TYBMS SEM V- STRATEGIC FINANCIAL MNGT

SYLLABUS
CHP-1--- DIVIDEND DECISION
1.

MEANING AND FORMS OF DIVIDEND

2.

DIVIDEND POLICY

3.

FACTORS DETERMINING DIVIDEND POLICY

4.

TYPES OF DIVIDEND POLICY

5.

MODELS

SYLLABUS
1

Dividend Decision and XBRL

a) Dividend Decision:
Meaning and Forms of Dividend, Dividend-Modigliani and Millers Approach, Walter Model, Gordon Model, Factors
determining Dividend Policy, Types of Dividend Policy
b) XBRL: (Extensible Business Reporting Language)
Introduction, Advantages and Disadvantages, Features and Users
2

Capital Budgeting and Capital Rationing

a) Capital Budgeting:
Risk and Uncertainty in Capital Budgeting, Risk Adjusted Cut off Rate, Certainty Equivalent Method, Sensitivity
Technique, Probability Technique, Standard Deviation Method, Co-efficient of Variation Method, Decision Tree
Analysis, Construction of Decision Tree.
b) Capital Rationing:
Meaning, Advantages, Disadvantages, Practical Problems

CONTD.
3

Shareholder Value and Corporate Governance/ Corporate Restructuring

a) Shareholder Value and Corporate Governance:

Financial Goals and Strategy, Shareholder Value Creation: EVA and MVA Approach, Theories of Corporate
Governance, Practices of Corporate Governance in India
b) Corporate Restructuring:
Meaning, Types, Limitations of Merger, Amalgamation, Acquisition, Takeover, Determination of Firms Value,
Effect of Merger on EPS and MPS, Pre Merger and Post Merger Impact.
4

Financial Management in Banking Sector and Working Capital Financing

a) Financial Management in Banking Sector:

An Introduction, Classification of Investments, NPA & their Provisioning, Classes of Advances, Capital
Adequacy Norms, Rebate on Bill Discounting, Treatment of Interest on Advances
b) Working Capital Financing:
Maximum Permissible Bank Finance (Tandon Committee), Cost of issuing Commercial Paper and Trade
Credit, Matching Approach, Aggressive Approach, Conservative Approach

CHP-1 --- DIVIDEND DECISION

TheDividend Decisionis one of the crucial

decisions made by the finance manager relating

to the payouts to the shareholders. The payout
is the proportion ofEarning Per Sharegiven
to the shareholders in the form of dividends.
The companies can pay either dividend to the

shareholders or retain the earnings within the

firm. The amount to be disbursed depends on
the preference of the shareholders and the
investment opportunities prevailing within the
firm.
The optimal dividend decision is when the

wealth of shareholders increases with the

increase in the value of shares of the company.
Dividend can NEVER be paid out of capital.

DIFFERENT FORMS / TYPES OF PAYING DIVIDENDS

Cash dividend:it is the common method to pay the dividend. Here the shareholders get cash in

form of dividend. But for distributing cash dividends, the company needs to have positive retained
earnings and enough cash for the payment of dividends.
Bonus Share:Bonus share is also called as the stock dividend. Bonus shares are issued by the

company when they have low operating cash, but still want to keep the investors happy. Each
equity shareholder receives a certain number of additional shares depending on the number of
shares originally owned by the shareholder. For example, if a person possesses 10 shares of
Company A, and the company declares bonus share issue of 1 for every 2 shares, the person will
get 5 additional shares in his account.
Scrip Dividend:Under this form, a company issues the transferable promissory note to the

shareholders, wherein it confirms the payment of dividend on the future date. A scrip dividend has
shorter maturity periods and may or may not bear any interest.. This type of dividend is used
when the company does not have sufficient funds for the issuance of dividends.

 Share Repurchase:Share repurchase occurs when a company buys back its own shares

from the market and reduces the number of shares outstanding. This is considered as an
alternative to the dividend payment as cash is returned to the investors through another way.
Property Dividend:The company makes the payment in the form of assets in the property

dividend. The asset could be any of this equipment,inventory, vehicle or any other asset.
The value of the asset has to be restated at the fair value while issuing a property dividend.
Bond Dividend:The Bond Dividends are similar to the scrip dividends, but the only

difference is that they carry longer maturity period and bears interest.
Liquidating Dividend:When the company returns the original capital contributed by the

equity shareholders as a dividend, it is termed as liquidating dividend. It is often seen as a

sign of closing down the company.

FACTORS DETERMINING DIVIDEND POLICY

1. Stability of Earnings.The nature of business has an important bearing on the dividend policy. Industrial units

having stability of earnings may formulate a more consistent dividend policy than those having an uneven flow of
incomes because they can predict easily their savings and earnings. Usually, enterprises dealing in necessities suffer
less from oscillating earnings than those dealing in luxuries or fancy goods.
2. Age of corporation.Age of the corporation counts much in deciding the dividend policy. A newly established

company may require much of its earnings for expansion and plant improvement and may adopt a rigid dividend
policy while, on the other hand, an older company can formulate a clear cut and more consistent policy regarding
dividend.
3. Liquidity of Funds.Availability of cash and sound financial position is also an important factor in dividend

decisions. A dividend represents a cash outflow, the greater the funds and the liquidity of the firm the better the
ability to pay dividend.
4. Extent of share Distribution.Nature of ownership also affects the dividend decisions. A closely held company is

likely to get the assent of the shareholders for the suspension of dividend or for following a conservative dividend
policy. On the other hand, a company having a good number of shareholders widely distributed and forming low or
medium income group, would face a great difficulty in securing such assent because they will emphasize to distribute
higher dividend.

5. Needs for Additional Capital. Companiesretain a part of their profits for strengthening their

financial position. The income may be conserved for meeting the increased requirements of
working capital or of future expansion. Small companies usually find difficulties in raising finance
for their needs of increased working capital for expansion programs. They having no other
alternative, use their ploughed back profits. Thus, such Companies distribute dividend at low rates
and retain a big part of profits.
6. Past dividend Rates.While formulating the Dividend Policy, the directors must keep in mind the

dividend paid in past years. The current rate should be around the average past rate. If it has been
abnormally increased the shares will be subjected to speculation.
7. Legal constraints. The legal rules act as boundaries within which a company can declare

dividends. In general, cash dividends must be paid from current earnings or from previous
earnings that have been retained by the corporations after providing for depreciation. However, a
company may be permitted to pay dividend in any financial year out of the profits of the company
without providing for depreciation.

8. Government Policies.The earnings capacity of the enterprise is widely affected by the change in

fiscal, industrial, labor, control and other government policies. Sometimes government restricts
the distribution of dividend beyond a certain percentage in a particular industry or in all spheres of
business activity. The dividend policy has to be modified or formulated accordingly in those
enterprises.
9. Ability to Borrow.Well established and large firms have better access to the capital market than

the new Companies and may borrow funds from the external sources if there arises any need.
Such Companies may have a better dividend pay-out ratio. Whereas smaller firms have to depend
on their internal sources and therefore they will have to built up good reserves by reducing the
dividend pay out ratio for meeting any obligation requiring heavy funds.
10.Trade Cycles.Businesscycles also exercise influence upon dividend Policy. Dividend policy is

adjusted according to the business oscillations. During the boom, prudent management creates
food reserves for contingencies which follow the inflationary period. Higher rates of dividend can
be used as a tool for marketing the securities in an otherwise depressed market.

TYPES OF DIVIDEND POLICY

Dividend policy depends upon the nature of the firm, type of shareholder and profitable position. On
the basis of the dividend declaration by the firm, the dividend policy may be classified under the
following types:

 Regular Dividend Policy

Dividend payable at the usual rate is called as regular dividend policy. This type of policy is suitable
to the small investors, retired persons and others.
Stable Dividend Policy

Stable dividend policy means payment of certain minimum amount of dividend regularly. It does not
change even if the earnings are volatile every year. This dividend policy consists of the following
three important forms:
i.

Constant dividend per share

ii.

Constant payout ratio

iii. Stable rupee dividend plus extra dividend - it means the payment of low dividend per share

constantly + extra dividend in the year when the company earns high profit.

 Residual Dividend Policy:Under the residual dividend policy, the company pays the dividends

from the funds left after the finances for the capital expenditures of the current period are
deducted from the internally generated funds of the company. This policy takes the companys
investment opportunity schedule, target capital structure and the cost of capital raised externally
into consideration.
Irregular Dividend Policy

When the companies are facing constraints of earnings and unsuccessful business operation, they
may follow irregular dividend policy. It is one of the temporary arrangements to meet the financial
problems. These types are having adequate profit. For others no dividend is distributed.
No Dividend Policy/ zero payout

Sometimes the company may follow no dividend policy because of its unfavorable working capital
position of the amount required for future growth of the concerns.

DIVIDEND MODELS / THEORIES

RELEVANCE OF DIVIDEND
According to this concept, dividend policy is considered to affect the value of the firm. Dividend
relevance implies that shareholders prefer current dividend and there is no direct relationship
between dividend policy and value of the firm [an economic measure reflecting the marketvalueof a
business. It is a sum of claims by all claimants: creditors (secured and unsecured) and shareholders
(preferred and common).] Relevance of dividend concept is supported by two eminent persons like
Walter and Gordon.

Walters model:
Professor James E. Walter argues that the choice of dividend policies almost always affects the value
of the enterprise. His model shows clearly the importance of the relationship between the firms
internal rate of return (r) and its cost of capital (k) in determining the dividend policy that will
maximize the wealth of shareholders.
The companies paying higher dividends have more value as compared to the companies that pay
lower dividends or do not pay at all.

 Walters model is based on the following assumptions:

1. The firm finances all investment through retained earnings; that is debt or new equity is
not issued;
2. The firms internal rate of return (r) it is the interestrateat which the net present value
of all the cash flows (both positive and negative) from a project orinvestmentequal zero.
and its cost of capital (k) - thecost of equityis the return a firm theoretically pays to
itsequityinvestors, to compensate for the risk they undertake by investing theircapital
are constant;
3. All earnings are either distributed as dividend or reinvested internally immediately.
4. Beginning earnings and dividends never change. The values of the earnings per share
(E), and the divided per share (D) may be changed in the model to determine results, but
any given values of E and D are assumed to remain constant forever.
5. The firm has a very long or infinite life.

 Following is the formula:

P = D + (E D)r / K
K
Where,
P = Market price of an equity share
D = Dividend per share
r = Internal rate of return
E = Earning per share
K = Cost of equity capital

GORDONS MODEL
Gordons theory on dividend policy is one of the theories believing in the relevance of dividends

concept.
It states that the current dividends are important in determining the value of the firm. Gordons

model is one of the most popular mathematical models to calculate the market value of the
company using its dividend policy.
Myron Gordons model explicitly relates the market value of the company to its dividend policy.

The determinants of the market value of the share are the perpetual stream of future dividends to
be paid, the cost of capital and the expected annual growth rate of the company.
The Gordons theory on dividend policy states that the companys dividend payout policy and the

relationship between its rate of return (r) and the cost of capital (k) influence the market price per
share of the company.

 Gordons model can be proved with the help of the following formula:

Where,
P = Price of a share
E = Earnings per share
1 b = Dividend pymt ratio (i.e., percentage of earnings distributed as dividends)
Ke = Capitalization rate
br = Growth rate (g)= rate of return on investment of an all equity firm.
b = fraction of earnings the firm ploughs back
The above model indicates that the market value of the companys share is the sum total of the

present values of infinite future dividends to be declared.

Relationship
between r and
k
r>k
r<k
r=k

Increase in
Dividend Payout
Price per share
decreases
Price per share
increases
No change in the
price per share

Assumptions of the Model:

No Debt:The model assumes that the company is an all equity company, with no proportion of
debt in the capital structure.

No External Financing:The model assumes that all investment of the company is financed by
retained earnings and no external financing is required.

Corporate Taxes:Corporate taxes are not accounted for in this model.

ASSUMPTIONS OF THE MODEL

Constant IRR:The model assumes a constantInternal Rate of Return(r), ignoring the

diminishing marginal efficiency of the investment.

Constant Cost of Capital:The model is based on the assumption of a constant cost of capital

(k), implying the business risk of all the investments to be the same.
Perpetual Earnings:Gordons model believes in the theory of perpetual earnings for the

company.
Constant Retention Ratio:The model assumes a constant retention ratio (b) once it is decided

by the company. Since the growth rate (g) = b*r, the growth rate is also constant by this logic.
K>g:Gordons model assumes that the cost of capital (k) > growth rate (g). This is important for

obtaining the meaningful value of the companys share.

CRITICISM OF GORDONS MODEL

Gordons theory on dividend policy is criticized mainly for the unrealistic assumptions

made in the model:

Constant Internal Rate of Return and Cost of Capital:The model is inaccurate in

assuming that r and k always remain constant. A constant r means that the wealth of the
shareholders is not optimized. A constant k means the business risks are not accounted for
while valuing the firm.
No External Financing:Gordons belief of all investments being financed by retained

earnings is faulty. This reflects sub-optimum investment and dividend policies.

MODIGLIANI AND MILLER MODEL

Modigliani Miller theory is a major proponent of Dividend Irrelevance notion. According to this

concept, investors do not pay any importance to the dividend history of a company and thus,
dividends are irrelevant in calculating thevaluationof a company. This theory is in direct contrast
to the Dividend Relevance theory.
Modigliani Miller theory was proposed by Franco Modigliani and Merton Miller in 1961. They

were the pioneers in suggesting that dividends and capital gains are equivalent when an investor
considers returns on investment. The only thing that impacts the valuation of a company is its
earnings, which is a direct result of the companys investment policy and the future prospects.
So, according to this theory, once the investment policy is known to the investor, he will not need

any additional input on the dividend history of the company. The investment decision is, thus,
dependent on the investment policy of the company and not on the dividend policy.

 Modigliani Miller theory goes a step further and illustrates the practical situations where

dividends are not relevant to investors. Irrespective of whether a company pays a dividend
or not, the investors are capable enough to make their own cash flows from the stocks
depending on their need for the cash.
If the investor needs more money than the dividend he received, he can always sell a part

of his investments to make up for the difference. Likewise, if an investor has no present
cash requirement, he can always reinvest the received dividend in the stock.
Thus, the Modigliani Miller theory firmly states that the dividend policy of a company has

no influence on the investment decisions of the investors.

ASSUMPTIONS OF THE MODEL

Perfect Capital Markets:This theory believes in the existence of perfect capital

markets. It assumes that all the investors are rational, they have access to free
information, there are no floatation or transaction costs and no large investor to influence
the market price of the share.
No Taxes:There is no existence of taxes. Alternatively, both dividends and capital gains

are taxed at the same rate.

Fixed Investment Policy:The company does not change its existing investment policy.

This means that new investments that are financed through retained earnings do not
change the risk and the rate of required return of the firm.
No Risk of Uncertainty:All the investors are certain about the future market prices and

the dividends. This means that the same discount rate is applicable for all types of stocks
in all time periods.

CRITICISM OFMODIGLIANI MILLERS MODEL

Perfect capital markets do not exist. Taxes are present in the capital markets.
According to this theory, there is no difference between internal and external

financing. However, if the flotation costs of new issues are considered, it is false.
This theory believes that the shareholders wealth is not affected by the

dividends. However, there are transaction costs associated with the selling of
shares to make cash inflows. This makes the investors prefer dividends.
The assumption of no uncertainty is unrealistic.