Dividend & Dividend Policy

Dividend refers to a reward, cash or otherwise, that a company gives to its

shareholders. Dividends can be issued in various forms, such as cash
payment, stocks or any other form. A company’s dividend is decided by its
board of directors and it requires the shareholders’ approval. However, it is
not obligatory for a company to pay dividend. Dividend is usually a part of
the profit that the company shares with its shareholders.

The term dividend refers to that part of profits of a company which is

distributed by the company among its shareholders. The investors are
interested in earning the maximum return on their investments and to
maximise their wealth. A company, on the other hand, needs to provide
funds to finance its long-term growth.
If a company pays out as dividend most of what it earns, then for business
requirements and further expansion it will have to depend upon outside
resources such as issue of debt or new shares. Dividend policy of a firm,
thus affects both the long-term financing and the wealth of shareholders.

Theories of Dividend

There are two types of Dividend theories-

· Relevant Dividend Theory
· Irrelevant Dividend Theory

Relevant Dividend Theory:

Dividends paid by the firms are viewed positively both by the investors and
the firms. The firms which do not pay dividends are rated in oppositely by
investors thus affecting the share price. The people who support relevance
of dividends clearly state that regular dividend reduce uncertainty of the
shareholders i.e. the earnings of the firm is discounted at a lower rate,
thereby increasing the market value. However, it’s exactly opposite in the
case of increased uncertainty due to non-payment of dividends. Two
important models supporting dividend relevance are given by
Walter's model:

Walter's model shows the relevance of dividend policy and its bearing on
the value of the share. Dividends are referred to as the opportunity cost of
the firm or the cost of capital, ke for the firm. Another situation where the
firms do not pay out dividends is when they invest the profits or retained
earnings in profitable opportunities to earn returns on such investments.
This rate of return r, for the firm must at least be equal to ke. If this happens
then the returns of the firm is equal to the earnings of the shareholders if
the dividends were paid. Thus, it's clear that if r is more than the cost of
capital ke, then the returns from investments is more than returns
shareholders receive from further investments.

If r > ke, the firm should have zero payout and make investments.
If r < ke, the firm should have 100% payouts and no investment of retained
earnings.
If r = ke, the firm is indifferent between dividends and investments.

P = D/K +r(E-D)/K/K

P = Market price of the share

D = Dividend per share
r = Rate of return on the firm's investments
E = Earnings per share'

The market price of the share consists of the sum total of:
· The present value of an infinite stream of dividends.
· The present value of an infinite stream of returns on investments made
from retained earnings.
Therefore, the market value of a share is the result of expected dividends
and capital gains according to Walter.
Gordon's Model:

Myron J. Gordon has also supported dividend relevance and believes in

regular dividends affecting the share price of the firm. According to this
model Investors are risk averse and believe that incomes from dividends
are certain rather than incomes from future capital gains, therefore they
predict future capital gains to be risky propositions. They discount the
future capital gains at a higher rate than the firm's earnings, thereby
evaluating a higher value of the share. In short, when retention rate
increases, they require a higher discounting rate. Gordon has given a
model similar to Walter’s formula to determine price of the share.

Where,
P = Market price of the share
E = Earnings per share
b = Retention ratio (1 - payout ratio)
r = Rate of return on the firm's investments
ke = Cost of equity
br = Growth rate of the firm (g)

Therefore the model shows a relationship between the payout ratio, rate of
return, cost of capital and the market price of the share.

Irrelevant Dividend Theory

The Modigliani and Miller school of thought believes that investors do not
state any preference between current dividends and capital gains. They
say that dividend policy is irrelevant and is not deterministic of the market
value. Therefore, the shareholders are indifferent between the two types of
dividends. All they want are high returns either in the form of dividends or in
the form of re-investment of retained earnings by the firm. There are two
conditions discussed in relation to this approach.

· Decisions regarding financing and investments are made and do not

change with respect to the amounts of dividends received.
· When an investor buys and sells shares without facing any transaction
costs and firms issue shares without facing any floatation cost, it is termed
as a perfect capital market.

Modigliani-Miller theorem:

The Modigliani–Miller theorem states that the division of retained earnings

between new investment and dividends do not influence the value of the
firm. It is the investment pattern and consequently the earnings of the firm
which affect the share price or the value of the firm. The dividend
irrelevancy in this model exists because shareholders are indifferent
between paying out dividends and investing retained earnings in new
opportunities. The firm finances opportunities either through retained
earnings or by issuing new shares to raise capital. The amount used up in
paying out dividends is replaced by the new capital raised through issuing
shares. This will affect the value of the firm in an opposite way. The
increase in the value because of the dividends will be offset by the
decrease in the value for new capital rising

Impact of Dividend on value of firm

Why dividend policy may increase firm value

The dividend policy on firm value argues that high dividends will increase
firm value. The main argument is that there exists natural clienteles for
dividend paying stocks, since many investors invest in stocks to maintain a
steady source of cash. If paying out dividends is cheaper than letting
investors realize the cash by selling stocks, then the natural clientele would
be willing to pay a premium for the stock. Transaction costs might be one
reason why its comparatively cheaper to payout dividends. However, it
does not follow that any particular firm can benefit by increasing its
dividends. The high dividend clientele already have plenty of high dividend
stock to choose from.

Why dividend policy may decrease firm value

Dividend policy states that low dividends will increase value. The main
argument is that dividend income is often taxed, which is something MM-
theory ignores. Companies can convert dividends into capital gains by
shifting their dividend policies. Moreover, if dividends are taxed more
heavily than capital gains, taxpaying investors should welcome such a
move. As a result firm value will increase, since total cash flow retained by
the firm and/or held by shareholders will be higher than if dividends are
paid. Thus, if capital gains are taxed at a lower rate than dividend income,
companies should pay the lowest dividend possible.

From the reviewed literature, it can be established that dividend policy

theories have divergent relevance between management and the
shareholders arising from opposing interests. Management is primarily
focused on the objective growth of the organization while the shareholders
are focused on the shareholders wealth in terms of share price that
determine their return on investment. The empirical studies reviewed show
a positive relationship between dividends payout and firm value. Although
abundant theories and empirical evidence have attempted to illuminate why
dividends are paid, their results are still inconclusive. This study conclude
with statement “the harder we try to understand the dividend decisions by
firm , the more it seems like a puzzle, with pieces that just do not fit
together.
 Working Capital

Working capital, also known as net working capital (NWC), is the difference
between a company’s current assets, such as cash, accounts receivable
(customers’ unpaid bills) and inventories of raw materials and finished
goods, and its current liabilities, such as accounts payable.

Working capital is a measure of a company's liquidity, operational

efficiency and its short-term financial health. If a company has substantial
working capital, then it should have the potential to invest and grow. If a
company's current assets do not exceed its current liabilities, then it may
have trouble growing or paying back creditors, or even go bankrupt.

Working Capital = Current Assets – Current Liabilities

Types of Working Capital

1. On the basis of Value

 Gross Working Capital: It denotes the company’s overall investment in
the current assets.
 Net Working Capital: It implies the surplus of current assets over
current liabilities. A positive net working capital shows the company’s
ability to cover short-term liabilities, whereas a negative net working
capital indicates the company’s inability in fulfilling short-term obligations.
On the basis of Time
 Temporary working Capital: Otherwise known as variable working
capital, it is that portion of capital which is needed by the firm along with
the permanent working capital, to fulfil short-term working capital needs
that emerge out of fluctuation in the sales volume.
 Permanent Working Capital: The minimum amount of working capital
that a company holds to carry on the operations without any interruption,
is called permanent working capital.
Other types of working capital include Initial working capital and Regular
working capital. The capital required by the promoters to initiate the
business is known as initial working capital. On the other hand, regular
working capital is one that is required by the firm to carry on its operations
effectively.

Factors Affecting Working Capital

(1) Nature of Business:

The requirement of working capital depends on the nature of business. The
nature of business is usually of two types: Manufacturing Business and
Trading Business. In the case of manufacturing business it takes a lot of
time in converting raw material into finished goods. Therefore, capital
remains invested for a long time in raw material, semi-finished goods and
the stocking of the finished goods.

(2) Scale of Operations:

There is a direct link between the working capital and the scale of
operations. In other words, more working capital is required in case of big
organizations while less working capital is needed in case of small
organizations.

(3) Business Cycle:

The need for the working capital is affected by various stages of the
business cycle. During the boom period, the demand of a product
increases and sales also increase. Therefore, more working capital is
needed. On the contrary, during the period of depression, the demand
declines and it affects both the production and sales of goods. Therefore, in
such a situation less working capital is required.
(4) Seasonal Factors:
Some goods are demanded throughout the year while others have
seasonal demand. Goods which have uniform demand the whole year their
production and sale are continuous. Consequently, such enterprises need
little working capital.

On the other hand, some goods have seasonal demand but the same are
produced almost the whole year so that their supply is available readily
when demanded.

(5) Production Cycle:

Production cycle means the time involved in converting raw material into
finished product. The longer this period, the more will be the time for which
the capital remains blocked in raw material and semi-manufactured
products.

Thus, more working capital will be needed. On the contrary, where period
of production cycle is little, less working capital will be needed.

(6) Credit Allowed:

Those enterprises which sell goods on cash payment basis need little
working capital but those who provide credit facilities to the customers need
more working capital.