Dividend Policy

What is Dividend Policy

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.

INTRODUCTION The term dividend refers to that part of profits of a company

which is distributed by the company among its shareholders. The investors basically have two desires, a) high percentage of dividends & b) increase in their investment. These two factors influence the dividend policies. The percentage of dividend is mainly a decision of the management which is decided on the basis of the present earnings, growth rate and opportunities for expansion & diversification. 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 profits. The company should therefore distribute a reasonable amount as dividends to its members and retain the root funds for its growth and survival.

MEANING
DIVIDEND:- It refers to the divisible profits of a company distributed or divided among its shareholders in proportion to their shareholdings.
DIVIDEND POLICY:- It is that policy of management of a company concerning the portion of profits to be distributed to shareholders as dividend & portion of profits to be retained in the company as retained earnings.

DIVIDEND DECISION:- It is concerned with allocation of profit towards payment of dividends to the shareholders as well as rate of retained earnings.

FACTORS INFLUENCING DIVIDEND POLICY

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. Stability of earnings Financial policy of the company Liquidity of funds Dividend policy of competitive concerns Past dividend rates Debt obligations Ability to borrow Growth need of the company Profit rate Legal requirement Policy of control Corporate taxation policy Tax position of shareholders Effects of trade cycle Attitude of interested group

TYPES/FORMS OF DIVIDEND POLICY

1.

REGULAR DIVIDEND POLICY The payment of dividend at the usual rate is termed as regular dividend. ADVANTAGES

Establishing a profitable record of the company. Creating confidence amongst the shareholders. It aids in long term financing & renders financing easier. Establishing the market value of shares. The ordinary shares view dividends as a source of funds to meet their day-to-day living expenses.

2. STABLE DIVIDEND POLICY The term stability of dividend means consistency or lack of variability in the stream of dividend payment to the shareholders. A stable dividend policy may be established in any of the following 3 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. b. Constant pay-out ratio:- It means payment of a fixed percentage of net earnings as dividends every year. 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.

3. IRREGULAR DIVIDEND POLICY Some companies follow irregular dividend payments on account of the following: Uncertainty of earnings Unsuccessful business operations Lack of liquid resources Fear of adverse effects of regular dividends on the financial standing of the company.

4 4. NO DIVIDEND POLICY

A company may follow a policy of paying no dividend presently because of its unfavourable working capital position on account of requirements of funds for future expansion and growth.

FORMS OF DIVIDEND
Dividends can be classified into various forms. Profit dividends Liquidation dividends. Dividends may also be classified on the basis of medium in which the payment made. They are, I. Cash dividend II. Scrip dividend III. Bond dividend IV. Property dividend V. Stock dividend/ Bonus shares

I.

II.

III.

IV.

V.

CASH DIVIDEND:- It is the dividend which is distributed to the shareholders in cash out of the earnings of the business. SCRIP DIVIDEND:- The shareholders are issued transferrable promissory notes which may/ may not be interest bearing. The objective of scrip dividend is to postpone the immediate payment of cash. BOND DIVIDEND:- The shareholders may have to wait few months to convert their bonus into cash. PROPERTY DIVIDEND:- This dividend is paid in the form of some assets other than cash. STOCK DIVIDEND:- If a company does not have liquid resources, it is better to declare stock dividend.

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 Model

Gordons Model

Modigliani and Millers Model

Walters Valuation Model

Prof. James E Walter argued that in the longrun the share prices reflect only the present value of expected dividends. Retentions influence stock price only through their effect on future dividends. Walter has formulated this and used the dividend to optimize the wealth of the equity shareholders.

Formula of Walters Model

D + r/k (E-D) P= k

Where, P = Current Market Price of equity share E = Earning per share D = Dividend per share (E-D) = Retained earning per share r = Rate of Return on firms investment or Internal Rate of Return k = Cost of Equity Capital

Assumptions of Walters Model

All financing is done through retained earnings and external sources of funds like debt or new equity capital are not used. Retained earnings represents the only source of funds. With additional investment undertaken, the firms business risk does not change. It implies that firms IRR and its cost of capital are constant. The return on investment remains constant. The firm has an infinite life and is a going concern. All earnings are either distributed as dividends or invested internally immediately. There is no change in the key variables such as EPS or DPS.

Effect of Dividend Policy on Value of Share

Case If Dividend Payout ratio Increases Market Value of Share decreases Market Value of Share increases If Dividend Payout Ration decreases Market Value of a share increases Market Value of share decreases

1. In case of Growing firm i.e. where r > k 2. In case of Declining firm i.e. where r < k

3. In case of normal firm i.e. where r = k

No change in value of Share

No change in value of Share

Criticisms of Walters Model

No External Financing Firms internal rate of return does not always remain constant. In fact, r decreases as more and more investment in made. Firms cost of capital does not always remain constant. In fact, k changes directly with the firms risk.

Illustration 1 (In case of Growing Firm)

The earnings per share of a company are Rs. 10. The Equity Capitalization rate is 10%. Internal Rate of return on retained earnings is 20%. Using Walters formula:
What

should be the optimum payout ratio of the company? What should be the price of share at optimum payout ratio? How shall this price be affected if different payout (say 80%) were employed?

Illustration 2 (In case of Normal Firm)

The earnings per share of a company are Rs. 10. The Equity Capitalization rate is 10%. Internal Rate of return on retained earnings is 10%. Using Walters formula:
What

should be the optimum payout ratio of the company? What should be the price of share at optimum payout ratio? How shall this price be affected if different payout (say 80%) were employed?

Illustration 3 (In case of Declining Firm)

The earnings per share of a company are Rs. 10. The Equity Capitalization rate is 20%. Internal Rate of return on retained earnings is 10%. Using Walters formula:
What

should be the optimum payout ratio of the company? What should be the price of share at optimum payout ratio? How shall this price be affected if different payout (say 80%) were employed?

GORDONS MODEL OF DIVIDEND POLICY

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 growth are relevant in valuation of shares. The model holds that the shares market price is equal to the sum of shares discounted future dividend payment.

Assumptions of Gordon Growth Valuation Model.

The firm is an all equity firm and has no debt External financing is not used in the firm. Retained earnings 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 the appropriate discount rate. Future annual growth rate dividend is expected to be constant. Growth rate of the firm is the product of retention ratio and its rate of return. Cost of Capital is always greater than the growth rate. The company has perpetual life and the stream of earnings are perpetual. Corporate taxes does not exist. The retention ratio b once decided upon, remain constant. Therefore, the growth rate g=br, is also constant forever.

Modigliani & Millers Irrelevance Model

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 the firm depends on the firms earnings and firms earnings are influenced by its investment policy and not by the dividend policy

Modigliani & Millers Irrelevance Model

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

Depends on

Firms Earnings

Depends on

Firms Investment Policy and not on dividend policy

Assumption of M-M Model

Perfect Capital Market: This means that:

The investors are free to buy and sell securities. The investors behave rationally. There are no transaction cost/ flotation cost. They are well informed about the risk-return on all types of securities. No investor is large enough to affect the market price of a share.

No Taxes Fixed Investment Policy No Risk

Formulae of M-M Model

According to M-M model the market price of a share, after dividend declared, is calculated by applying the following formula: P1 + D1 P0 = 1 + Ke
P0 = Prevailing 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

Where,

Ke = Cost of equity capital

Formulae of M-M Model

The number of shares to be issued to implement the new projects is ascertained with the help of the following: I (E-nD1) N = P1
N I E n D1 P1 = Change in the number of shares outstanding during the period. = Total Investment amount required for capital budget = Earning of net income of the firm during the period = Number of shares outstanding at the beginning of the period = Dividend to be received at the end of period one = Market price of a share at the end of period one

Where,

Criticism of M-M Model

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