irrelevant from the point of view of S/H
Arbitrage through the process of “Home Made
Dividend” Narain
Evaluation of MM Theory

The assumptions used by MM challenged

Dividend does matter due to –

Uncertainty characterising the future

The imperfections in the capital market

The existence of taxes

The existence of floatation costs

Narain
Bird-in-Hand Theory
By Gordon and Lintner
Cost of equity decreases as the dividend payout
increases
Investors less certain of receiving the capital
gains which are supposed to result from RE
than they are of receiving dividend payment
Investors value a rupee of expected dividend more
than a rupee of expected capital gains
The dividend yield component (D1/P0) is less
risky than the g component in the total
expected return equation
ke = (D1/P0 )+ g Narain
Tax Preference Theory
Investors prefer low dividend payout to high payout
Three reasons:
1. LTCG tax paid by individuals
• Tax on dividend paid by the Co.
• Low dividend => low tax by the Co. => reinvestment of Profit
=> appreciation of share price => capital gains tax on selling
• Generally capital gains tax lower than that paid on dividend
2. Taxes not paid on the gain until a share is sold
• Due to time value effect, a rupee of taxes paid in the future has
a lower effective cost than a rupee paid today
• Also the inflation effect
3. If a share is held by someone until s/he dies
• No capital gains tax even after death until sold Narain
Empirical Evidences
1. Firm have got LT target payout ratio
2. Dividend tends to be sticky & stable in
practice
3. Firm try to have non-decreasing dividend
stream
4. Firm are conscious not to increase DPS
beyond a sustainable level
5. Dividend is considered to be an active
decision rather than a residual of
investment & financing decisions Narain
Illustration
A company has following streams of historical &
expected dividends:
Years 2006 2007 2008 2009 2010 2011 2012 2013
EPS 0.44 1.00 0.60 1.05 -0.85 1.20 1.56 1.4
Examine different Dividend Policies of stability and
regularity of the dividend using the following cases –
1. Constant DPR of 50%
2. Constant DPS of Re 0.50. If consecutively
EPS>1 for two years, then DPS=0.60
3. Constant DPS of Re 0.50 + 60% of (EPS-1)
4. Combination of case (2) & (3) but cut off
EPS=1.10
Narain
 Solution
Dividends
Year EPS Case Case Case Case
(1) (2) (3) (4)
2013 1.40 0.70 0.60 0.74 0.78
2012 1.56 0.73 0.60 0.84 0.88
2011 1.20 0.60 0.50 0.62 0.56
2010 -0.85 Nil 0.50 0.50 0.50
2009 1.05 0.53 0.50 0.53 0.50
2008 0.60 0.30 0.50 0.50 0.50
2007 1.00 0.50 0.50 0.50 0.50
2006 0.44 0.22 0.50 0.50 0.50
Narain
Forms of Dividend Payments
1. Cash Dividend
Reduces cash (resources) of the firm
2. Bonus Share (stock dividend)
Increases market float
Does not affect capital structure
No immediate cash outflow
Future dividend payment goes up
3. Stock Split
Issue shares of smaller denomination
Brings down EPS
Similar implications as with bonus shares
Narain
Forms of Dividend Payments

4. Share Buyback (repurchase of shares)

Increases EPS by reducing No. of
shares outstanding
Signals to the market that the shares
are undervalued
Holds decline in the share price by
reducing float in the market
Discourage unfriendly takeover
Narain
 Illustration
XY ltd. currently have 10,000 equity shares of Rs. 10
each. The earnings per share of the company for the
current year is Rs. 36. The current market price of the
share is Rs. 30. The company is considering the
following two alternatives:
1) 20% Bonus Share
2) A stock split of 5:4
The management of the company is of the view that the
company’s shares are overvalued and increasing the
float in the market will help the situation. Analyze the
impact for the company, stock price and the
investors. Narain
Determinants of Dividend Policy

1. Historical Dividend Payout Ratio

2. Stability of dividends
Constant DPS
Consistent Dividend Payout Ratio
Stable rupee dividend + extra dividend
• Reasons for preferring stable dividend
– Desire for current income
– Informational contents (signaling effect)
– Requirements of institutional investors
3. Legal requirements
Capital impairment rules and insolvency
Distributable profits
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Determinants of Dividend Policy
4. Contractual requirements: e.g. Prepayment of EMI
5. Internal constraints
Liquid assets
Growth prospects
Financial requirements
Availability of funds
Earnings stability and growth
6. Owner’s considerations (clientele effect)
Taxes
Opportunities
Dilution of ownership control Narain
Determinants of Dividend Policy

7. Capital market considerations

8. Inflation effects

Narain
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