Dividend Decisions in Financial Management

Dividend Decisions

1. Chapter - IV DIVIDEND DECISIONS

2. INTRODUCTION The Major functions of finance are Investment Decisions Financing Decisions Liquidity Decisions Dividend Decisions

3. Meaning of Dividend A dividend is the distribution of a portion of the company's earnings, decided and managed by the company’s board of directors, and paid to a class of its shareholders. Dividends are payments made by publicly-listed companies as a reward to investors for putting their money into the venture.

4. Definition of Dividend A dividend is a share of profits and retained earnings that a company pays out to its shareholders. When a company generates a profit and accumulates retained earnings, those earnings can be either reinvested in the business or paid out to shareholders as a dividend. The annual dividend per share divided by the share price is the dividend yield.

5. Types of Dividend Types of dividends There are various types of dividends a company can pay to its shareholders.  Below is a list and a brief description of the most common types that shareholders receive. Types include: Cash  – this is the payment of actual cash from the company directly to the shareholders and is the most common type of payment. The payment is usually made electronically (wire transfer), but may also be paid by cheque or cash.

6. Types of Dividend Stock  – stock dividends are paid out to shareholders by issuing new shares in the company. These are paid out pro-rata based on the number of shares the investor already owns. Assets  – a company is not limited to paying distributions to its shareholders in the form of cash or shares.  A company may also pay out other assets such as investment securities, physical assets, and real estate, although this is not a common practice. Special  – a special dividend is one that’s paid outside of a company’s regular policy (i.e., quarterly, annual, etc.). It is usually the result of having excess cash on hand for one reason or another.

7. Determinants of Dividend Policy Legal Restrictions: Desire and Type of Shareholders Nature of Industry: Age of the Company: Future Financial Requirements: Government’s Economic Policy: Taxation Policy: Requirements of Institutional Investors: Stability of Dividends:

8. Theories of Dividend Policies MM Approach ( Modigliani – Miller ). Gorden’s Approach Walter’s Approach. The major concept of the theories of Dividend polices is that the dividend policies of the firm are affecting the value of the firm or not. That means the dividend decisions of the firm are relevant or irrelevant.

9. MM Approach (Modigliani – Miller) This approach explains that the dividend decisions are irrelevant that means the dividend decisions of the firm doesn’t affect the market value of the firm. The value of the firm is unaffected by the distribution of dividends and is determined solely by earning power and risk of it’s assets. Assumptions: Perfect Capital Market Rational Investors Absence of Tax Investment policy of the firm is constant

10. MM Approach (Modigliani – Miller) Formula for determining the value of the firm: nPo (V) = Value of the firm, n= No.of shares outstanding at the period. (Held Shares) P 1 = Price of the share the end of year 1. E= Total earnings of the period. I= Investment required , m = no. of shares to be issued during the period.

11. MM Approach (Modigliani – Miller) P 1 = Price of the share the end of year 1. P 1 = Po (1+Ke) – D 1 Po = Price of the share beginning of the year. D 1 = Dividend for the end of the year. Steps in calculation of Value of the firm (npo) or V Step 1 : Calculation of P 1 = Po (1+Ke) – D 1 Step 2: Calculation of no. of shares to be issued during the period (m) Step 3: Calculation of the value of the firm (npo)

12. Gorden’s Approach Gorden’s supported to the statement that “Dividends are relevant and dividend decisions can affect the value of the firm and value of the shares. Assumptions: The firm is all equity firm. No external financing is used. The rate of return on the firm’s investment is constant. The retention ratio (b) is constant. The cost of capital ( Ko ) is also constant. Corporate Taxes does not exist.

13. Gorden’s Approach Gorden’s formula for calculation of market price of the share. Where: P= Market price of share, E= Earnings per share, b=Retention Ratio, r= rate of return, Ke = Cost of equity.

14. Walter’s Approach To support the statement that the dividend decisions are relevant and affect the value of the firm. The relationship between rate of return earned by the firm and it’s cost of capital is very significant in determining the value of the firm in dividend policy. According to Prof. Walter : If “r > k “, the firm should retain the earnings, such firms termed as growth firms. If “r < k”, the firm doesn’t have profitable investments the shareholders would stand to gain if the distributes it’s earnings. These firms termed as decline firms.

15. Walter’s Approach If “r=k”, the firm dividend policy will affect the market price of share. Such firms, there is no optimum dividend payout and value of the firms would not change with the change in dividend rates. The market price of shares will remain constant. Assumptions: All financing through the retained earnings; no external source. With additional business undertaken, firm’s business risk would not change. Thus, ROI ( r) and required rate of return on capital ( k) are constant. There is no change in key variables, which are E and D.

16. Walter’s Approach Walter’s formula for determining the market price of the share: Where : P= Market price of share, E= Earnings per share, D=Dividend per share, r= rate of return, Ke= Cost of equity.