DIVIDEND AND RETENTION POLICY
Introduction :
What is Dividend?
What is dividend policy?
Theories of Dividend Policy
Relevant Theory
Walter’sModel
Gordon’s Model
Irrelevant Theory
M-M’s Approach
Traditional Approach
What is Dividend?
“A dividend is a distribution to shareholders out of
profit or reserve available for this purpose”.
- Institute of Chartered Accountants of India
Forms/Types of Dividend
On the basis of Types of Share
EquityDividend
Preference Dividend
On the basis of Mode of Payment
Cash Dividend
Stock Dividend
Bond Dividend
Property Dividend
Composite Dividend
Contd.
On the basis of Time of Payment
InterimDividend
Regular Dividend
Special Dividend
What is Dividend Policy :
“ Dividend policy determines the division of
earnings between payments to shareholders and
retained earnings”.
- Weston and Bringham
Contd.
Dividend Policies involve the decisions, whether-
To retain earnings for capital investment and other
purposes; or
To distribute earnings in the form of dividend among
shareholders; or
To retain some earning and to distribute remaining
earnings to shareholders.
Factors Affecting Dividend Policy
Legal Restrictions
Magnitude and trend of earnings
Desire and type of Shareholders
Nature of Industry
Age of the company
Future Financial Requirements
Taxation Policy
Stage of Business cycle
Contd.
Regularity
Requirements of Institutional Investors
Dimensions of Dividend Policy
Pay-out Ratio
Funds requirement
Liquidity
Access to external sources of financing
Shareholder preference
Difference in the cost of External Equity and Retained
Earnings
Control
Taxes
Contd.
Stability
Stable dividend payout Ratio
Stable Dividends or Steadily changing Dividends
Types of Dividend Policy
Regular Dividend Policy
Stable Dividend Policy
Constant dividend per share
Constant pay out ratio
Stable rupee dividend + extra dividend
Irregular Dividend Policy
Dividend Theories
Relevance Theories Irrelevance Theories
(i.e. which consider dividend (i.e. which consider dividend
decision to be relevant as it decision to be irrelevant as it does
affects the value of the firm) not affects the value of the firm)
Walter’s Gordon’s
Model Model
Modigliani and Traditional
Miller’s Model Approach
Walter’s Model
Prof. James E Walter argued that in the long-run
the share prices reflect only the present value of
expected dividends. Retentions influence stock price
only through their effect on future dividends. Walter
has formulated this and used the dividend to
optimize the wealth of the equity shareholders.
Assumptions of Walter’s Model:
Internal Financing
constant Return in Cost of Capital
100% payout or Retention
Constant EPS and DPS
Infinite time
Formula of Walter’s Model
D + r (E-D)
P = k
k
Where,
P = Current Market Price of equity share
E = Earning per share
D = Dividend per share
(E-D) = Retained earning per share
r = Rate of Return on firm’s investment or Internal Rate of Return
k = Cost of Equity Capital
Illustration :
Growth Firm (r > k):
r = 20% k = 15% E = Rs. 4
If D = Rs. 4
P = 4+(0) 0.20 /0 .15 = Rs. 26.67
0.15
If D = Rs. 2
P = 2+(2) 0.20 / 0.15 = Rs. 31.11
0.15
Illustration :
Normal Firm (r = k):
r = 15% k = 15% E = Rs. 4
If D = Rs. 4
P = 4+(0) 0.15 / 0.15 = Rs. 26.67
0.15
If D = Rs. 2
P = 2+(2) 0.15 / 0.15 = Rs. 26.67
0.15
Illustration :
Declining Firm (r < k):
r = 10% k = 15% E = Rs. 4
If D = Rs. 4
P = 4+(0) 0.10 / 0.15 = Rs. 26.67
0.15
If D = Rs. 2
P = 2+(2) 0.10 / 0.15 = Rs. 22.22
0.15
Effect of Dividend Policy on Value of Share
Case If Dividend Payout ratio If Dividend Payout Ration
Increases decreases
1. In case of Growing firm Market Value of Share Market Value of a share
i.e. where r > k decreases increases
2. In case of Declining firm Market Value of Share Market Value of share
i.e. where r < k increases decreases
3. In case of normal firm No change in value of No change in value of
i.e. where r = k Share Share
Criticisms of Walter’s Model
No External Financing
Firm’s internal rate of return does not always
remain constant. In fact, r decreases as more and
more investment in made.
Firm’s cost of capital does not always remain
constant. In fact, k changes directly with the firm’s
risk.
Gordon’s Model
According to Prof. Gordon, Dividend Policy almost
always affects the value of the firm. He Showed how
dividend policy can be used to maximize the wealth
of the shareholders.
The main proposition of the model is that the value of
a share reflects the value of the future dividends
accruing to that share. Hence, the dividend payment
and its growth are relevant in valuation of shares.
The model holds that the share’s market price is equal
to the sum of share’s discounted future dividend
payment.
Assumptions:
Allequity firm
No external Financing
Constant Returns
Constant Cost of Capital
Perpetual Earnings
No taxes
Constant Retention
Cost of Capital is greater then growth rate (k>br=g)
Formula of Gordon’s Model
E (1 – b)
P =
K - br
Where,
P = Price
E = Earning per Share
b = Retention Ratio
k = Cost of Capital
br = g = Growth Rate
Illustration :
Growth Firm (r > k):
r = 20% k = 15% E = Rs. 4
If b = 0.25
P0 = (0.75) 4 = Rs. 30
0.15- (0.25)(0.20)
If b = 0.50
P0 = (0.50) 4 = Rs. 40
0.15- (0.5)(0.20)
Illustration :
Normal Firm (r = k):
r = 15% k = 15% E = Rs. 4
If b = 0.25
P0 = (0.75) 4 = Rs. 26.67
0.15- (0.25)(0.15)
If b = 0.50
P0 = (0.50) 4 = Rs. 26.67
0.15- (0.5)(0.15)
Illustration :
Declining Firm (r < k):
r = 10% k = 15% E = Rs. 4
If b = 0.25
P0 = (0.75) 4 = Rs. 24
0.15- (0.25)(0.10)
If b = 0.50
P0 = (0.50) 4 = Rs. 20
0.15- (0.5)(0.10)
Criticisms of Gordon’s model
As the assumptions of Walter’s Model and
Gordon’s Model are same so the Gordon’s
model suffers from the same limitations as
the Walter’s Model.
Modigliani & Miller’s Irrelevance Model
Value of Firm (i.e. Wealth of Shareholders)
Depends on
Firm’s Earnings
Depends on
Firm’s Investment Policy and not on dividend policy
Modigliani and Miller’s Approach
Assumption
Capital Markets are Perfect and people are Rational
No taxes
Floating Costs are nil
Investment opportunities and future profits of firms
are known with certainty (This assumption was
dropped later)
Investment and Dividend Decisions are independent
M-M’s Argument
If a company retains earnings instead of giving it
out as dividends, the shareholder enjoy capital
appreciation equal to the amount of earnings
retained.
If it distributes earnings by the way of dividends
instead of retaining it, shareholder enjoys dividends
equal in value to the amount by which his capital
would have appreciated had the company chosen
to retain its earning.
Hence,
the division of earnings between dividends and
retained earnings is IRRELEVANT from the point of
view of shareholders.
Formula of M-M’s Approach
1 ( D1+P1 )
Po =
(1 + p)
Where,
Po = Market price per share at time 0,
D1 = Dividend per share at time 1,
P1 = Market price of share at time 1
1 (nD1+nP1)
nPo =
(1 + p)
The expression of the outstanding equity shares of
the firm at time 0 is obtained as:
1 {nD1+(n + m)P1- mP1}
nPo =
(1 + p)
mP1 = I – (X – nD1)
Where,
X = Total net profit of the firm for year 1
nPo 1 [nD1+ (n + m)P1– {I – (X – nD1)}]
=
(1 + p)
nPo 1 nD1+ (n + m)P1– I +X – nD1
=
(1 + p)
nPo 1 (n + m)P1– I +X
=
(1 + p)
Criticism of M-M Model
No perfect Capital Market
Existence of Transaction Cost
Existence of Floatation Cost
Lack of Relevant Information
Differential rates of Taxes
No fixed investment Policy
Investor’s desire to obtain current income
Traditional 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
Or if the funds are not required in the business they
may be distributed as dividends.
Thus the decision to pay the dividends or retain the
earnings may be taken as a residual decision
This theory assumes that the investors do not
differentiate between dividends and retentions by
the firm
Thus, a firm should retain the earnings if it has
profitable investment opportunities otherwise it
should pay than as dividends.
Synopsis
Dividend is the part of profit paid to Shareholders.
Firm decide, depending on the profit, the
percentage of paying dividend.
Walter and Gordon says that a Dividend Decision
affects the valuation of the firm.
While the Traditional Approach and MM’s
Approach says that Value of the Firm is irrelevant to
Dividend we pay.
Bibliography
Google
Financial management by prasanna chandra.
