ICWAI Dividend Policy-Financial Management & International Finance Study Material Download

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2.7 Dividend Policy

This Section Includes :
• Dividend Decision and Valuation of Firm
• Walters Model
• Gordon Model
• MM model
• Residual Model
• Divident Discount Model
• Lintner Model
• Types of Dividends and Dividend Policies
• Factors Affecting Dividend Policies
• Stability of Divident
• Share Buyback
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. As a result,
the firm’s decision to pay dividends must be reached in such a manner so as to equitably
apportion the distributed profits and retained earnings. Since dividend is a right of
shareholders to participate in the profits and surplus of the company for their investment in
the share capital of the company, they should receive fair amount of the profits. The company
should, therefore, distribute a reasonable amount as dividends (which should include a normal
rate of interest plus a return for the risks assumed) to its members and retain the rest for its
growth and survival.
DIVIDEND DECISION AND VALUATION OF FIRM :
The value of the firm can be maximized if the shareholders wealth is maximized. There are
conflicting views regarding the impact of dividend decision on the valuation of the firm.
According to one school of thought dividend decision does not affect the share-holders’ 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
groups:
a. The Relevance Concept of Dividend or the Theory of Relevance.
b.The Irrelevance Concept of Dividend or the Theory of Irrelevance
Fianancial Management & international finance 289

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Financial Management Decisions
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.
The Irrelevance Concept of Dividend : The other school of thought propounded by
Modigliani and Miller in 1961. According to 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.
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 Capital, Ke (normal
capitalization rate) in determining such dividend policy as will maximize the wealth of the
stockholders.
Water’s model is based on the following premises:
(1) The firm finance its entire investments by means of retained earnings. New equity
stock or debenture is not issued to raise funds.
(2) Internal rate of return (r) and cost of capital (Ke) of the firm remain constant.
(3) The firm’s earnings are either distributed as dividends or reinvested internally.
(4) Earnings and dividends of the firm never change.
(5) The firm has long or infinite life.
The formula used by Walter to determine the market price per share is :
r
D+ ( E − D)
P= K
K
Where,
P = Market price per share
D = Dividend per share
E = Earnings per share
r = Internal rate of return (Actual capitalization rate)
K = Cost capital (External 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 Water’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 its weighted value under different situations
as discussed below:
290 Fianancial Management & international finance

1. Growth Firms
In growth firms internal rate of return is greater than the normal rate(r > k). Therefore,
r/k factor will 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 Water’s formula than a comparable rupee of dividends.
Thus, large the firm retains, higher the value of the firm. Optimum dividend payout
radio for such a firm will be zero.
2. Normal Firm
Normal firms comprise those firms whose internal rate of return is equal to normal
capitalization (r=k). These firms earn on their investments rate of return equal to market
rate of return. For such firms dividend policy will have no effect on the market value
per share in the 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.
3. Declining Firms
Firms which earn on their investments less than the minimum rare required by
investments are designated as declining firms. The management of such firms would
like to distribute its earnings to the stockholders so that they may either spend it or
invest elsewhere to earn higher return than earned by the declining firms. Under such
a situation each rupee of retained earnings will receive lower weight than dividends
and market value of the firm will tend to be maximum when it does not retain earnings
at all.
4. Evaluation of the Walter’s Model
Professor Walter has endeavoured to show in an erudite manner the effects of dividend
policy on value of equity shares under different situations of a firm. However, the basic
premises on which edifice of the theory is laid down are unrealistic and therefore,
conclusions drawn from the Walter’s model are hardly true for real life situations.
Thus, for instance assume that a firm finances its investment opportunities only by means of
internal sources and no external financing is resorted to for this purpose. Under such a
situation, either the value of the firm’s investment or dividend or both will be sub-optimum.
In its attempt to maximize the value of the firm, the management should go on making
investments so long as return of investment is equal to the cost of capital. This is the optimum
level of investment, the remaining amount should be raised from external sources. On the
contrary, Walter argues that value of the firm is maximized by retaining all the profits because
magnitude of investments financed by retained earnings may be less than the optimum level
of investment.
Further, Professor Walter has assumed that ‘r’ remains constant under all the situations. As
a matter of fact, ‘r’ tends to decrease in correspondence with increase in level of investments.
This is why it is suggested that the management should make investments upto optimal level
where r = k.

Finally, assumption of constant cost of capital k is incorrect. On the contrary, it varies in

tune with change in risk of the firm.
Illustration 1 : The earnings per share of a company is Rs. 8 and the rate of capitalisation
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.
Computation of market price of Company’s share by applying Walter’s formula
Ra
D+ (E − D )
P Rc
=
Rc
Where P = Market price per share
R a = Internal rate of return on investment
Rc = Cost of capital i.e.,10%or 0.10
E = Earnings per share i.e., Rs. 8
Now, we can calculate the market price per share based on different IRRS and dividend
payout rations.
(i) Market price per share when Ra = 15%
When dividend payout ratio is 50%
Dividend paid = 8 × 50/100 = Rs. 4
0.15
4+ (8 − 4)
P= 0.10 = Rs. 100
0.10
(b) When dividend payout ratio is 75%
Dividend paid = Rs. 8×75/100 = Rs. 6
0.15
6+ (8 − 6)
P= 0.10 = Rs. 90
0.10
(c) When dividend payout ratio is 100%
i.e., dividend paid = Rs. 8
0.15
8+ (8 − 8)
P= 0.10 = Rs. 80
0.10

(II) Market price per share when Ra = 10%

(a) When dividend payout ratio is 50% i.e., Rs. 4
0.10
4+ (8 − 4)
P= 0.10 = Rs. 80
0.10
(b) When dividend payout ratio is 75% i.e., Rs. 6
0.10
6+ (8 − 6)
P= 0.10 = Rs. 80
0.10
(c) When dividend payout ratio is 100% i.e., Rs. 8
0.10
8+ (8 − 8)
P= 0.10 = Rs. 80
0.10
(III) Market price per share when Ra = 5%

(a) When dividend payout ratio is 50% i.e., Rs. 4
0.05
4+ (8 − 4)
P= 0.10 = Rs. 60
0.10
(b) When dividend payout ratio is 75% i.e., Rs. 6
0.05
6+ (8 − 6)
P= 0.10 = Rs. 70
0.10
(c) When dividend payout ratio is 100% i.e., Rs. 8
0.05
8+ (8 − 8)
P= 0.10 = Rs. 80
0.10
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.
2. No external financing is available or used. Retained earnings represent the only source
of financing investment programmes.
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 prepetual life.
7. Corporate taxes do not exist.
According to Gordon, the market value of a share is equal to the present value of future
stream of dividends. Thus,
D1 D2 Dt
P = + +
(1 + K ) (1 + K ) 2 (1 + K ) t
n
Dt
=∑
t =1 (1 + K ) t
Gordon’s basis valuation formula can be simplified as under:
E (1 − b )
P =
Ke − br
D
or, P =
Ke − g
Where,
P = Price of shares
E = Earnings per share
b = Retention Ratio
ke = Cost of equity capital
br = g = growth rate in r, i.e., rate of return on investment of an all-equity firm
The implications of Gordon’s basic valuation model may be summarized as below:

1. When the rate of return of firm’s investment is greater than the required rate of return,
i.e. when r > k, the price per share increases as the dividend payout ratio decreases.
Thus, growth firm should distribute smaller dividends and should retain maximum
earnings.
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 by dividend policy. Thus, for a
normal firm there is no optimum dividend payout.

3. When the rate of return is less than the required rate of return, i.e., when r<k, the
price per share increases as the dividend payout ratio increases. Thus, the shareholders
of declining firm stand to gain if the firm distributes its earnings. For such firms, the
optimum pay out would be 100%.
MODIGLIANI-MILLER’S MODEL (M-M’S MODEL) :

Modigliani-Miller’s (M-M’s) thoughts for 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 value of the firm.
Basic Assumptions of M-M Approach

(1) There exists perfect capital market where all investors are rational. Information is
available to all at no cost; there are no transaction costs and floatation costs. There is
no such investor as could alone influence market value of shares.
(2) There does not exist taxes. Alternatively, there is no tax differential between income
on dividend and capital gains.
(3) Firm has uncertainty as to future investments and profits of the firm. Thus, investors
are able to predict future prices and dividend with certainty. This assumption is
dropped by M-M later.
M-M’s irrelevance approach is based on arbitrage argument. Arbitrage is the process of

entering into such transactions simultaneously as exactly balance or completely offset each
other. The two transactions in the present case are payment of dividends and garnering
funds to exploit investment opportunities. Suppose, for example, a firm decides to invest in a
project it has alternatives:
(1) Pay out dividends and raise an equal amount of funds from the market;
(2) Retain its entire earnings to finance the investment programme. The arbitrage
process is involved where a firm decides to pay dividends and raise funds
from outside.
When a firm pays its earnings as dividends, it will have to approach market for procuring
funds to meet a given investment programme. Acquisition of additional capital will dilute
the firms share capital which will result in drop in share values. Thus, what the stockholders
gain in cash dividends they lose in decreased share values. The market price before and after
payment of dividend would be identical and hence the stockholders would be indifferent
between dividend and retention of earnings. This suggests that dividend decision is irrelevant.
M-M’s argument of irrelevance of dividend remains unchanged whether external funds are
obtained by means of share capital or borrowings. This is for the fact that investors are
indifferent between debt and equity with respect to leverage and cost of debt is the same as
the real cost of equity.
Finally, even under conditions of uncertainty, divided decision will be of no relevance because
of operation of arbitrage. Market value of share of the two firms would be the same if they

identical with respect to business risk, prospective future earnings and investment policies.
This is because of rational behavior of investor who would prefer more wealth to less wealth.
Difference in respect of current and future dividend policies cannot influence share values of
the two firms.
M-M approach contains the following mathematical formulations to prove irrelevance of

dividend decision.
The market value of a share in the beginning of the year is equal to the present value of
dividends paid at the year end plus the market price of the share at the end of the year, this
can be expressed as below:
D1 + P1
Po = − − − − − −− → Equation (1)
(1 + K )
Where,
P0 = Existing price of a share
k = Cost of capital
D1 = Dividend to be received at the year end
P1 = Market value of a share at the year end
If there is no additional financing from external sources, value of the firm (V) will be number
of share (n) multiplied by the price of each share (Po). Symbolically:
n ( D 1 + P 1)
V = nPo = − − − − − −− → Equation ( 2 )
(1 + K )
If the firm issues m number of share to raise funds at the end of year 1 so as to finance
investment and at price P1, value of the firm at time o will be:
nD 1 + ( n − m ) P1 − mP1
nPo = − − − − − −− → Equation (3)
1+ K
Thus, the total of the firm as per equation (3) is equation to the capitalized value of the
dividends to be received during the period, plus the value of the number of share outstanding
at the end of the period, less the value of the newly issued shares.
A firm can finance its investment programme either by ploughing back of its earnings
or by issue of new share or by both. Thus, total amount of new share that the firm will issue
to finance its investment will be:
mP 1 = l1 – (X1 - nD1)
= 11 − X 1 + nD1 − − − − − −− → Equation(4)

Where,
mP 1 = Total amount of funds raised by issue of new share to finance investment

projects.
11 = Total amount of investment during first period
X1 = Total amount of net profit during first period
If equation (4) substituted into equation (3), we find the following equation:
( n + m ) P1 − L1 + X 1
nPo = − − − − − −− → Equation 5
1+ K
On comparison of equation (5) with equation (3) we find that there is no difference between
the two valuation equations although equation (5) has expressed the value of firm without
dividends. This led M-M to conclude that dividend policy has no role to play in influencing
share value of a firm.
Criticism of MM Approach
MM hypothesis has been criticised on account of various unrealistic assumptions as given
below.
1. Perfect capital market does not exist in reality.
2. Information about the company is not available to all the persons.
3. The firms have to incur flotation costs while issuing securities.
4. Taxes do exit and there is normally different tax treatment for dividends and capital
gain.
5. The firms do not follow a rigid investment policy.
6. The investors have to pay brokerage, fees etc., while doing any transaction.
7. Shareholders may prefer current income as compared to further gains.
Illustration. 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 diviend 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?
Modigliani and Miller - Dividend Irrelevancy Model
P1 + D1
Po =
1 + Ke

Where,
D1 = Contemplated dividend per share i.e., Rs. 6
P1 = Market price of share at the year end (to be determined)
Po = Existing market price of share i.e., Rs. 100
Ke = Cost of equity capital or rate of capitalisation i.e., 10% or 0.10
(i) If dividend is not declared
⎡ P1 + D1 ⎤
P0 = ⎢ ⎥
⎣ 1+ Ke ⎦
⎡ P1 + 0 ⎤
100 = ⎢ ⎥
⎣1 + 0.10 ⎦
⎡ P1 ⎤
100 = ⎢
⎣1.10 ⎥⎦
100 × 1.10 = P1
P1 = Rs. 110
(ii) If dividend is declared :
⎡ P + D1 ⎤
P0 = ⎢ 1 ⎥
⎣ 1+ K e ⎦
⎡ P1 + 6 ⎤
100 = ⎢ ⎥
⎣1 + 0.10 ⎦
⎡P +6⎤
100 = ⎢ 1 ⎥
⎣ 1.10 ⎦
100× 1.10 = P 1 + 6
110 = P1 + 6
P1 = 110 - 6
P1 = Rs. 104

(ii) Calculation of No. of Shares to be issued

Particulars Dividend Dividend
declared not declared
Net Income 10,00,000 10,00,000
Less : Dividends paid 6,00,000
Retained earnings 4,00,000 10,00,000
New investments 20,00,000 20,00,000
Amount to be raised by issue of new shres (A) 16,00,000 10,00,000
Market pice per share (B) Rs. 104 Rs. 110
New shares to be issued (A)/(B) (C) 15,385 9,091
Alternatively, the number of new shares to be issued is calculated as follows :
I − (E − nD1 )
∆N =
P1
Where,
n= Number of Shares outstanding at the beginning of the period i.e., 1,00,000
shares
∆N = Change in the number of Shares outstanding during the period (to be
ascertained)
I = Total investment required for capital budget i.e., Rs. 20,00,000
E = Earning of the firm during the period after payment of dividend.
If dividend declared =10,00,000 - 6,00,000 = Rs.4,00,000
If no dividend declared = 10,00,000
Now we can calculate the number of new shares to be issued:
(I)If dividend declared:
20 ,00 ,000 − 4 ,00 ,000
∆N = = 15385 Shares
Rs.104
(II) If no dividend declared:
20 ,00 ,000 − 10 ,00 ,000
∆N = = 9091 Shares
110

Verification of M.M. Dividend Irrelevancy Theory

Particulars Dividend Dividend
declared not declared
Existing shares 1,00,000 1,00,000
New shares issued 15,385 9,091
Total No. of shares at the end (i) 1,15,385 1,09,091
Market price per share (ii) Rs. 104 Rs. 110
Total market value of shares at the year end (i)×(ii) Rs. 120 lacs Rs. 120 lacs
Therefore, whether dividends are paid or not, value of the firm remains the same as per
M.M. approach.
RESIDUAL MODEL :
If a firm wishes to avoid issue of shares, then it will have to rely on internally generated
funds to finance new positive NPV projects. Dividends can only be paid out of what is left
over. This leftover is called a residual and such a dividend policy is cllaed residual dividend
approach.
When we treat dividend policy as strictly a financing decision, the payment of cash dividends
is a passive residual. The amount of dividend payount will fluctuate from period to period in
keeping with fluctuations in the number of acceptable investment opportunities available to
the firm. If these oportunities abound, the percentage of dividend payout is likely to be zero.
On the other hand if the firm is unable to find pofitable investment opportunities, dividend
payout will be 100%.
With a residual dividend policy, the firm’s objective is to meet its investment needs and
mostly to maintain its desired debt equity ratio before paying dividends. To illustrate
imagine that a firm has Rs. 1000 in earnings and a debt equity ratio of 0.5. Thus the firm has
0.5 of debt for every 1.5 of the total value. The firms capital structure is 1/3 of debt and 2/3
of equity.
The first stpe in implementing a residual dividend policy is to deermine the amount of funds
that can be generated without selling new equity. If the firm reinvests the entire Rs. 1000 and
pays no dividend, then equity will increase by Rs. 1000. To keep the debt equity ratio constant,
the firm must borrow Rs. 500.
The second stpe is to decide whether or not the dividend will be paid. If funds needed are less
than the funds generated then a dividend will be paid. The amount of dividend will be the
residual after meeting investment needs. Suppose we require Rs. 900 for a project. Then 1/3
will be contributed by debt (i.e. Rs. 300) and the balance by equity/retained earnings. Thus
the firm would borrow Rs. 300 and fund Rs. 600 from the retained earnings. The residual i.e.
Rs. 1000 – Rs. 600 = Rs. 400 would be distributed as dividend.
More clarity can be had from the data givne below :

PAT New Invst. Debt portion Retained Additional Dividends

Earnings Equity
1000 3000 1000 1000 1000 0
1000 2000 667 1000 333 0
1000 1500 500 1000 0 0
1000 1000 333 667 0 333
1000 500 167 333 0 667
1000 0 0 0 0 1000
DIVIDEND DISCOUNT MODEL :
The dividend disocunt model is a more conservative variation of discounted cash flows, that
says a share of stock is worth the present value of its future dividends, rather than its earnings.
This model was popularized by John Burr Williams in The Theory of Investment Value.
... a stock is worth the present value of all the dividends ever to be paid upon it, no more, no
less... Present earnings, outlook, financial condition, and capitalization should bear upon the
price of a stock only as they assist buyers and sellers in estimating future dividends.
The dividend discount model can be applied effectively only when a company is already
distributing a significant amount of earnings as dividends. But in theory it applies to all
cases, since even retained earnings should eventually turn into dividends. That’s because
once a company reaches its “mature” stage it won’t need to reinvest in its growth, so
management can begin distributing cash to the shareholders. As Williams puts it.
If earnings not paid out in dividends are all successfully reinvested... then these earnings
should produce dividends later; if not, then they are money lost... In short, a stock is worth
only what you can get out of it.
The Dividend Discount Model (DDM) is a widely accepted stock valuation tool found in
most introdutory finance and invesment taxtbooks. The model calculates the present value
of the future dividends that a company is expected to apply to its shareholders. It is particularly
useful because it allows investors to determine an absolute or “intrinsic” value of a particular
comapny that is not influenced by current stock market conditions. The DDM is also useful
because the measurement of future dividends (as opposied to earnings for example) facilitates
an “apples-to-apples” comparison of companies across different industries by focusing on
the actual cash investors can expect to receive.
There are three alternative dividend discount models used to determine the intrinsic
value of a share of stock
a. the constant (or no-growth) dividend model;
b. the constant growth dividend model; and
c. the two-stage (or two-phase) dividend growth model.

Constant dividends :
P=D 1 /Ke where : • P = intrinsic value
• D1 = expected dividend
• ke = appropriate discont factor for the investment
This method is useful for analyzing preferred shares where the dividend is fixed. However,
the constant dividend model is limited in that it does not allow for future growth in the
dividend payments for growth industries. As a result the constant growth dividend model
may be more useful in examining a firm.
Constant dividend growth :

P=D1 /(ke-g) where : • P = intrinsic value
• D1 = expected dividend
• ke = appropriate discont factor for the investment
• g = constant dividend growth rate
The constand dividend growth model is useful for mature industries, where the dividend
growth is likely to be steady. Most mature blue chip stocks may be analyzed quickly with the
constant dividend growth model. This model has its limitations when considering a firm
which is in its growth phase and will move into a mature phase at some time the future. A
two stage growth dividend model may be utilized in such situations. This model allows for
adjustment to the assumptions of timing and magnitude of the growth of the firm.
For initial dividend growth & then steady growth :
n
⎡ D 0 (1 + g1 )t ⎤ D 0 (1 + g 2
P= ∑ ⎢
t =1 ⎣ (1 + K e )
t ⎥
⎦
+
ke − g2
where : P = instrinsic value = PV of dividends + PV of price
D 0 = expected dividend
ke = appropriate discount factor for the investment
g1 = initial dividend growth rate
g2 = steady dividend growth rate
LINTNER MODEL :
John Lintner surveyed dividend behavior of several corporate and showed that
a. Firms set long run target payout ratios.
b. Managers are concerned more about change in the dividend than the absolute level
c. Dividends tend to follow earnings, but dividends follow a smoother path than earnings
d. Dividends are sticky in nature because managers have a reluctance to effect dividend
changes that may have to be reversed.

Lintner expressed corporate dividend behavior in the form of a following model :

D t= cr EPSt + (1-c)Dt–1
D t = DPS for year t
c = Adjustment rate or Speed or Adjustment
r = Target Payout Rate
EPS 1 = EPS for year t
D t–1 = DPS for year t–1
The Lintner model shows that the current dividend depends partly on curent earnings and
partly on previous years dividend. Likewise the dividend for the previous year depends on
the earnings of that year and the dividend for the year preceding that year, so on and so
forth. Thus as per the Lintner Model, dividends can be described in terms of a weighted
average of past earnings.
Dividend Dates
What is a Declaration, Record, Ex-Dividend & Payment dates?
Decleration date : The date on which board of directors declare dividend is called a
declaration date.
Record date : Record date, is that date when the company closes its stock transfer
books and makes up a list of the shareholders for payment of dividends.
Ex-dividend date : It is that date notified by the stock exchange, as a date which will
entail a buyer of shares, the dividend, if bought before the ex-dividend
date. This date sets up the convention of declaring that the right to
the dividend remains with the stock until ‘x’ days prior to the Record
date. Thus whoever buys share on or beyond the ex-dividend date
are not entitled to dividend.
Payment date : The date on which the company mails the cheques to the recorded
holders.
Example :
Let us say, settlement of stocks follows “T+3”, which means that, when you buy a stock, it
takes three days from the transaction date (T) for the change to be entered into the comany’s
record books. As mentioned, if you are not in the company’s record books on the date of
record, you won’t receive the dividend payment. To ensure that you are in the record books,
you need to buy stock at least three days before the date of record, which also happens to be
the day before the ex-dividend date.
Ex-Dividend Date Date of Record
Monday Tuesday Wednedsday Thursday Friday
5th 6th 7th 8th 9th

As you can see by the diagram above, if you buy on the ex-dividend date, which is only two
days before the date of record, you will not recive the dividend because your name will not
appear in the company’s record books until Friday. If you want to buy the stock and receive
the dividend, you need to buy it on the Monday the 5th. (When the stock is trading with the
dividend the term “cum dividend” is used). If you want to sell the stock and still receive the
dividend, you need to sell on or after Tuesday the 6th.
TYPES OF DIVIDEND POLICY :

The various types of dividend policies are discussed as follows:
1. Regular Dividend Policy

Payment of dividend at the usual rate is termed as regular dividend. The investors such as
retired persons, widows and other economically weaker persons prefer to get regular dividends.
A regular dividend policy offers the following advantages.
a. It establishes a profitable record of the company.
b. It creates confidence amongst the shareholders.
c. It aids in long-term financing and renders financing easier.
d. It stabilizes the market value of shares.
e. The ordinary shareholders view dividends as a source of funds to meet their day-to-
day living expenses.
f. If profits are not distributed regularly and are retained, the shareholders may have to
pay a higher rate of tax in the year when accumulated profits are distributed.
However, it must be remembered that regular dividends can be maintained only by companies
of long standing and stable earnings. A company should establish the regular dividend at a
lower rate as compared to the average earnings of the company.
2. Stable Dividend Policy

The term ‘stability of dividends’ means consistency or lack of variability in the stream of
dividend payments. In more precise terms, it means payment of certain minimum amount
of dividend regularly. A stable dividend policy may be established in any of the following
three forms.
(a) Constant dividend per share: Some companies follow a policy of paying fixed dividend
per share irrespective of the level of earnings year after year. Such firms, usually,
create a ‘Reserve for Dividend Equalisation’ to enable them to pay the fixed dividend
even in the year when the earnings are not sufficient or when there are losses. A
policy of constant dividend per share is most suitable to concerns whose earnings are
expected to remain stable over a number of years. Figure given below shows the
behavior of dividend in such policy.

EPS
Earnings and
Dividend DPS
Time Years
(b) Constant pay out ratio: Constant pay-out ratio means payment of a fixed percentage
of net earnings as dividends every year. The amount of dividend in such a policy
fluctuates in direct proportion to the earnings of the company. The policy of constant
pay-out is preferred by the firms because it is related to their ability to pay dividends.
Figure given below shows the behavior of dividends when such a policy is followed.
EPS
Earnings and
Dividend DPS
Time Years
(c) Stable rupee dividend plus extra dividend: Some companies follow a policy of paying
constant low dividend per share plus an extra dividend in the years of high profits.
Such a policy is most suitable to the firm having fluctuating earnings from year to
year.

Advantages of Stable Dividend Policy

A stable dividend policy is advantageous to both the investors and the company on account
of the following;
a) It is sign of continued normal operations of the company.
b) It stabilizes the market value of shares.
c) It creates confidence among the investors.
d) It provides a source of livelihood to those investors who view dividends as a source of
funds to meet day-to-day expenses.
e) It meets the requirements of institutional investors who prefer companies with stable
dividends.
f) It improves the credit standing and makes financing easier.
g) It results in a continuous flow to the national income stream and thus helps in the
stabilization of national economy.
Dangers of Stable Dividend Policy

Inspite of many advantages, the stable dividend policy suffers from certain limitations. Once
a stable dividend policy is followed by a company, it is not easier to change it. If the stable
dividends are not paid to the shareholders on any account including insufficient profits, the
financial standing of the company in the minds of the investors is damaged and they may
like to dispose off their holdings. It adversely affects the market price of shares of the company.
And if the company pays stable dividends in spite of its incapacity, it will be suicidal in the
long-run.
3. Irregular Dividend Policy
Some companies follow irregular dividend payments on account of the following:
a. Uncertainty of earnings.
b. Unsuccessful business operations.
c. Lack of liquid resources.
d.Fear of adverse effects of regular dividends on the financial standing of the company.
4. No Dividend Policy
A company may follow a policy of paying no dividends presently because of its unfavourable
working capital position or on account of requirements of funds for future expansion and
growth.
5. Residual Dividend Policy

When new equity is raised floatation costs are involved. This makes new equity costlier than
retained earnings. Under the Residual approach, dividends are paid out of profits after
making provision for money required to meet upcoming capital expenditure commitments.
TYPES OF DIVIDENDS:
Dividends may be declared in the form of cash, stock, scrips, bonds and property. We shall
discuss each of these forms.

1. Cash Dividends
Cash dividend is, by far, the most important form of dividend. In cash dividends stock
holders receive cheques for the amounts due to them. Cash generated by business earnings
is used to pay cash dividends. Sometimes the firm may issue additional stock to use proceeds
so derived to pay cash dividends or approach bank for the purpose. Generally, stockholders
have strong preference for cash dividends.
2. Stock Dividends
Stock dividends rank next to cash dividends in respect of their popularity. In this form of
dividends, the firm issues additional shares of its own stock to the stockholders in proportion
to the number of shares held in lieu of cash dividends. The payment of stock dividends
neither affects cash and earnings position of the firm nor is ownership of stockholders changed.
Indeed there will be transfer of the amount of dividend from surplus account to the capital
stock account which tantamount to capitalization of retained earnings. The net effect of this
would be an increase in number of shares of the current stockholders. But there will be no
change in their equity. With payment of stock dividends the stockholders have simply more
shares of stock to represent the same interest as it was before issuing stock dividends. Thus,
there will be merely an adjustment in the firm’s capital structure in terms of both book value
and market price of the common stock.
3. Stock Splits
Closely related to a stock dividend is a stock split. From a purely economic point of view a
stock split is nothing but a gaint stock dividend. A stock split is a change in the number of
outstanding shares of stock achieved through a proportional reduction of increase in the par
value of the stock. The management employs this device to make a major adjustment in the
market price of the firm’s stock and consequently in its earnings and dividends per share. In
stock split only the par value and number of outstanding shares are affected. The amounts
in the common stock, premium and retained earnings remain unchanged. This is exhibited
in the table. It may be noted from the table that although number of shares was doubled,
capital account of the firm did not change because of proportional reduction in par value of
the stock.
EFFECT OF A 2-FOR-1 STOCK SPLIT ON A FIRM’S EQUITY
Before the Stock Split After the Stock Split

Common Stock (Re. 1 par, 40,000 shares) 4,00,000
0.50 par, 8,00,000 4,00,000
Premium 3,00,000 3,00,000
Retained earnings 40,00,000 40,00,000
47,00,000 47,00,000
Except in accounting treatment, the stock dividend and stock split are very similar. Stock
split is recorded as a doubling of the number of the shares outstanding and having of the par
value per share. For a stock dividend, however, the account increases by the par value of

shares issued, increases the capital-surplus account by the difference between the market
value of the shares issued and the par value, and reduces the retained earnings account by
an amount needed to leave networth unchanged. For both stock splits and stock dividends,
therefore, networth is unaffected. The difference in accounting procedure may be illustrated.
A company has the following networth:

Capital Stock:
Common Shares, Rs. 10 par, 2,00,000 20,00,000
Retained earnings 45,00,000
65,00,000
After a 2-for-1 split, this would appear as follows:

Capital Stock:
65,00,000
After a 100 per cent stock dividend the networth would show as follows (using par value as
a basis for the transfer):
Capital Stock:
65,00,000
Owing to differences in accounting procedure the balance sheet will differ in each case, the
net effect is the same.
A. Reasons for stock splits

A number of reasons may be offered for splitting of the firm’s common stock. These are:
i) Broader Marketability of the stock
The basic reason of stock split is to provide broader and more stable market for the stock. It
is agreed that when stock prices of a company tend to rise sharply due to economic prosperity
of the company and its improved profitability and it is believed that the price of the sock has
moved out of the price range of any investors narrowing the market of stock, the management
may, in a bid to promote wider distribution of shares, resort to stock split. Stock split will
result in lowering price of stock and the stocks will be within easy reach of common investors.
ii) Need for Garnering External Resources

A company contemplating to garner funds from the market may use stock split to prepare
ground for new issues. In times of rising stock prices, market price of shares of profitable and
prosperous companies rises beyond the reach of a large number of investors. In view of
limited saleability of shares, companies may experience a great problem in acquiring desired

amount of capital. Thus, to increase the marketability of new issues, stock split is very often
used.
iii) Merger or Acquisition of Companies
A firm contemplating merger or acquisition through exchange of stock will often split its
stock to make the transactions more attractive to stockholders of the firm it is taking over.
Suppose, for example, Globe Company offers to acquire assets of Alfred Company through
an exchange of stock. The management of Globe Company decides that an exchange ratio
of 1 to 10 (1 share of Globe Company for 10 shares of Alfred Company) would be fair to
stockholders of both companies. However, 1:10 exchange ratio may not appeal to stockholders
of Alfred company and the offer may be rejected. In such a situation stock split may be
employed to make the offer attractive. Thus, the management of Globe Company by splitting
1 share in 5 shares, may put the exchange ratio at 1:2 which may be readily accepted by
stockholders of Alfred Company.
B. Reverse Split
Sometimes, a company may think of reducing the number of shares so as to enhance its
share price. This can be accomplished by means of reverse split which means reduction in
number of outstanding shares. To illustrate, assume a company has 4,00,000 outstanding
shares of Re. 1 share. If the management declares 1-for-2 reverse split, the company will
have 2,00,000 shares of Rs. 2 per share. Under this arrangement stockholders receive fewer
shares with higher par value.
The basic purpose of reverse split is to increase the market value of each share. Companies
experiencing financial trouble usually find their share prices declining in the market. Such
companies follows the policy of reverse split so as to check further price decline and raise it.
The announcement of a reverse split is an indication that the company is in financial jeopardy.
Reverse stock splits are not as common as stock split ups.
Stock splits must be approved by a majority in number, representing three-fourths in value

of members of the firm and approved by a Court of Law. The firm is required to give notice
of this alternation to the Registrar of Joint Stock Companies within 30 days of doing so
(Section 391, Indian Companies Act, 1956).
4. Scrip Dividend
Scrip dividend means payment of dividend in scrip of promissory notes. Sometimes company
needs cash generated by business earnings to meet business requirements because of temporary
shortage of cash. In such cases the company may issue scrip or notes promising to pay
dividend at a future date. The scrip usually bears a definite date of maturity or sometimes
maturity date is not stipulated and its payment is left to the discretion of the Board of Directors.
Scrips may be interest-bearing or non-interest bearing. Such dividends are relatively scarce.
The issue of scrip dividends is justified in the following circumstances:
1. When a company has plentitude of earnings to distribute dividends but cash position
is temporarily meager because bulk of the sale proceeds which are tied in receivable

for time being will be released very shortly, the management in such a situation may
issue certificates to the stockholders promising them to pay dividend in the near future.
2. When a company wants to maintain an established dividend record without paying
out cash immediately, it may take recourse to scrip dividend.
3. When the management believes that stock dividends will not be useful because further
earnings of the company will not increase sufficiently to maintain dividend rate on
increased shareholding, issue of promissory notes to pay dividends in future would
be a wise step.
4. When the company does not wish to borrow to cover its dividend requirements the
danger lies in their use as a sop to stockholders when business earnings are inadequate
to make dividend payments.
Such a form of dividend is non-existent in India.
5. Bond Dividend
As in scrip dividends, dividends are not paid immediately in bond dividends. Instead the
company promises to pay dividends at a future date and to that effect bonds are issued to
stock holders in place of cash. The purpose of both the bond and scrip dividends is alike, i.e.,
postponement of dividend payments. Difference between the two is in respect of the date of
payment and their effect is the same. Both result in lessening of surplus and addition to the
liability of the firm. The only difference between bond and scrip dividends is that the former
carries longer maturity than the latter. Thus, while issue of bond dividend increases long-
term obligation of the company, current liability of the company would rise as a consequence
of the issuance of the scrip-dividends. In bond dividends stockholders have stronger claim
against the company as compared to dividends.
Bond used to pay dividends carry interest. This means that the company assumes fixed
obligation of interest payments annually and principal amount of bond at maturity date. It
should be remembered that the company is assuming this obligation in return for nothing
except credit for declaring dividends. How far the company will be able to satisfy this
obligation in future, is also difficult to predict at the time of issue of bonds. The management
should, therefore, balance cost of issuing bond dividends against benefits resulting from them
before deciding about distribution of dividends in the form of bonds. Bond dividends are not
popular in India.
6. Property Dividends
In property dividend the company pays dividends in the form of assets other than cash.
Generally, asses which are superfluous for the company are distributed as dividends to the
stockholders. Sometimes the company may use its products to pay dividends. Securities of
the subsidiary companies owned by the company may also take the form of property dividends.
This kind of dividend payment is not in vogue in India.
FACTORS AFFECTING DIVIDEND POLICY :

There is a controversy amongst financial analysts regarding impact of dividends on market
price of a company’s shares. Some argue that dividends do not have any impact on such

price while others hold a different opinion. However, preponderance of evidence suggests
that dividend policies do have a significant effect on the value of the firm’s equity shares in
the stock exchange. Having accepted this premise, it will now be appropriate to consider
those factors which affect the dividend policy of a firm.
The factors affecting the dividend policy are both external as well as internal.
External factors
Following are the external factors which affect the dividend policy of a firm:
1. General state of economy - The general state of economy affects to a great extent the
management’s decision to retain or distribute earnings of the firm. In case of uncertain
economic and business conditions, the management may like to retain the whole or a
part of the firm’s earnings to build up reserves to absorb shocks in the future. Similarly
in periods of depression, the management may also withhold-dividends payment to
retain a large part of its earnings to preserve the firm’s liquidity position. In periods of
prosperity the management may not be liberal in dividend payments though the
earning power of a company warrants it because of availability of larger profitable
investment opportunities.
Similarly in periods of inflation, the management may withhold dividend payments

in order to retain larger proportion of the earnings for replacement of worn-out assets.
2. Legal restrictions - A firm may also be legally restricted from declaring and paying
dividends. For example, in India, the companies Act, 1956 has put several restrictions
regarding payments and declaration of dividends. Some of these restrictions are as
follows:
(i) Dividends can only be paid out of (a) the current profits of the company, (b)
the past accumulated profits or (c) money provided by the Central or State
Governments for the payment of dividends in pursuance of the guarantee
given by the Government. Payment of dividend out of capital is illegal.
(ii) A company is not entitled to pay dividends unless (a) it has provided for present
as well as all arrears of depreciation, (b) a certain percentage of net profits of
that year as prescribed by the Central Government not exceeding 10%, has
been transferred to the reserves of the company.
(iii) Past accumulated profits can be used for declaration of dividends only as per
the rules framed by the Central Government in this behalf.
Similarly, the Indian Income Tax Act also lays down certain restrictions on payment of
dividends. The management has to take into consideration all the legal restrictions before
taking the dividend decision otherwise it may be declared as ultra vires.

Internal factors
The following are the internal factors which affect the dividend policy of a firm:
1. Desire of the shareholders - Of course, the directors have considerable liberty
regarding the disposal of the firm’s earnings, but the shareholders are technically the
owners of the company and, therefore, their desire cannot be overlooked by the
directors while deciding about the dividend policy.
Shareholders of a firm expect two forms of return from their investment in a firm:
(i) Capital gains - The shareholders expect an increase in the market value of the
equity shares held by them over a period of time. Capital gain refers to the
profit resulting from the sale of capital investment i.e., the equity shares in
case of shareholders. For example, if a shareholder purchases a share for Rs.
40 and later on sells it for Rs.60 the amount of capital gain is a sum of Rs. 20.
(ii) Dividends - The shareholders also expect a regular return on their investment
from the firm. In most cases the shareholders’ desire to get dividends takes
priority over the desire to earn capital gains because of the following reasons:
(a) Reduction of uncertainty - Capital gains or a future distribution of earnings
involves more uncertainty than a distribution of current earnings.
(b) Indication of strength - The declaration and payment of cash dividend
carries an information content that the firm is reasonably strong and healthy.
(c) Need for current income - Many shareholders require income from the
investment to pay for their current living expenses. Such shareholders are
generally reluctant to sell their shares to earn capital gain.
2. Financial needs of the company - The financial needs of the company are to be
considered by the management while taking the dividend decision. Of course, the
financial needs of the company may be in direct conflict with the desire of the
shareholders to receive large dividends. However, a prudent management should
give more weightage to the financial needs of the company rather than the desire of
the shareholders. In order to maximize the shareholders’ wealth, it is advisable to
retain earnings in the business only when company has better profitable investment
opportunities as compared to the shareholders. However, the directors must retain
some earnings, whether or not profitable investment opportunity exists, to maintain
the company as a sound and solvent enterprise.
3. Desire of control - Dividend policy is also influenced by the desire of shareholders or

the management to retain control over the company. The issue of additional equity
shares for procuring funds dilutes control to the detriment of the existing equity
shareholders who have a dominating voice in the company. At the same time, recourse
to long-term loans may entail financial risks and may prove disastrous to the interests
of the shareholders in times of financial difficulties.
In case of a strong desire for control, the management may be reluctant to pay
substantial dividends and prefer a smaller dividend pay out ratio. This is particularly
true in case of companies which need funds for financing profitable investment

opportunities and an outside group is seeking to gain control over the company.
However, where the management is strongly in control of the company either because
of substantial shareholdings or because of the shares being widely held, the firm can
afford to have a high dividend pay out ratio.
4. Liquidity position - The payment of dividends results in cash outflow from the firm.
A firm may have adequate earnings but it may not have sufficient cash to pay dividends. It
is, therefore, important for the management to take into account the cash position and the
overall liquidity position of the firm before and after payment of dividends while taking the
dividend decision. A firm may not, therefore, be in a position to pay dividends in cash or at
a higher rate because of insufficient cash resources. Such a problem is generally faced by
growing firms which need constant funds for financing their expansion activities.
STABILITY OF DIVIDEND :
Another important diemention of a dividend policy is the stability of dividends i.e. how
stable, regular or steady should the dividend stream be, over time? It is generally said that
the shareholders favour stable dividends and those dividends, which have prospects of steady
upward growth. If a firm develops such a pattern of paying stable and steady dividends,
then the investors/shareholders may be willing to pay a higher price for the shares. So while
designing a dividend policy for the firm, it is also to be considered as to whether the firm will
have a consistency in dividend payments or the dividends will fluctuate from one year to
another. In the long run, every firm will like to have a consistent dividend policy, yet
fluctuations from one year to another may be unfavourable.
Rationale for stability or dividend
Most of the firms follow stable dividends or gradually increasing dividends due to following
reasons —
a. Many investors consider dividends as a part of regular income to meet their expenses.
Hence, they prefer a predictable pattern of dividends rather than fluctuating pattern.
A fall in the dividend inocme may lead to sale of some shares. On the other hand
when the dividend income increases, an investor may invest some of the proceeds as
reinvestment in shares. Both the cases involve transaction cost and inconvenience for
investor. Hence, they prefer regular dividends.
b. The dividend policy of firms conveys a lot to the investors. Increasing dividends means
better prospects of the company. On the contrary, decreasing dividends suggest bad
earnings expectations. In addition, stable dividends are sings of stable earnings of the
company. On the other hand, varying dividends lead to uncertainty in the mind of
shareholders.
c. Certain investors mainly institutional, consider the stability of dividends as an
important criterion before they decide on the investment in that particular firm.
SHARE BUYBACK (REPURCHASE) :
When companies have sufficient liquid assets they resort to share buy back or share repurchase,
wherein they cancel or retire a part of its outstanding shares by purchasing from the market
or directly from the shareholders. This is particularly relevant when the shares are available

in the market much below its book value. When the shares are repurchased, the underlying
motive is to distribute the excess cash to the shareholders. The cancellation of shares means
the shareholders will receive cash for their shares, reduced outstanding number of shares in
the books of the coampany, earnings per share increase and also market price of the share
increases.
There are three methods of shares repurchase :
a. Repurchase Tender Offer : Here the firm specifies the number of shares it proposes
to buy back, the price it would pay and the time period for which the offer would be
open for the shareholders to tender their shares. The firm may retain the flexibility to
withdraw the offer if insufficient number of shares are submitted for repurchase.
b. Open Market Repurchase : Here the firm buys from the market at the prevailing
price. The time period is generally longer than that is adopted for Tender Offers. In
terms of flexibility, the open maket repurchase provides the firm more fredom in
deciding when to repurchase and how many shares to be repurchased.
c. Negotiated Repurchase : In this case the firm may buy shares from a large shareholder
at a negotiated pice. This is adopted only when a large shareholder groups viz.
promoters, are willing to sell their stake.
Let S denote the number of outstanding shares. Po be the current market price and le N be
the number of shares that would be bought back by the company then
S × P0
Theoretical post Buy Back price (P1) is given as = . As it can be seen the price after buy
S−N
back would increase, as the number of shares outstanding gets reduced.
Advantages of Shares Repurchase over Dividends
1. Cash dividend implies a commitment on the part of a company to continue payments
in future, as investors keep expectivng them. However, share repurchase is an one
time affair.
2. The decision to repurchase the shares offers a company more flexibility as to number
of shares, the period etc.
3. Share repurchase are more focused in terms of paying out cash only to those
shareholders who need it. However, dividends are paid to all.
4. Share buy back provide a way of increasing insiders control in the firm. If only outsiders
tender their shares, automatically insiders control increases.
When Share buyback is adopted by the companies?
a. If excess cash flows are temoporary, share repurchase can be adopted. If cash flows
are stable, then the firm may prefer to give dividends.
b. Firms uncertain about their future investment opportunities in the business are more
likely to use share repurchase as a means of returning cash to shareholders.
c. The share repurchase is relevant especially when the shares of the firm are undervalued.
d. When the promoters want to increase their control in the firm they use share buyback
to the maximum effect.

Clientele effect
Investors have diverse preferences. Some want more dividend income; others want more
capital gains; still others want a balanced mix of dividend income and capital gains. Over a
period of time, investors naturally migrate to firms which have a dividend policy that matches
their preferences. The concentration of investors in comapanies with dividend policies that
are matched to their preferences is called the clientele effect. The existence of a clientele
effect implies that (a) firms get investors they deserve and (b) it will be difficult for a firm to
change and established dividend policy.
PROBLEMS AND SOLUTIONS:

Illustration 1
A company has following capital:
7% Preference Shares of Rs.100 each 6,00,000
Ordinary Shares of Rs.10 each 16,00,000
22,00,000
The following information are available relating to its financial year ending 31-12-84:
i) Profit, after taxation @ 40%, Rs.5,42,000
ii) Ordinary dividend paid 20%.
iii) Depreciation Rs.1,20,000
iv) Market price of Ordinary Shares Rs.40
v) Capital Commitment Rs.2,40,000.
You are required to calculate the following:
a) The dividend yield on the Ordinary Shares.
b) The cover for the preference and Ordinary dividends.
c) The earnings yield,
d) The price-Earning ratio,
e) The Net Cash Flow,
f) The reason for the comparison of net cash flow with capital commitment.
Solution :
a) Dividend yield on ordinary shares (or) dividend yield ratio
= (DPS / market price) x 100
= (10 x 20% / 40) x 100
= 5%
[Market price = Capitalized value of dividend]

b) Dividend coverage ratio:

ð preference = (PAT / Preference dividend)
= 542000 / 42000
= 12.9 times
=> Equity = (PAT – Preference dividend) / equity dividend
= 500000 / 320000
= 1.5625 times
c) Earnings yield ratio = (EPS / market price ) x 100
= (3.125 / 40) x 100
= 7.8125 %
[EPS = 500000 / 160000 = Rs 3.125]
d) Price Earning Ratio = [(40 / 3.125)] = 12.8 times
(Market price / EPS)
e) Net cash flow Rs
PAT 542000
(+) depreciation 120000
662000
(-) preference dividend 42000
(-) equity dividend 320000
Net cash flow 300000
f) Since the cash flow position shows the firms ability to meet the capital expenditure
/ capital commitment.
Illustration 2
ABC Ltd. has a capital of Rs.10 lakhs in equity shares of Rs.100 each. The shares currently
quoted at par. The company proposes declaration of a dividend of Rs.10 per share at the end
of the current financial year. The capitalisation rate for the risk class to which the company
belongs is 12%.
What will be the market price of the share at the end of the year, if
i) A dividend is not declared?
ii) A dividend is declared?
iii) Assuming that the company pays the dividend and has net profits of Rs.5,00,000
and makes new investments of Rs.10 lakhs during the period, how many new
shares must be issued? Use the M.M. model.

Solution :
Modigliani – Miller Approach
n = no of shares = 10000
P0 = market price = Rs100
D1 = Expected dividend = Rs10
Ke = cost of capital = 12%
i. Market price of share ( P1) if dividend not declared
Given D1 = 0
We know,
P0 = (D1+P1)/ (1+Ke)
ð P1 = 112
ii. P1 if dividend declared
D1 = Rs10
P0 = (D1+P1) / (1+ Ke )
P1 = Rs.102
iii. No of shares to be issued:
Dn = (I – E + n D1 )/ P1
= (1000000 – 500000 + 100000) / 102
= 5882 shares
Illustration 3
A textile company belongs to a risk-class for which the appropriate PE ratio is 10. It currently
has 50,000 outstanding shares selling at Rs.100 each. The firm is contemplating the declaration
of Rs.8 dividend at the end of the current fiscal year which has just started. Given the
assumption of MM, answer the following questions.
i) What will be the price of the share at the end of the year: (a) if a dividend is not
declared, (b) if its is declared?
ii) Assuming that the firm pays the dividend and has a net income of Rs.5,00,000
and makes new investments of Rs.10,00,000 during the period, how many new
shares must be issued?
iii) What would be the current value of the firm: (a) if a dividend is declared, (b) if a
dividend is not declared?

Solution :
Given,
P/E ratio = 10
n = 50,000shares
P0 = Rs. 100
D1 = Rs. 8
E = Rs. 5,00,000
I = Rs. 10,00,000
Ke = 1 / (P/E ratio)
1. Calculation of P1
1. if dividend not declared:
P0 = (D1+ P1) / (1+Ke)
P1 = Rs110
2. if dividend declared:
P0 = (D1+ P1) / (1+Ke)
P1 = Rs.102
3. If the company pay dividend:
P1 = Rs. 102
Dn = (I – E +nD1) / P1
No of new shares, Dn = 900000 / 102 = 8823.5294 shares
4. Value of the firm:
a) If the company pay dividend:
V = (n + Dn) P1 = (58823.5294) 102
= Rs. 6000000
b) If the company does not pay dividend:
V = (n+Dn) P1 = 54545.4545 x 110
= Rs. 6000000
Working notes:
Dn = (1000000 - 500000) / 110 = 4545.4545

Illustration 4
(i) From the following information supplied to you, ascertain whether the firm’s D/P ratio is
optimal according to Walter. The firm was started a year ago with an equity capital of Rs. 20
lakh.
Earnings of the firm Rs. 2,00,000.00
Dividend paid 1,50,000.00
P/E ratio 12.50
Number of shares outstanding, 20,000 @ Rs.100 each. The firm is expected to maintain its
current rate of earnings on investment.
ii) What should be the P/E ratio at which the dividend payout ratio will have no effect on the
value of the share?
iii) Will your decision change if the P/E ratio is 8, instead of 12.5?
Solution :
i. Ke = (EPS / market price) = 1 /(12.5) = 8 %
r = (200000 / 2000000) x 100 = 10 %
Payout ratio = (150000/200000) x 100 = 75%
It is the growth firm (r > Ke), as per WALTER’s model the optimum payout ratio is Zero.
So in the given case pay out ratio is not optimum.
Proof:
a). Market price at 75% payout ratio
EPS = Rs10
DPS =Rs7.5
r = 10 % & Ke = 8%
r
DPS + (EPS − DPS)
Market Price = Ke
Ke
0.1
7.5+ (2.5)
Market Price = 0.08 = Rs. 132.81
0.08
b). Market price at zero payout:
EPS = Rs10
DPS = Rs0
r = 10 % & Ke = 8 %
r
DPS + (EPS − DPS)
Market Price = Ke = 156.25
Ke

Therefore Zero Payout is optimum.

i. The payment of dividend in case of normal firms(r = Ke) has no effect on the market
value of the share.
Ke = r = 10%
P/E ratio = 10times i.e [ 1 / Ke]
ii. If P/E ratio = 8 , Ke= 12.5 %
r = 10%
When r < Ke the firm is Decline firm as per WALTER and its Optimum payout ratio is
100%.
So in the given case it is 75% payout only, it is not optimum payout.
Proof:
Market price at 75% payout:
r
DPS + (EPS
Market Price = Ke
Ke
At 100% payout.
r
DPS + (EPS
Market Price = Ke
Ke
Illustration 5
Excellence Ltd registered earnings of Rs. 800,000 for the year ended 31st March. They finance
all investments from out of retained earnings. The opportunities for investments are many.
If such opportunities are not availed their earnings will stay perpetually at Rs. 800,000.
Following figures are relevant.
Policy Retention (%) Growth (%) Cost of equity on all investments.
A 0 0 14
B 25 5 15
C 40 7 16
The returns to shareholders are expected to rise if the earnings are retained because of the
risk attached to new investments. As for the current year, dividend payments will be made
with or without retained earnings. What according to you, should be retained ?

Solution :
D0 (1 + g)
GORDAN Model: Market Price =
K0 - g
Evaluation of different dividend policies:
Policy A Policy B Policy C

Retention ratio 0% 25 % 40%
Payout ratio 100% 75% 60%
g 0% 5% 7%
Dividend (D0) 800000 600000 480000
D1 800000 630000 513600
Ke 14 % 15% 16%
Value of firm [(D 1)/ (Ke-g)] 5714286 6300000 5706667
(Add) dividend 800000 630000 513600
Cum dividend Value of firm 6514286 6930000 6220267
From the above policies, policy B gives more value to the share holders. Hence it is advisable
to adopt the policy B.
Illustration 6
X Ltd. has 1000 shares of Rs 10 each raised at a premium of Rs. 15 per share. The company’s
retained earnings are Rs. 552500. The Company’s stock sells for Rs. 20 per share.
a. If a 10% stock dividend is declared how may new shares would be issued?
b. What would be the market price after the stock dividend?
c. How would the equity account change?
d. If a 25% stock dividend is declared what changes will take place?
e. If the company instead declares a 5:1 stock split, how many shares will be outstanding?
What would be the new part value? What would be the new market price?
f. If the company declares a 1:4 reverse split, how many shares will be outstanding? What
would be the new par value? What would be the new market price?
g. If the company declares a dividend of Rs. 2 per share and the stock goes ex dividend
tomorrow, what will be the price at which it will sell?

Solution :
a) If 10% stock dividend declared:
No of new shares issued as bonus = 100
b) Market price after bonus issue = [(1000 x 20) + (100 x 0 )] / 1100
= Rs.18.18
c) Change in equity account
Equity share capital increased by Rs1000
Reserves decreased by Rs1000.
Hence, there is no change in the Net Equity
d) If 25% stock dividend declared
1) No new shares issued = 1000 @ 25 % = 250 shares
2) Market price after stock dividend = [(1000 x 20) + (250 x 0)] / 1250
= Rs.16
3) Change in EQUITY account:
Capital increased by Rs. 2500
Reserve decreased Rs.2500
There is no change in Net Equity.
e) If the company declares 5 : 1 stock split i.e. 5 shares issued in exchange of 1 share
each.
No of shares outstanding = 5000
New face value of share = 10/ 5 = Rs.2
New market price = 20 / 5 = Rs.4
f) If the company declares 1: 4 reverse split i.e 1 share issued in exchange of every 4
shares.
No of shares outstanding = 250
New face value = 4 x 10 = Rs.40
Market price = 20 x 4 = Rs.80
g) Cum dividend market price = Rs. 20
(-) dividend = 2
Ex-dividend market price Rs. 18
Illustration 7
Following is the capital structure of Progressive Co. Ltd. as on 31st March, 2003.
Rs.
Equity Share Capital (1,00,000 shares of Rs. 10 each) 10,00,000
Share premium 15,00,000
Reserves & Surpluses 5,00,000
Net worth 30,00,000

On 1st April, 2001, the company made a bonus issue of two shares for every five held. The
market price at the time of bonus issue was Rs. 40 per share. X holds 100 shares of the
Progressive Co. Ltd. purchased on 1st April, 1997 a market price of Rs. 30. He sold these
shares on 31st March, 2003 at Rs. 50 per share. The income – tax rate for X is 20% and capital
gain tax is 15% for him. If the company pays a regular dividend of 10% on par before
transferring earnings to reserves and surpluses, state whether X was able to earn his re-
quired rate of return of 10% on his investment? (The PV at 10% 1st year 0.91; 2nd year 0.83;
3rd year 0.75; 4th year 0.68; 5th year 0.62 and 6th year 0.56).
Solution :
Appraisal of Investment decision: [NPV method ]
1) Initial Investment (out flow):
100 shares @ 30 each = 3000
2) Present value recurring cash inflows
Year Dividend Tax Net cash Pv factor Present value

inflow @ 10%
1 100 20 80 0.91 72.80
2 100 20 80 0.83 66.40
3 100 20 80 0.75 60.00
4 140 28 112 0.68 76.16
5 140 28 112 0.62 69.44
6 140 28 112 0.56 62.72
386.00
3) Present value of terminal cash inflow:

Sale proceeds 140shares@ 50 each = 7000
(-) capital gain tax 4000@ 15% = 600
6400
Its present value = 6400 x 0.56 = 3584
4) NET PRESENT VALUE:

Present value of cash inflow (386+3584) = 3970
(-) outflow 3000
Net present value 970
The investment yields more than 10 % return to the investor.
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2.7 Dividend Policy

Fianancial Management & international finance 289

290 Fianancial Management & international finance

Fianancial Management & international finance 291

Finally, assumption of constant cost of capital k is incorrect. On the contrary, it varies in

292 Fianancial Management & international finance

(II) Market price per share when Ra = 10%

(III) Market price per share when Ra = 5%

Fianancial Management & international finance 293

Gordon’s basis valuation formula can be simplified as under:

The implications of Gordon’s basic valuation model may be summarized as below:

294 Fianancial Management & international finance

MODIGLIANI-MILLER’S MODEL (M-M’S MODEL) :

Basic Assumptions of M-M Approach

M-M’s irrelevance approach is based on arbitrage argument. Arbitrage is the process of

Fianancial Management & international finance 295

M-M approach contains the following mathematical formulations to prove irrelevance of

296 Fianancial Management & international finance

mP 1 = Total amount of funds raised by issue of new share to finance investment

Fianancial Management & international finance 297

(i) If dividend is not declared

(ii) If dividend is declared :

298 Fianancial Management & international finance

(ii) Calculation of No. of Shares to be issued

Alternatively, the number of new shares to be issued is calculated as follows :

Fianancial Management & international finance 299

Verification of M.M. Dividend Irrelevancy Theory

300 Fianancial Management & international finance

PAT New Invst. Debt portion Retained Additional Dividends

Fianancial Management & international finance 301

Constant dividend growth :

302 Fianancial Management & international finance

Lintner expressed corporate dividend behavior in the form of a following model :

Ex-Dividend Date Date of Record

Monday Tuesday Wednedsday Thursday Friday

5th 6th 7th 8th 9th

Fianancial Management & international finance 303

TYPES OF DIVIDEND POLICY :

1. Regular Dividend Policy

2. Stable Dividend Policy

304 Fianancial Management & international finance

Fianancial Management & international finance 305

Advantages of Stable Dividend Policy

Dangers of Stable Dividend Policy

5. Residual Dividend Policy

306 Fianancial Management & international finance

EFFECT OF A 2-FOR-1 STOCK SPLIT ON A FIRM’S EQUITY

Before the Stock Split After the Stock Split

Fianancial Management & international finance 307

A company has the following networth:

After a 2-for-1 split, this would appear as follows:

A. Reasons for stock splits

ii) Need for Garnering External Resources

308 Fianancial Management & international finance

Stock splits must be approved by a majority in number, representing three-fourths in value

Fianancial Management & international finance 309

FACTORS AFFECTING DIVIDEND POLICY :

310 Fianancial Management & international finance

Similarly in periods of inflation, the management may withhold dividend payments

Fianancial Management & international finance 311

3. Desire of control - Dividend policy is also influenced by the desire of shareholders or

312 Fianancial Management & international finance