CHAPTER - 18

Dividend Policy

PRACTICAL CONSIDERATION IN PAYING DIVIDENDS Financial Need of company. Shareholders Expectations. Closely / Widely Held Company. Constraints on Paying Dividends.

Legal Restrictions Liquidity Borrowing Capacity Access to the Capital Markets Restrictions in Loan Agreements

STABILITY OF DIVIDENDS
Constant Dividend per Share or Dividend Rate. Constant Payout. Constant Dividend per Share Plus Extra Dividend.

SIGNIFICANCE OF STABILITY OF DIVIDENDS

Resolutions of investors uncertainty. Investors desire for current income. Institutional Investors Requirement. Raising Additional Finances.

FORMS OF DIVIDENDS
Cash Dividends Bonus Shares (Stock Dividend).

Advantages for Shareholders and Company. Limitations of Bonus Issue. Conditions for Issue of Bonus Shares.

CORPORATE DIVIDEND BEHAVIOUR

Lintners Model
DIVt a +b * p * EPSt (1 b)DIVt 1 et

CHAPTER - 17

Dividend Theory

ISSUES IN DIVIDEND POLICY

Earnings to be Distributed High Vs. Low Payout. Objective Maximize Shareholders Return. Effects Taxes, Investment and Financing Decision.

RELEVANCE VS. IRRELEVANCE

Walter's Model Gordon's Model Modigliani and Miller Hypothesis The Bird in the Hand Argument Informational Content Market Imperfections

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WALTERS MODEL
Assumptions Valuation Optimum Payout Ratio Criticism

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ASSUMPTIONS
Internal Financing Constant Return and Cost of Capital 100% Payout or Retention Constant EPS and DIV Infinite Time

VALUATION

Market price per share is the sum of the present value of the infinite stream of constant dividends and present value of the infinite stream of capital gains.
P (DIV / k ) (r / k ) (EPS DIV) k

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EXAMPLE
r 0.15, 0.10, 0.08 k 0.10 EPS Rs 10 DPS 40% (0.15 / 0.1) P (4 / 0.1) (10 4) Rs 130 0.1 (0.10 / 0.1) P (4 / 0.1) (10 4) Rs 100 0.1 (0.08 / 0.1) P (4 / 0.1) (10 4) Rs 88 0.1

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OPTIMUM PAYOUT RATIO

Growth Firms Retain all earnings Normal Firms Distribute all earnings Declining Firms No effect

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CRITICISM
No external Financing Constant Rate of Return Constant opportunity cost of capital

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GORDON'S MODEL
Assumptions Valuation Optimum Payout Ratio Criticism

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ASSUMPTIONS
All Equity Firm No External Financing Constant Return and Cost of Capital Perpetual Earnings No Taxes Constant Retention Cost of Capital greater than Growth Rate

VALUATION
Market value of a share is equal to the present value of an infinite stream of dividends to be received by shareholders
P EPS(1 b) /(k br )

EXAMPLE
r 0.15, 0.10, 0.08 k 0.10 EPS Rs 10 b 60% P (1 0.6) / 0.10 (0.15 * 0.6) = Rs 400 P 10(1 6) / 0.10 (0.10 * 0.6) = Rs 100 P 10(1 0.6) / 0.10 (0.08 * 0.6) = Rs 77

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OPTIMUM PAYOUT RATIO

Financial Management, Ninth Edition I M Pandey Vikas Publishing House Pvt. Ltd.

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Growth Firms Retain all earnings Normal Firms Distribute all earnings Declining Firms No effect

THE BIRD IN THE HAND

Argument put forward, first of all, by Kirshman Investors are risk averters. They consider distant dividends as less certain than near dividends. Rate at which an investor discounts his dividend stream from a given firm increases with the futurity of dividend stream and hence lowering share prices.

MODIGLIANI AND MILLER

According to M-M, under a perfect market situation, the dividend policy of a firm is irrelevant as it does not affect the value of the firm. They argue that the value of the firm depends on firm earnings which results from its investment policy. Thus when investment decision of the firm is given, dividend decision is of no significance.

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MARKET IMPERFECTIONS
Tax Differential Low Payout Clientele Flotation Cost Transaction and Agency Cost Information Asymmetry Diversification Uncertainty High Payout Clientele Desire for Steady Income No or Low Tax on Dividends

INFORMATIONAL CONTENT OF DIVIDEND

. In an uncertain world in which verbal statements can be ignored or misinterpreted, dividend action does provide a clear cut means of making a statement that speaks louder than a thousand words. Solomon