Dividend Policy
Dividend
The term dividend refers to that part of profits
of a company which is distributed by the
company among its shareholders. Dividend
concepts are broadly divided in two
A. The irrelevance Concept of Dividend or The
Theory of Irrelevance.
B. The Relevance Concept of Dividend or The
Theory of Relevance.
The irrelevance Concept of Dividend or The
Theory of Irrelevance.
A. Residual Approach:-
This theory regards dividend decision merely as a
part of financing decision because the
earnings available may be retained in the
business for re – investment. But, if the funds
are not required in the business they may be
distributed as dividends. Thus, the decision to
pay dividends or retain the earnings may be
taken as a residual decision.
Modigliani and Miller Approach (MM Model)
MM maintained that dividend policy has no effect on the market
price of the shares and the value of the firm is determined by the
earning capacity of the firm or its investment policy. The splitting
of earnings between retentions and dividends, may be in any
manner the firm likes, does not affect the value of the firm.
Assumptions of MM Hypothesis
The MM hypothesis of irrelevance of dividends is base on the
following assumptions:
I. There are perfect capital markets.
II. Investors behave rationally
III. Information about the company is available to all without any cost.
IV. There are no floatation and transaction costs.
V. There are no taxes or there are no differences in the tax rates
applicable to dividends and capital gain.
VI. The firm has a rigid investment policy.
VII. There is no risk or uncertainty in regard to the future of the firm.
Value of Firm under M-M Hypothesis
when Dividends are paid:
Price per share at the end of year 1
Po = D1+ P1
1+ Ke
Po = market price per share at the beginning of the
period, or prevailing market price of a share
D1 = Dividend to be received at the end of the period.
P1 = Market price per share at the end of the period.
Ke = cost of equity capital or rate of capitalisation.
The value of P1 can be derived by the above equation
as under:
P1 = Po (1+ Ke) – D1
The MM hypothesis can be explained in another form also presuming that
investment required by the firm on account of payment of dividends is financed
out of the new issue of equity shares.
Computation of the number of new shares to be issued:
M ={ I – (E-nD1)}/P1
Further, the value of the firm can be ascertained with the help of the following
formula:
nPo = (n+m) P1 – ( I – E)
1+ Ke
Where, M= number of shares to be issued.
I = Investment required,
E = Total earnings of the firm during the period.
P1 = market price per share at end of the period.
Ke = cost of equity capital.
N = number of shares outstanding at the beginning of the period
D1 = dividend to be paid at the end of the period.
nPo = Value of the firm.
1. XYZ Ltd. has a capital of Rs. 1 lakhs in equity shares of
Rs. 100 each. The shares are currently quoted at par.
The company proposes declaration of a dividend of Rs.
10 per share at the current financial year. The
capitalization rate for the risk class to which the
company belongs is 20%. The company expects to have
a net income of Rs. 25,000.
What will be the market price of the share at the end of
the year, if;
I. A dividend is not declared?
II. A dividend is declared?
Assuming that the company pays the dividend and has to
make new investment of Rs. 48,000 in the coming period,
how many shares must be issued. Use MM model.
Solution . 1
P1 = Po (1+ Ke) – D1 P0 = 100; Ke = 0.20
When Dividend is paid ; D1 = Rs. 10
P1 = 100(1+0.20) – 10 = Rs. 110 ; P1 = 110
When Dividend is not paid ; D1 = Rs. 0
P1 = 100(1+0.20) – 0 = Rs. 120 ; P1 = 120
The number of new shares when dividend is paid
Computation of the number of new shares to be issued:
M ={ I – (E-nD1)}/P1
I = 48,000; E = 25000; n = 1,000; D1 = Rs. 10 ; P1 = 110
= {48,000 – (25,000 – 1000*10)}/110
New shares to be issued = 3,000 shares.
2. ABC Ltd. belongs to a risk class for which the
appropriate capitalisation rate of 10%. It
currently has outstanding 25, 000 shares
selling at Rs. 100 each. The firm is
contemplating the declaration of dividend of
Rs. 5 per share at the end of the current
financial year. The company expects to have a
net income of Rs. 2,50,000 and has a proposal
for making new investments of Rs. 5,00,000.
show under MM hypothesis, the payment of
dividend does not effect the value of the firm.
Solution . 2
Value of the Firm under MM hypothesis:
when dividends are paid
P1 = Po (1+ Ke) – D1 P0 = 100; Ke = 0.10; D1 = 5
P1 = 100(1+0.10) – 5 = 105; P1 = 105
Amount required to be raised from the issue of new shares:
M ={ I – (E-nD1)}/P1
I = 5,00,000; E = 2,50,000; n = 25,000; D1 = Rs. 5 ; P1 = 105
M = {5,00,00 – (2,50,000 – 25000*5)}/105 = 3,571.428571428571
Value of Firm (nPo) = (n+m) P1 – ( I – E)
1+ Ke
= {(25,000+3,571.42857)105 – (5,00,000 – 2,50,000))}/1+0.10
Value of Firm = Rs. 25,00,000
Solution . 2
Value of the Firm under MM hypothesis:
when dividends are not paid
P1 = Po (1+ Ke) – D1 P0 = 100; Ke = 0.10; D1 = 5
P1 = 100(1+0.10) – 0= 110; P1 = 110
Amount required to be raised from the issue of new shares:
M ={ I – (E-nD1)}/P1
I = 5,00,000; E = 2,50,000; n = 25,000; D1 = Rs. 0 ; P1 = 110
M = {5,00,00 – (2,50,000 – 25000*0)}/110 = 2,272.727272727
Value of Firm (nPo) = (n+m) P1 – ( I – E)
1+ Ke
= {(25,000+2,272.72727)110 – (5,00,000 – 2,50,000))}/1+0.10
Value of Firm = Rs. 25,00,000
The Relevance Concept of Dividend
or The Theory of Relevance
The other school of thought on dividend decision holds
that the dividend decisions considerable affect value of
the firm. According to this theory dividends
communicate information to the investors about the
firm’s profitability and hence dividend decision
become relevant. Those firms which pay higher
dividends, will have greater value as compared to
those which do not pay dividends or have a lower
dividend pay out ratio.
We have examined below two theories representing this
notion:
A. Walter’s Approach
B. Gordon’s Approach
Walter’s Approach
The relationship between the internal rate of return earned by the
firm and its cost of capital is very significant in determining the
dividend policy to subserve the ultimate goal of maximising the
wealth of the share holders. Prof. Walter’s model is based on the
relationship between the firm’s (i) return on investment, i.e., r and
(ii) the cost of capital or the required rate of return, i.e. k.
If r> k i.e., if the firms earns a higher rate of return on its investment
than the required rate of return, the firm should retain the earnings.
Such firms are termed as growth firm’s and the optimum pay-out
would be zero in their case. This would maximise the value of
shares.
If r< k, the shareholders would stand gain if the firm distributes its
earnings. For such firms, the optimum pay-out would be 100 per
cent and the firm should distribute the entire earnings as dividends.
If r= k, the dividend policy will not affect the market value of share as
the shareholders will get the same return from the firm as expected
by them.
Walter’s Approach
Assumption of Walter’s Model
i. The investments of the firm are financed through retained earnings only and
the firm does not use external sources of funds.
ii. The internal rate of return( r) and the cost of capital (k) of the firm are constant
iii. Earnings and dividends do not change while determining the value.
iv. The firm has a very long life.
Walter’s Formula
P = D/ Ke – g, P = price of equity, D = initial dividend per share, Ke = cost of equity
capital, g = Expected growth rate of earnings/ dividend
To ascertain the market price of a share:
P=D + r(E – D)/ Ke (OR) P = DIV+(r/Ke)(EPS – DIV)
Ke Ke Ke
P = Market price per share, D = dividend per share, r= Internal rate of return, E =
Earnings per share, Ke = Cost of equity capital
Problems
1. The following information is available in
respect of a firm:
Capitalization rate = 10%
Earnings per share = Rs. 50
Assumed rate of return on investment:
(1) 12%, (2) 8%, and (3) 10%
Show the effect of dividend policy on market
price of shares applying Walter’s formula
when dividend pay out ratio is (a) 0% (b)
20%, ( c) 40%, (d) 80%, and 100%.
1. The following information is available in respect of a firm:
Capitalization rate = 10% ; Earnings per share = Rs. 10
Assumed rate of return on investment: (1) 15%, (2) 10%, and (3)8%
Show the effect of dividend policy on market price of shares applying Walter’s formula when
dividend pay out ratio is (a) 0% (b) 40%, ( c) 80%, and 100%.
r=0 .15; k = 0.10; EPS = Rs.10 r=0 .10; k = 0.10; EPS = Rs.10 r=0 .08; k = 0.10; EPS = Rs.10
a) Pay out ratio = 0% DIV= 0 DIV= 0
DIV= 0 P = 0+(0.10/0.10) (10 -0)/0.10 P = 0+(0.08/0.10) (10 -0)/0.10
P = 0+(0.15/0.10) (10 -0)/0.10 = Rs. 100 = Rs. 80
= Rs. 150
b) Pay out ratio = 40% DIV= 4 DIV= 4
DIV= 4 P = 4+(0.10/0.10) (10 -4)/0.10 P = 4+(0.08/0.10) (10 -4)/0.10
P = 4+(0.15/0.10) (10 -4)/0.10 = Rs. 100 = Rs. 88
= Rs. 130
c) Pay out ratio = 80% DIV= 8 DIV= 8
DIV= 8 P = 8+(0.10/0.10) (10 -8)/0.10 P = 8+(0.08/0.10) (10 -8)/0.10
P = 8+(0.15/0.10) (10 -8)/0.10 = Rs. 100 = Rs. 96
= Rs. 110
d) Pay out ratio = 100% DIV= 10 DIV= 10
DIV= 10 P = 10+(0.10/0.10) (10 P = 10+(0.08/0.10) (10
P = 10+(0.15/0.10) (10 -10)/0.10 -10)/0.10 -10)/0.10
= Rs. 100
= Rs. 100 = Rs. 100
2. The earnings per share of a company are Rs.
16. the market rate of discount applicable to
the company is 12.5%. Retained earnings can
be employed to yield a return of 10%. The
company is considering a pay-out of 25%. 50%
and 75%. Which of these would maximize the
wealth of shareholders.
The earnings per share of a company are Rs. 16. the market rate of discount applicable to the
company is 12.5%. Retained earnings can be employed to yield a return of 10%. The company
is considering a pay-out of 25%. 50% and 75%. Which of these would maximize the wealth of
shareholders.
r=0 .10; k = 0.12.5; EPS = Rs.16
a) Pay out ratio = 25%
DIV= 4
P = 4+(0.10/0.125) (16 -4)/0.125 = Rs. 80.8
c) Pay out ratio = 50%
DIV= 8
P = 8+(0.10/0.125) (16 -8)/0.125 = Rs. 59.2
b) Pay out ratio = 75%
DIV= 12
P = 12+(0.10/0.125) (16 -12)/0.125 = Rs. 37.6
3. The earnings per share of ABC Ltd. is Rs. 20
and rate of capitalization applicable to it is
10%. The company has before it the options
of adopting a pay-out of 20% or 40% or 80%.
Using Walter’s formula, compute the market
value of the company’s share if the
productivity of retained earning is (i) 20%, (ii)
10%, or (iii) 8%.
3. The earnings per share of ABC Ltd. is Rs. 20 and rate of capitalization applicable to it is 12%.
The company has before it the options of adopting a pay-out of 20% or 40% or 80%. Using
Walter’s formula, compute the market value of the company’s share if the productivity of
retained earning is (i) 20%, (ii) 10%, or (iii) 8%.
r=0 .20; k = 0.12; EPS = Rs.20 r=0 .10; k = 0.12; EPS = Rs.20 r=0 .08; k = 0.12; EPS = Rs.20
a) Pay out ratio = 20% DIV= 4 DIV= 4
DIV= 4 P = 4+(0.10/0.12) (20 P = 4+(0.08/0.12) (20
P = 4+(0.20/0.12) (20 -4)/0.12 -4)/0.12 -4)/0.12
= Rs. 226.222 = Rs.115.111 = Rs. 92.88
b) Pay out ratio = 40% DIV= 8 DIV= 8
DIV= 8 P = 8+(0.10/0.12) (20 P = 8+(0.08/0.12) (20
P = 8+(0.20/0.12) (20 -8)/0.12 -8)/0.12 -8)/0.12
= Rs. 164.67 = Rs.91.333 = Rs. 74.67
c) Pay out ratio = 80% DIV= 16 DIV= 16
DIV= 16 P = 16+(0.10/0.12) (20 P = 16+(0.08/0.12) (20
P = 16+(0.20/0.12) (20 -16)/0.12 -16)/0.12
-16)/0.12 = Rs. 43.77 = Rs. 38.22
= Rs. 71.55
Gordon’s Approach
Gordon has also developed on the lines of Prof. Walter suggesting that dividends are relevant and the
dividends decision of the firm affects its value. His basic valuation model is based on the following
assumptions:
a. The firm is an all equity firm.
b. No external financing is available or used. Retained earnings represent the only source of
financing.
c. The rate of return on the firm’s investment r, is constant.
d. The retention ratio, b, once decided upon is constant. Thus, the growth rate of the firm g= br, is
also constant.
e. The cost of capital for the firm remains constant and it is greater than the growth rate, i.e., k> br,
f. The firm has perpetual life.
g. Corporate taxes do not exit.
Gordon’s Formula
P = EPS(1 – b)
Ke – br
P = Price of shares, EPS = Earnings per share, b = Retention ratio ( 100 – payout ratio)
Ke, Cost of equity capital, br = g = Growth rate in r, i.e., rate of return on investment of an all-equity
firm
4. The following information is available in respect of the rate
of return on investment(r), the cost of capital (k) and
earning per share (E) of ABC Ltd.
Rate of return on investment (r) = (i) 15%; (ii) 10%; and (iii) 8%
Cost of capital = (k) 10%
Earnings per share (E) = Rs. 10
Determine the value of its shares using Gordon’s Model
assuming the following:
D/p ratio (1-b) Retention ratio (b)
(a) 40 60
(b) 60 40
(c) 90 10
r=0 .15; k = 0.10; EPS = Rs.10 r=0 .10; k = 0.10; EPS = Rs.10 r=0 .08; k = 0.10; EPS = Rs.10
a) Pay out ratio = 40%
g= br= 0.6*0.15 = 0.09 g= br= 0.6*0.10 = 0.06 g= br= 0.6*0.08 = 0.048
P = 10(1 – 0.60)/ 0.10 – 0.06 P = 10(1 – 0.60)/ 0.10 – 0.048
P = 10(1 – 0.60)/ 0.10 – 0.09 = 4/0.04 = 4/0.052
= 4/0.01
= Rs.400 = Rs.100 = Rs.77
b) Pay out ratio = 60%
g= br= 0.4*0.15 = 0.06 g= br= 0.4*0.10 = 0.04 g= br= 0.4*0.08 = 0.032
P = 10(1 – 0.40)/ 0.10 – 0.06 P = 10(1 – 0.40)/ 0.10 – 0.04 P = 10(1 – 0.40)/ 0.10 – 0.032
= 6/0.04
= Rs.150 = 6/0.06 = 6/0.068
= Rs.100 = Rs.88
c) Pay out ratio = 90%
g= br= 0.10*0.15 = 0.015 g= br= 0.10*0.10 = 0.01 g= br= 0.10*0.08 = 0.008
P = 10(1 – 0.10)/ 0.10 – 0.015 P = 10(1 – 0.10)/ 0.10 – 0.01 P = 10(1 – 0.10)/ 0.10 – 0.008
= 9/0.085
= Rs.106 = 9/0.09 = 9/0.092
= Rs.100 = Rs.96
5. The following information is available in
respect of XYZ Ltd.
EPS Rs. 10
Rate of return 20%
Required rate of return of equity investment, Ke
16%
Find out the market price of the share under
Gordon model if the firm follows a payout of
50% or 25%.
Determinants of Dividend Policy
1. Legal Restrictions
2. Magnitude and Trend of Earnings
3. Desire and types of Shareholders
4. Nature of industry
5. Age of the company
6. Future Financial Requirements
7. Government’s Economic policy
8. Taxation policy
9. Inflation
10.Control objectives
11.Requirements of institutional investors
12.Stability of dividends
13.Liquid resources.
