Module V: Dividend

Decisions
Syllabus
Module V: Dividend Decisions
• Dividend Decisions - Dividend Policy - Conservative Vs Liberal
policy - Pay-out ratio, Retention ratio - Dividend theories -
Irrelevance theory - Modigliani-Miller Hypothesis; Relevance
theories - Walter’s Model, Gordon’s Model - Determinants of
dividend policy - Bonus shares, Stock split
 Finance Functions and Decisions
Long-Term Financial Decisions:
•Investment Decision (Long-Term Asset-Mix): Determining where to
invest funds for maximum returns, such as in new projects, machinery,
or expansions.
•Financing Decision (Capital-Mix): Deciding how to raise funds (e.g.,
through equity, debt, or retained earnings) to finance investments.
•Dividend Decision (Profit Allocation): Deciding how much of the earned
profits should be distributed to shareholders as dividends versus
reinvested into the business.
Short-Term Financial Decisions:
•Liquidity Decision (Short-Term Asset-Mix): Managing the balance
between cash inflows (e.g., revenue) and outflows (e.g., expenses) to
ensure the firm can meet its immediate obligations and maintain
operational stability.
Dividend Meaning
• Dividend is that part of Profit After Tax (PAT) which is
distributed to the shareholders of the company.
• Further, the profit earned by a company after paying taxes can
be used for:
i. Distribution of dividend, or
ii. Retaining as surplus for future growth
FORMS OF DIVIDEND
1. Cash dividend:
• It is the most common form of dividend.
• Cash here means cash, cheque, warrant, demand draft, pay
order or directly through Electronic Clearing Service (ECS) but
not in kind.
2. Stock Dividend (Bonus Shares)
• Bonus shares are additional shares given to existing
shareholders instead of a cash dividend, issued free of cost and
in proportion to their current holdings.
• For example, a 10% bonus means a shareholder with 100 shares
receives 10 extra shares.
• This increases the equity share capital while reducing retained
earnings, but the company’s total net worth remains unchanged
since no new funds are involved—only reserves are capitalized.
Conditions for Stock Dividend (Bonus
Issue) –
To issue bonus shares, a company must meet SEBI’s conditions:
• Bonus shares must not replace cash dividends.
• The company’s Articles of Association must authorize bonus
issues.
• All partly paid shares must be fully paid before a bonus issue.
• The company must not have defaulted on loans, interest, or
statutory dues.
• Bonus shares can only be issued from share premium or free
reserves, not from revaluation reserves.
3. Interim Dividend
• Declared and paid before the finalization of annual profits
(during the financial year).
• Declared by the Board of Directors.
4. Final Dividend
• Declared at the Annual General Meeting (AGM) after final
accounts are approved.
• Recommended by the board but approved by shareholders.
5. Property Dividend
• Rare.
• Paid in the form of assets or goods instead of cash or shares.
6. Scrip Dividend
• Company issues a promissory note to pay dividends at a later
date (a kind of credit dividend).
• Used when the company has profits but insufficient cash.

7. Liquidating Dividend
• Paid out of the company’s capital rather than profits.
• Happens when a company is winding up.
• Considered a return of capital, not income.
Factors Affecting Dividend Policy:
[Link] of Funds:
• If a business needs funds, it may retain earnings instead of paying dividends.
• Retention helps avoid dilution of control and high financing costs.
[Link] of Capital:
• If external financing is costly, it's better to use retained earnings for funding.
[Link] Structure:
• An optimal debt-equity ratio should be maintained, influencing the dividend
decision.
[Link] Price:
• Higher dividends can increase market value of shares.
[Link] Opportunities:
• Companies with better investment prospects retain earnings rather than pay
high dividends.
6. Trend of Industry:
• Firms in stable industries often pay regular dividends; new or high-
growth industries may not.
7. Expectation of Shareholders:
• Shareholders seeking regular income expect steady dividends.
• Growth-focused investors prefer reinvestment over dividends.
8. Legal Constraints:
• As per Section 123 of the Companies Act, 2013, dividends can be
declared only:
• Out of current or past profits (after depreciation and statutory dues).
• Out of funds provided by the Central or State Government under a guarantee.
Conservative Dividend Policy
• The company pays low or no dividends, preferring to retain most of
its earnings for reinvestment in the business.
• Objective: Focuses on long-term growth, expansion, and
strengthening the financial position.
• Features:
• High retention ratio (more profits retained).
• Suitable for growing companies or those with high capital needs.
• Provides internal financing, reducing reliance on external debt.
• Pros:
• Supports long-term growth.
• Enhances financial stability.
• Less burden during low-profit years.
• Cons:
• May disappoint income-seeking shareholders.
• Could signal lack of profitability if not communicated properly.
Liberal Dividend Policy
• The company pays a high proportion of its profits as dividends to
shareholders.
• Objective: To provide regular and generous income to shareholders.
• Features:
• High dividend pay-out ratio.
• Suitable for stable, mature companies with limited reinvestment needs.
• Pros:
• Attracts income-oriented investors.
• Enhances market reputation and investor confidence.
• Cons:
• May reduce funds available for growth.
• Can lead to cash flow issues if not managed properly.
 Pay-out Ratio
The portion of net profits distributed to shareholders as dividends.

Example: If a company earns ₹10 crore and pays ₹4 crore as dividends,

Pay-out Ratio = (4 / 10) × 100 = 40%
Implication: A higher ratio suggests a liberal policy, while a lower ratio
implies a conservative approach.
3. Retention Ratio
• The portion of net profits retained in the business for
reinvestment.

Example: If Pay-out Ratio is 40%,Retention Ratio = 100% - 40% = 60%

Implication: A high retention ratio indicates a focus on growth and
expansion.
Significance of Dividend Policy
• A firm's dividend policy is important for two main decisions:
(i) Long-Term Financing Decision:
• Companies can finance using equity, which may come from issuing
new shares or using retained earnings.
• Retained earnings are preferred due to no flotation costs.
• The decision to retain or distribute profits is key, as distributing
dividends reduces the funds available for future investments.
• The firm must consider:
• If it has good opportunities to invest retained profits.
• If the expected return on investment (ROI) is more than the expected
return by shareholders (Ke).
(ii) Wealth Maximization Decision:
• This relates to how much dividend should be paid out (Dividend
Payout Ratio or D/P) relative to the market price of shares
(MPS).
• Shareholders prefer current dividends due to market
uncertainty.
• High dividends can raise share value; low dividends may
reduce it.
• A balance is needed between dividends and future gains.
• Retaining earnings can lead to fewer dividends and a drop in
market price.
• However, retained earnings can finance profitable
investments, increasing future share value.
• Lack of dividends may upset shareholders if investment
opportunities are not fruitful.
Theories of Capital
Structure
Dividend’s Irrelevance Theory – MM
Hypothesis
• According to Modigliani and Miller (1961), a firm's dividend
policy is irrelevant—it has no impact on the firm’s stock price
or cost of capital.
• What matters is the firm’s earning power, not whether profits
are paid as dividends or retained.
According to MM Hypothesis:
• Market value of equity shares of a firm depends solely on its
earning power and is not influenced by the manner in which its
earnings are split between dividends and retained earnings.
• Dividend size does not affect the value of equity shares.
• No difference between dividends and share buybacks—both are
just ways of returning money to shareholders.
Assumptions of MM Hypothesis:
[Link] Capital Markets – All investors have access to the
same information and act rationally.
[Link] Taxes – No difference in taxation between dividends and
capital gains.
[Link] Investment Policy – Investments are financed only
through equity.
[Link] Floatation or Transaction Costs – No cost in issuing shares
or trading.
[Link] Risk or Uncertainty – Future returns are known and
predictable.
Situations under MM Hypothesis:
1. Firm pays cash dividends from Reserve & Surplus:
• In this case, shareholders receive a cash dividend directly from
the firm’s existing reserves.
• This reduces the cash balance of the firm but does not change
the overall value of the shareholders’ wealth.
• It is simply a transfer of assets (cash) from the firm to
shareholders—like moving money from one pocket to another.
• Conclusion: No gain or loss in shareholder wealth; the value of
the firm remains unchanged.
2. Firm pays cash dividends from new issue of shares:
• If the firm lacks sufficient cash for dividends, it may issue new
shares to raise funds and pay dividends.
• While shareholders receive a dividend, they also face a capital
loss due to:
• Dilution of control over company assets.
• Reduction in earnings per share (EPS) due to an increase in
the number of shares.
• Conclusion: Any gain from dividends is offset by the capital
loss, so shareholder wealth remains unchanged.
3. Firm does not pay any dividend:
• If no dividend is paid but a shareholder desires cash, they can
sell a part of their shareholding in the market.
• The cash received is known as a “home-made dividend.”
• Though the shareholder gets cash, they experience a capital
loss due to reduced ownership/control.
• Conclusion: The overall wealth of the shareholder stays the
same, and the value of the firm remains unchanged.
Formula
• According to MM, the market price of a share today is equal to
the present value of dividends plus the present value of the
price of the share at the end of the period:
1. Walter’s Model
Proposed by: Prof. James E. Walter
• Walter’s Model explains the relationship between the firm’s
dividend policy and the market value of its shares.
• It suggests that dividend decisions are relevant and can affect
the value of the firm.
• Walter’s Model explains how dividend policy affects the value
of a firm and, therefore, the wealth of equity shareholders.
• The model suggests that the choice between distributing
profits as dividends or retaining them for reinvestment does
influence share value.
• Prof. Walter argues that in the long run, Share prices reflect the
present value of expected dividends.
• Explains - relationship between IRR (r) and Ke (cost of capital)
and its impact on share price & dividend policy
• Walter’s Model focuses on how the return the company earns on
its retained earnings (r) compares to the return investors expect
(Ke).
This relationship helps determine:
• Whether the company should pay dividends or retain earnings.
• How that decision affects the market price of the company’s
shares.
1. When r > Ke (Growth Company)
• The company earns more on reinvested profits than what shareholders
expect from other investments.
• For example:
• r = 15%, but Ke = 10%
• In this case, retaining earnings is more beneficial than paying
dividends.
• Even if the dividend is low or zero, the share price will rise because:
• Future earnings from reinvested funds will lead to higher future
dividends.
• Shareholders gain more wealth through capital appreciation.

• Conclusion: Shareholders are okay with lower dividends because

retained earnings create higher future value.
2. When r = Ke (Constant/Normal Company)
• The company earns just as much on reinvested profits as
shareholders expect from other opportunities.
• Example:
• r = 10%, Ke = 10%
• In this case, it doesn't matter whether the firm pays dividends
or retains earnings.
• Both decisions will have no impact on the market price of
shares.
• Conclusion: Dividend policy is irrelevant—shareholders are
indifferent to whether they receive dividends now or later.
3. When r < Ke (Declining Company)
• The company earns less on reinvested profits than shareholders can
earn elsewhere.
• Example:
• r = 8%, Ke = 12%
• If the company retains earnings, it is destroying shareholder value,
because:
• Shareholders could earn more by receiving that cash and
investing elsewhere.
• So, shareholders prefer high or full dividends.
• Conclusion: It’s better to distribute all earnings as dividends. This
keeps shareholders happy and maximizes their wealth.
Condition Interpretation Best Dividend Policy

Retaining profits increases Retain all earnings

r > Ke
share value (Low/No Dividend)
No effect on value from
r = Ke Any payout is fine
dividend decision
Paying dividends preserves
r < Ke Pay full dividend
shareholder value
 Assumptions of Walter’s Model
Walter’s approach is based on the following key assumptions:
[Link] Through Retained Earnings Only
• All investments are financed through retained earnings.
• No external financing (like debt or new equity issue) is used.
[Link] Return and Cost of Capital
• The rate of return (r) on the firm’s investments and the cost of equity
capital (Ke) remain constant.
[Link] Capital Markets
• All investors are rational.
• Information is freely available and there are no market imperfections.
3. No Taxes or Tax Discrimination
• No taxes exist, or there is no difference between taxation on
dividends and capital gains.
• This assumption ensures uniform application of the model
across countries.
4. No Flotation or Transaction Costs
• There are no costs involved in buying, selling, or issuing
securities.
• This helps isolate the effect of dividend policy on share
value.
5. Perpetual Life of the Firm
• The firm has an infinite lifespan, allowing long-term effects
of retained earnings to be analyzed.
Walter’s Formula
2. Gordon’s Dividend Capitalization
Model
• Proposed by: Myron J. Gordon
• Dividend policy is relevant—and it does affect the value of a firm.
• Gordon’s Model supports the idea that investors prefer dividends
now over uncertain future capital gains (also known as the “bird-in-
hand” theory).
• Stock prices reflect the discounted value of future dividends that
investors expect to receive forever. OR
• A stock’s price is what people are willing to pay today, based on
how much cash they believe it will give them in the future —
adjusted for time and risk.
Assumptions of Gordon’s Model:
[Link]-Equity Firm
• The firm is financed entirely by equity (no debt).
[Link] IRR (r)
• The internal rate of return remains unchanged over time.
[Link] Cost of Equity (Ke)
• The discount rate (Ke) stays constant.
[Link] Retention Ratio (b)
• The company retains a fixed percentage of its earnings.
[Link] Growth Rate (g = br)
• Since both b and r are constant, g is also constant.
[Link] External Financing
• All investment is done through retained earnings, not through debt or new
equity.
 Condition (r Optimum Dividend
Company Type Explanation
vs Ke) Payout Ratio

The firm earns more on retained

earnings than what shareholders
Growth Company r > Ke 0% (retain all earnings)
expect, so it should reinvest
everything to maximize value.

Retaining or paying out doesn't

No specific optimum
Normal Company r = Ke affect value. Dividend policy is
ratio
irrelevant.

Shareholders can earn more

Declining 100% (pay all as
r < Ke elsewhere, so company should not
Company dividends)
retain earnings.
• When the company can grow profits faster than what investors
expect, it’s smarter to retain earnings.
• When the company cannot beat investor expectations, better
to pay dividends and let investors reinvest elsewhere.
The Bird-in-Hand Theory (Gordon’s Revised Model)
• as an extension of his earlier dividend relevance theory.
• A bird in the hand is worth more than two in the bush.
• Investors prefer current, certain dividends over future,
uncertain capital gains.
Assumptions:
[Link] are risk-averse
→ They don’t like uncertainty and prefer safety.
[Link] income is more valuable
→ A certain dividend today is valued more than a potentially
higher return tomorrow.
Gordon’s Revised Formula:
 • Both Walter and Gordon use this logic to recommend dividend
policy based on whether a firm can earn more or less than
what investors expect.
Walter Gordon
• If the company earns more than • If dividend growth is strong and
investors expect: predictable:
That’s good reinvestment. Share price is high, because investors
Share price goes up. love stable income.
• If the company earns less than Useful for blue-chip companies with
investors expect: consistent dividend histories.
Better to pay dividends instead. • If dividend growth is low or
Reinvesting would actually hurt uncertain:
shareholder value. Share price drops, since the income
• So Walter’s model helps answer: stream isn't attractive.
“Should we pay out profits or reinvest "How can we make our stock
them? attractive to investors through stable
dividends?"