Dividend Policy

(Unit IV)

Dr.M.Velavan
Faculty
School of Management
SASTRA Deemed University
Thanjavur – 613 401
Chapter Overview:
1. Introduction:
The term dividend refers to that part of profits of a company which is
distributed by the company among its shareholders. It is the reward of the
shareholders for investments made by them in the shares of the company.
The investors are interested in earning the maximum return on their
investments and to maximize their wealth.
A company, on the other hand, needs to provide funds to finance its long-
term growth. If a company pays out as dividend most of what it earns, then
for business requirements and further expansion it will have to depend upon
outside resources such as issue of debt or new shares. Dividend policy of a
firm, thus affects both the long-term financing and the wealth of
shareholders
2. Meaning of Dividend:
The dividend is that part of the Profit After Tax (PAT) that is distributed to
the shareholders of the company. Further, the profit earned by a company
after paying taxes can be used for:
• Distribution of dividends, or
• Retaining as surplus for future growth
3. Forms of Dividend:
Generally, the dividend can be of the following forms (depending upon some
factors that will be discussed later):
• Cash dividend: It is the most common form of a dividend. Cash here
means cash, cheque, warrant, demand draft, pay order or directly through
Electronic Clearing Service (ECS) but not in kind.
• Stock dividend (Bonus Shares): It is a distribution of shares in lieu of a
cash dividend. When the company issues new shares to its existing
shareholders without any consideration it is called bonus shares. Such
shares are distributed proportionately thereby retaining proportionate
ownership of the company.
6. Dividend Decision and Valuation of Firm:
The value of the firm can be maximized if the shareholder’s wealth is
maximized. There are conflicting views regarding the impact of dividend
decisions on the valuation of the firm. According to one school of thought,
dividend decision does not affect the shareholder’s wealth and hence the
valuation of the firm. On the other hand, according to the other school of
thought, dividend decision materially affects the shareholders’ wealth and
also the valuation of the firm.
We have discussed below the views of the two schools of thought under two
Methods:
a. The Relevance Concept of Dividend or The Theory of Relevance
b. The Irrelevance Concept of Dividends or The Theory of Irrelevance
Theories/Methods of Dividend:
a) The Relevance Concept of Dividends:
According to this school of thought, dividends are relevant and the amount of
dividend affects the value of the firm. Walter, Gordon and others propounded
that dividend decisions are relevant in influencing the value of the firm.
Walter argues that the choices of dividend policies almost and always affect
the value of the enterprise.
1. Walter’s Model:
Walter’s model, one of the earlier theoretical models, clearly indicates that
the choice of appropriate dividend policy always affects the value of the
enterprise. Professor James E. Walter has very scholarly studied the
significance of the relationship between the firm’s internal rate of return (r)
(or actual capitalization rate) and its Cost of Equity Capital (Ke) (normal
capitalization rate) in determining such dividend policy as will maximize the
wealth of the stockholders.
The formula used by Walter to determine the market price per share is :

Where:
P = Market price per equity share,
D = Dividend per share,
E = Earnings per share,
r = Internal rate of return,
Ke = Cost of equity capital (Capitalization rate).
It may be noted that Walter’s formula has the same effect as the continuing
dividend growth formula. It seeks to measure the effect of dividends on
common stock value by comparing actual and normal capitalization rates.
Another feature of Walter’s formula is that it provides an added or reduced
Weight to the retained earnings portion of the capitalization earnings
formula. The factors ‘r’ and ‘k’ are placed in front of retained earnings to
change their weighted value under different situations as discussed below:
a) Growth Firms
b) Normal Firms
c) Declining Firms
a) Growth Firms:
In growth firms internal rate of return is greater than the normal rate (r > k).
Therefore, the r/k factor will be greater than 1. Such firms must reinvest
retained earnings since existing alternative investments offer a lower return
than the firm is able to secure. Each rupee of retained earnings will have a
higher weighting in Walter’s formula than a comparable rupee of dividends.
Thus, the large the firm retains, the higher the value of the firm. The
optimum dividend pay-out ratio for such a firm will be zero.
b) Normal Firms:
Normal firms comprise those firms whose internal rate of return is equal to
normal capitalization (r=k). These firms earn on their investments a rate of
return equal to the market rate of return. For such firms, dividend policy will
not affect the market value per share in Walter’s model. Accordingly, retained
earnings will have the same weighted value as dividends. In this case, the
market value per share is affected by the payout ratio.
Solved Problems:
P1. Following are the details regarding three companies A Ltd., B Ltd., and C
Ltd.:
A Ltd B Ltd C Ltd

r = 15% r = 5% r = 10%
Ke = 10% Ke = 10% Ke = 10%
E = Rs. 8 E = Rs. 8 E = Rs. 8

Calculate the value of an equity share of each three companies by applying

Walter’s formula when the dividend payout ratio is a) 50%, b) 75%, and c)
25%.
Solution: Value of equity shares (P):
P = D+[(r/Ke) (E-D)]/Ke
a) When dividend payout ratio is 50%
A Ltd B Ltd C Ltd
P = Rs. 4+[(0.15/0.10) (Rs. 8-Rs. P = Rs. 4+[(0.05/0.10) (Rs. 8-Rs. P = Rs. 4+[(0.10/0.10) (Rs. 8-
4)]/0.10 4)]/0.10 Rs. 4)]/0.10
= Rs. 100 = Rs. 60 = Rs. 80
b) When D/P ratio is 75%
P = 6+[(0.15/0.10) (8-6)]/0.10 P = 6+[(0.05/0.10) (8-6)]/0.10 P = 6+[(0.10/0.10) (8-6)]/0.10
= Rs. 90 = Rs. 70 = Rs. 80
c) When D/P ratio is 25%
P = 2+[(0.15/0.10) (8-2)]/0.10 P = 2+[(0.05/0.10) (8-2)]/0.10 P = 2+[(0.10/0.10) (8-2)]/0.10
= Rs. 110 = Rs. 50 = Rs. 80
P2.The earnings per share of a company are Rs. 8 and the rate of
capitalization applicable is 10%. The company has before it an option of
adopting (i) 50%, (ii) 75%, and (iii)100% dividend payout ratio. Compute the
market price of the company’s quoted shares as per Walter’s model if it can
earn a return of (i) 15%, (ii) 10%, and (iii) 5% on its retained earnings.
2. Gordon’s Model:
Myron Gordon has also developed a model on the lines of Prof. Walter
suggesting that dividends are relevant and the dividend decision of the firm
affects its value. His basic valuation model is based on the following
assumptions:
1. The firm is an all-equity firm i.e., no debt
2. No external financing is available or used. Retained earnings represent
the only source of financing investment programs.
3. The rate of return on the firm’s investment r, is constant.
4. The retention ratio, b, once decided upon is constant. Thus, the growth
rate of the firm g = br, is also constant.
5. The cost of capital for the firm remains constant and it is greater than the
growth rate, i.e. k > br.
6. The firm has perpetual life.
7. Corporate taxes do not exist.
According to Gordon, the market value of a share is equal to the present
value of the future stream of dividends. Thus,

Where:
Po = Price of shares at the end of year 0
E1 = Earnings per share at the end of year 1
(1-b) = The fraction of earnings the firm distributes by way of dividends
b = The fraction of earnings the firm retains or Retention Ratio
K = Rate of return required by the shareholders or Cost of equity capital
br = Growth rate of earnings and dividend
P3. Following are the details regarding three companies A Ltd., B Ltd., and C
Ltd.:
A Ltd B Ltd C Ltd

r = 20% r = 15% r = 10%

K = 15% K = 15% K = 15%
E = Rs. 4 E = Rs. 4 E = Rs. 4

Calculate the value of an equity share of each three companies applying

Gordon’s formula when the dividend retention ratio is a) 25% and b) 50%.
Solution:
Value of Market Price of an Equity Share [Po]:

Growth firm: r ≥ k Normal firm: r = k Declining firm: r ≤ k

a) When b = 25%
= (0.75)4/0.15-[(0.25)(0.20)] = (0.75)4/0.15-[(0.25)(0.15)] = (0.75)4/0.15-[(0.25)(0.10)]
= Rs. 30 = Rs. 26.67 = Rs. 24
b) When b = 50%
= (0.50)4/0.15-[(0.50)(0.20)] = (0.50)4/0.15-[(0.50)(0.15)] = (0.50)4/0.15- [(0.50)(0.10)]
= Rs. 40 = Rs. 26.67 = Rs. 20
P4. The following data relates to Yuktha Ltd: Earnings per share: Rs.14;
Capitalization rate:15%; Rate of return:20%. Determine the market price per
share under Gordon’s model if retention is (a) 40% (b) 60% (c) 20%.
Solution:
Value of Equity Share:
Po = E1 (1-b)/[K-br]
a) When b = 40%
= (0.60) 14 /0.15 – [(0.40)(0.20)]
= Rs. 120
b) When b = 60%
= (0.40)14 /0.15 – [(0.60)(0.20)]
= Rs. 186
= Rs. 186.67
c) When b = 20%
= (0.80)14 /0.15 – [(0.20)(0.20)]
= Rs. 101.82
b) The Irrelevance Concept of Dividend:
The other school of thought was propounded by Modigliani and Miller in
1961. According to the MM approach, the dividend policy of a firm is
irrelevant and it does not affect the wealth of the shareholders. They argue
that the value of the firm depends on the market price of the share; the
dividend decision is of no use in determining the value of the firm.
1) The Irrelevance Concept of Dividend [MM Model]:
Modigliani-Miller’s (MM’s) thoughts on the irrelevance of dividends are most
comprehensive and logical. According to them, dividend policy does not
affect the value of a firm and is therefore, of no consequence. It is the
earning potentiality and investment policy of the firm rather than its pattern
of distribution of earnings that affects the value of the firm.
The MM approach contains the following mathematical formulations to
prove the irrelevance of dividend decisions.
1) Calculation of P1:
P1 = Po (1+Ke) – D1
Where:
Po = Prevailing market price of a share
Ke = Cost of equity capital
D1 = Dividend to the received at the end of the period one
P1 = Market price of a share at the end of period one
2) Calculation of the number of new shares to be issued:
m×P1 = I – (X- nD1)
Where:
m = Number of new shares to be issued
P1 = Price at which new issue is to be made
I = Amount of investment required
X = Total net profit of the firm during the period
nD1 = Total dividend paid during the year
P5. The present share capital of A Ltd., consists of 1,000 shares selling at Rs.
100 each. The company is contemplating a dividend of Rs.10 per share at the
end of the current financial year. The company belonging to a risk class for
which appropriate capitalisation rate is 20%. The company expects to have a
net income of Rs. 25,000.
What will be the price of the share at the end of the year if:
i) dividend is not declared and
(ii) a dividend is declared.
Presuming that the company pays the dividend and has to make new
investment of Rs. 48,000 in the coming period, how many new shares be
issued in finance the investment programme? You are required to use the
MM model for the purpose.
Solution:
1) Calculation of P1:
a) When the dividend is not paid:
P1= Po (1+Ke) – D1
= Rs. 100 (1+0.20) - 0
= Rs. 120
b) When the dividend is paid:
P1= Po (1+Ke) – D1
= Rs. 100 (1+0.20) – Rs. 10
= Rs. 110
2) Calculation of the number of new shares to be issued:
m×P1 = I – (X- nD1)
m×Rs.110 = Rs. 48,000 – [Rs. 25,000 – (1,000 shares × Rs. 10)]
Rs. 110m = Rs. 48,000 – Rs. 15,000
Rs. 110m = Rs. 33,000
m = Rs. 33,000/Rs. 110
m = 300 shares
P6. Agile Ltd. belongs to a risk class of which the appropriate capitalisation
rate is 10%. It currently has 1,00,000 shares selling at Rs. 100 each. The firm
is contemplating declaration of a dividend of Rs.6 per share at the end of the
current fiscal year which has just begun. Answer the following questions
based on Modigliani and Miller Model and assumption of no taxes:
(i) What will be the price of the shares at the end of the year if a dividend is
not declared?
(ii) What will be the price if dividend is declared?
(iii) Assuming that the firm pays dividend, has net income of Rs. 10 lakh and
new investments of Rs. 20 lakhs during the period, how many new
shares must be issued?
Solution:
1) Calculation of P1:
a) When the dividend is not paid:
P1= Po (1+Ke) – D1
= Rs. 100 (1+0.10) - 0
= Rs. 110
b) When the dividend is paid:
P1= Po (1+Ke) – D1
= Rs. 100 (1+0.10) – Rs. 6
= Rs. 104
2) Calculation of the number of new shares to be issued:
m×P1 = I – (X- nD1)
m × Rs. 104 = Rs. 20,00,000 – [10,00,000 – (1,00,000 Shares × Rs. 6)]
Rs.104m = Rs. 20,00,000 – Rs. 4,00,000
Rs. 104m = Rs. 16,00,000
m = Rs.16,00,000/Rs.104
m = 15,385 shares
7. Factors determining dividend policy:
• Availability of funds
• Cost of capital
• Capital structure
• Stock price
• Investment opportunities in hand
• Internal rate of return (IRR)
• The trend of the industry
• The expectation of shareholders
• Legal constraints
• Taxation
Thank You