Dividend policy Dividends refer to that portion of a firms net earnings which are paid out to the shareholders

Since dividends are distributed out of the profits, the alternative to the payment of dividends is the retention of earnings. The retained earnings constitute an easily accessible important source of financing the investment requirements of firms. Thus, there is inverse relationship b/w retained earnings and cash dividends: larger retention means lesser dividends, lesser retention means larger dividends. Thus, alternative use of net earnings dividends and retained earnings are competitive ! conflicting. " ma#or decision in financial management is the dividend decision in the sense that the firm has to choose b/w distributing the profits to the shareholders and ploughing then bac$ into the business. The relationship b/w dividends and value of firm should be the decision criteria There are conflicting school of thoughts: %. Dividends are irrelevant: "mount of dividend paid has no effect on the valuation of the firm &. Dividends are relevant to the value of the firm. I. Dividends are irrelevant

Modigliani and Miller (MM) hypothesis Dividend irrelevance implies that the value of firm is unaffected by the distribution of dividends and is determined solely by the earning power and ris$ of its assets. '' maintains that dividend policy has no effect on the share price of the firm. '' hypothesis assumptions: %. (erfect capital mar$ets in which are investors are rational. )nformation is available to all free of cost &. *o ta+es ,- no difference in ta+ rates applicable to capital gains and dividends. .. /irms investment policy will not change i.e. financing of new investments out of retained earnings will not change the business ris$ comple+ion and thus there will be no change in required rate of return. (roof for '' hypothesis: Step %: The mar$et price of share in the beginning of the period is equal to the present value of dividends paid at the end of the period plus the mar$et price of a share at the end of the period ( 0 1D% 2 (%3 4 5%/1%2$36

Step &: "ssuming there is no e+ternal financing, the total capitali7ed value of the firm will be no. of shares 1n3 times the price per share 1(3. Thus: n( 0 1nD% 2 n(%3 4 5%/1%2$36 Step .: )f the firms internal source of financing its investment opportunities fall short of the funds required, and n is the no. of new shares issued at the end of the year % at price (%. n( 0 5nD% 2 1n2n3 (% 8 n(%6 4 5%/1%2$36 This is equivalent to step & equation. Step 9: )f the firm were to finance all investment proposals, the total amount raised through new shares is: n(% 0 ) n(% 0 ) 1:8nD%3 : 2 nD%

;here: n(% is amount obtained from sale of new shares ) is Total amount required : is earnings of the firm during the period nD% is the total dividends 1: nD%3 is the retained earnings "bove equation means that investment needs 1)3 that are not financed by retained earnings must be financed through sale of new shares. Step <: Substitute the step 9 equation into step . equation. n( 0 5nD% 2 1n2n3 (% or n( 0 5nD% 2 1n2n3 (% thus: n( 0 51n2n3 (% ) 2 :6 4 5%/1%2$36 ) 2 : 8 nD%36 4 5%/1%2$36 1) : 2 nD%36 4 5%/1%2$36

=onclusion: Since dividends are not found in step < equation, thus '' concludes that dividends do not count i.e. dividend policy has *, effect on the share price. *umerical: ">= ltd. has capitali7ation rate %?@. )t has &<,??? o/s shares selling at -s.%?? each. The firm is contemplating the declaration of dividend of -s. < per share at the end of the current /A. )t e+pects to have a net income of -s. &,<?,??? and has a proposal for ma$ing new

investment of -s. <,??,???. Show that under '' hypothesis, the payment of dividend does not affect the value of the firm. "ns: A. Value of firm when dividends are paid: %. (rice per share at the end of year % ( 0 1D% 2 (%3 4 5%/1%2$36 %?? 0 1< 2 (%3/%.%? (% 0 %?<B &. "mount required to be raised from the issue of new shares n(% 0 ) 1:8nD%3 0 <,??,??? 1&,<?,??? %,&<,???3 0 .,C<,??? .. *o. of shares to be issued n 0 .,C<,???/%?< 0 C<,???/&% shares 9. Dalue of firm n( 0 51n2n3 (% ) 2 :6 4 5%/1%2$36 <,??,??? 2 &,<?,??? 6 / %.%?

5 1&<???/% 2 C<???/&% 3 4 %?< 0 &<,??,???

B. Value of firm when dividends are !" paid: %. (rice per share at the end of the year % is (% %?? 0 (%/%.%? E (% 0 %%? &. "mount required to be raised from the issue of shares <,??,??? &,<?,??? 0 &,<?,??? .. *o. of additional shares 0 &,<?,???/%%? 0 &<,???/%% 9. Dalue of firm 5 1&<???/% 2 &<???/%% 3 4 %%? 0 &<,??,??? Thus, whether dividends are paid or not, the value of firm remains the same. '' argue that dividends are irrelevant in the sense that the value of firm is independent of it. The cru+ of the argument is that the investors are indifferent b/w dividend and retention of earnings. <,??,??? 2 &,<?,??? 6 / %.%?

This is mainly because of the balancing nature of internal financing 1retained earnings3 and e+ternal financing 1raising of funds e+ternally3 consequent upon distribution of earnings to finance investment. The validity of '' hypothesis is open to questions due to assumptions made li$e: %. (erfect capital mar$ets in which are investors are rational. )nformation is available to all free of cost &. *o ta+es ,- no difference in ta+ rates applicable to capital gains and dividends. .. /irms investment policy will not change i.e. financing of new investments out of retained earnings will not change the business ris$ comple+ion and thus there will be no change in required rate of return. II. Dividends are relevant to the value of the firm

%. ;alters 'odel Dividends are relevant The investment policy of firm cannot be separated from its dividends policy and both are interlin$ed The choice of an appropriate dividend policy affects the value of an enterprise "rgument 8 relationship b/w the return on firms investment or )-- 1r3 and its cost of capital or the required rate of return 1$3 /irms optimum dividend policy is determined the relationship b/w r and $ )f the return on investment 1r3 e+ceeds the cost of capital 1$3 , the firm should retain earnings. 1r F G3 -ationale the firm is able to earn more than what shareholders could by reinvesting, if the earnings are paid to them. Such firms are called as growth firms. /or growth firms, the optimum dividend policy would be given by D#$ ratio of %ero. That is firm should plough bac$ the entire earnings within the firm. The mar$et value of the shares will be ma+imi7ed as a result. )f r H $ , the firm should distribute the earnings to shareholder. -ationale shareholders can earn higher return by investing elsewhere. )n such cases, the mar$et price of the shares will be ma+imi7ed by the distribution of the entire earnings as dividend. D/( ratio of %?? will be optimum dividend policy. ;hen r 0 $, called as normal firms, it is matter of indifference whether earnings are retained or distributed. This so because for all D/( ratios 1ranging b/w 7ero and %??3 the mar$et price of the shares will remain constant /or such firms there is no optimum dividend policy

"ssumptions: %. "ll financing is done through retained earnings, e+ternal sources 1debt or new equity3 are not used &. ;ith additional investments, the firms business ris$ does not change i.e. r and $ remains constant .. *o change in : 1earnings per share3 and D 1dividend3

9. The firm has perpetual life "s per ;alters model: ( 0 D / 1$8g3 ( 0 price of share To reflect retained earnings: ( 0 D / 1$8 rb3 , where r 0 e+pected rate of return on firms investment b0 retention rate 1%8 payout ratio or 1:8D3/:3 Thus, rb measures the growth rate in dividends which is the product of the rate of profitability of retained earnings 1r3 and the earnings retention percentage 1b3. Ising ( 0 D / 1$8g3, we have: $ 0 1D/(3 2 g Since, g 0 1( / ( 3 $ 0 1D/(3 2 1( / (3 $ 0 1D2(3/( Since, ( 0 1: D3 4 1r / $3

(utting value of ( in highlighted eq. $ 0 J D 2 51: or ( 0 J D 2 51: D3 4 1r/ $36 K # $ , where: D3 4 1r/ $36 K #(

( 0 prevailing mar$et price of share D 0 Dividend : 0 :(S r 0 rate of return on firms investment "bove equation shows that the value of share is the present value of all dividends plus the present value of all capital gains. *umerical e+ample:

=apitalisation rate 1$3 0 %?@ :(S 0 %? Show the effect of dividend policy on the mar$et price of shares, using walter model, when r is equal to: %. %<@ &. L@ .. %?@ ( 0 J D 2 51: D3 4 1r/ $36 K # $

%. r 0 %<@ i.e. r F $, the effect on dividend policy 1D/( ratio3 on the mar$et price of shares is depicted below: a. when D/( 0 ? ( 0 J? 2 51%?8?3 4 1?.%</?.%?36 K # ?.%? b. when D/( 0 <? ( 0 J< 2 51%?8<3 4 1?.%</?.%?36 K # ?.%? c. when D/( 0 %?? ( 0 J%? 2 51%?8%?3 4 1?.%</?.%?36 K # ?.%? 0 -s.%?? 0 -s.%&< 0 -s.%<?

&. r 0 L@ i.e. r H $, the effect on dividend policy 1D/( ratio3 on the mar$et price of shares is depicted below: a. when D/( 0 ? ( 0 J? 2 51%?8?3 4 1?.?L/?.%?36 K # ?.%? b. when D/( 0 <? ( 0 J< 2 51%?8<3 4 1?.?L/?.%?36 K # ?.%? c. when D/( 0 %?? ( 0 J%? 2 51%?8%?3 4 1?.?L/?.%?36 K # ?.%? 0 -s.%?? 0 -s.M? 0 -s.L?

.. r 0 %?@ i.e. r 0 $, the effect on dividend policy 1D/( ratio3 on the mar$et price of shares is depicted below: a. when D/( 0 ? ( 0 J? 2 51%?8?3 4 1?.%?/?.%?36 K # ?.%? b. when D/( 0 <? ( 0 J< 2 51%?8<3 4 1?.%?/?.%?36 K # ?.%? 0 -s.%?? 0 -s.%??

c. when D/( 0 %?? ( 0 J%? 2 51%?8%?3 4 1?.%?/?.%?36 K # ?.%? =onclusion for ;alters model: %. ;hen r F G, the value of shares is inversely related to D/( ratio &. ;hen r H G, the value of shares is positively related to D/( ratio .. ;hen r 0 G, the value of shares is constant irrespective to D/( ratio, thus there is no optimum dividend policy. Nimitations: %. "ssumption of constant r ! $ is not realistic. &ordon's Model This model opines that dividend policy of firm affects its value. "ssumptions: %. The firm is equity firm. "ll financing is done through retained earnings, no e+ternal financing (. )ith additional investments* the firm's +usiness ris, does not change i.e. r and , remains constant .. "he firm has perpetual life 9. The retention ratio once decided, remains constant. Thus growth rate 1 g 0 br3 is also constant <. $ F br r 0 e+pected rate of return on firms investment b0 retention rate 1%8 payout ratio or 1:8D3/:3 Oordons argument: Dividend policy of the firm is relevant and that investors put a positive premium on current income/dividend. Thus following are two8fold assumptions: a. investors are ris$ averse b. investors put a premium on certain return and discount/penali7e uncertain returns. )f the firm retains the earnings 1i.e. current dividends are withheld3, the investors can e+pect to get a dividend in future. This future dividend is uncertain, both with respect to amount and timing. -ationale investors can reasonably be e+pected to prefer current divideng Thus they would discount future dividends i.e. would place less importance on it as compared to current dividend The retained earnings are considered as ris$y promise Thus, in case the earnings are retained, the mar$et price of shares would be adversely affected. The above argument is based on the logic of a bird in hand is better than two in bush Thus, investors are inclined to pay higher price for shares on which current dividends are paid and they would discount the value of shares of those firms that postpone dividends. 0 -s.%??

"s per Oordon model: ( 0 5: 4 1%8b36 / 1$8br3 , where: : 0 :(S b 0 retention ratio $ 0 cost of capital br 0 g 0 rate of return on investment

umerical -uestions for practice %. ">=. earns -s. < per share, capitalised rate 1$3 %?@ and the -,) ?f %L@. "ccording to walter model what should be the price per share at &<@ div payout ratioP )s this optimal payout ratioP D3 4 1r/ $36 K # $

Ising, ( 0 J D 2 51: ( 0 J%.&< 2 51<

%.&<341?.%L/?.%?36 K # ?.%? 0 -s.L?

This is not optimum div payout ratio, because walter suggests that when r F $, div payout ratio should be 7ero to ma+imi7e the value of share. "t 7erp D/( ratio, the value is ma+imi7ed at M?. &. QAR. Ntd has cost of capital of %?@, the current mar$et value of firm 1D3 is -s.&?,??,??? 1S -s. &? per share3. ) 1new investment 3 0 T,L?,??? A 1earnings3 0 %,<?,??? D 1Div3 0 % per share Show that under '' hypothesis, the payment of dividend does not affect the value of firm. "ns: a. Dalue of firm when dividends are paid %. 'ar$et price of share at the end of year 1(%3 Ising, ( 0 1D% 2 (%3 4 5%/1%2$36 &? 0 1% 2 (%3 4 5%/1%.%?36 $. / (. &. "mount required for new financing: Ising, ) 1A nD%3 E T,L?,??? 1%,<?,??? %,??,???3 0 T,.?,???

.. *o. of shares to be issued 0 T,.?,???/&% 0 .?,??? shares 9. Dalue of firm 0 5nD% 2 1n2n3 (% J%,??,??? 2 51%,??,??? 2 .?,???34&%6 0 (0*00*000 Dalue of firm when dividends are not paid %. 'ar$et price of share at the end of year 1(%3 Ising, ( 0 1D% 2 (%3 4 5%/1%2$36 &? 0 1? 2 (%3 4 5%/1%.%?36 $. / (( 1) A 2 nD%36 4 5%/1%2$36 %,??,???K / %.%?

T,L?,??? 2 %,<?,???

&. "mount required for new financing: Ising, ) 1A nD%3 E T,L?,??? %,<?,??? 0 <,.?,??? .. *o. of shares to be issued 0 <,.?,???/&& shares 9. Dalue of firm 0 5nD% 2 1n2n3 (% J51%,??,??? 2 1<,.?,???/&&34&&6 / (0*00*000 .. :(S 0 L, Ge 0 %?@ The company can adopt i. <?@ ii. C<@ iii. %??@ dividend payout ratio. =ompute the mar$et price of the companys shares as per walter model, if it can earn return of: i. %<@ ii. %?@ iii. <@ on its retained earnings. "ns: %. D/( ratio 0 <?@ (rice of share, if r 0 ?.%< Ising, ( 0 J D 2 51: D3 4 1r/ $36 K # $ , where: 1) A 2 nD%36 4 5%/1%2$36

T,L?,??? 2 %,<?,???K / %.%?

( 0 prevailing mar$et price of share D 0 Dividend : 0 :(S r 0 rate of return on firms investment ( 0 J 9 2 51L 93 4 1?.%</ ?.%?36 K # ?.%? 0 %??

"nd so onUU 9. :arnings 0 %<,??,??? Div paid 0 <,??,??? *o.of issued shares 0 %,??,??? (/: 0 %? -ate of return on investment 0 %< a. Determine the theoretical mar$et price of share b. ;hat should be the optimum div payout ratio "ns: Ge 0 %?@ 1because the it is the reciprocal of (/:3 :(S 0 %<,??,???/%,??,??? 0 %< D(S 0 <,??,???/%,??,??? 0 < a. Ising, ( 0 J D 2 51: J < 2 51%< D3 4 1r/ $36 K # $

<3 4 1?.%</ ?.%?36 K # ?.%? 0 (00

b. Since rF $, the optimum D/( ratio is 7ero. Thus ma+ value of the share is J ? 2 51%< ?3 4 1?.%</ ?.%?36 K # ?.%? 0 ((1

2actors affecting dividend policy decision: %. Dividend payout ratio &. Stability of dividends it has . types: a. constant div per share. b. constant D/( ratio c. constant div 2 e+tra div .. )nvestors desire for current income 9. Niquid assests <. Ta+ T. Dilution of ownership C. 'ar$et consideration L. /uture opportunities