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Chapter - 12P. K. Sinha

Dividend Policy

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Practical Consideration in Paying Dividends

Financial Need of company. Shareholders Expectations. Closely / Widely Held Company. Constraints on Paying Dividends.

Legal Restrictions Liquidity Borrowing Capacity Access to the Capital Markets Restrictions in Loan Agreements

Factors affecting Dividend decisions Priority of Dividends over Capital gains: Reduction of Uncertainty Indication of strength Need for Current Income Constraints on paying dividends from

firm’s point of view : Insufficient cash Contractual restrictions: Covenants of Debenture holders Legal restrictions: cannot declare dividends unless certain

portion is ploughed back into the Business as RE.

Importance of Stability of Dividends Perception of Stability of the Company. Preference of Investors – receive steady Dividends. Stable dividend decision becomes a routine

decision. Flexibility of Extra dividend. Desire for current income by the shareholders –

retired persons or Widows. Resolutions of investors uncertainty. Institutional Investors’ Requirement. Raising Additional Finances.

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Stability of Dividends - Payout

Constant Dividend per Share or Dividend Rate.

Constant Payout (30% of EPS – Div payout ratio).

Constant Dividend per Share Plus Extra Dividend.

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Forms of Dividends Cash Dividends Bonus Shares (Stock Dividend)

Free Reserves are converted into stocks. A person holding 100 shares will hold 200 shares if it

is 1:1 Bonus issue. Stock (Share) split – Not a Dividend Stock repurchase (Viewed as Dividend) – Form

of Distribution of Profit as it increases market price of the share.

Advantages of Bonus shares Conserves cash Indicates higher future profits Raises future dividends for

investors Has high psychological value Retains proportional ownership for

shareholders

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Issues in Dividend Policy

Earnings to be Distributed – High Vs. Low Payout.

Objective – Maximize Shareholders Return.

Effects – Taxes, Investment and Financing Decision.

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Relevance Vs. Irrelevance of Dividend Policy

Walter's Model Gordon's Model Modigliani and Miller Hypothesis The Bird in the Hand Argument

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Walters Model: Dividend Relevance Model Walter Model says that the Choice

of Dividend almost always affects the value of the firm.

Assumptions Valuation Optimum Payout Ratio Criticism

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Assumptions Internal Financing: Correlates Dividend

and Investment policies. No correlation with Financing Policy.

Constant Return ® and Cost of Capital (k)

100% Payout or Retention

Constant EPS and DIV forever.

Infinite Time – Life of the Firm

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Market price per share is the sum of the present value of the infinite stream of constant dividends and present value of the infinite stream of capital gains.

k = Normal Capitalization rate – Expected by Investors r = Actual Capitalization rate – Actual return on Investment

Valuation

( / )(DIV / ) (EPS – DIV)

r kP k

k

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Example0.15, 0.10, 0.08

0.10

EPS Rs 10

DPS 40%

(0.15 / 0.1)(4 / 0.1) (10 4) Rs 130

0.1(0.10 / 0.1)

(4 / 0.1) (10 4) Rs 1000.1

(0.08 / 0.1)(4 / 0.1) (10 4) Rs 88

0.1

r

k

P

P

P

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Optimum Payout Ratio Growth Firms – Retain all earnings Because r > k, The firm can grow only on

Retained earnings. Firm value increases as r > k.

Normal Firms – Dividend policy has no effect on the market value per share as r = k.

Declining Firms – Distribute all earnings as r < k. Investors can earn better returns elsewhere. If they retain earnings, Firm value will decrease.

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Criticism

No external Financing: Firm cannot issue Debt or External Equity. This is erroneous because firm should keep on investing till r = k. Therefore, firm should finance Investment – Earnings, if required. (If Earnings are less than Investment to be made).

Constant Rate of Return ( r ): r decreases as more and more investment is made.

Constant opportunity cost of capital (k): It is not constant. It changes directly with the firm’s risk.

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Gordon's Model: Dividend Relevance Model

Gordon’s argues that Dividend policy is relevant and affects the Value of the firm.

Assumptions Valuation Optimum Payout Ratio Criticism

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Assumptions All Equity Firm – Firm has no debt. No External Financing Constant Rate of Return and Cost of Capital Perpetual Earnings: Firm and its Earnings are

perpetual. No Taxes Constant Retention ratio; g = br constant Cost of Capital greater than Growth Rate: k >

g.To make Po = DIV1/ (k – g) have meaning.

ValuationMarket value of a share is equal to the present value of an infinite stream of dividends to be received by shareholdersKe = EPS formula (Dividend Growth model)

EPS(1 ) /( )P b k br

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Example (Answer to be calculated again)

0.15, 0.10, 0.08

0.10

EPS Rs 10

60%

(1 – 0.6) / 0.10 – (0.15 * 0.6) = Rs 400

10(1 – 6) / 0.10 – (0.10 * 0.6) = Rs 100

10(1 – 0.6) / 0.10 – (0.08 * 0.6) = Rs 77

r

k

b

P

P

P

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Optimum Payout Ratio Growth Firms – Retain all earnings Because r > k, The firm can grow only on

Retained earnings. Firm value increases as r > k.

Normal Firms – Dividend policy has no effect on the market value per share as r = k.

Declining Firms – Distribute all earnings as r < k. Investors can earn better returns elsewhere.

The Bird in the HandArgument put forward, first of all, by Kirshman

Investors are risk averters. They consider distant dividends as less certain than near dividends. Rate at which an investor discounts his dividend stream from a given firm increases with the futurity of dividend stream and hence lowering share prices.

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Dividend Irrelevance – The Miller – Modigliani (MM) Hypothesis

Under a perfect market situation, the dividend policy of a firm is irrelevant, as it does not affect the value of the firm.

Value of firm depends on the firm’s earnings that result from its investment policy.

Split of earning between dividends and retained earnings – is of no significance in determining value of the firm.

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Assumptions – MM Hypothesis Perfect Capital markets

Investors are rational Market is efficient – Information freely

available to all No Transaction costs No Investor is large enough to

influence the market price of Securities

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Assumptions – MM Hypothesis No Taxes.

Investment Policy is known and does not change. Financing of new Investment out of RE does not change the Risk profile of the firm and consequently there is no change in the required rate of return in Equity (ke).

Perfect certainty – Investors can forecast the Future Price of Shares and Future dividends with certainty.

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MM Hypothesis: Suppose a firm has some Investment opportunity. It has two alternatives:A) It can retain its earnings to finance the

investment.B) Distribute the dividend to the shareholders and

raise an equal amount externally through sale of New Shares.

In case firm chooses Alternative B: The effect of Dividend payment on the

shareholders will be exactly offset by the effect of raising additional shares.

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MM Hypothesis: The effect of dividend payment on the shareholder

wealth will be exactly offset by the effect of raising additional shares.

When dividends are paid, the market price of the share will increase.

But the terminal value of the share will decrease because of additional issue of Shares.

Therefore the value of the share before and after paying dividend remains the same.

The market price of the share depends entirely upon the expected future earnings of the firm.

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Critical Analysis of the Assumptions in MM approach Tax rate on Dividend and Capital gains are

different (for Investors). Flotation Costs are there (Usually 10 to 15%

of the IPO). Transaction costs is there in buying and selling

of Shares. Market Conditions do effect the investment

decisions of the firm.

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Assignment Questions on page 359.

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