Dividend Decision &

Theories
Dividend
• Dividend refers to the business concerns net profits distributed among the
shareholders. It may also be termed as the part of the profit of a business
concern, which is distributed among its shareholders.
• Dividend is defined as a distribution to shareholders out of
profits or reserves available for this purpose
Types of dividend
• Cash dividend
• Stock dividend
• Bond dividend
• Property dividend
Stock dividend
• Stock dividend is paid in the form of the company stock due to
raising of more finance.
• Under this type, cash is retained by the business concern
Cash dividend
• If the dividend is paid in the form of cash to the shareholders, it is called cash
dividend. It is paid periodically out of the business concerns EAIT (Earnings
after interest and tax).
• Cash dividends are common and popular types followed by majority of the
business concerns
• Company should have enough cash when cash dividend are declared else
arrangement should be made to borrow funds
Bond dividend
Bond dividend is also known as script dividend. If the company does not have
sufficient funds to pay cash dividend, the company promises to pay the
shareholder at a future specific date with the help of issue of bond or notes.
Property dividend
• Property dividends are paid in the form of some assets other than cash. It
will distributed under the exceptional circumstance. This type of dividend is
not published in India.
• A company may issue a non-monetary dividend to investors, rather than
making a cash or stock payment.
FACTORS AFFECTING DIVIDEND POLICY

1.Stability of Earnings:
>More stable incomes, consistent dividend policy

2.Age of Corporation
> A newly established corporation will require more money for expansion and
may not a rigid policy
3.Liquidity of funds
>Greater the liquidity, greater company’s ability ot pay dividend
 4.Ability to Borrow:
>Greater the ability to borrow (established firms), better would be the dividend
policy
5.Policy of Control:
> If greater control is desired, dividends will be declared at low rates to keep out
investors
6.Repayments of loan:
>Loan indebtedness usually means low or now dividends
>Sometimes lenders may demand restricted dividend distribution till the
repayments
7.Time :
>Dividend declaration should be at the time when cash outflow is at the
minimum
8.Regularity and Stability
>Greater the regularity and stability of dividend payment, more investers will be
attracted.
Introductio
n:
Dividend refer to the portion of profit after tax which is
distributed among the shareholders of the firm. It is return
that shareholders get on their investment.

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”.
Dividend
Decision:
The Dividend Decision is one of the crucial decisions made by
the finance manager relating to the payouts to the
shareholders. The payout is the proportion of Earning Per
Share given to the shareholders in the form of dividends.

Payment of dividend is two opposing effects:

It increases dividend thereby stock price rise.
It reduces the fund available for investment.
Theories of
Dividend
Dividend Theories

Relevance Theory Irrelevance Theory

Walter’s Model Residual Theory

Gordon’s Model MM Approach

Walter’s Model:
Assumptions:
 Retained earnings are the only source of financing investments in the firm, there is
no external finance involved.
 The cost of capital (ke) and the rate of return on investment (r) are constant i.e. even
if new investments decisions are taken, the risks of the business remains same.
 The firm has an infinite life
Three cases of model:
 Growth Firm : r > k
The price per share increases as the dividend payout ratio decreases.
 Normal Firm: r = k
The price per share does not vary with changes in dividend payout ration.
 Declining Firm: r < k
The price per share increases as the dividend per share increases
Gordon Model
Proposed a model of stock valuation using the dividend capitalization approach.
Assumptions:
 Retained earnings are the only source of financing for the firm
 The rate of return on the firms investment is constant.
 The product of retention ratio b and the rate of return r gives us the growth rate of the firm g.
 The cost of capital ke, is not only constant but greater than the growth rate i.e. ke>g.
 The firm has a perpetual life.
 Tax does not exist.
E(1-b)
Valuation formula : P= K-br
P = price per share
E = Earnings per share
b = Retention ratio (1 - payout ratio)
r = Rate of return on the firm's investments
ke = Cost of equity
br = Growth rate of the firm (g)
Miller- Modigliani theorem
Modigliani and Miller argued that the value of firm is solely determined by the earning
capacity of a firm’s assets and split of earnings between dividend and retained earnings
does not affect the shareholders’ wealth.

Assumptions:
 Information is freely available.
 No taxes.
 Flotation and transaction cost do not exist.
 Rational behavior by investors.
 Securities are divisible (split into any part).
 Capital markets are perfectly exist.
 Perfect certainty of future profit of firm.
(Contd.)
Valuation Model:
Step 1- Market price of the share in the beginning of the period = Present value of
dividends paid at the end of the period + Market price of share at the end of the
period.

1 (D₁+P₁)
P₀ = 1+Kₑ
PO = Market price per share at beginning of period 0.
D1 = Dividend to be received at end of period 1.
P1 = Market price per share at end of period 1.
Ke = Cost of equity capital.
 (Contd.)
Step 2- If the firm’s internal source of financing its investment opportunities fall short of
the funds required, and n is the number of new shares issued at the end of the year 1 at
price of P1 then equation:

1
1n1P+₀K= {nD₁ + (n+m) P₁ - mP₁}
ₑ 1+Kₑ
Where,
n = Number of outstanding shares
nP₀ = Total market value of outstanding shares at time 0
nD₁ = Total dividends in year 1 payable on equity share outstanding at time 0
m = Number of equity shares
P₁ = the prevailing market share at time 1
(n+m) P₁ = total market value of outstanding shares at time 1
mP₁ = Market value of shares issued at time 1