CHAPTER TWO

DIVIDEND POLICY AND

DIVIDEND THEORY
INTRODUCTION
• Dividend refers to the portion of a firm’s profit (net earnings)
which is distributed to the owners / shareholders of the firm.

• dividend is that part of the net earnings of a corporation that is

distributed to its stockholders.

• It is a payment made to the equity shareholders for their

investment in the company

• The retained earning constitutes an easily accessible important

source of financing for investment fund requirement of firms.
There is, thus, a type of inverse relationship between retained
earnings and cash dividend: larger retentions, lesser dividends;
smaller retentions, larger dividends.
 Dividend classifications
• Cash Dividends

a) Regular cash dividend – cash payments made

directly to stockholders, usually each quarter.
b) Extra cash dividend – indication that the “extra”
amount may or may not be repeated in the future.
c) Special cash dividend – similar to extra dividend, but
unusual or one time event & definitely won’t be
repeated in the future.
d) Liquidating dividend – when some or all of the
business has been sold.

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Cash Dividend Payment-
Chronology
Declaration Date – Board declares the
dividend and it becomes a liability of the firm.
Ex-Dividend Date - Date that determines
whether a stockholder is entitled to a dividend
payment; anyone holding stock before this
date is entitled to a dividend.

Record Date - Person who owns stock on this

date received the dividend.

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Cash Dividend Payment-
Chronology
Payment Date - It is the date that the dividend
checks are mailed.
November 15 November 27 November 29 January 2
The date on which Shares start to trade Shareholders The date on which
the firm announces without the dividend registered on this dividend checks are
it intends to pay a thus the phrase “ex- date will receive the mailed to the
dividend dividend” dividend shareholders

Declaration Record Payment

Date Ex-dividend Date Date
Date

6
 Dividend Policy Theories

• There are conflicting opinions regarding the impact of dividends on

the valuation of a firm. According to a school of thought,

dividends are irrelevant so the amount of dividends paid has no

effect on the valuation of the firm. On the other hand, certain

theories consider the dividend decision as relevant to the value

of the firm measured in terms of the market price of the shares.

• Dividend Irrelevance Theory

• The theory of dividends are irrelevant is based on the investors are
indifferent between dividends and capital gains. So long as the
firm is able to earn more than the equity- capitalization rate, the
investors would be content with the firm retaining the earnings.
Cont. …
• The most comprehensive argument in support of the irrelevance of
dividends is provided by the Miller and Modigliani (MM) hypothesis.

• MM maintains that dividend policy has no effect on the share price of

the firm, and is therefore, of no consequence.

• What matters, according to them, is the investment policy through

which the firm can increase its earning and thereby the value of the
firm.

• Assumptions of MM approach

A. Perfect capital markets

B. Rational investors

C. Absences of tax

D. Capital appreciation

E. The firm’s investment policy,

 Cash Flow Analysis

• MM approach can be proved with the help of the following

formula:

• Where,

• Po = Prevailing market price of a share.

• Ke = Cost of equity capital.

• D1 = Dividend to be received at the end of period one.

• P1 = Market price of the share at the end of period one.

• P1 can be calculated with the help of the following formula.
• P1 = Po (1+Ke) – D1
 Example
• Ram company belongs to a risk class for which the appropriate
capitalization rate is

• 12%. It currently has outstanding 30000 shares selling at Rs. 100

each. The firm is

• contemplating the declaration of dividend of Rs. 6 per share at the end

of the current

• financial year. The company expects to have a net income of Rs.

3,00,000 and a proposal

• for making new investments of Rs. 6,00,000. Show that under the MM
assumptions, the

• payment of dividend does not affect the value of the firm. How many
new shares issued and what is the market value at the end of the
year?
 Cont. ..
Solution

(I) If the dividend is paid

• Po = 100
• D1 = Rs. 6
• P1 = ?
• Ke = 12%

• 6 + P1 = 112
• P1 = 112 – 6
• P1 = Rs. 106
 Cont. …

(ii) If the dividend is not paid

• Ke = 12%, Po = 100, D1 = 0, P1 = ?

• P1 = Rs. 112
Calculation of number of new shares to be issued
Dividends Paid Dividends not Paid
• Net Income 300000 300000
• Total Dividends 180000 –
• Retained Earnings 120000 300000
• Investment Budget 600000 600000
• Amount to be raised as
• new shares 480000 300000
• (Investment – Retained Earnings)
• Relevant – Market Price
• per share Rs. 106 Rs. 112
• No. of new shares to be issued 4528.3 2678.6
• Total number of shares at the
• end of the year 300000 30000
• Existing shares 4528.3 2678.6
• (+) new shares issued 34528.3 32678.6
• Market price per share Rs. 106 112
• Market value for shares Rs. 3660000 3660000

• NB: There is no change in the total market value of shares

 Mini test( 5%)
• Z Ltd., has risk allying firm for which capitalization rate is 12%. It
currently has outstanding 8,000 shares selling at Rs. 100 each. The
dividend for the current financial year is Rs. 7 per share.

• The company expects to have a net income of Rs. 69,000 and has a
proposal formatting new investments of Rs. 1,60,000. Show that under
the MM hypothesis the payment of dividend does not affect the value of
the firm.

(A) Value of the firm when dividends are paid. Price of the shares at the end
of the current financial year.

P1 = Po (1+Ke) – D1

= 100 (1 + .12) – 7

= 100×1.12 – 7

P1 = Rs. 105
• (B) Number of shares to be issued.
 Criticism of MM approach

• MM approach consists of certain criticisms also. The following are

the major criticisms of MM approach.

• MM approach assumes that tax does not exist. It is not applicable

in the practical life of the firm.

• MM approach assumes that, there is no risk and uncertain of the

investment. It is also not applicable in present day business life.

• MM approach does not consider floatation cost and transaction

cost. It leads to affect the value of the firm.

• MM approach considers only single decrement rate, it does not

exist in real practice.

• MM approach assumes that, investor behaves rationally. But we

cannot give assurance that all the investors will behave rationally.
 RELEVANCE OF DIVIDEND
*In sharp contrast to the MM hypothesis, there are some theories
that consider dividend decisions to be an active variable in
determining the value of the firm.

1. Walter’s Model

The key argument in support of the relevant proposition of Walter’s

model is the relationship between the return of the firm’s investment
or its internal rate of return (r) and its cost of capital or the required
rate of return(ke).

*The firm would have to have an optimal dividend policy which will be
determined by the relationship of internal rate of return and required
rate of return.
 RELEVANCE OF DIVIDEND
*in other words, if the return on investments exceeds the cost of capital,
the firm should retain the earnings; whereas it should distribute the
earnings to the shareholders in case the required rate of return exceed the
expected return on the firm’s investments.
*The rationale is that if the IRR is greater than the RRR, the firm is able to
earn more than what the shareholders could by reinvesting elsewhere, if
the earnings are given to them. The implication of internal rate of return
less than the required rate of return is that shareholders can earn a higher
return by investing elsewhere.
*Walter’s model, thus, relates the distribution of dividends (retention of
earnings) to available investment opportunities. If a firm has adequate
profitable investment opportunities, it will be able to earn more than
what the investors expect. Such firms may be called growth firms. For such
firms optimal payout ratio should be zero as per prof. walter.
 ………..
*In contrast if the firm does not have profitable investment opportunities,
where IRR is less than the rrr, ( he call such firms declining) the
shareholders will be better off as far as earnings are paid out so as to
enable them earn a higher return by using the funds elsewhere. In such a
case, the market price of shares will be maximized by the distribution of
the entire earnings as dividends.
A dividend pay out ratio of 100 percent would give an optimum dividends
policy for such firms
*Finally, when the IRR is equal to the RRR( he calls such firms normal
firms), it is a matter of indifference whether earnings are retained or
distributed. This is so because for all dividend pay out ratios, ranging
between zero and 100, the market price of share will remain constant. For
such firms, there is no optimum dividend policy or dividend pay out ratio.
 Assumptions of Walter’s Model

• The main assumptions of the Walter Model are as follows:

A. All financing is done through retained earnings; external sources of funds like debt
or new equity capital are not used.
B. With additional investments undertaken, the firm’s business risk does not change. It
implies that internal rate of return and required rate of return are constant.
C. There is no change in the key variables, namely, beginning earnings per share(E),
and dividend per share(D). The value of dividend per share and earning per share may
be changed in the model to determine the result, but any given value of earning per
share and dividend per share are assumed to remain constant in determining the given
value.
D. The firm has perpetual or very long life.
Assumptions of Walter’s Model
Gordon’s Model
• Gordon’s Model is also in favor of the relevance of dividends. This model,
which discourse that dividend policy of a firm affects its value, is based on
the following assumptions:
• The firm is an all-equity firm. No external financing is used and investment
programs are financed exclusively by retained earnings
• Internal rate of return and cost of equity capital are constant
• The firm has perpetual life
• The retention ratio, once decided upon, is constant. Thus the growth rate is
also constant.
• Cost of equity capital is greater than the growth rate.
*The crux of Gordon’s assumptions is a two-fold assumption: 1) investors are
risk averse, and 2) they put premium on certain return and discount/
penalize uncertain returns.
1. Bird-in-the-Hand Theory (By Myron Gordon and John Litner)
• High dividends increase stock value
• “A bird in the hand is worth two in the bush”
• Investors may prefer “dividend today” as it is less risky compared to “uncertain
future capital gains”.
• This implies a higher required rate for a dollar of capital gain than a dollar of
dividends.

Investors are more certain about current income, dividends, than future income,
capital gain.

❖ Therefore, high pay-out ratio maximizes stock price than low pay-out ratio,
according to Gordon and Lintner.

❖ M&M called it “bird-in-the-hand fallacy” arguing that the riskiness of the firm to
shareholders emanate from the riskiness of operating cash flows from the firm’s
assets instead of how these cash flows are distributed.
2. Tax Preference Theory
❖ Low dividend increases stock values
• In 2003, the tax rates on capital gains and dividends were
made equal to 15 percent (In the USA).
• However, current dividends are taxed immediately while the
tax on capital gains can be deferred until the stock is actually
sold. Thus, capital gains have definite financial advantage
for shareholders.
• Stocks that allow tax deferral (i.e. low dividends and high
capital gains) will possibly sell at a premium relative to
stocks that require current taxation (i.e. high dividends and
low capital gains).
Other dividend policy issues that have to be considered:

(1) The information content, or signalling, hypothesis

• Asymmetric information – managers have more information
about the health of the company than investors
• Managers hate to cut dividends, so won’t raise dividends unless they think raise is
sustainable
• Changes in dividends convey information
• Increase in dividend - Positive signal
• Decrease in dividend – negative signal

2) The clientele effect

• Some investors, clientele, prefer low dividend payouts and will buy stock in those
companies that offer low dividend payouts
• Some investors prefer high dividend payouts and will buy stock in those companies
that offer high dividend payouts
• Managers should focus on capital budgeting decisions and ignore investor
preferences
END OF CHAPTER 2