22502650 Dividend Policies

8/3/2019 22502650 Dividend Policies

1/23


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Is the part of business income which is

among shareholders

Paid on equity as well as preference shares


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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.


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As a long term financing decision

As maximization of wealth decision


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Capital gain

Dividends

Reduction of uncertainty

indication of strength

need of current income


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Cash dividend

Stock dividend or bonus share

Interim dividend

Extra dividend

Property dividend

Composite dividend


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Steady dividends at the present level policy

Steady dividends at a lower level policy

Steady dividend at higher level policy

Dividend fluctuating with earning policy

Low regular dividends plus extra dividend

Policy of eliminating the dividend policy


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Financial needs of company

Liquidity

Growth prospects

Availability of funds

Earning stability

Control

Taxes Inflation

Investment opportunities


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Dividend Theories

Relevance Theories(i.e. which consider

dividend decision to

be relevant as it

affects the value of

the firm)

Irrelevance Theories(i.e. which consider

dividend decision to be

irrelevant as it does not

affects the value of the

firm)

Walters ModelGordons

Model

Modigliani and

Millers Model


10/23

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 growthare relevant in valuation of shares.

According to Gordon, The dividend policy of

a firm affects its value.


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External financing is not used in the firm. Retainedearnings represent the only source of financing.

The internal rate of return is the firms cost of

capital k. It remains constant and is taken as theappropriate discount rate.

Future annual growth rate dividend is expected to beconstant.

Cost of Capital is always greater than the growth

rate. Corporate taxes does not exist.

The retention ratio b once decided upon, remainconstant. Therefore, the growth rate g is alsoconstant forever.


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P= E(1-b)

Ke br

Where:-P=price of share

E=earning per share

(1-b)=percentage of earning as dividend

b=Required rate of returnr=rate of return on investment

br=growth rate of earnings and

dividends


13/23

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 theireffect on future dividends. Walter has

formulated this and used the dividend to

optimize the wealth of the equity

shareholders.


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D + r (E-D)

k

P = k

Where,

P = Current Market Price of equity share

E = Earning per share

D = Dividend per share

(E-D) = Retained earning per sharer = Rate of Return on firms investment or Internal

Rate of Return

k = Cost of Equity Capital


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y All financing is done through retained earningsand external sources of funds like debt or newequity capital are not used. Retained earningsrepresents the only source of funds.

y With additional investment undertaken, thefirms business risk does not change. It impliesthat firms IRR and its cost of capital areconstant.

y The return on investment remains constant.

y The firm has an infinite life and is a goingconcern.

y There is no change in the key variables such asEPS or DPS.


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Case If Dividend Payoutratio Increases

If Dividend PayoutRation 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 ofDeclining firm i.e.where r < k

Market Value of Shareincreases

Market Value of sharedecreases

3. In case of normal

firm i.e. where r = k

No change in value of

Share

No change in value of

Share


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No External Financing

Firms internal rate of return does not always

remain constant. In fact, r changes as e is

changes in the investment. Firms cost of capital does not always remain

constant. In fact, k changes directly with the

firms risk.


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According to M-M, under a perfect market

situation, the dividend policy of a firm is

irrelevant as it does not affect the value of

the firm. They argue that the value of thefirm depends on the firms earnings and

firms earnings are influenced by its

investment policy and not by the dividend

policy


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

Firms Earnings

Firms Investment Policy and not on dividend policy

Depends on

Depends on


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Perfect Capital Market: This means that:

The investors are free to buy and sell securities.

There are no transaction cost/ flotation cost.

They are well informed about the risk-return on alltypes of securities.

No investor is large enough to affect the market

price of a share.

No Taxes

Fixed Investment Policy

No Risk


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According to M-M model the market price of

a share, after dividend declared, is

calculated by applying the following

formula:P1 + D1

1 + KeWhere,

P0 = current market price of a share

P1 = Market Price of a share at the end of the

period one

D1 = Dividend to be received at the end of

period one

P0 =


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The number of shares to be issued to implement

the new projects is ascertained with the help of the

following:I (E-nD1)

P1Where,

N = Change in the number of shares outstanding during the period.

I = Total Investment amount required for capital budget

E = Earning of net income of the firm during the period

n = Number of shares outstanding at the beginning of the period

D1 = Dividend to be received at the end of period one

P1 = Market price of a share at the end of period one

N =


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No perfect Capital Market

Existence of Transaction Cost

Existence of Floatation Cost

Lack of Relevant Information

Taxes Exist

No fixed investment Policy

Investors desire to obtain current income

22502650 Dividend Policies

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