DIVIDEND POLICY

Chapter 18, Fundamentals of Financial Management (James C Vanhorne & John M Wachowicz)
Chapter 14, Fundamentals of Financial Management (Brigham and Houston)
CONTENTS
Dividend
Dividend policy
Types of dividends
Factors affecting dividend policy
Theories of dividend policy (Relevance and Irrelevance theories)
Dividend distribution procedure
DIVIDENDS
Dividends are payments made to stockholders from a firm's earnings

Dividends are paid taking into account the dividend payout ratio

The dividend-payout ratio determines the amount of earnings that can be retained
DIVIDEND POLICY
Dividend policy is the set of guidelines to decide how much of a firm’s earnings
will be paid to shareholders

It is an integral part of the firm’s financing decision

It determines the appropriate allocation of profits between dividend payments and

retained earnings

Dividend policy depends on the preferences of investors and potential investors

OPTIMAL DIVIDEND POLICY

The dividend policy that strikes a balance between current dividends and future
growth and maximizes the firm’s stock price
DIVIDEND POLICY DECISIONS
To retain earnings for capital investment and other purposes

To distribute earnings in the form of dividend among shareholders

To retain some earning and to distribute remaining earnings to shareholders

No obligation for firms to pay dividends to common shareholders

Shareholders cannot force a Board of Directors to declare a dividend

TYPES OF DIVIDENDS/
SHAREHOLDERS
Common dividends /shareholders

Preferred dividends/ shareholders

TYPES OF DIVIDENDS
Cash Dividend

Money paid to stockholders, normally out of the corporation's current earnings or accumulated profits

Scrip Dividend

Payment when the company cannot pay in cash

Shareholders are paid with commodities, vouchers, tokens or some other indication of credit instead
of cash
TYPES OF DIVIDENDS
Bond Dividend

Referred to as fixed-income investment instruments because they promise the holder a fixed
payment as returns on investment

The process is just like that of bonds, however it is a dividend

Property Dividend

Formal distribution of an asset other than cash to holders of preferred or common shares of stock
TYPES OF DIVIDENDS
Bonus share or Stock dividends

Instead of cash, additional shares given to shareholders as dividends

Amount of dividends paid to stockholders varies depending on the profits

of the issuing company
PAYMENT OF DIVIDENDS
Regular dividend

The dividend that is normally expected to be paid by the firm

Extra dividend

A nonrecurring dividend paid to shareholders in addition to the regular dividend. It is

brought about by special circumstances
FACTORS AFFECTING
DIVIDEND POLICY
Legal Restrictions
e.g. Company laws

Trend of earnings
High profit or low

Desire and type of Shareholders

FACTORS AFFECTING
DIVIDEND POLICY
Nature of Industry
Capital intensive, asset intensive, share Intensive

Age of the company

Old or new in market

Taxes on Retained Earnings

FACTORS AFFECTING
DIVIDEND POLICY

Future Financial Requirements

need of loan, expansion, going international etc.

Stage of Business cycle

Recession, boom, depression, recovery
DIVIDEND POLICY THEORIES/
MODELS
Dividend Relevance Models

Walter Model
Gordon Model

Dividend Irrelevance Model

Miller & Modigliani Model

WALTER’S MODEL

Dividends are relevant and they affect the share price

Two factors influence the market price of the share: EPS and DPS

There exists relationship between the internal rate of return (r) and the cost of
capital of the firm(K), to give a dividend policy that maximizes the shareholders’
wealth
WALTER’S MODEL

The criterion is in such a way that :

 
When

r > Ke the firm has to adopt Zero% payout policy

r < ke the firm has to adopt 100% payout policy
r = ke any policy between 0 to 100% payout
WALTER’S MODEL

Formula of Walter’s Model

Where,
P = Current Market Price of equity share
E= Earnings per share
D = Dividend per share (use payout ratio to calculate)
(E-D)= Retained earnings per share (EPS- DPS)
r = Rate of Return on firm’s investment or % of retained earnings
k = Cost of Equity Capital or Cost of capitalization
WALTER’S MODEL
ASSUMPTIONS OF WALTER’S
MODEL
The firm finances all investment through retained earnings

The firm’s internal rate of return (r), and its cost of capital (k) are constant
 
All earnings are either distributed as dividend or reinvested internally immediately
 
The firm has a very long or infinite life
CRITICISMS OF WALTER’S
MODEL
Model does not consider all the factors affecting dividend policy and share prices.

Ignores external financing

  
Firm’s internal rate of return does not always remain constant
In fact, r decreases as more and more investment in made
 
Ignores the business risk of the firm, which has a direct impact on the value of the firm

Thus, k cannot be assumed to be constant

GORDON’S MODEL

Gordon uses the dividend capitalization approach to study the effect of the firms
dividend policy on the stock price

According to him, what is presently available is more preferred that what may be
available in the future
GORDON’S MODEL

The firms with rate of return greater than the cost of capital should have a higher
retention ratio

Firms which have rate of return less than the cost of capital, should have a lower
retention ratio

The firms which have a rate of return equal to the cost of capital will however not
have any impact on its share value, it can adopt any retention policy
ASSUMPTIONS OF GORDON’S
MODEL
Investors are rational, they want to avoid risk

Investors would prefer to pay a higher price for the shares now which earn them
current dividends income

Investors would retain their earnings if the company postpones dividends

Share price and the dividend depend on the retention rate

ASSUMPTIONS OF GORDON’S
MODEL
The firm is an all equity firm, only financed by retained earnings

The internal rate of return (r) and the cost of capital (k)of the firm is constant

The retention ratio (b), once decided upon, is Constant

CRITICISMS OF GORDON’S
MODEL
As the assumptions of Walter’s Model and Gordon’s Model are same so the
Gordon’s model suffers from the same limitations as the Walter’s Model
BIRD-IN-THE-HAND THEORY
 
Given by Myron Gordon and John Lintner

Argues that ks decreases as the dividend payout is increased

Firm’s value will be maximized by setting a high dividend payout ratio

Modigliani and Miller called the Gordon-Lintner argument the bird-in-the-hand

fallacy
MODIGLIANI & MILLER’S
THEORY
Dividend irrelevance theory

Value of firm remains same whether or not the company pays dividend

Value of firm depends solely on its earnings power resulting from the
investment policy

Not influenced by the manner in which its earnings are split between
dividends and retained earnings
ASSUMPTIONS OF MODIGLIANI &
MILLER’S THEORY

Capital markets are perfect

Investors are rational, information is freely available, transaction cost are
nil, and no investor can influence the market price of the share

Taxes do not exist

The firm has a fixed investment policy

CRITICISM OF MODIGLIANI &
MILLER’S THEORY
No perfect capital market

Lack of relevant information

The assumption that taxes do not exist is unrealistic

No fixed investment policy

TAX PREFERENCE THEORY

Investors might prefer a low dividend payout due to tax benefits

Long-term capital gains are taxed at a lesser rate, whereas dividend income is taxed at effective rates
that are higher

Wealthy investors might prefer to have companies retain and plow earnings back into the business

Taxes are not paid on the gain until a stock is sold

STOCK DIVIDENDS
 
A stock dividend is the payment of additional shares of common stock to
shareholders

A shareholder’s proportional ownership in the firm remains unchanged

STOCK SPLITS
Stock split is increase in the number of shares outstanding by reducing the par
value of the stock:

for example, a 2-for-1 stock split where par value per share is reduced by one-half

 
It increases the number of shares outstanding, such as doubling the number of
shares outstanding by giving each shareholder two new shares for each one
previously owned
REVERSE STOCK SPLIT

A stock split in which the number of shares outstanding is decreased:

for example, a 1-for-2 reverse stock

split where each shareholder receives one new share in exchange for every two old
shares held
DIVIDEND DISTRIBUTION
PROCEDURE
Record date
The date, set by the board of directors when a dividend is declared

Investor must be a shareholder of record to be entitled to the upcoming dividend

 
Ex-dividend date
The first date on which a stock purchaser is no longer entitled to the recently
declared dividend
 
DIVIDEND DISTRIBUTION
PROCEDURE
Declaration date
The date when the board of directors announces the amount and date of the
next dividend
 
Payment date
The date when the corporation actually pays the declared dividend
DIVIDEND DISTRIBUTION
PROCEDURE
NUMERICAL QUESTION
(WALTER’S MODEL)
SOLUTION
NUMERICAL QUESTION
(GORDON’S MODEL)
SOLUTION
PRACTICE QUESTION 1
SOLUTION
PRACTICE QUESTION 2
THANK YOU