Earnings management is the use

of accounting techniques to produce financial

reports that present an overly positive view of a
company's business activities and financial
position.

Many accounting rules and principles require

company management to make judgments.

Earnings management takes advantage of how

accounting rules are applied and creates financial
statements that inflate earnings, revenue or total
assets.
The word dividend is derived form
‘dividendrum’ which means that
divisible sum.

It is the share of profits of a

company divided among its share
holders.
According to the Institute of Chartered
Accountant of India, dividend is defined as
“a distribution to shareholders out of profits
or reserves available for this purpose”.
1. Scrip Dividend
2. Debenture dividends
3. Bonus shares(stock dividends)
4. Property dividend
5. Composite dividends
 Legal aspects regarding declaration
& payment of dividend
1. Dividend to be paid only out of Profits (Section 205)
1. Profit—Dep than pay dividend
2. Past profit (unpaid)—Dep than pay dividend
3. Depreciation shall be calculated as per section 350
4. Guarantee by Govt. they pay dividend in non profit
conditions
5. Sections, 205,205A,205C,206,206A & 207 of Company Act
shell also apply to interim dividend. (Declared before final
dividend issue)
2. Company (Transfer of profits to Reserve) Rules,1975-Provide that before
dividend declaration, a percentage of profit as specified below should be
transferred to the reserves of the company.
It dividend proposed is upto 10% Nil
10.01% to 12.50% 2.5% of current profit
12.51 to 15.00% 5%
15.01 to 20.00% 7.5%
20.00% 10%

3. Requirement of stock exchange

1. Board of director meeting with in 5 days proposed advance
2. Information dividend payment to stock exchange 21 days
advance
4. Payment of dividend only in cash section 205 (3)
5. Payment of dividend to be transferred to specified person
sec.206
6. Unpaid dividend to be transferred to special dividend
a/c(sec.205A) 7days & 30 days
 Dividend Policy

Weston & Brigham, “Dividend policy

determines the division of earnings
between payments to shareholders
and retained earnings”
 Types of Dividend Policy
1. Conservative or strict dividend policy
2. Liberal dividend policy
3. Irregular dividend policy
4. Sound or stable dividend policy
1. Constant dividend per share
2. Constant pay-out ratio
3. Constant dividend per share plus extra
dividend
FACTORS DETERMINING DIVIDEND POLICY
1. Profitable Position of the Firm-Dividend decision depends on
the profitable position of the business concern. When the
firm earns more profit, they can distribute more dividends to
the shareholders.
2. Uncertainty of Future Income-Future income is a very
important factor, which affects the dividend policy. When the
shareholder needs regular income, the firm should maintain
regular dividend policy.
3. Legal Constrains-The Companies Act 1956 has put several
restrictions regarding payments and declaration of dividends.
Similarly, Income Tax Act, 1961 also lays down certain
restrictions on payment of dividends.
4. Liquidity Position-Liquidity position of the firms leads to easy
payments of dividend. If the firms have high liquidity, the
firms can provide cash dividend otherwise, they have to pay
stock dividend.
4) Sources of Finance-If the firm has finance sources, it will be
easy to mobilise large finance. The firm shall not go for
retained earnings.
5) Growth Rate of the Firm-High growth rate implies that the
firm can distribute more dividend to its shareholders.
6) Tax Policy-Tax policy of the government also affects the
dividend policy of the firm. When the government gives tax
incentives, the company pays more dividend.
7) Capital Market Conditions-Due to the capital market
conditions, dividend policy may be affected. If the capital
market is prefect, it leads to improve the higher dividend.
RELEVANCE OF DIVIDEND
According to this concept, dividend policy is
considered to affect the value of the firm.

Relevance of dividend concept is supported

by two eminent persons like Walter and
Gordon.
 Walter’s Model
Prof. James E. Walter argues that the dividend policy almost
always affects the value of the firm.

Walter model is based in the relationship between the

following important factors:
• Value of the form (i) • Rate of return (r) • Cost of capital (k)

1) Growth firms ( r > k) the firm is able to earn more than

what the shareholders could by reinvesting, if the earnings
are paid to them. The implication of r > k is that the
shareholders can earn a higher return by investing
elsewhere pay out ratio = zero
2) Normal firms (r = k) it is a matter of indifferent whether
earnings are retained or distributed. No effect
3) Declining firms (r < k) pay out ration 100%
Assumptions
Walters model is based on the following important
assumptions:

1. The firm uses only internal finance.

2. The firm does not use debt or equity finance.

3. The firm has constant return and cost of capital.

4. The firm has 100 percent payout.

5. The firm has constant EPS and dividend.

6. The firm has a very long life.

Walter has evolved a mathematical formula for
determining the value of market share.

Where,
P = Market price of an equity share
D = Dividend per share
r = Internal rate of return
E = Earning per share
Ke = Cost of equity capital
The earnings per share of a company are
Rs. 10 and the rate of capitalization
applicable to the company is 10%. The
company has before it an option of
adopting a payment ratio of 50% (or)
75%(or) 100%. Using Walter’s formula of
dividend payout, compute the market
value of the company’s share of the
productivity of retained earnings (i) 15% (ii)
10%(iii) 8%.
 Criticism of Walter’s Model

1. It ignores the benefits of optimal capital structure.

2. Walter model assumes that there is no extracted
finance used by the firm. It is not practically
applicable.
3. There is no possibility of constant return. Return
may increase or decrease, depending upon the
business situation.
4. According to Walter model, it is based on constant
cost of capital. But it is not applicable in the real life
of the business.
 Gordon’s Model
Myron Gorden suggest one of the popular model
which assume that dividend policy of a firm affects its
value, and it is based on the following important
assumptions:
1. The firm is an all equity firm.
2. The firm has no external finance.
3. Cost of capital and return are constant.
4. The firm has perpetual life.
5. There are no taxes.
6. Constant relation ratio (g=br).
7. Cost of capital is greater than growth rate (Ke>br).
1) Growth firms ( r > k) Market price of shares increases with the
increase in retention ratio. The implication of r > k is that the
company should distribute lesser dividend and retain higher amount
of profits.
2) Normal firms (r = k) Market price of shares is not effected by the
retention ratio.
3) Declining firms (r < k) Market price of shares decreases with the
increase in retention ratio. The implication of r < k is that the
retention becomes undesirable and more and more profits should be
distributed as dividends.
The following information is given about LNT ltd.
1) Cost of capital (k) = 10%
2) Earning per share (E) = Rs.10
3) Internal rate of return (r) = 5%, 10%, & 8%
Determine the value per share assuming the
following retention (b):-
Retention Ratio (b=r/e) Payout ratio (D/E)
a. 0% 100%
b. 10% 90%
c. 30% 70%
d. 50% 50%
e. 60% 40%
Assuming that Gorden valuation model holds, what
rate of return should be earned on investments.
Criticism of Gordon’s Model
Gordon’s model consists of the following important
criticisms:
1. Gordon model assumes that there is no debt and
equity finance used by the firm. It is not
applicable to present day business.

2. Ke and r cannot be constant in the real practice.

3. According to Gordon’s model, there are no tax

paid by the firm. It is not practically applicable.
 Irrelevance of Dividend
According to professors Soloman, Modigliani and Miller, dividend
policy has no effect on the share price of the company. There is no
relation between the dividend rate and value of the firm.

Dividend decision is irrelevant of the value of the firm. Modigliani

and Miller contributed a major approach to prove the irrelevance
dividend concept.

Franco Modigliani and Merton Miller’s Approach

According to MM, under a perfect market condition, the dividend
policy of the company is irrelevant and it does not affect the value
of the firm.

“Under conditions of perfect market, rational investors, absence

of tax discrimination between dividend income and capital
appreciation, given the firm’s investment policy, its dividend
policy may have no influence on the market price of shares”.
Assumptions
MM approach is based on the following important assumptions:
1. Perfect capital market.
2. Investors are rational.
3. There are no tax.
4. The firm has fixed investment policy.
5. No risk or uncertainty.
 Value of the Firm

V= {(n+∆n)P1—I+E}
(1+k)
N=no.of outstanding share,
I= Total investment
∆n = Additional No. of shares
E= Earnings of the company
Xyz ltd has a cost of equity capital of 12%, the current
market value of the company (V) is Rs.10,00,000 (@RS
10 per share). Assume value for new investments (I),
earnings (E) and dividends (D) at the end of first year
as Rs.3,40,000; Rs.2,75,000 and Rs.2.50 per share
respectively. Show under M.M. assumptions, the
payment of ‘D’ doses not affect the value of the
company
 P1 = P0 (1+k) – D1
P0=10 , D1 = 2.50, k= 12% or .12
 V= {(n+∆n)P1—I+E}
(1+k)
Note:
10,00,000/10=1,00,000
10,00,000x2.50=2,50,000
 Criticism of MM approach
MM approach consists of certain criticisms also. The following
are the major criticisms of MM approach.
1. MM approach assumes that tax does not exist. It is not
applicable in the practical life of the firm.
2. MM approach assumes that, there is no risk and uncertain of
the investment. It is also not applicable in present day
business life.
3. MM approach does not consider floatation cost and
transaction cost. It leads to affect the value of the firm.
4. MM approach considers only single decrement rate, it does
not exist in real practice.
5. MM approach assumes that, investor behaves rationally. But
we cannot give assurance that all the investors will behave
rationally.