Dividend Policy

Concept and Significance

The term dividend refers to that portion of profit

which is distributed among the shareholders of the firm. The establishment and determination of an effective dividend policy is therefore, of significant importance to the firms overall objective. The dividend decision requires a financial manager to decided about the distribution of profits as dividends. The profits may be distributed in the form of cash dividends to shareholders or in the form of stock dividends (bonus shares).

Dividend Policy
Different models have been proposed to evaluated

the dividend policy decision in relation to value of the firm. Two schools of thoughts have emerged on the relationship between the dividend policy and value of the firm. Relevance of dividend policy
Walters model Gordons model

Irrelevance of dividend policy

Residuals theory of dividends
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Modigliani and Miller approach

Relevance of Dividend Policy Walters Model

Walter J.E. supports the view that the dividend

policy has a bearing on the market price of the share and has presented a model to explain the relevance of dividend policy for valuation of the firm based on the following assumptions:
All investment proposals of the firm are to be financed through

retained earnings only and no external finance is available to the firm. The business risk complexion of the firm remains same even after fresh investment decisions are taken, i.e. rate of return on investment r and the cost of capital of the firm ke are constant. The firm has an infinite life.
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Relevance of Dividend Policy Walters Model

If the firm pays dividend to shareholders, they in turn,

will invest this income to get further returns. This expected return to shareholders is the opportunity cost of the firm and hence the cost of capital, ke. On the other hand, if the firm does not pay dividends, and instead retains, then these retained earnings will be reinvested by the firm to get return on these investment. This rate of return on the investment, r, of the firm must be at least equal to ke, that means the firm is earning a return just equal to what the shareholders could have earned, had the dividends been paid to them.
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Relevance of Dividend Policy Walters Model

In nutshell, therefore, the dividend policy of a firm

depends upon the relationship between r and ke. If r>ke, the firm should have zero payout and reinvest the entire profits to earn more than the investors. If r<ke, then the firm should have 100% payout ratio and let the shareholders reinvest their dividend income to earn higher returns. If r=ke, the dividend is irrelevant and the dividend policy is not expected to affect the market value of the share.
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Relevance of Dividend Policy Walters Model

In order to testify the above, Walter has

suggested a mathematical model, i.e. P = (D/ke) + ((r/ke)(E-D))/ke Where, P = Market price of Equity share D = Dividend per share paid by the firm r = rate of return on investment of the firm ke = cost of equity share capital E = EPS of the firm

Relevance of Dividend Policy Gordons Model

Myron Gordan has also proposed a model suggesting

that the dividend policy is relevant and can affect the value of the share and that of the firm. It is based on the following assumptions:
All investment proposals of the firm are to be financed through

retained earnings only and no external finance is available to the firm. The business risk complexion of the firm remains same even after fresh investment decisions are taken, i.e. rate of return on investment r and the cost of capital of the firm ke are constant. The firm has an infinite life. The growth rate of the firm g, is the product of its retention ratio b and its rate of return r, i.e. g = br. The cost of capital besides being constant is more than the growth rate, i.e. ke>g

Relevance of Dividend Policy Gordons Model

This model suggests that the dividend policy is

relevant as the investors prefer current dividends as against the future uncertain capital gains. When the investors are certain about their returns, they discount the firms earnings at a lower rate and therefore, placing higher value for the share and that of the firm. This model shows that there is a relationship between payout ratio, cost of capital ke, rate of return r and the market value of the share.
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Relevance of Dividend Policy Gordons Model

Under this model, the market price of a share can

be calculated as follows: P = (E(1-b))/(ke-br) Where, P = Market price of equity share E = EPS of the firm b = Retention ratio (1-dividend payout ratio) r = rate of return on investment of the firm Ke = cost of equity share capital Br = growth rate of the firm
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Irrelevance of Dividend Policy Residuals Theory of Dividends

Two theories have been discussed here to focus

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on the irrelevance of dividend policy for valuation of the firm. Residual theory of dividends is based on the assumption that either the external financing is not available to the firm or if available, cannot be used due to its excessive costs for financing the profitable investment opportunities of the firm. If a firm has sufficient profitable investment opportunities, then the wealth of the shareholders will be maximized by retaining profits and reinvesting them in the financing of investment opportunities either by reducing or even by paying no dividend to the shareholders.

Irrelevance of Dividend Policy Residuals Theory of Dividends

Under the Residuals Theory, the firm would treat the dividend decision in 3 steps:
Determining the level of capital expenditure which is

determined by the investment opportunities. Using the optimal financing mix, find out the amount of equity financing needed to support the capital expenditures as above. Kr<ke (new equity), the retained earnings would be used to meet the equity portions financing in the above step. If the available profits are more than this need, then the surplus may be distributed as dividends to shareholders.

Hence in Residual theory, the dividend policy is influenced by:

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The companys investment opportunities and The availability of internally generated funds, where

Irrelevance of Dividend Policy Modigliani and Miller Approach

As per MM Model the dividend policy is immaterial

and is of no consequence to the value of the firm. What matters is the investment decisions which determine the earnings of the firm and thus affect the value of the firm. Assumptions of the MM Approach:
1. 2. 3. 4. 5. 6.
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The capital markets are perfect and the investors behave rationally. All information's are freely available to all the investors. There is no transaction cost and no time lag. Securities are divisible and can be split into any fraction. There is no taxes an no flotation cost. The firm has a defined investment policy and the future profits are known with certainty. The implication

Irrelevance of Dividend Policy Modigliani and Miller Approach

The model has used the arbitrage process to

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show that the division of profits between dividends and retained earnings is irrelevant from the point of view of the shareholders. The model shows that given the investment opportunities, a firm will finance these either by ploughing back profits or if pays dividends, then will raise an equal amount of new share capital externally by selling new shares. The amount of dividends paid to existing shareholders will be replaced by new share capital raised externally. The benefit of increase in market value as a

Irrelevance of Dividend Policy Modigliani and Miller Approach

Po = 1 / (1+ke) * (D1 + P1)
Where, Po = Present market price of the share Ke = Cost of equity share capital D1 = Expected dividend at the end of year 1 P1 = Expected market price of the share at the end of year 1

If the firm is going for fresh share capital: nPo = 1/(1+ke) * [(n+m)P1 I + E]
Where, nPo = Value of the firm Ke = Cost of equity share capital n = existing no of equity shares m = New no of equity shares P1 = Expected market price of the share at the end of year 1 I = Total funds required for investments E = Total Earnings

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Irrelevance of Dividend Policy Modigliani and Miller Approach

The success of the MM model depends upon the

arbitrage process i.e. replacement of amount paid as dividend by the issue of fresh capital.
The arbitrage process involves 2 simultaneous

actions:
Payment of dividend by the firm and Raising of fresh capital

With the help of arbitrage process, MM have

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shown that the dividend payment will not have any effect on the value of the firm.