ACFM: Dividend Decision and Theories PDF Notes

Introduction - Dividend Decisions: Meaning - Types of Dividends – Types of Dividends Polices – Significance of Stable Dividend Policy - Determinants of Dividend Policy; Dividend Theories: Theories of Relevance – Walter’s Model and Gordon’s Model and Theory of Irrelevance – The Miller Modigliani (MM) Hypothesis - Problems.

1. DIVIDEND THEORIES
MEANING OF DIVIDEND:
The term dividend refers to that part of after
distributed to the owners of the company.
MEANING OF RETAINED EARNINGS:
The undistributed part of
MEANING OF DIVIDEND DECISION:
Dividend decision refers to the policy that the management formulates
in regard to earnings for
shareholders. Dividend decision determines the
between payments to shareholders and retained earnings.
DIVIDEND POLICY
The term dividend policy refers to the policy concerning how much
profits to be distributed as dividend and how much to be retained in
the business.
ADVANCED FINANCIAL MANAGEMENT
CHETHAN.S
DEPARTMENT OF MANAGEMENT, AIGS
UNIT-3
DIVIDEND THEORIES

MEANING OF DIVIDEND: -
The term dividend refers to that part of after-tax profit which is
distributed to the owners of the company.
MEANING OF RETAINED EARNINGS: -
The undistributed part of the profit is known as retained earnings.
MEANING OF DIVIDEND DECISION: -
Dividend decision refers to the policy that the management formulates
in regard to earnings for distribution as dividends among
shareholders. Dividend decision determines the division of earnings
between payments to shareholders and retained earnings.

The term dividend policy refers to the policy concerning how much
profits to be distributed as dividend and how much to be retained in
ADVANCED FINANCIAL MANAGEMENT
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DEPARTMENT OF MANAGEMENT, AIGS
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tax profit which is
the profit is known as retained earnings.
Dividend decision refers to the policy that the management formulates
distribution as dividends among
division of earnings
The term dividend policy refers to the policy concerning how much
profits to be distributed as dividend and how much to be retained in
ADVANCED FINANCIAL MANAGEMENT

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TYPES OF DIVIDEND POLICY
1. Stable dividend policy
2. Regular dividend policy
3. Irregular Dividend Policy
4. No dividend Policy
DIFFERENT FORMS OF DIVIDEND :
1] Scrip Dividend– An unusual type of dividend involving the
distribution of promissory notes that calls for some type of payment at
a future date.
2] Bond Dividend– A type of liability dividend paid in the dividend
payer’s bonds. When you buy a bond, you are lending money to a
company or government entity. In exchange, the borrower agrees to
pay you a fixed rate of interest, known as a bond dividend.
3] Property Dividend–Property dividend refers to a dividend paid to
investors in the form of assets and not cash.
For example, a company may decide to send its products to the
investors as a dividend. The issuer calculates the dividend at the
fair market value of the products sent.
4] Cash Dividend– A dividend paid in cash to a company’
shareholders, normally out of the its current earnings or accumulated
profits.
5] Optional Dividend– Dividend which the shareholder can choose
to take as either cash or stock.

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SIGNIFICANCE OF DIVIDEND DECISION
1. The firm has to balance between the growth of the company and
the distribution to the shareholders.

2. It has a critical influence on the value of the firm.

3. It has to also to strike a balance between the long term financing
decision (company distributing dividend in the absence of any
investment opportunity) and the wealth maximization.

4.The market price gets affected if dividends paid are less.

5. Retained earnings help the firm to concentrate on the growth,
expansion and modernization of the firm.

6. To sum up, it to a large extent affects the financial structure,
flow of funds, corporate liquidity, stock prices, and growth of the
company and investor’s satisfaction.
FACTORS INFLUENCING THE DIVIDEND
DECISION
External factors
1. General state of economy
2. State of capital market
3. Legal restrictions
4. Contractual restrictions
5. Tax policy

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Internal factors
1. Desire of the shareholders
2. Financial needs of the company
3. Nature of earnings
4. Desire of Control
5. Liquidity position

The factors affecting the dividend policy are classified into external
and internal:
External factors
Following are the external factors which affect the dividend policy of
a firm:
1. General state of economy: The general state of economy affects to
a great extent the management’s decision to retain or distribute
earnings of the firm.
In case of uncertain economic and business conditions - the
management may like to retain the whole or a part of the firm’s
earnings to build up reserves to absorb shock in the future.
In periods of depression - the management may also like to retain a
large part of its earnings to preserve the firm’s liquidity position.
In periods of prosperity - the management may not be liberal in
dividend payments though the earning power of a company warrants
it because of availability of larger profitable investment opportunities.
In periods of inflation - the management retain larger proportion of
the earnings for replacement of worn-out assets.

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2. State of capital market: In case a firm has an easy access to the
capital market either because it is financially strong or because
favourable conditions prevail in the capital market, it can follow a
liberal dividend policy (retains less and distributes more).
However, if the firm has no easy access to capital market because
either of weak financial position or because of unfavourable
conditions in the capital market. It is likely to adopt a more
conservative dividend policy (retain more and distribute less profits
to equity shareholders).
3. Legal restrictions: In India Companies Act 1956 has put several
restrictions regarding payment and declaration of dividends.
i) Dividends can only be paid out of current profits or past profits or
money provided by the central government or state government.
Payment of dividend out of capital is illegal.
ii) Dividend should be paid only out of profits after providing for
depreciation and transferring to reserves not less than 10%.
4. Contractual restrictions: Lenders of the firm generally put
restrictions on dividend payment to protect their interest and capital
repayment in periods when the firm is experiencing liquidity or
profitability problems. For example it may be provided in a loan
agreement that the firm shall not pay dividend of more than 12% so
long the firm does not clear the loan.
5. Tax policy: The tax policy followed by the Government also
affects the dividend policy. For example the Government gives tax
incentives to companies retaining larger share of their earnings.

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Internal factors
1. Desire of the shareholders: Of course, the directors of the
company have considerable freedom in declaring the dividend but the
shareholders are the real owners of the company and therefore, their
desires should not be overlooked by the directors while deciding
about the divided policy.
2. Financial needs of the company: Shareholders’ desire and
financial needs of the company are two conflict issues while
determining the dividend policy. If company retains more profits, it
may not meet the desires of the shareholders.
3. Nature of earnings: A firm having stable income may follow
higher dividend payout ratio. For example Public Utility Companies
like Electricity Boards and Air lines carrying business purely on cash
system may pay higher dividends. Similarly Liquor Companies can
follow liberal dividend policy since people used to drink liquor both
in boom as well as in recession.
4. Desire of control: The company which follows low dividend
payout ratio does not dilute the control of the existing shareholders
whereas the company following high dividend payout ratio dilutes the
control of the existing shareholders as it issues new shares to acquire
funds to finance future finance requirements.
5. Liquidity position: The payment of dividends results in cash
outflow from the firm. A firm may have adequate earnings but it may
not have sufficient cash to pay dividends. It is therefore important for
the management to take into account the cash position and the overall
liquidity position of the firm before and after payment of dividends
while making dividend decision.

7. DIVIDEND THEORIES:
1. Walter’s Model
2. Gordon’s Model
3. Modigliani and Miller’s Model / MM Model


1. WALTER’S MODEL:

Walter Model was proposed by Professor
According to Professor
almost always affects the value of the company. According to him, the
dividend policy of the companies must be framed by keeping in mind the
availability of new investment opportunities.
If the company has abundant profitable investment
dividends should he paid because retained earnings will be a source of
fund for such investment.
Theory of
Relevance
1.Walter Model
2.Gordon Model
CHETHAN.S
DEPARTMENT OF MANAGEMENT, AIGS
DIVIDEND THEORIES:-
digliani and Miller’s Model / MM Model
MODEL:
Walter Model was proposed by Professor James E Walter.
According to Professor James E Walter, the choice of the dividend policy
almost always affects the value of the company. According to him, the
dividend policy of the companies must be framed by keeping in mind the
availability of new investment opportunities.
If the company has abundant profitable investment opportunities, no cash
dividends should he paid because retained earnings will be a source of
fund for such investment.
Dividend
Theories
Theory of
Relevance
1.Walter Model
2.Gordon Model
Theory of
Irrelevance
1. MM Model
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DEPARTMENT OF MANAGEMENT, AIGS
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the dividend policy
almost always affects the value of the company. According to him, the
dividend policy of the companies must be framed by keeping in mind the
opportunities, no cash
dividends should he paid because retained earnings will be a source of

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On the other hand, if there are no profitable investment opportunities
available, a hundred per cent of earning should be distributed as dividend.
For the situation between these two extremes, dividend payment will be
between zero and a hundred.
Walter identified three kinds of firm
1. Growth Firms: (R>K): The firms having R>K may be referred to as growth
firms. These firms have investment opportunities and they can earn a return
which is more than what shareholders could earn on their own. So optimum
payout ratio for growth firm is 0%.
2. Normal Firms (R = K): If R is equal to K the firm is known as a normal
firm. These firms do not have unlimited profitable investment opportunities and
they can earn a rate of return which is equal to that of shareholders. In this case
dividend policy will not have any influence on the price per share. So there is
nothing like optimum. Payout ratio for a normal firm. All the payout ratios are
optimum.
3. Declining Firms (R<K): If the company has no profitable investment
opportunities and the company earns a return which is less than, what the
shareholders can earn on their investments, it is known as a declining firm. Here
it should not make any sense to retain the earnings. So entire earnings optimum
payout ratio for declining firms is 100%. So according to Walter, the optimum
payout ratio is either 0% (when R>K) or 100% (when R<K)

Walter’s model is based on the following assumptions:-
1 All investments are financed through retained earnings.
1 The company’s internal rate of return (r) and the cost of capital (k) is
constant.
1 All earnings are either reinvested internally or distributed as dividend
1 There is no change in key factors like EPS and DPS
1 The company has a very long and perpetual life.
1 Retained earnings in the business affect the expected future dividend and
this, in turn, affect the market value of a share.

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Walters Model Formula:-

P =

12
+
3412567 8
12

P= Market price per share
D= Dividend per share
R= Internal rate of return
E= Earnings per share
Ke= Cost of equity capital

Criticisms of Walter’s Model:

1. The basic assumption that investments are financed through
retained earnings only is seldom true in real world. Firms do raise
funds by external financing.
2. Walter’s model of share valuation mixes dividend policy with
investment policy of the firm.
3. Walter’s model is based on the assumption that r is constant. In fact
with increased investment the rate of return also changes.
4. The assumption that cost of capital (k) will remain constant also
does not hold good. As a firm’s risk pattern does not remain constant,
it is not proper to assume that k will always remain constant.

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The following information is available in respect of a firm:
Capitalization Rate = 10%
Earnings per Share = Rs.50
Assumed rate of return on Investments:
(i) 12%
(ii) 8%
(iii) 10%
Show the effect of dividend policy on market price of shares applying
Walter’s formula when dividend payout ratio is [a] 0% [b] 20%
[c] 40% [d] 80% and [e] 100%






PROBLEM - 01
SOLUTION
WALTER MODEL

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The following information is available in respect of a firm:
Capitalization Rate = 10%
Earnings Per Share = Rs.40
Assumed rate of return on Investments:
(i) 13%
(ii) 10%
(iii) 8%
You are required to show the effect of dividend payment on the
market price per share by using Walter’s Model when dividend
payout ratio is [a] 0% [b] 20% [c] 40% [d] 80% and [e] 100%






SOLUTION
PROBLEM - 02 WALTER MODEL

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The following information is available in respect of a firm:
Capitalization Rate = 10%
Earnings per Share = Rs.60
Assumed rate of return on Investments:
(i) 10%
(ii) 12%
You are required to show the effect of dividend payment on the
market price per share by using Walter’s Model when dividend
payout ratio is [a] 20% [b] 60%


2. GORDON’S MODEL:

Gordon Model was proposed by Myron Gordon.
This Model is also called as “Bird in Hand Theory”.
“A bird in the hand is worth two in the bush”
Meaning:- What you already have is more valuable than the
prospect to have something greater (Example: You may not like
your job, but don't quit merely on the hope of finding a better one. A
bird in the hand is worth two in the bush)
Investors will prefer current dividend rather than future dividend
as future is Uncertain. Future capital gain is more risky.
Discounting the future capital gain at a higher rate (Ke > g).
WALTER MODEL PRACTICE QUESTION
PROBLEM

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The authors believed that investors would prefer to get paid
dividend now than capital gain in a while. In other words,
dividends are more certain for investors than capital gain.
They would not accept the proposal to decrease dividend payout
in order to increase retained earnings and get bigger capital
gains in the future. The longer is the period of time the greater is
uncertainly, thus capital gains are more risky for investors than
dividends.
If investors are risk averse, they would prefer certain dividend
than risky capital gains. Therefore, the required rate of return on
capital gains is higher than on dividend for the same stock.
The Gordon’s theory on dividend policy states that the
company’s 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.
Gordon’s model is one of the most popular mathematical
models to calculate the market value of the company using its
dividend policy.
Relationship between r and k Increase in Dividend Payout
R > K
Price per share Increases as the
dividend payout ratio Decreases.
R < K
Price per share increases as the
dividend payout ratio Increases.
R = K No change in the price per share

Assumptions:

1. The firm is an all Equity firm
2. No external financing is available
3. The internal rate of return (r) of the firm is constant.
4. The appropriate discount rate (K) of the firm remains constant.

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5. The firm and its stream of earnings are perpetual
6. The corporate taxes do not exist.

IMPLICATIONS OF GORDON’S MODEL
• Growth firm
• Normal firm
• Declining firm

CRITICISM OF GORDON’S MODEL
Gordon’s theory on dividend policy is criticized mainly for the
unrealistic assumptions made in the model.
1. 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.
2. No external financing
Gordon’s belief of all investments being financed by retained earnings
is faulty. This reflects sub-optimum investment and dividend policies.
Gordon’s Model Formula
P =
90578
OFS G,

P= Price of shares
E= Earnings per share
B= Retention Ratio
Ke= Cost of equity capital
r= Rate of return on investment of an all-equity firm

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The following information is available in respect of the rate of return
on Investment (r), the cost of capital (k) and Earning per share (E) of
ABC Ltd.
Rate of return on investment (r) = (i) 15%; (ii) 12; and (iii) 10%
Cost of Capital = (k) 12%
Earnings Per Share (E) = Rs.10
Determine the value of its shares using Gordon’s model assuming the
following:
Situation D/P ratio (1-b) Retention ratio (b)
(a) 100 0
(b) 80 20
(c) 40 60








SOLUTION
PROBLEM - 03 GORDON MODEL

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The company earning per share is Rs.12.
The Cost of equity is 12%
The company is adopting 70%, 40% and 10% as a Retention Ratio.
Compute the Market price of Shares when (R) is
(a) 12%
(b) 10%
(c) 14%














SOLUTION
PROBLEM - 04 GORDON MODEL

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The following information is available in respect of the rate of return
on Investment (r), the cost of capital (k) and Earning per share (E) of
XYZ Ltd.
Rate of return on investment (r) = 12%
Earnings Per Share (E) = Rs.20
Assume the following:
Situation D/P ratio (%) Retention ratio
(b)
Ke (%)
(a) 10 90 20
(b) 20 80 19
(c) 30 70 18
(d) 40 60 17
(e) 50 50 16
(f) 60 40 15
(g) 70 30 14





SOLUTION
PROBLEM - 05 GORDON MODEL

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24. GORDON MODEL
PROBLEM
PROBLEM
CHETHAN.S
DEPARTMENT OF MANAGEMENT, AIGS
GORDON MODEL PRACTICE QUESTION


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PRACTICE QUESTION

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3. Modigliani and Miller’s hypothesis (MM Model):

Modigliani – Miller theory was proposed by Franco Modigliani
and Merton Miller in 1961.
According to Modigliani and Miller (M-M), dividend policy of a
firm is irrelevant as it does not affect the wealth of the
shareholders. The only thing that impacts the valuation of a
company is its earnings, which is a direct result of the
company’s 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.

Assumptions.
1. The firm operates in perfect capital market
2. Taxes do not exist
3. The firm has a fixed investment policy
4. Risk of uncertainty does not exist. That is, investors are able
to forecast future prices and dividends with certainty and one
discount rate is appropriate for all securities and all time
periods.

Criticisms:
1 Because of the unrealistic nature of the assumption, M-M’s
hypothesis lacks practical relevance in the real world situation.
Thus, it is being criticized on the following grounds.
1 Perfect capital markets do not exist. Taxes are present in the
capital markets.

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1 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.
1 This theory believes that the shareholder’s 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.
1 The assumption of no uncertainty is unrealistic. The dividends
are relevant under the certain conditions as well.

Modigliani and Miller Approach (MM Model) Formula

a) Price of the share at the end of the current financial year

P1 = P0 (1+Ke)-D1

b) Number of shares to be issued


m =
tfrlfMdaR
2a


c) Value of the firm


nP0 =
(GDi)()






m= Number of shares to be issued
I= Investment required
E= Total earnings of the firm during
the period
P
1= Market price per share at the end
of the period
Po= Selling price of the share
K
e= Cost of equity capital
n= Number of shares outstanding at
the beginning of the period
D
1= Dividend to be paid at the end of
the period
nP
0= Value of the firm

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ABC Ltd., belongs to Risk class for which the appropriate
capitalization rate is 10%. It currently has outstanding 5,000 shares
selling at Rs.100 Each. The firm is contemplating the declaration of
dividend of Rs.6 per share at the end of the current financial year. The
company expects to have a net income of Rs.50,000 and has a
proposal for making new Investments of Rs.1,00,000. Show that
under the MM hypothesis, the payment of dividend does not affect the
value of the firm.













SOLUTION
PROBLEM - 06 MM MODEL

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The Abestors company belongs to a risk class of which the
appropriate capitalization rate is 10%. It currently has 1,00,000 shares
selling at Rs.100 each. The firm is contemplating the declaration of a
Rs.6 dividend at the current fiscal year, which has just begun. Answer
the following questions based on the MM Model and the assumption
of no taxes:
(a) What will be the price of the shares at the end of the year if (i)
Dividend is not declared; and (ii) if it is declared?
(b) Assuming that the firm pays dividend, has Net Income of
Rs.10,00,000 and makes new investment of Rs.20,00,000 during the
period, how many new shares must be issued?









SOLUTION
MM MODEL PROBLEM - 07

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DEPARTMENT OF MANAGEMENT, AIGS
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Expandent Ltd., had 50,000 equity shares of Rs.10 each outstanding
on January 1. The shares are currently being quoted at par in the
market. In the wake of the removal of dividend restraint, the company
now intends to pay a dividend of Rs.2 per share for the current
calendar year. It belongs to a risk-class whose appropriate
capitalization rate is 15%. Using MM Model and assuming no taxes,
ascertain the price of company’s share as it is likely to prevail at the
end of the year (i) When dividend is declared and (ii) when no
dividend is declared. Also find out the number of equity shares that
the company must issue to meet its investment needs of Rs.2 lakhs,
assuming a net income of Rs.1.1 lakh and also assuming that the
dividend is paid.
PROBLEM
MM MODEL PRACTICE QUESTION