DIVIDEND POLICY

K.VISWANATAHAN

4/13/15

DIVIDEND POLICY
What is dividend policy?
The proportion of earnings to be paid to
the shareholders and the amount to be
ploughed back into the business.
A higher dividend pay out will entail higher
external financing. Thus Dividend decision
affects capital budgeting decision.
There is a reciprocal relationship between
dividend payout and retained earnings
The relationship between dividend policy and
market price of shares is one of the most
controversial and unresolved questions in
corporate finance.
4/13/15

DIVIDEND POLICY
What factors affect Dividend Policy decisions?
External Factors affecting Dividend decisions:
1. General State of Economy
2. State of Capital Market
3. Legal Restrictions
4. Contractual Restrictions
Internal Factors affecting Dividend decisions:
5.
Desire of the Shareholders
6.
Financial Needs of the Company
7.
Nature of earnings
8.
Desire to retain the control of management
9.
Liquidity position

4/13/15

DIVIDEND POLICY
Dividend Policy Models
In
most of the Models, investment and
dividend decisions are unrelated and
independent.
But some models assume dependence of
one on another. They consider dividend as
relevant for the investors
to decide on
investing in a company.
The models we will study are:
1.
Walter Model- relevant
2.
Gordon Model- relevant
3.
Traditional Position-relevant
4/13/15
4
4.
Miller and Modigliani Position- irrelevant

DIVIDEND POLICY
1.
Walter Model:
James Walters Model supports the view that the dividend policy of a firm has bearing
on share valuation. The model is based on the following assumptions:
2. The firm is an all equity financed entity, which will rely only on retained earnings to
finance its future investments.
3. The rate of return on investments is consistent.
4. The firm has infinite life.
The following is the formula put forward:
Equation 1
P- Price per Equity share
D- Dividend per share
E- Earnings per share
r- Rate of return on investment
k- Cost of capital
So price per share is a sum of two components :
Equation 2
The first is the present value of an infinite stream of dividends
The second is the present value of an infinite stream of returns from retained
earnings.
4/13/15

DIVIDEND POLICY

The present value of an infinite stream of dividends (D) is:

The second component is derived as follows:
The return from the first retained earnings (E-D) would be
Time 0
1
2
3
4
(E-D)r
(E-D)r
(E-D)r
( Since the retained earnings at the end of period 1 earns
returns only at the end of period 2.)
The present value of this stream of returns is:
Time 0

5
(E-D)r

(E-D)r

(E-D)r
The present value of this stream of returns is:

4/13/15

DIVIDEND POLICY
The present value of this stream of returns is :
(4)
Likewise the present value of the stream of returns from the 3rd retained
earnings will be :
(5)
and so on and so forth.
Adding the present value of stream of returns from all retained
earnings , we get
(6)
4/13/15

DIVIDEND POLICY
Exercise:
Consider a growth firm (r > k), a normal firm(r=k)
and a declining firm (r < k), each of them with the
following details:
r=20%,15% and 10%; k=15%, E=Rs.4, D=Rs.4
Find the value of their shares using Walter Model.
Find their value if D=Rs.2 instead of Rs.4

4/13/15

DIVIDEND POLICY
Numerical Examples for Walter
Model:

4/13/15

DIVIDEND POLICY
Implications of Walter Model:
1. When the rate of return is greater than the cost
of capital (r>k), the price per share
increases as the dividend payout ratio
decreases.
2. When the rate of return is equal to the cost of
capital (r=k), the price per share does not vary
with changes in dividend payout ratio.
3. When the rate of return is lesser than the
cost of capital (r<k), the price per share
decreases, as the dividend payout ratio
decreases.
4/13/15

10

DIVIDEND POLICY
Implications of Walter Model:
Thus the Walter model implies that :
The optimal payout ratio for a growth firm (r>k) is Nil.
The optimal payout ratio for a normal firm (r=k) is
irrelevant.
The optimal payout ratio for a declining firm (r<k) is 100%.
But these policy implications lead to very extreme courses of
action, which make limited sense in the real world.
Despite this, this Model is a useful tool to show the effects of
dividend policy under varying profitability assumptions.

4/13/15

11

DIVIDEND POLICY
Gordon Model
Myron Gordon proposed this model for stock valuation
using the dividend capitalisation approach
Assumptions:

Retained earnings represent the only source of

financing for the firm.

The rate of return on the firms investment is

constant.

The growth rate of the firm is the product of its

retention ratio and its rate of return. This follows the
first two assumptions.

The cost of capital for the firm remains constant

and it is greater than the growth rate.

The firm has perpetual life.

Tax does not exist.

4/13/15
12

DIVIDEND POLICY
Gordon Model
Gordons valuation formula is :

Equation
P0
E1
(1-b)
b
k
r
br

is the price of the share at the end of year o

is the earnings per share at the end of year 1.
is the fraction of the earnings that the firm distributes as
dividend
is the fraction of earnings the firm retains.
is the rate of return required by shareholders
is the rate of return earned on investments by the
firm
is the growth rate of earnings and dividends

An
Exercise under Gordon Model is given in a subsequent slide
4/13/15
13

DIVIDEND POLICY
The formula is derived as under:

4/13/15

14

DIVIDEND POLICY
Exercise:
Consider a growth firm (r > k), a normal firm(r=k)
and a declining firm (r < k), each of them with the
following details:
r=20%, 15% AND 10%; k=15%, E=Rs.4, b=0.25
Find the value of their shares using Gordon Model.
Find their value if B=0.50

4/13/15

15

DIVIDEND POLICY
Gordon Model- Illustration

4/13/15

16

DIVIDEND POLICY
Gordon Model- Implications:
1.
When the rate of return is greater than the discount
rate (r>k), the price per share increases as dividend
payout ratio decreases
2.
When the rate of return is equal to the discount rate
(r=k), the price per share remains unchanged in
response to the variations in dividend payout ratio.
3.
When the rate of return is less than the discount rate
(r<k), the price per share increases as the dividend
payout ratio increases.
Basic Gordon model leads to dividend policy implications,
which are same as that of Walter Model :
.
The optimal payout ratio for a growth firm ( r>k) is Nil.
.
The payout ratio for a normal firm (r=k) is irrelevant
.
The optimal payout ratio for a declining firm (r<k) is
100%
4/13/15

17

DIVIDEND POLICY
Traditional Position: (Graham & Dodd):
Stock market places considerably more weight on dividends than
on retained earnings.
The multiplier applied to the portion of earnings paid out in
dividends is larger compared to the multiplier applied on

retained earnings:
The model proposed is as under:

P- Mkt price per share

m- Multiplier
D- Dividend per share
E- Earnings per share
4/13/15

18

DIVIDEND POLICY
Traditional Position: ( Graham & Dodd):
According to them the weight attached to dividends is
4 times the weight attached to retained earnings . This
is clear from the following version of the equation in
which E is replaced by (D+R).

The weights provided by Graham and Dodd are based

on their subjective judgment
The major contention of the position is that liberal
payout policy has favourable impact on stock
price
4/13/15

19

DIVIDEND POLICY
According to Traditional Position expounded by Graham
and Dodd, Price is given by the cross- section regression
equation
Price= a+ b Dividend+ c Retained earnings
( Equation 4)
In such a regression equation, the dividend co-efficient
b is higher than the co-efficient for retained
earnings c.
But it basically omits the risk element
The better regression co-efficient should be :
Price = a+ b Dividend+ c Retained earnings +d Risk
(Equation 5)
In this equation b and c are expected to be positive
where as d is negative- because dividend and risk are
inversely correlated- the higher the level of risk the
smaller the dividend etc. Thus if risk is omitted, there
can
be an upward bias to b.
4/13/15
20

DIVIDEND POLICY
Another point is the measurement
error.
Measurement of earnings is always subject to
error. However the figure of dividend is given
precisely, where as retained earnings = total
earnings- dividend. Thus the error in a regression
analysis,
whose
co-efficient
is
subject
to
measurement error makes the co-efficient biased
downwards.
Thus the omission of risk imparts an upward bias to
b and the measurement error imparts a downward
bias to c. Hence the claim of the traditionalists that
b>c implies that a higher dividend payout increases
stock value cannot be vindicated.
4/13/15

21

DIVIDEND POLICY
Miller and Modigliani Position:
They are of the view that the value of the firm depends
solely on its earning power and is not influenced by
the manner in which the earnings are split between
dividend and retained earning. Their view, referred to
as the dividend irrelevance theorem, is based on
following assumptions:
Capital markets are perfect and investors are rational,
transactions are instantaneous and costless, securities are
divisible and no investor can influence the market prices.
Floatation costs are nil .
There are no taxes
Investment costs and future profits of the firm are known
with certainty (Assumption dropped later)
Investment and dividend decisions are independent
4/13/15

22

DIVIDEND POLICY

Miller and Modigliani Position:

If a company retains earnings, the investor enjoys
capital appreciation.
If earnings are distributed, they earn dividend equal
in value to the capital appreciation.
Hence the division is irrelevant for valuation.
The valuation formula used is :

Equation 1
P0
D1
P1
p4/13/15

=
=
=
=

Market price at time 0,

Dividend per share at time 1.
Market price per share at time 1.
Discount applicable to the risk 23

DIVIDEND POLICY

Miller and Modigliani Position:

From the above equation, the value of the outstanding shares of

the firm at time 0:

Equation 2
n
nP0
nD1
o/s at

= No of equity shares at time 0;

= the total mkt value of the o/s shares at time 0;
= total dividends in year 1 payable on equity shares

time1 @price P1( prevailing mkt price at time1);

m = No of equity shares issued at time 1 @price P1
(prevailing market price at Time 1)
(n+m)P1 = total market value of all equity shares o/s at time 1;
mP1
= Market value of shares issued at time 1
p
= discount rate
4/13/15

24

DIVIDEND POLICY

Miller
and
Illustration:

Modigliani

Position-

The position of Zeta Ltd is as under:

No of shares:
1000
(n 0)
Price per share
Rs. 10
(P 0)
Expected earning Rs. 1000
(X 1)
Investment need for next year Rs. 1110 (I 1)
Dividend paid
Re 1
(D 1)
If Zeta Ltd pays out the dividend, P 1 will be Rs.10 and it will have to
issue 111shares @ Rs. 10 each to raise the finance for its investment
If it does not pay dividend , but retains it, then the share price will be
Rs. 11 and it will have to issue only 10 shares @ Rs. 11 each to fund
the investment
Thus irrespective of what D1 is (n+m)P1 ( the total value of equity at
then end of year 1 ) will be Rs. 11,110.
4/13/15

25

DIVIDEND POLICY
Miller and Modigliani PositionImplications :
MM dividend irrelevance theorem rests on their leverage
irrelevance theorem. In the Zeta Ltd example, it was assumed
that external finance was raised by issuing additional equity.
Since the real cost of debt and equity as per MM Leverage
irrelevance theorem is the same, it is immaterial how the
finance is raised- by way of debt or equity.
There is no conflict between dividend capitalisation approach
to valuation and the MM dividend irrelevance theorem. MM
dividend irrelevance
does not imply that the value of an
equity share is not equal to the present value of future streams
of dividends expected from its ownership. It only means that
even though the dividend policy of the firm may influence the
timing and magnitude of the dividend payments, it cannot
change the present value of the total stream of dividends.
4/13/15

26

DIVIDEND POLICY
Miller and Modigliani Position-Criticism :
According to critics, dividends matter due to
uncertainty characterising the future, imperfections of
the capital market and the existence of taxes.
Information about future prospects of the co.
Uncertainty and fluctuations make investors prefer a
higher pay out ratio.
MM assumes offering additional equity at same price.
In reality it will be at lower prices

Higher
dividend
payout

4/13/15

Greater Volume of
underpriced
equity issue to
finance a given
level of
investment

Greater
dilution of
the value
of equity
27

DIVIDEND POLICY

Miller and Modigliani Position-Criticism :

Issue Cost : In real world , issue costs are
there.
Transaction costs- commission etc increase
the cost of share sale and purchase
Differential rates of taxes- taxes on current
income and capital gains are different
Rationing: Dividend policy and investment
policy may have correlation.
Firms may make unwise investments- where
return is lower than cost of capital.
Information content: Lower or higher dividend
announcement signals managements view of
4/13/15 future of the company.
28
the

DIVIDEND POLICY
Rational Expectation hypothesis: A way of
reconciliation
Its central argument is that what matters is not what
happens, but the difference between what happens
and what was expected to happen.
If the dividend declared is what the market expected,
there would be no change in the market price of the
share, even if the dividend is higher or lower than the
previous dividend. Market normally discounts the
dividend in advance.
But if the dividend is higher than that expected by the
market, market revises its assessment. This will push
up prices. A similar downward revision is also possible.
The revisions are nothing but the underlying revision
of
the estimate of the earning potential.
4/13/15
29

DIVIDEND POLICY
Radical position:
Since dividends are taxed heavier than capital gains ,
the argument is that there should be lesser dividends.

4/13/15

30

DIVIDEND POLICY
Explanation of Radical Position:
Capital gains are taxed lighter than dividends. Hence
preferred.
In the example both A and B have the same expected pre-tax
pay off of Rs. 120 .
Investors consider the worth of the share of A = Rs. 120 even
though it does not plan to pay dividend next year. From the
share of B investors expect Dividend of Rs. 15 and capital of
Rs. 105.
Even though both offer Rs. 120 pay off in the next year, As
stock sells at a higher price because investors prefer capital
gains as against dividend.
Again capital gains tax has to be paid only at the time of
sale. The longer the shares are held, the lesser the present
value of the tax liability.
Dividend tax is to be paid immediately.
4/13/15

31

DIVIDEND POLICY

THANK YOU

4/13/15

32