DIVIDEND THEORY & POLICY
The idea behind adoption of any dividend policy
should be ideally --- maximization of
shareholders wealth. The returns to the
shareholders consist of two parts viz. Dividends
and Capital gains.
The dividend policy adopted by the firm directly
influences both of these components of returns
to shareholders.
DIVIDEND THEORY & POLICY
That percentage of the total return on equity
which is allowed by the firm to be distributed in
the form of dividends is called the Pay out ratio.
Say, the PAT is 100 and 60 is allowed to be
distributed as dividend then Pay out ratio would
be 60% and 100-60=40% would be the Retention
ratio.
Recall : ROE = PAT/NET WORTH
NET WORTH = SHARE CAPITAL + RESERVES
GROWTH RATE = ROE X RETENTION RATIO
DIVIDEND THEORY & POLICY
Assume there are two companies namely LPC &
HPC. ROE of both the companies is 20% and
both the companies have one share of Rs.100/-.
DP ratio of HPC is 80% while LPC’s DP ratio is
20%.
HIGH PAYOUT COMPANY
YEAR CAPITAL/EQUIT ROE @ 20% DIVIDEN DS @ RETAINED
Y 80% EARNINGS
1 100 20 16 4
2 104 20.80 16.64 4.16
3 108.16 21.63 17.31 4.32
4 112.48 22.50 18 4.50
5 116.98 23.40 18.72 4.68
10 142.33 28.47 22.77 5.69
15 173.17 34.63 27.71 6.92
20 210.68 42.14 33.71 8.43
LOW PAYOUT COMPANY
YEAR CAPITAL/EQUIT ROE @ 20% DIVIDEN DS @ RETAINED
Y 20% EARNINGS
1 100 20 4 16
2 116 23.20 4.64 18.56
3 134.56 26.91 5.38 21.53
4 156.09 31.22 6.24 24.98
5 181.07 36.21 7.24 28.97
10 380.30 76.06 15.21 60.85
15 798.75 159.75 31.95 127.80
20 1677.65 335.53 67.11 268.42
COMPARISON HPC VRS. LPC
YEAR DIVIDEND HPC DIVIDEND LPC REMARKS
1 16 4
2 16.64 4.64
3 17.31 5.38
4 18 6.24
5 18.72 7.24
10 22.77 15.21
15 27.71 31.95 HIGHER THAN HPC
20 33.71 67.11 HIGHER THAN HPC
• LPC’s policy produces higher returns in the
long run because of accelerated earnings
growth.
• Growth = ROE x Retention ratio
For LPC : Growth = 20% x 80% = 16%(GROWTH
COMPANY)
For HPC : Growth = 20% x 20% = 4%
• If Growth is supposed to be a leading factor for
deciding the market price of shares of a company
then LPC’s shares will command higher market
prices and thus the shareholders will get the
advantage of capital gains.
• But, market price of shares also depend on the
demand of the shares in the market. Low dividend
in the initial years and Capital gains in the distant
future may also reduce the demand of such shares
thereby adversely affecting the market value of
these shares.
• HPC’s policy means more current dividends
and less retained earnings which leads to a
slow growth rate. This slow growth rate may in
turn reduce the market price of shares.
• Moreover, taxation policy of dividends and
capital gains may also play a major role in
deciding the demand for the shares of the
firms.
COMPARISON HPC VRS. LPC
YEAR RETAINED RETAINED REMARKS
EARNINGS HPC EARNINGS LPC
1 4 16
2 4.16 18.56
3 4.32 21.53
4 4.50 24.98
5 4.68 28.97
10 5.69 60.85
15 6.92 127.80
20 8.43 268.42
High pay out companies will have lesser funds at
their disposal for further expansions and new
projects.
This means that expansion and new projects will
be more difficult than Low payout companies.
However, for new projects and expansions the
company can always go for fresh capital issues.
Moreover, the market price of shares actually
depends on many other factors other than the
dividend policy or growth rate or expansion
schemes for that matter.
WALTER’S MODEL OF RELEVANCE OF DIVIDENDS
BASIC THEORY : Choice of dividend policy always
affects the market price of the shares.
ASSUMPTIONS : The firms finances all investments
through retained earnings, i.e., debt or new equity
is not issued.
The firms rate of return and cost of capital remain
constant.
100% of the earnings are either distributed as
dividends or are reinvested internally
immediately.
The firm has a very long or infinite life.
WALTER’S MODEL OF RELEVANCE OF DIVIDENDS
Walter gave the following formula for
determining the market price of shares.
DIV + (r/k) ( EPS-DIV)
P= ------------------------------ Where,
k
P = Market Price of Share
DIV = Dividend per share
EPS = Earnings per share
r = Firms average rate of return
k = Firms cost of capital walters [Link]
WALTER’S MODEL OF RELEVANCE OF DIVIDENDS
CRITICISM : The criticism of Walter’s model
are all of its assumptions viz.
No external financing
Constant rate of return
Constant cost of capital
GORDON’S MODEL( A BIRD IN HAND ARGUMENT)
Comparing two stocks of equal earnings record
and prospects, the one which pays a larger
dividend than the other, will naturally command a
higher price merely because shareholders prefer
the present to the future values.
The equation forwarded by Gordon is :
P = EPS ( 1 – b ) DIVIDED BY (k – g) WHERE,
b= retention ratio, k = Cost of capital, g=growth
rate, AND g = br
gordon's [Link]
MILLER MODIGLIANI HYPOTHESIS
Under a perfect market situation the dividend
policy of a firm is irrelevant as it does not
affect the value of a firm. (Here Value means
the wealth in the hands of the shareholders).
The argument is based on the hypothesis that
the value of a firm is primarily decided by the
firms investment policy. Thus it is argued that
the value of a firm will improve with a good
investment decision and dividend policies will
have no significance.
MILLER MODIGLIANI HYPOTHESIS
There can be three situations for a firm
operating in a perfect market condition.
A) The firm has sufficient funds to pay dividends.
B) The firm does not have sufficient funds to pay
dividends, given new investment plans and
hence issues new shares to finance the
payment of dividends.
C) The firm does not pay any dividends BUT the
shareholders need cash.
MILLER MODIGLIANI HYPOTHESIS
First case : Shareholders get cash in the form of
dividends BUT the assets of the firm reduce
(cash). The gain of the shareholders in the
form of dividends is offset by reduction of their
claims on the assets of the firm. The value of
the firm remains unaffected.
Second case : Increase in the capital base of the
firm through issue of new shares is set off by
decrease in the assets through payment of
dividends. Hence, here also there is no change
in the value of the firm.
MILLER MODIGLIANI HYPOTHESIS
Third case: When the firm does not pay any
dividend and the shareholders require cash,
the MM hypothesis suggests that the
shareholders will create “ HOME MADE
DIVIDEND” by selling a part of his
shareholding( at fair market value) and thus
obtain cash. Now the shareholder has less
number of shares with him BUT the number of
shares of the company has not changed.
Hence, the situation is as before and there is
no change in the value of the firm.
MILLER MODIGLIANI HYPOTHESIS
The decision of whether or not to pay
dividends is a financing decision as per MM. It
considers the earnings of a firm to be a source
of long term funds. Hence, dividends will only
be paid when the firm has no profitable
investment opportunities.
Further, the assumption of MM is that new
projects and operations can be funded by fresh
capital issues only and only when there are no
floatation costs.
MILLER MODIGLIANI HYPOTHESIS
Further, another assumption of MM is that
since the ability of the shareholders to earn
returns is less than that of the firm, the
shareholders will be indifferent as between
current dividends and retained earnings.
Hence, payment of dividends will not affect
the market price of the firm BUT the plans of
the firm for dealing with the retained earnings
will definitely increase the demand of the
shares.
DIVIDENDS – SOME FACTS
The view of some that dividends are irrelevant
is not entirely correct considering the realities.
In practice every firm follows some kind of
dividend policy. A typical policy generally
followed by most of the firms is to retain
between one third to half of the net earnings
and distribute the remaining.
Most companies in India tend to increase the
dividend rate with the increase in profits.
DIVIDIDEND RATE ?
DIVIDENDS – SOME FACTS
The two major factors, while considering a
particular dividend policy is :
a) Desire of the shareholders.
b) Needs of the firm.
The job of the BOD in this respect is to bring
about, a balance between the two factors
and thus decide on a practical dividend
policy.
DIVIDENDS – SOME FACTS
Investment opportunities of the firm and their
financial needs : Dividend policies have to be
tailored without causing frictions and keeping in
view the investment opportunities that are to be
tapped. Some firms have larger investment
opportunities and they should give precedence to
retention of earnings over payment of dividends.
There are some firms who are called “matured
firms” and they enjoy huge retained earnings
which provide cover for further investments and
hence these firms may at times declare 100%
dividend and tap the investment opportunities at
the same time.
DIVIDENDS – SOME FACTS
Shareholder’s expectations : Legally, the
shareholders are the owners of the company and
the Directors are just the agents appointed by the
shareholders. Therefore, the expectation of the
shareholders deserve due consideration. The
shareholder’s preference for current dividend or
capital gains depend on their economic status and
also on the taxation rules of the economy. The
decision on the expectation of the shareholders
depend on the concentration of the quality of
shareholders in a particular firm. ( Wealthy,
Retired people, Middle class, Institutional etc.)
DIVIDENDS – SOME FACTS
Some general observations regarding
Shareholder’s expectations :
It is easy to formulate a dividend policy of a closely
held company whereas it is a formidable task in
case of widely held company.
Small shareholders are not frequent purchasers of
shares and hold the shares generally for dividend
income.
Retired and old people hold the shares to get a
regular annual income in the form of dividends.
DIVIDENDS – SOME FACTS
Some general observations regarding
Shareholder’s expectations :
Wealthy investors generally like a policy of
retaining profits along with distribution of bonus
shares. They generally enjoy a dominating
position.
Institutional investors hold large blocks of shares
for a long period of time. They are not concerned
about taxation issues like the general investors.
They also prefer to receive current dividends to
incorporate in the income statement.
DIVIDENDS – SOME FACTS
Liquidity : The payment of dividends means
cash outflow. Although, a firm may have
adequate earnings to declare dividends, it may
not always have sufficient cash to pay it. Thus
the cash position is an important factor in
deciding on the dividend issue. A mature
company generally sufficiently liquid and is
able to pay large amount of dividends.
Stability of dividends is another major issue to
be considered.
DIVIDENDS – SOME FACTS
Bonus issue : In India, bonus shares are issued
in addition to, and not in lieu of dividends.
However, the fact of the matter remains that it
adds to the shareholders wealth and
complements the dividend.
Bonus shares are issued out of share premium
account and free reserves.
A company can declare bonus shares once in a
year.
The maximum bonus shares ratio is 1 : 1.
DIVIDENDS – SOME FACTS
Bonus issue :
The total net worth does not change as the
balance in the reserves & surplus accounts are
diluted to increase the basic capital accounts.
The objective of bonus shares is to create a
psychological value effect among the
shareholders. This is generally not possible by
any dividend policy.
DIVIDENDS – SOME FACTS
Share split : It is a method to increase the
number of shares through a proportional
reduction in the par value of the share. It
affects only the par value along with the
number of shares, while the net worth remains
unaffected as in the case of bonus shares.
Reasons may be : (a) Make trading attractive ,
(b) Signal possibility of higher profits in the
future(remain in the popular trading range)
and © Give higher dividend to shareholders.
• When the share is split, seldom does the
company reduce or increase the cash dividend
per share proportionately. That is the reason
why the total dividends receivable by a
shareholder increases. Example : A company
may have been paying cash dividend of Rs.3/-
per share before the split. After a split of
three-of –one , the company may pay a cash
dividend of Rs.1.50/- per share, thus giving the
shareholder a gain of 0.50 per share.
Perception of managers of Indian
companies
• Various studies show that the managers of Indian
companies are strongly in favour of paying regular
dividends. Most of the companies strive for
achieving stability of dividends and desire to
change only when they believe that the change
can be maintained. Many managers feel that the
current dividend are the mirror for current
earnings as well as for the future earnings
potential and past earnings. Dividend must be
paid even when a company needs funds for
undertaking profitable investment projects.