DIVIDEND DECISION

Vishal Tanwar Room 32 Roll no. 506 St. Xaviers College

DIVIDEND POLICY INTRODUCTION:

Dividend is the amount which is paid by the company to the Investors as cash returns on their investments in the company. It is the distribution of Shareholders wealth.

Dividend policy is concerned with taking a decision regarding paying cash dividend in the present or paying an increased dividend at a later stage. The firm could also pay in the form of stock which unlike cash dividends do not provide liquidity to the investors; however, it ensures capital gains to the stockholders. The expectations of dividends by shareholders helps them determine the share value, therefore, dividend policy is a significant decision taken by the financial managers of any company.

Dividends paid by the firms are viewed positively both by the investors and the firms. The firms which do not pay dividends are rated in oppositely by investors thus affecting the share price. The people who support relevance of dividends clearly state that regular dividends reduce uncertainty of the shareholders i.e. the earnings of the firm is discounted at a lower rate, ke thereby increasing the market value. However, its exactly opposite in the case of increased uncertainty due to non-payment of dividends.

Different Types of Dividends

1. Cash dividends: These are the most common and are usually paid four times a year. 2. Stock dividends Stock dividends are not true dividends in that a distribution of stock does not affect the value of the firm or the wealth of the shareholder. These dividends are paid out of Treasury stock. 3. Stock split Similar to a stock dividend. The NYSE requires share distributions of less than 25% to be treated as stock dividends. 4. Share repurchases The company repurchases the stock. Shareholders pay tax only on the capital gains portion.

DIVIDEND POLICY DIFFERENT MODELS OF

The Dividend should reflect the

position and

profitability of the company. The various dividend policies followed by the corporates are as follows:

1. STABLE DIVIDEND POLICY:

The theory states that the dividend payout of the company should be guided with level of profitability. Hence essentially the PAYOUT RATIO is constant here.

2.RESIDUAL THEORY OF DIVIDEND:

One of the assumptions of this theory is that external financing to re-invest is either not available, or that it is too costly to invest in any profitable opportunity. If the firm has good investment opportunity available then, they'll invest the retained earnings and reduce the dividends or give no dividends at all. If no such opportunity exists, the firm will pay out dividends. If a firm has to issue securities to finance an investment, the existence of floatation costs needs a larger amount of securities to be issued. Therefore, the pay out of dividends depend on whether any profits are left after the financing of proposed investments as floatation costs increases the amount of profits used. Deciding how much dividends to be paid is not the concern here, in fact the firm has to decide how much profits to be retained and the rest can then be distributed as dividends. This is the theory of Residuals, where dividends are residuals from the profits after serving proposed investments. [6] This residual decision is distributed in three steps:

evaluating the available investment opportunities to determine capital expenditures. evaluating the amount of equity finance that would be needed for the investment, basically having an optimum finance mix.

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cost of retained earnings<cost of new equity capital, thus the retained profits are used to finance investments. If there is a surplus after the financing then there is distribution of dividends.

3. GORDONs MODEL:

Myron J. Gordon

Gordon's theory contends that dividends are relevant. This model is of the view that dividend policy of a firm affects its value. Assumptions of this model: 1. The firm is an all equity firm. No external financing is used and investment programmes are financed exclusively by retained earnings. 2. Return on investment( r ) and Cost of equity(Ke) are constant. 3. The firm has perpetual life. 4. The retention ratio, once decided upon, is constant. Thus, the growth rate, (g = br) is also constant. 5. Ke > br Arguments of this model: 1. Dividend policy of the firm is relevant and that investors put a positive premium on current incomes/dividends. 2. This model assumes that investors are risk averse and they put a premium on a certain return and discount uncertain returns. 3. Investors are rational and want to avoid risk. 4. The rational investors can reasonably be expected to prefer current dividend. They would discount future dividends. The retained earnings are evaluated by the investors as a risky promise. In case the earnings are retained, the market price of the shares would be adversely affected. In case the earnings are retained, the market price of the shares would be adversely affected. 5. Investors would be inclined to pay a higher price for shares on which current dividends are paid and they would discount the value of shares of a firm which postpones dividends. 6. The omission of dividends or payment of low dividends would lower the value of the shares.

DIVIDEND POLICY

Dividend Capitalization model: According to Gordon, the market value of a share is equal to the present value of the future streams of dividends. P = E(1 - b) Ke - br

Where: P E b 1-b Ke br - g = = = = = = Price of a share Earnings per share Retention ratio Dividend payout ratio Cost of capital or the capitalization rate Growth rate (rate or return on investment of an all-equity firm)

4. MM Model:

Franco Modigilliani

Merton Miller

Miller and Modigliani Model assume that the dividends are irrelevant. Dividend irrelevance implies that the value of a firm is unaffected by the distribution of dividends and is determined solely by the

DIVIDEND POLICY
earning power and risk of its assets. Under conditions of perfect capital markets, rational investors, absence of tax discrimination between dividend income and capital appreciation, given the firms investment policy, its dividend policy may have no influence on the market price of the shares, according to this model. Assumptions of MM model 1. Existence of perfect capital markets and all investors in it are rational. Information is available to all free of cost, there are no transactions costs, securities are infinitely divisible, no investor is large enough to influence the market price of securities and there are no floatation costs. 2. There are no taxes. Alternatively, there are no differences in tax rates applicable to capital gains and dividends. 3. A firm has a given investment policy which does not change. It implies that the financing of new investments out of retained earnings will not change the business risk complexion of the firm and thus there would be no change in the required rate of return. 4. Investors know for certain the future investments and profits of the firm (but this assumption has been dropped by MM later). Argument of this Model 1. By the argument of arbitrage, MM Model asserts the irrelevance of dividends. Arbitrage implies the distribution of earnings to shareholders and raising an equal amount externally. The effect of dividend payment would be offset by the effect of raising additional funds. 2. MM model argues that when dividends are paid to the shareholders, the market price of the shares will decrease and thus whatever is gained by the investors as a result of increased dividends will be neutralized completely by the reduction in the market value of the shares. 3. The cost of capital is independent of leverage and the real cost of debt is the same as the real cost of equity, according to this model. 4. That investors are indifferent between dividend and retained earnings implies that the dividend decision is irrelevant. With dividends being irrelevant, a firms cost of capital would be independent of its dividend-payout ratio. 5. Arbitrage process will ensure that under conditions of uncertainty also the dividend policy would be irrelevant. MM Model: 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. P0 = 1/(1 + ke) x (D1 + P1) Where: P0 = Prevailing market price of a share ke = cost of equity capital Dividend to be received at the end of D1 = period 1 and Market price of a share at the end of P1 = period 1. Value of the firm, nP0 Where: n = n = (n + n) P1 I + E = (1 + ke) number of shares outstanding at the beginning of the period change in the number of shares outstanding during the period/ additional

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I E = = shares issued. Total amount required for investment Earnings of the firm during the period.

FACTORS AFFECTING DIVIDEND POLICY

1. External Factors 2. Internal Factors

External Factors Affecting Dividend Policy

1. General State of Economy:

In case of uncertain economic and business conditions, the management may like to retain whole or large part of earnings to build up reserves to absorb future shocks. In the period of depression the management may also 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 because of availability of larger profitable investment opportunities. In periods of inflation, the management may retain large portion of earnings to finance replacement of obsolete machines. 2. State of Capital Market:

Favourable Market: liberal dividend policy. Unfavourable market: Conservative dividend policy. 3. Legal Restrictions:

Companies Act has laid down various restrictions regarding the declaration of dividend: Dividends can only be paid out of: Current or past profits of the company. Money provided by the State/ Central Government in pursuance of the guarantee given by the Government. Payment of dividend out of capital is illegal. A company cannot declare dividends unless: 4. Contractual Restrictions: Lenders sometimes may put restrictions on the dividend payments to protect their interests (especially when the firm is experiencing liquidity problems) Example: A loan agreement that the firm shall not declare any dividend so long as the liquidity ratio is less than 1:1. The firm will not pay dividend more than 20% so long as it does not clear the loan.

DIVIDEND POLICY Internal Factors affecting dividend decisions

1. Desire of the Shareholders: Though the directors decide the rate of dividend, it is always at the interest of the shareholders. Shareholders expect two types of returns: [i] Capital Gains: i.e., an increase in the market value of shares. [ii] Dividends: regular return on their investment. Cautious investors look for dividends because, [i] It reduces uncertainty (capital gains are uncertain). [ii] Indication of financial strength of the company. [iii] Need for income: Some invest in shares so as to get regular income to meet their living expenses. 2. Financial Needs of the Company: If the company has profitable projects and it is costly to raise funds, it may decide to retain the earnings. 3. Nature of earnings: A company which has stable earnings can afford to have a higher dividend payout ratio 4. Desire to retain the control of management: Additional public issue of share will dilute the control of management. 5. Liquidity position: Payment of dividend results in cash outflow. A company may have adequate earning but it may not have sufficient funds to pay dividends

Conclusion:
Hence we can say that Dividend is one of the most strategic decisions taken by the Board of Directors as it to a high degree affects the shareholders market capitalisation.