Unit-4: Dividend Policy

 Dividend
According to the Institute of Chartered Accountants of India, dividend is "a distribution to
shareholders out of profits or reserves available for this purpose."
"The term dividend refers to that portion of profit (after tax) which is distributed among the
owners / shareholders of the firm”.
In other words, dividend is that part of the net earnings of a corporation that is distributed to
its stockholders. It is a payment made to the equity shareholders for their investment in the
company.
Dividend is a reward to equity shareholders for their investment in the company. It is a basic
right of equity shareholders to get dividend from the earnings of a company.

 Dividend Policy
"Dividend policy means the practice that management follows in making dividend payout
decisions, or in other words, the size and pattern of cash distributions over the time to
shareholders."
In other words, dividend policy is the firm's plan of action to be followed when dividend
decisions are made. It is the decision about how much of earnings to pay out as dividends
versus retaining and reinvesting earnings in the firm.

 Stable and unstable dividend policy

Under a stable dividend policy, firm provides a fixed dividend payment every year, even
when earnings are volatile.
There are three forms of stability of dividends –
 Constant Dividend Per Share
 Constant Payout
 Constant Dividend Per Share Plus Extra dividend

Now, let's analyze each of these forms in detail.

1. Constant Dividend Per Share
In some countries, companies prefer to pay dividends which are a portion of the paid-up
capital. It is usually measured in percentage terms of the paid-up capital. In such a case, the
companies pay equal dividends every year irrespective of the difference in income generated
by the company.

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 2. Constant Payout ratio
Instead of paying a fixed amount of dividend to shareholders, some companies pay dividends
that are a constant proportion of the net earnings. In such a situation, the payouts are
dependent on the net income of the company. So, the dividends paid fluctuate with the net
earnings of the company.
3. Constant Dividend Per Share Plus Extra Dividend
To make things simpler, some organizations may pay extra dividends along with a constant
dividend payout. This extra dividend is paid when the net earnings of a company is higher
than usual and the company does not have to feel any stress for paying the extra dividend. In
such a case of dividend payout, the dividends paid fluctuate from time to time according to
the net earnings of a company.
The shareholders of companies that pay constant dividends plus extra dividends do know that
the company is doing well when an increasing amount of dividends is paid. However, the
companies that follow such kind of stability of dividend payment do not need to pay large
amounts of extra premium to their shareholders every year.

 Factors affecting (Determinants) dividend policy

The following are the some major factors which influence the dividend policy of the firm.

1. Legal requirements: There is no legal compulsion on the part of a company to distribute

dividend. However, there are certain conditions imposed by law regarding the way dividend
is distributed. Basically there are three rules relating to dividend payments. They are the net
profit rule, the capital impairment rule and insolvency rule.

a. The net profit rule states that dividends can be paid out from past and current earnings.

b. Capital impairment rule protects the creditors by forbidding dividend payout from the capital.
Dividend payout from capital would mean distributing the investment in the company, not
the earnings, and such dividend is called liquidating dividend.

c. The insolvency rule states that corporations cannot pay out dividends as long as they are
insolvent, i.e. as long as their liabilities exceed the value of their assets. Dividend payout
under such circumstances would mean giving the funds to the shareholders which rightfully
belong to the creditors.

2. Firm's liquidity position: Dividend payout is also affected by firm's liquidity position. In
spite of sufficient retained earnings, the firm may not be able to pay cash dividend if the
earnings are not held in cash.

3. Repayment need: A firm uses several forms of debt financing to meet its investment needs.
These debt must be repaid at the maturity. If the firm has to retain its profits for the purpose
of repaying debt, the dividend payment capacity reduces.

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4. Expected rate of return: If a firm has relatively higher expected rate of return on the new
investment, the firm prefers to retain the earnings for reinvestment rather than distributing
cash dividend.

5. Stability of earning: If a firm has relatively stable earnings, it is more likely to pay
relatively larger dividend than a firm with relatively fluctuating earnings. A company having
higher and stable earnings can declare higher dividends than a company with lower and
unstable earnings.

6. Stability of Dividends: Generally, companies try to stabilise dividends per share. A steady
dividend is given each year. A change is only made if the company's earning potential has
gone up and not just the earnings of the current year. Dividends are paid out of current and
past earnings. Thus, earnings are a major determinant of dividend decision.

7. Growth Opportunities: Companies having good growth opportunities retain more money
out of their earnings so as to finance the required investment. Therefore the dividend
declared in growth companies is smaller than that in the non-growth companies.

8. Cash Flow Position: Dividend involves an outflow of cash. Availability of enough case is
necessary for payment or declaration of dividends.

9. Shareholders' Preference: While declaring dividends, the management must keep in mind
the preferences of the shareholders. Some shareholders in general desire that at least a certain
amount is paid as dividend. The companies should consider the preferences of such
shareholders.

10. Taxation Policy: If the tax on dividends is higher, it is better to pay less by way of
dividends. But if the tax rates are lower, higher dividends may be declared. This is because as
per the current taxation policy, a dividend distribution tax is levied on companies. However,
shareholders prefer higher dividends, as dividends are tax-free in the hands of shareholders.

11. Stock Market Reaction: Generally, an increase in dividends has a positive impact on the
stock market and vice-versa. Thus, while deciding on dividends, this should be kept in mind.

12. Access to Capital Market: Large and reputed companies generally have easy access to the
capital market and, therefore, may depend less on retained earnings to finance their growth.
These companies tend to pay higher dividends than smaller companies.

13. Contractual Constraints: While granting loans to a company, sometimes, the lender may
impose certain restrictions on the payment of dividends in the future. The companies are
required to ensure that the dividend payout does not violate the terms of the loan agreement
in this regard.

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 Important/Key Dividend Dates

There are four key dates to keep in mind when holding a dividend-paying stock:

1. Declaration Date/Announcement Date

The declaration date is the date on which the board of directors announces and approves
the payment of a dividend.

It is simply an announcement – no dividends are paid on the declaration date. The declaration
includes the size of the dividend being issued and outlines the record date and payment date.

For example: On October 18, 2023 (declaration date), RK Ltd. declared a dividend of Rs.10
per share payable on December 14, 2023 (payment date) to shareholders of record as of
November 30, 2023 (record date).

Declaration Date Ex-Dividend Date Record Date Payable Date

Wednesday, Wednesday, Thursday, Thursday,

18/10/2023 29/11/2023 30/11/2023 14/12/2023

2. Ex-Dividend Date/Ex-Date

The ex-date or ex-dividend date is the trading date on (and after) which the dividend is
not paid to a new buyer of the stock.

The company does not set the ex-dividend date. The ex-dividend date is set by the stock
exchange where the company’s stock is traded. The ex-dividend date is generally one day
before the record date. Buyers of shares on or after the ex-dividend date are not entitled
to a dividend.

The ex-dividend date is earlier than the record date due to the fact that there is a settlement
period (T+2 days) for stock trades on exchanges.

For example, the ex-dividend date for RK Ltd. is November 29, 2023, which is one day
before the record date.

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 3. Record Date

The record date, also known as the date of record, is the date on which the investor must
be on list of the company’s books in order to receive a dividend.

When an investor purchases a stock on an exchange, it takes time for the investor’s
information to be updated on the company’s books. In India companies’ securities are on a
T+2 settlement period. In other words, it takes two business days for a stock trade to settle.

For example, the ex-dividend date for RK Ltd. is November 29, 2023, while the record date
is November 30, 2023. In addition, the settlement period is T+2.

 A stock purchaser of RK Ltd. on November 29 that is the ex-dividend date or after

November 29 would not be entitled to a dividend because the trade would settle on
December 1 (past the record date).
 A stock purchaser of RK Ltd. on November 28, the day before the ex-dividend date, would
be entitled to a dividend because the trade would settle on November 30, so the investor
would be on the company’s books on the record date.

4. Payment/Due Date

The payment date is the date on which the dividend is paid to shareholders. Dividend
payments may be either mailed or electronically transferred to the accounts of shareholders.

For example, the dividend payables date for RK Ltd. is December 14, 2023. On December
14, shareholders of RK Ltd. before the ex-dividend date would receive a dividend of Rs. 10
per share.

Note: In order to be eligible for payment of stock dividends, you must buy the stock (or
already own it) at least two days before the date of record. That's one day before the ex-
dividend date.

 Dividend Theories/Models

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 Walter's model
1. A company earns Rs. 5 per share, is capitalized at a rate of 10% and has a rate of return on
investment of 18%. According to Walter’s model, what should be the price per share at 25%
dividend payout ratio? Is this optimum payout ratio according to Walter?

2. The earnings per share of a company is Rs.20 for the face value of Rs.100. it has a rate of
return of 25%. Capitalization rate of its risk class is 12.5%. If Walter’s model is used, what
should be the optimum payout ratio? What should be the price per share if payout ratio is
zero? If payout ratio is 25% of EPS, calculate the value of share.

3. Determine the market value of equity shares of the company from the following information.
Earning of the company Rs. 5,00,000
Dividend paid Rs.3,00,000
Number of share outstanding 1,00,000
Price-Earnings ratio 8
Rate of Return on Investment 15%
Are you satisfied with the current dividend policy of the firm? Using Walter's model
calculate optimum dividend payout ratio.

4. Determine the market value of equity shares of the company from the following
Earning of the company Rs. 6,00,000
Dividend paid Rs.3,60,000
Number of share outstanding 1,00,000
Price-Earnings ratio 10
Rate of Return on Investment 15%
Are you satisfied with the current dividend policy of the firm? If not, what should be the
optimum dividend pay-out ratio? Use Walter's Model.

5. The EPS of a company is Rs. 10. It has an internal rate of return of 15% and the capitalization
rate of its risk class is 12.5%. If Walter's model is used :
(i) What should be the optimum payout ratio ?
(ii) What would be the price of the share at this payout ?
(iii) How shall the price of the share be affected if 20% payout were employed.

6. The EPS of a company is Rs. 16. The market capitalization rate applicable to the company is
12.5 percent. Retained earnings can be employed to yield a return of 10 percent. The
company is considering a pay-out of 25 per cent and 75 percent. Which of these would
maximize the wealth of shareholders as per waiter's model?

7. Sandhya Ltd. has total liabilities of Rs. 2 crore in the form of 2 lakhs equity shares of Rs. 100
each. It earns after tax rate of 8% on its total assets. The appropriate equity capitalization rate
is 10%. You are required to calculate price of equity share under Walter’s Model if company
is considering dividend pay out ratio of 0%, 80% and 100%.

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8. The following three firms have earning per share of Rs. 18 and their rate of returns is 15%.
These firms have the cost of capital of 18%, 15% and 12% respectively. Assuming that the
firms are considering three different levels of payout ratios of 25%, 40% and 60%. Apply the
mathematical formula given by Walter to find out the value of the share for different payout
ratios.

 Gordon's model
1. Assuming the rate of return expected by investor is 11%, internal rate of return is 12% and
earnings per share is Rs.15, calculate the price per share by Gordon Approach method if
dividend payout ratio is 10% and 30%.

2. Vidya Ltd. has total liabilities of Rs. 2 crore in the form of 2 lakhs equity shares of Rs. 100
each. It earns after tax rate of 8% on its total assets. The appropriate equity capitalization rate
is 10%. You are required to calculate price of equity share under Gordon Model if company
is considering dividend pay out ratio of 0%, 80% and 100%.

3. The following three firms have earning per share of Rs. 18 and their cost of capital is 15%.
These firms have the rate of returns of 18%, 15% and 12% respectively. Assuming that the
firms are considering three different levels of payout ratios of 25%, 40% and 60%. Apply the
mathematical formula given by Gordon to find out the value of the share for different payout
ratios.

4. The company earns Rs 20 per share. The return on investment is 12%. Using Gordon’s model
determine price of a share if capitalization rate is 10%, 12% and 14%. Calculate the price if
dividend payout is 20%, 40% and 60%.

5. The following data is available about Ziya Ltd. Earning per share Rs. 5 Rate of return
required by shareholders 16%. Assuming that Gordon valuation model holds, what rate of
returns should be earned on investments to ensure that the market price is Rs. 50, when the
dividend pay out is 40%.

 M-M model
1. Exponent Ltd. had 50,000 equity shares of Rs. 10 each outstanding on 1st April. The shares
are being quoted at par in the market. The company intends to pay a dividend of Rs. 2 per
share for current financial year. It belongs to a risk class whose appropriate capitalization rate
is 15%. Using M-M model and assuming no taxes, ascertain in price of company's share as it
is likely to prevail at the end of the year when (i) dividend is declared; and (ii) when dividend
is not declared.

2. The company has a cost of equity capital of 10 percent. The current market value of the firm
is Rs. 20,00,000 Rs. 20 per share. Assume values for new investment as Rs. 6,80,000,
earnings as Rs. 1,50,000 and dividends as Re. 1 per share at the end of the year. Calculate the
amount required for new financing and number of shares to be issued to raise this finance.

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3. Manex Company has outstanding 50 lakh shares selling at Rs. 120 per share. The company is
thinking of paying a dividend of Rs. 10 per share at the end of current year. The capitalization
rate for the risk class of this firm is 10%. Using MM model you are required :
(i) to calculate the price of the share at the end of the current year if dividends are paid
and if they are not paid.
(ii) to determine the number of share to be issued if the company earns Rs. 9 Cr., pays
dividends and makes new investments of Rs. 6.60 Cr ?

4. Textile Engineering Company has 10,00,000 equity shares outstanding at beginning of

accounting year 2010. The ruling market price per share is Rs. 150. The board of directors of
company contemplates declaring Rs. 8 as dividend at the end of current year. The rate of
capitalization appropriate to the risk class to which the company belongs is 12%.

(i) Based on mm approach calculate market price per share of company where
contemplated
a) Dividend is declared
b) Dividend is not declared

(ii) How many shares are to be issued by the company at the end of the accounting year
on assumption that net income of year is 2 crores, Investment budget is Rs. 4 crores
? when….
a) Dividend is declared
b) Dividend is not declared

(iii) Show that the total market value of share at the end of accounting year will remain
the same whether dividends are either distributed or not distributed. Also find out
current market value of firm under both situations.

5. The Dhwani Ltd. belongs to a risk class of which the appropriate capitalization rate is 10%. It
currently has 100,000 shares selling at 100 each. The firm is contemplating the declaration of
Rs. 6 dividend at the end of the current fiscal year, which has just begun. Answer the
following questions based on M-M Model and the assumptions of no taxes.
a) What will be the price of the shares at the end of the year, if a dividend is not
declared? What will be it be if it is declared?
b) Assume that the firm pays dividend, has a net income of Rs. 10,00,000/- and makes
new investment of Rs. 20,00,000/-during the period, how many new share must be
issued?

6. A company has outstanding 1,00,000 shares selling at Rs.100 each. The firm is considering to
declare a dividend of Rs.5 per share at the end of current year. The firm's opportunity cost of
capital is 10%. What will be the price of the share at the end of current year if (i) a dividend
is declared and (ii) if dividend is not declared? Assuming that the firm pays the dividend, has
net profits of Rs.10,00,000 and makes new investments of Rs. 20,00,000 during the period,
how many new shares must be issued? Use MM model to answer.

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7. The number of shares at the beginning of the year is 25,000. Share price at the beginning of
the year is Rs. 150. The discount rate applicable to the company is 10%. The company
declares Rs. 10 as dividends at the end of a year. Find out the Market price of the share at the
end of one year using the Modigliani - Miller’s model if company declares dividend and if
dividend is not declared. Also calculate new number of shares if earnings are Rs.3, 00,000
and new investment requirement is Rs. 7,00,000 in case of dividend payments.

8. A company had 50,000 equity shares of Rs. 10 face value. The shares are currently quoted at
par in the market. The company now intends to pay a dividend of Rs.2 per share. It belongs to
a risk class whose appropriate capitalization rate is 15%. Using MM approach calculate the
prize of share at the end of year if (i) dividend is paid and (ii) dividend is not paid.
Also find out the number of share that company must issue to meet its investment needs of
Rs. 2 lakhs, assuming a net income of Rs. l.1 lakhs and also assuming that dividend is paid.

9. A company has 10,000 equity shares of Rs.100 each. The shares are currently quoted at par.
The company proposes to declare a dividend 10% at the end of current financial year. The
capitalization rate for the risk class to which company belongs to is 12%. What will be the
market price of the share at the end of current year if dividend is declared and if it is not
declared? Assuming that the company pays the dividend and has net profit of Rs. 5,00,000
and makes new investment of Rs. 10,00,000 during the period, how many new shares must be
issued? Use MM model.

10. Ghajini Ltd. Currently has 10,00,000 equity shares outstanding. Current market price per
share is Rs 100. The net income for the current year is Rs 3,00,00,000 and investment budget
is Rs 4,00,00,000. Cost of equity is 10%. The company is contemplating declaration of
dividends @ Rs 5 per share.
Assuming MM approach,
i) Calculate market price per share if dividend is declared and if it is not declared.
ii) How many equity share are to be issued under both the options
iii) Show that the total market value of share at the end of accounting year will remain the
same whether dividends are either distributed or not distributed.

11. The MILO company belongs to a risk class of which the appropriate capitalization rate is
12%. It currently has Rs. 10,00,000 share capital selling at Rs. 100 each. The firm is
contemplating the declaration of Rs. 10 dividend at the end of the current fiscal year, which
has just begun. Answer the following questions based on M-M Model and the assumptions of
no taxes. What will be the price of the shares at the end of the year,
(a) if a dividend is not declarted ?
(b) if a dividend is declared.
(c) Assume that the firm pays dividend, has a net profit of Rs. 5,00,000/- and makes new
investment of Rs. 10,00,000/- during the period, how many new share must be issued ?