Dividend Policies

Vaibhav Banjan

Dividend
Dividend is a share of Profit of the company divided among its shareholders. Dividend is Proposed by the Board of Directors and approved by the shareholders in the General Body Meeting of the company

Types of Dividend
1. Interim Dividend Interim Dividend is a dividend which is declared between two annual general meetings.
2. Final Dividend: Dividend declared at the Annual General Body Meeting.

Factors affecting Dividend Policy

1. Transaction Costs There are two types of transaction cost
Firm Transaction Cost : Cost of Raising New Capital i.e Floatation Cost Shareholders Transaction Cost : When the Stock are sold, the investors has to pay transaction cost

Factors ..
2. Income Tax Company is subjected to DDT on Dividend paid to shareholders.
At the time of selling of shares investors will be subjected to Capital Gains Tax

Factors ..
3. Divisible Profits 4. Liquidity 5. Rate of expansion of business 6. Rate of Return 7. Stability of earnings 8. Contractual constraints

10. Cost of external financing 11. Degree of control 12. Access to Capital Market 13. General State of Economy

Dividend Growth Valuation Model

Dividend are expected to grow and this model assumes a constant level of growth in dividend in perpetuity. This model is known as Gorden Growth Model

Formula
PE = do (1+g) ---------Ke - g

Assumption
Retained Earning represent the only source financing Rate of Return is constant Growth Rate of the firm is the product of retention ratio and its rate of return Cost of Capital remains constant and is greater than the growth rate The company has perpetual life Tax does not ecist

Implications
1. When the rate of return is greater than the discount rate, the price per share increases as the dividend ratio decreases If the return is less than discount rate it is vice versa The price per share remains unchanged where the rate of return and discount rate are equal.

Dividend Relevance: Walters Model

Prof. James E. Walter argues that the choice of dividend policies almost always affect the value of the firm. His model is based on the following assumptions: 1. Internal financing: The firm finances all investment through retained earnings; i.e. debt or new equity is not issued. 2. Constant return and cost of capital: the firms rate of return, r , and its cost of capital, k , are constant. 3. 100% payout or retention: All earnings are either distributed as dividends or reinvested internally immediately. 4. Infinite time: the firm has infinite life

Valuation Formula:
Based on the above assumptions, Walter put forward the following formula: P = DIV + (EPS-DIV) r/k k P = market price per share DIV= dividend per share

EPS = earnings per share DIV-EPS= retained earnings per share r = firms average rate of return

k= firms cost o capital or capitalisation rate

Implication
A) The Optimal payout ratio for a growth firm is Nil B) The Optimal payout ratio for a Normal Firm is irrelevant C) The Optimal payout ratio for a declining firm is 100 %

Modigliani and MillerIrrelevancy Theory

It says that firms dividend policy has no effect on the value of firm Po = P1 + D1 ------------- 1+ KE

Assumptions
There are no personal or corporate tax There are no stock floatation or transaction costs. Dividend policy has no effect on the firms cost of equity The firms capital investment policy is independent of its dividend policy Investors and managers have the same set of information regarding future opportunities

Reasoning..
According to MM, value of the firm is determined by its basic earning power and the risk class, and therefore firm value depend on its asset investment policy rather than on how earnings are split between dividend and retained earnings

Clientele effect
It states that a firm will attract shareholders whose preference with respect to the payments pattern and stability of dividends corresponds to the firms payment pattern and stability of dividends. Since the clientele of the firm get what they expect, the value of the firms stock is unaffected by changes in the dividend policy

Types of Dividend Policy

1. Constant Payout Ratio 2. Constant Dividend Rate policy 3. Multiple Dividend Increase Policy 4. Regular Dividend plus extra dividend 5. Uniform Cash Dividend plus bonus policy