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Dividend is that portion of profits of a company which is distributable

among its shareholders according to the decision taken and resolution
passed in the meeting of Board of Direct ors. . Thi s may be pai d as a
f i xed percent age on t he share capital contributed by them or at a fixed
amount per share. It means onl y profi ts af ter meeting al l the expenses
and provi ding for taxation and depreciation and transferring a reasonable
amount to reserve funds should be distributed to shareholders as
dividend. There is always a problem before top management or Board of
Directors to decide how much profit should be t r ansf e r r e d t o Re s e r v e
f unds t o me e t any unf or e s e e n conti ngenci es and how much shoul d
be di stri buted to sharehol der s as di vi dend. Payment of di vi dend i s
desi rabl e because it aff ects the goodwill of the concern in the market
on the one hand, and on the other, shareholders get a reasonable, return
on their investment. Retained earnings are the source of i nt er nal
f i nance f or t he f i nanci ng of cor por at e f ut ur e pr oj ect s but payment
of di vi dend const i t ut es an out f l ow of cash t o sharehol ders.
Al t hough bot hexpansi on and payment of dividendare desirable,
these two are in conflicts. It i s, theref ore, one of the i mportant
f uncti ons of the f i nanci al management to constitute a dividend policy
which can balance these two contradictory viewpoints and allocate the
reasonable amount of profits after tax between retained earnings and

Such payment of dividend in between the two Annual General meetings before
finalizing the accounts is called Interim Dividend. No Interim Dividend can be
declared or paid unless depreciation for the full year (not proportionately) has
been provided for. It is, thus, an extra dividend paid during the year requiring
no need of approval of the Annual General Meeting.
Stock Dividend: Companies, not having good cash position, generally pay
dividend in the form of shares by capitalising the profits of current year
and of past years. Such shares are issued instead of paying dividend in
cash and called 'Bonus Shares'. Basically there is no change in the equity of
Scrip Dividend: Scrip dividends are used when earnings justify a dividend, but
the cash position of the company is temporarily weak. So, shareholders are
issued shares or debentures if other companies held by the company as
investment. Such payment of dividend is called Scrip Dividend.
Shareholders generally do not like such dividend because the shares or
debentures so paid are worthless for the shareholders as directors would
use only such investments which they found were not good. Such dividend
was allowed before passing of the Companies (Amendment) Act 1960, but
thereafter this unhealthy practice was stopped. - - -
Bond Dividends: In rare instance, dividends are paid in the form of debentures or
bonds or notes for a long-term period bearing interest at fixed rate. The effect
of such dividend is the same as that of paying dividend in scrip. The
shareholders become the secured creditors if the bonds have a lien on assets.
Property Dividend: Sometimes, dividend is paid in the form of asset instead
of payment of, dividend in cash. The distribution of dividend is made
whenever the benefits no longer required in the business such as investment
or stock of finished goods.
But, it is, however, important to note that in India, distribution of
dividend is permissible in the form of cash or bonus shares only. Distribution
of dividend in any other form is not allowed.

Dividend Policy:
The economic soundness of a company is generally judged by the amount of
dividend declared and paid by it to the shareholders. It affects its goodwill
among the shareholders and the prospective shareholders.
Dividend is a part of profits distributed among the shareholders. The
basic question before the Board of Directors is how much profits should be
divided among shareholders as dividend and how much shoul d be
r et ai ned as reserves t o meet the future contingencies and for expansion
of business. It requires a sound dividend policy to be followed by the
According to Weston and Brigham "Dividend policy determine, the
division of earnings between payments to shareholders and retained
In this connection, the dividend declared during previous years may be
taken as a base and the same rate is followed in the coming years.
Generally, Board of Directors aims at maintaining the dividend rate
which we may call a 'Stable Dividend Policy'. For this purpose a
'dividend equalization fund' is created out of profits to equalize the
profits of the coming years.
Basic Issues Involved in Dividend Policy. There
are certain basic
questions 'which are involved in determining the sound dividend policy.
Such questions are:--
1. Cost of Capital: Cost of capital is one of the considerations
for taking a decision whether to distribute dividend or not. As a
decision making tool, the Board calculates the ratio of rupee profits the
business expects to earn (Ra) to the rupee profits that the shareholders can
expect to earn outside (Rc) Ra/Rc. If the
ratio is less than one, it is a signal to distribute divi dend and if it is
more than one, the distribution of dividend will be discontinued.
2. Realisation of Objectives: The main objectives of the
firm, i e., maximisation of wealth for shareholders including the current
rate of dividend should also be aimed at in formulating the dividend policy.
3. Shareholders' Group: Dividend policy affects the
shareholders' group. It means a company with low pay-out and heavy
reinvestment attracts shareholders interested in capital gains rather than
in current income whereas a company with high dividend payout
attracts those who are interested in current income.
4. Release of Corporate Earnings: Dividend distribution is
taken as a means of distributing unused funds. Dividend policy affects
the shareholders wealth by varying its dividend pay-out ratio. In dividend
policy, the financial managers decide whether to release corporate earnings
or not.
These are certain basic issues involved in formulating a dividend
policy. Dividend policy to a large extent affects the financial structure,
the flow of funds, liquidity,, stock prices a-,d in the last shareholders'
satisfaction. That is why management exercises a high degree of judgment
in establishing a sound dividend pattern.
Factors affecting Dividend Policy: A number of considerations
affect the dividend policy of a company. The major factors are
1. Stability of Earnings: The nature of business has an im-
portant bearing on the dividend policy. Industrial units having
stability of earnings may formulate a more consistent dividend policy
than those having an even flow of incomes because they can predict easily
their savings and earnings. Usually, enterprises dealing in necessities
suffer less from oscillating earnings than those dealing in luxuries or fancy
2. Age of a Corporation: Age of the corporation counts much in
deciding the dividend policy. A newly established company may require
much of its earnings for expansion and plant improvement and may
adopt a rigid dividend policy while, on the other hand, an older
company can formulate a clear cut and more consistent policy
regarding dividend.
3. Liquidity of funds: Availability of cash and sound, financial
position is also an important factor in dividend decisions. A dividend
represents a cash outflow, the greater the funds and the liquidity of
the firm, the better the ability to pay dividend. The liquidity of a firm
depends very much on the investment and financial decisions of the firm
which in turn determines the rate of expansion and the manner of
financing. If cash position is weak, stock dividend will be preferred and
if cash_ positions good, company can distribute cash dividend.
4. Extent of Share Distribution: Nature of ownership also
affects the dividend decisions. A closely held company is likely to get
the assent of the shareholders for the suspension of dividend or for
following a conservative dividend policy. On the other hand, a
company having a good number of shareholders widely distributed and
forming low or medium income group would face a great difficulty in
securing such assent because they will emphasis to distribute higher
dividends in Cash immediately.
5. Needs for Additional Capital: Companies retain a part or
their profits for strengthening their financial position. The income may
be conserved for meeting the increased requirements of working capital or
of future expansion. Small companies usually find difficulties in raising
finance for their needs of increased working capital for expansion
programmes. They, having no other alternative use their ploughed back
profits. Thus, such companies distribute' dividend at low rates and
retain a big part of profits.
6. Trade Cycles: Business cycles also exercise influence upon
dividend policy. Dividend policy is adjusted according to the business
oscillations. During the boom, prudent management creates good
reserves for contingencies. Higher rates of dividend can be used as a
tool for marketing the securities in an otherwise depressed market. The
financial solvency can be proved and maintained by the companies in
dull years if the adequate reserves have been built up.
7. Government Policies: The earning capacity of the enter-
prises is widely affected by the change in fiscal, industrial, labour,
control and other Government policies. Sometimes Government
restricts the distribution of dividend beyond a certain percentage in a
particular industry or in all spheres of business activity, as was done
by the Government of India in emergency. The dividend policy has to be
modified or formulated accordingly.

The value of the firm can be maximized if the shareholders wealth is
maximized. There are contradictory views about the impact of dividend
decision on the value of the firm.
According to one school of thought dividend decision does not affect the
shareholders wealth and hence the value of the firm. On the other hand,
according to the other school of thought, dividend decision significantly
affects the shareholders wealth and also the value of the firm. There are the
views of the two schools of thought under two groups:
a. The Relevance Concept of Dividend or the Theory of Relevance
b. The Irrelevance Concept of Dividend or the Theory of Irrelevance
The Relevance Concept of Dividends: According to this school of thought,
dividends are relevant and the amount of dividend paid affects the value of
the firm. Walter, Gordon and others advocated that dividend decisions are
important in determining the value of the firm. Walter argues that the
choices of dividend policies almost and always affect the value of the
The Irrelevance Concept of Dividend: The other school of thought
propounded by Modigliani and Miller in 1961. According to MM approach,
the dividend policy of a firm is irrelevant and it does not affect the wealth of
the shareholders. They advocate that the value of the firm depends on the
market price of the share; the dividend decision is of no use in determining
the value of the firm.
Walters model, clearly indicates that the choice of appropriate dividend
policy always affects the value of the enterprise. Professor James E.
Walter has very scholarly studied the importance of the relationship between
the firms internal rate of return, r, (or actual capitalization rate) and its
Cost of Capital, Ke (normal capitalization rate) in determining such dividend
policy as will maximize the wealth of the stockholders.
Walters model is based on the following premises:
1) The firm finance its entire investments by means of retained earnings.
New equity stock or debenture is not issued to raise funds.
2) Internal rate of return (r) and cost of capital (Ke) of the firm remain
3) The firms earnings are either distributed as dividends or reinvested
4) Earnings and dividends of the firm never change.
5) The firm has long or infinite life.
The formula used by Walter to determine the market price per share is:

P = Market price per share
D = Dividend per share
E = Earnings per share
r = Internal rate of return (Actual capitalization rate)
K = Cost capital (External capitalization rate)
It may be noted that Walters formula has the same effect as the continuing
dividend growth formula. It seeks to measure the effect of dividends on
common stock value by comparing actual and normal capitalization rates.
Another characteristic of Walters formula is that it provides an added or
reduced Weight to the retained earnings portion of the capitalization
earnings formula. The factors r and k are placed in front of retained
earnings to change its weighted value under different situations as
discussed below:

1. Growth Firms:
In growth firms internal rate of return is greater than the normal rate(r > k).
Therefore, r/k factor will greater than 1.
Such firms must reinvest retained earnings since existing alternative
investments offer a lower return than the firm is able to secure. Each rupee
of retained earnings will have a higher weighting in Walters formula than a
comparable rupee of dividends. Thus, large the firm retains, higher the value
of the firm. Optimum dividend payout ratio for such a firm will be zero.
2. Normal Firm
Normal firms comprise those firms whose internal rate of return is equal to
normal capitalization (r=k). These firms earn on their investments rate of
return equal to market rate of return. For such firms dividend policy will
have no effect on the market value per share in the Walters model.
Accordingly, retained earnings will have the same weighted value as
dividends. In this case the market value per share is affected by the payout
3. Declining Firms
Firms which earn on their investments less than the minimum rate required
are designated as declining firms. The management of such firms would like
to distribute its earnings to the stockholders so that they may either spend
it or invest elsewhere to earn higher return than earned by the declining
firms. Under such a situation each rupee of retained earnings will receive
lower weight than dividends and market value of the firm will tend to be
maximum when it does not retain earnings at all.
4. Evaluation of the Walters Model
Professor Walter has endeavoured to show in an erudite manner the effects
of dividend policy on value of equity shares under different situations of a
firm. However, the basic premises on which edifice of the theory are laid
down are unrealistic and therefore, conclusions drawn from the Walters
model are hardly true for real life situations.

Thus, for instance assume that a firm finances its investment opportunities
only by means of internal sources and no external financing is resorted to
for this purpose. Under such a situation, either the value of the firms
investment or dividend or both will be sub-optimum.
In its attempt to maximize the value of the firm, the management should go
on making investments so long as return of investment is equal to the cost
of capital. This is the optimum level of investment; the remaining amount
should be raised from external sources. On the contrary, Walter argues that
value of the firm is maximized by retaining all the profits because magnitude
of investments financed by retained earnings may be less than the optimum
level of investment.
Further, Professor Walter has assumed that r remains constant under all
the situations. As
a matter of fact, r tends to decrease in correspondence with increase in
level of investments.
This is why it is suggested that the management should make investments
upto optimal level where r = k.
Finally, assumption of constant cost of capital k is incorrect. On the
contrary, it varies in tune with change in risk of the firm.

Illustration 1 : The earnings per share of a company is Rs. 8 and the rate of
capitalisation applicable is 10%. The company has before it an option of
adopting (i) 50%, (ii) 75% and (iii)100% dividend payout ratio. Compute the
market price of the companys quoted
shares as per Walters model if it can earn a return of (i) 15%, (ii) 10% and
(iii) 5% on its retained earnings.
Computation of market price of Companys share by applying Walters

Now, we can calculate the market price per share based on different IRRs
and dividend payout rations.
(i) Market price per share when Ra = 15%
(a) When dividend payout ratio is 50%
Dividend paid = 8 50/100 = Rs. 4

(b) When dividend payout ratio is 75%
Dividend paid = Rs. 875/100 = Rs. 6

(c) When dividend payout ratio is 100%
i.e., dividend paid = Rs. 8

Myron Gordon has also developed a model on the lines of Prof. Walter
suggesting that dividends are relevant and the dividend decision of the firm
affects its value. His basic valuation model is based on the following
1. The firm is an all equity firm.
2. No external financing is available or used. Retained earnings represent
the only source of financing investment programmes.
3. The rate of return on the firms investment r, is constant.
4. The retention ratio, b, once decided upon is constant. Thus, the growth
rate of the firm (g = br), is also constant.
5. The cost of capital for the firm remains constant and it is greater than the
growth rate, i.e. k > br.
6. The firm has perpetual life.
7. Corporate taxes do not exist.
According to Gordon, the market value of a share is equal to the present
value of future stream of dividends. Thus, Gordons basic valuation formula
is as under:


P = Price of shares
E = Earnings per share
b = Retention Ratio
ke = Cost of equity capital
br = g = growth rate in r, i.e., rate of return on investment of an all-equity
D = Dividend per share
The implications of Gordons basic valuation model may be summarized as
below :
1. When the rate of return of firms investment is greater than the required
rate of return, i.e. when r > k, the price per share increases as the dividend
payout ratio decreases.
Thus, growth firm should distribute smaller dividends and should retain
maximum earnings.
2. When the rate of return is equal to the required rate of return, i.e, when r
= k, the price per share remains unchanged and is not affected by dividend
policy. Thus, for a normal firm there is no optimum dividend payout.
3. When the rate of return is less than the required rate of return, i.e., when
r<k, the price per share increases as the dividend payout ratio increases.
Thus, the shareholders of declining firm stand to gain if the firm distributes
its earnings. For such firms, the optimum pay out would be 100%.

Modigliani-Millers (M-Ms) thoughts for irrelevance of dividends are most
comprehensive and logical. According to them, dividend policy does not
affect the value of a firm and is therefore, of no consequence. It is the
earning potentiality and investment policy of the firm rather than its pattern
of distribution of earnings that affects value of the firm.
Basic Assumptions of M-M Approach
(1) There exists perfect capital market where all investors are rational.
Information is available to all at no cost; there are no transaction costs and
floatation costs. There is no such investor as could alone influence market
value of shares.
(2) There does not exist taxes. Alternatively, there is no tax differential
between income on dividend and capital gains.
(3) Firm has uncertainty as to future investments and profits of the firm.
Thus, investors are able to predict future prices and dividend with certainty.
This assumption is dropped by M-M later.
M-Ms irrelevance approach is based on arbitrage argument. Arbitrage is the
process of entering into such transactions simultaneously as exactly
balance or completely offset each other. The two transactions in the present
case are payment of dividends and garnering funds to exploit investment
opportunities. Suppose, for example, a firm decides to invest in a project it
has alternatives:
(1) Pay out dividends and raise an equal amount of funds from the market;
(2) Retain its entire earnings to finance the investment programme. The
arbitrage process is involved where a firm decides to pay dividends and raise
funds from outside.
When a firm pays its earnings as dividends, it will have to approach market
for procuring funds to meet a given investment programme. Acquisition of
additional capital will dilute the firms share capital which will result in drop
in share values. Thus, what the stockholders gain in cash dividends they
lose in decreased share values. The market price before and after payment of
dividend would be identical and hence the stockholders would be indifferent
between dividend and retention of earnings. This suggests that dividend
decision is irrelevant.
M-Ms argument of irrelevance of dividend remains unchanged whether
external funds are obtained by means of share capital or borrowings. This is
for the fact that investors are indifferent between debt and equity with
respect to leverage and cost of debt is the same as the real cost of equity.
Finally, even under conditions of uncertainty, divided decision will be of no
relevance because of operation of arbitrage. Market value of share of the two
firms would be the same if they identical with respect to business risk,
prospective future earnings and investment policies.
This is because of rational behavior of investor who would prefer more
wealth to less wealth.
Difference in respect of current and future dividend policies cannot
influence share values of the two firms.
M-M approach contains the following mathematical formulations to prove
irrelevance of dividend decision.
The market value of a share in the beginning of the year is equal to the
present value of dividends paid at the year end plus the market price of the
share at the end of the year, this can be expressed as below :

P0 = Existing price of a share
K = Cost of capital
D1 = Dividend to be received at the year end
P1 = Market value of a share at the year end
If there is no additional financing from external sources, value of the firm (V)
will be number of share (n) multiplied by the price of each share (Po).

If the firm issues m number of share to raise funds at the end of year 1 so
as to finance investment and at price P1, value of the firm at time o will be :

Thus, the total value of the firm as per equation (3) is equal to the
capitalized value of the dividends to be received during the period, plus the
value of the number of share outstanding at the end of the period, less the
value of the newly issued shares.
A firm can finance its investment programme either by ploughing back of its
earnings or by issue of new share or by both. Thus, total amount of new
share that the firm will issue to finance its investment will be :
mP1 = I1 (X1 - nD1)
mP1 = Total amount of funds raised by issue of new share to finance
investment projects.
I1 = Total amount of investment during first period
X1 = Total amount of net profit during first period
Criticism of MM Approach
MM hypothesis has been criticised on account of various unrealistic
assumptions as given below.
1. Perfect capital market does not exist in reality.
2. Information about the company is not available to all the persons.
3. The firms have to incur flotation costs while issuing securities.
4. Taxes do exit and there is normally different tax treatment for dividends
and capital gain.
5. The firms do not follow a rigid investment policy.
6. The investors have to pay brokerage, fees etc., while doing any
7. Shareholders may prefer current income as compared to further gains.
Illustration: Agile Ltd. belongs to a risk class of which the appropriate
capitalisation rate is
10%. It currently has 1,00,000 shares selling at Rs. 100 each. The firm is
contemplating declaration of a dividend of Rs.6 per share at the end of the
current fiscal year which has just begun. Answer the following questions
based on Modigliani and Miller Model and assumption of no taxes:
(i) What will be the price of the shares at the end of the year if a diviend is
not declared?
(ii) What will be the price if dividend is declared?
(iii) Assuming that the firm pays dividend, has net income of Rs. 10 lakh
and new investments of Rs. 20 lakhs during the period, how many new
shares must be issued?

Modigliani and Miller - Dividend Irrelevancy Model

100 1.10 = P1 + 6
110 = P1 + 6
P1 = 110 - 6
P1 = Rs. 104

(ii) Calculation of No. of Shares to be issued
Particulars Dividend
Dividend not
Net Income
Less: Dividend Paid
Retained Earning
New investment
Amount to be raised by new issue (A)
Market Price per share (B)
New shares to be issued (A / B)
4,00,000 10,00,000
16,00,000 10,00,000
104 110
15,385 9,091

Alternatively, the number of new shares to be issued is calculated as follows

n = Number of Shares outstanding at the beginning of the period i.e.,
N = Change in the number of Shares outstanding during the period (to be
I = Total investment required for capital budget i.e., Rs. 20,00,000
E = Earning of the firm during the period after payment of dividend.
If dividend declared =10,00,000 - 6,00,000 = Rs. 4,00,000
If no dividend declared = 10,00,000
Now we can calculate the number of new shares to be issued :
(I) If dividend declared:

(II) If no dividend declared :

MM Dividend irrelevance theory

Particulars Dividend
Dividend not
Existing shares
New shares issued
Total No. of shares at the end
1,15,385 1,09,091
Market price per share
Total market value of shares at the year
104 110
1,20,00,000 1,20,00,000
Therefore, whether dividends are paid or not, value of the firm remains the
same as per M.M. approach.

The various types of dividend policies are discussed as follows:
1. Regular Dividend Policy
Payment of dividend at the usual rate is termed as regular dividend. The
investors such as retired persons, widows and other economically weaker
persons prefer to get regular dividends.
A regular dividend policy offers the following advantages.
a. It establishes a profitable record of the company.
b. It creates confidence amongst the shareholders.
c. It aids in long-term financing and renders financing easier.
d. It stabilizes the market value of shares.
e. The ordinary shareholders view dividends as a source of funds to meet
their day-today living expenses.
f. If profits are not distributed regularly and are retained, the shareholders
may have to pay a higher rate of tax in the year when accumulated profits
are distributed.
However, it must be remembered that regular dividends can be maintained
only by companies of long standing and stable earnings. A company should
establish the regular dividend at a lower rate as compared to the average
earnings of the company.
2. Stable Dividend Policy
Under this policy, stable or almost stable rate of dividend is
maintained. Company maintains reserves in the years of prosperity
and uses them in paying dividend in lean years. If company follows
stable dividend policy, the market price of its shares shall be higher.
'There are several reasons why investors prefer stable dividend policy.
Main reasons are
(a) Confidence among Shareholders: A regular and stable dividend
payment may serve to resolve uncertainty in the minds of shareholders.
There are 'many resorts not to cut the dividend rate even if its profits are
declining, it maintains the
rate of dividend by appropriating its
reserves. Stable dividend presents a good image of the company and
thus gains the confidence of the shareholders and the goodwill of the
company increases in the eyes of the investors
(b) Income Conscious Investors: The second factor favoring stable
dividend policy is that some investors are income conscious and favor
a stable rate of dividend. They, too, never favor an unstable rate of
dividend. A stable dividend policy may also satisfy such investors.
(c) Stability in Market Price of Shares: Other things being equal,
the market price vary with the rate of dividend the company declares on
its equity shares. The value of shares of a company 'laving a stable
dividend policy fluctuates not widely even if the earnings of the
company is lower than the previous year. Thus, this policy buffers the
market price of the stock.
(d) Encouragement to Institutional Investors: A stable dividend policy
attracts investments from institutional investors. Such institutional
investor generally prepare a list of securities, mainly incorporating the
securities of the companies having stable dividend policy in which they
invest their surpluses or their long-term funds such as pensions or
provident funds etc.
In this way, stability and regularity of dividends not only
affects the market price of shares but also increases the general credit
of the company that benefits the company in the long run. The company
with stable dividend policy can formulate its financial planning very easily
because the financial manager can correctly estimate the future demand
and supply of capital in the firth. Timing of dividend payment can
also be forecasted easily by preparing cash flow statement.

Stability of dividends can taken three distinct forms:

(a) Constant dividend per share: Under this policy, the management follows
the policy of paying a fixed amount of dividend per share every year
irrespective of the fluctuations in the earnings. It does not imply that the
rate of dividend will never be increased. When the earnings of the company
increase at a new level and the management is of the view that it can easily
.maintain that level of earnings, it increases the rate of dividend per share.
The policy is easy to follow when company earnings are stable. lf earnings
fluctuate widely, the company can policy by maintaining a dividend
fluctuation fund in surplus years.

(b) Constant payout ratio: Some companies follow the policy of paying a fixed
per cent or net profits as dividend every year, i e., policy of constant'
payout ratio. Suppose, a
company adopts a 40 per cent payout ratio, it means, 40 per cent net
earnings of the company will be paid-out to shareholders every year as
dividend. In the year of loss, no dividend is paid. Internal financing under
this policy is automatic. For example, in the above case, 60% of the profits
are transferred to reserves. Thus the policy leaves nothing to the
management discretion.

(c) Stable rupee dividend plus extra dividend: Some companies follow a
policy of paying constant low dividend per share plus an extra dividend in
the years of high profits.
Such a policy is most suitable to the firm having fluctuating earnings from
year to year.
Dangers of Stable Dividend Policy
In spite of many advantages, the stable dividend policy suffers from certain
limitations. Once a stable dividend policy is followed by a company, it is not
easier to change it. If the stable dividends are not paid to the shareholders
on any account including insufficient profits, the financial standing of the
company in the minds of the investors is damaged and they may like to
dispose off their holdings. It adversely affects the market price of shares of
the company.
And if the company pays stable dividends in spite of its incapacity, it will be
suicidal in the long-run.

3. Irregular Dividend Policy
Some companies follow irregular dividend payments on account of the
a. Uncertainty of earnings.
b. Unsuccessful business operations.
c. Lack of liquid resources.
d. Fear of adverse effects of regular dividends on the financial standing of
the company.

4. No Dividend Policy
A company may follow a policy of paying no dividends presently because of
its unfavourable working capital position or on account of requirements of
funds for future expansion and growth.

5. Residual Dividend Policy
When new equity is raised floatation costs are involved. This makes new
equity costlier than retained earnings. Under the Residual approach,
dividends are paid out of profits after making provision for money required
to meet upcoming capital expenditure commitments.

Another important dimension of a dividend policy is the stability of
dividends i.e. how stable, regular or steady should the dividend stream be,
over time? It is generally said that the shareholders favour stable dividends
and those dividends, which have prospects of steady upward growth. If a
firm develops such a pattern of paying stable and steady dividends, then the
investors/shareholders may be willing to pay a higher price for the shares.
So while designing a dividend policy for the firm, it is also to be considered
as to whether the firm will have a consistency in dividend payments or the
dividends will fluctuate from one year to another. In the long run, every firm
will like to have a consistent dividend policy, yet fluctuations from one year
to another may be unfavourable.
Rationale for stability of dividend
Most of the firms follow stable dividends or gradually increasing dividends
due to following reasons
a. Many investors consider dividends as a part of regular income to meet
their expenses.
Hence, they prefer a predictable pattern of dividends rather than fluctuating
A fall in the dividend income may lead to sale of some shares. On the other
hand when the dividend income increases, an investor may invest some of
the proceeds as reinvestment in shares. Both the cases involve transaction
cost and inconvenience for investor. Hence, they prefer regular dividends.
b. The dividend policy of firms conveys a lot to the investors. Increasing
dividends means better prospects of the company. On the contrary,
decreasing dividends suggest bad earnings expectations. In addition, stable
dividends are sings of stable earnings of the company. On the other hand,
varying dividends lead to uncertainty in the mind of shareholders.
c. Certain investors mainly institutional, consider the stability of dividends
as an important criterion before they decide on the investment in that
particular firm.

Illustration 1
A company has following capital :
7% Preference Shares of Rs. 100 each 6,00,000
Ordinary Shares of Rs. 10 each 16,00,000
The following information are available relating to its financial year ending 31-12-
i) Profit, after taxation @ 40%, Rs. 5,42,000
ii) Ordinary dividend paid 20%.
iii) Depreciation Rs. 1,20,000
iv) Market price of Ordinary Shares Rs. 40
v) Capital Commitment Rs. 2,40,000.
You are required to calculate the following:
a) The dividend yield on the Ordinary Shares.
b) The cover for the preference and Ordinary dividends.
c) The earnings yield,
d) The price - earnings ratio,
e) The Net Cash Flow,
f) The reason for the comparison of net cash flow with capital commitment.
a) Dividend yield on ordinary shares (or) dividend yield ratio
= (DPS / market price) 100
= (10 20% /40) 100
= 5%
[Market price = Capitalized value of dividend]
b) Dividend coverage ratio:
Preference = (PAT / Preference dividend)
= 542000 / 42000
= 12.9 times
Equity = (PAT Preference dividend) / equity dividend
= 500000 / 320000
= 1.5625 times
c) Earnings yield ratio = (EPS / market price ) x 100
= (3.125 / 40) x 100
= 7.8125 %
[EPS = 500000 / 160000 = Rs 3.125]
d) Price Earning Ratio = [(40 / 3.125)] = 12.8 times
(Market price / EPS)
e) Net cash flow Rs
PAT 542000
(+) depreciation 120000
(-) preference dividend 42000
(-) equity dividend 320000
Net cash flow 300000
f) Since the cash flow position shows the firms ability to meet the capital
expenditure / Capital commitment.

Illustration 2: ABC Ltd. has a capital of Rs.10 lakhs in equity shares of Rs.100
each. The shares currently quoted at par. The company proposes declaration of a
dividend of Rs.10 per share at the end of the current financial year. The
capitalisation rate for the risk class to which the company belongs is 12%.
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?
iii) Assuming that the company pays the dividend and has net profits of
Rs.5,00,000 and makes new investments of Rs.10 lakhs during the period, how
many new shares must be issued? Use the M.M. model.

Modigliani Miller Approach
n = no of shares = 10000
P0 = market price = Rs100
D1 = Expected dividend = Rs10
Ke = cost of capital = 12%
i. Market price of share ( P1) if dividend not declared
Given D1 = 0
We know,
P0 = (D1+P1)/ (1+Ke)
P1 = 112
ii. P1 if dividend declared
D1 = Rs10
P0 = (D1+P1) / (1+ Ke )
P1 = Rs.102
iii. No of shares to be issued :
n = (I E + n D1 )/ P1
= (1000000 500000 + 100000) / 102

Illustration 3
A textile company belongs to a risk-class for which the appropriate PE ratio is 10. It
currently has 50,000 outstanding shares selling at Rs.100 each. The firm is
contemplating the declaration of Rs.8 dividend at the end of the current fiscal year
which has just started. Given the assumption of MM, answer the following
i) What will be the price of the share at the end of the year: (a) if a dividend is not
declared, (b) if it is declared?
ii) Assuming that the firm pays the dividend and has a net income of Rs.5,00,000
and makes new investments of Rs.10,00,000 during the period, how many new
shares must be issued?
iii) What would be the current value of the firm: (a) if a dividend is declared, (b) if a
dividend is not declared?

P/E ratio = 10
n = 50,000shares
P0 = Rs. 100
D1 = Rs. 8
E = Rs. 5,00,000
I = Rs. 10,00,000
Ke = 1 / (P/E ratio)
1. Calculation of P1
1. If dividend not declared:
P0 = (D1+ P1) / (1+Ke)
P1 = Rs110
2. if dividend declared:
P0 = (D1+ P1) / (1+Ke)
P1 = Rs.102
3. If the company pay dividend:
P1 = Rs102
n = (I E +nD1) / P1
No of new shares, n = 900000 / 102 = 8823.5294 shares
4. Value of the firm:
a) If the company pay dividend:
V = (n + n) P1 = (58823.5294) 102
= Rs6000000
b) If the company does not pay dividend:
V = (n+n) P1 = 54545.4545 x 110
= Rs6000000
Working notes:
n = (1000000 - 500000) / 110 = 4545.4545

Illustration 4
(i) From the following information supplied to you, ascertain whether the firms D/P
ratio is optimal according to Walter. The firm was started a year ago with an equity
capital of Rs. 20 lakh.
Earnings of the firm Rs 2,00,000.00
Dividend paid 1,50,000.00
P/E ratio 12.50
Number of shares outstanding, 20,000 @ Rs.100 each. The firm is expected to
maintain its current rate of earnings on investment.
ii) What should be the P/E ratio at which the dividend payout ratio will have no
effect on the value of the share?
iii) Will your decision change if the P/E ratio is 8, instead of 12.5?
i. Ke = (EPS / market price) = 1 /(12.5) = 8 %
r = (200000 / 2000000) x 100 = 10 %
Payout ratio = (150000/200000) x 100 = 75%
It is the growth firm (r > Ke), as per WALTERs model the optimum payout ratio is
So in the given case pay out ratio is not optimum.
a). Market price at 75% payout ratio
EPS = Rs10
DPS =Rs7.5
r = 10 % & Ke = 8%

b). Market price at zero payout:
EPS = Rs10
DPS = Rs0
r = 10 % & Ke = 8 %

Therefore Zero Payout is optimum.
i. The payment of dividend in case of normal firms(r = Ke) has no effect on the
market value of the share.
Ke = r = 10%
P/E ratio = 10times i.e [ 1 / Ke]
ii. If P/E ratio = 8 , Ke= 12.5 %
r = 10%
When r < Ke the firm is Decline firm as per WALTER and its Optimum payout ratio
is 100%.
So in the given case it is 75% payout only, it is not optimum payout.

Market price at 75% payout:

100% payout

Illustration 5
Excellence Ltd registered earnings of Rs. 800,000 for the year ended 31st March. They
finance all investments out of retained earnings. The opportunities for investments are many.
If such opportunities are not availed their earnings will stay perpetually at Rs. 800,000.
Following figures are relevant.

The returns to shareholders are expected to rise if the earnings are retained because of the
risk attached to new investments. As for the current year, dividend payments will be made
with or without retained earnings. What according to you, should be retained?


Evaluation of different dividend policies:

From the above policies, policy B gives more value to the share holders. Hence it is
advisable to adopt the policy B.

Illustration 6
X Ltd. has 1000 shares of Rs 10 each raised at a premium of Rs. 15 per share. The
companys retained earnings are Rs. 552500. The Companys stock sells for Rs. 20
per share.
a. If a 10% stock dividend is declared how many new shares would be issued?
b. What would be the market price after the stock dividend?
c. How would the equity account change?
d. If a 25% stock dividend is declared what changes will take place?
e. If the company instead declares a 5:1 stock split, how many shares will be
What would be the new par value? What would be the new market price?
f. If the company declares a 1:4 reverse split, how many shares will be
outstanding? What would be the new par value? What would be the new market
g. If the company declares a dividend of Rs. 2 per share and the stock goes ex
dividend tomorrow, what will be the price at which it will sell?

a) If 10% stock dividend declared:
No of new shares issued as bonus = 100
b) Market price after bonus issue = [(1000 x 20) + (100 x 0 )] / 1100
= Rs.18.18
c) Change in equity account
Equity share capital increased by Rs1000
Reserves decreased by Rs1000.
Hence, there is no change in the Net Equity
d) If 25% stock dividend declared
1) No. of new shares issued = 1000 @ 25 % = 250 shares
2) Market price after stock dividend = [(1000 x 20) + (250 x 0)] / 1250
= Rs.16
3) Change in EQUITY account:
Capital increased by Rs. 2500
Reserve decreased Rs.2500
There is no change in Net Equity.
e) If the company declares 5 : 1 stock split i.e. 5 shares issued in exchange of 1
No of shares outstanding = 5000
New face value of share = 10/ 5 = Rs.2
New market price = 20 / 5 = Rs.4
f) If the company declares 1: 4 reverse split i.e 1 share issued in exchange of every
No of shares outstanding = 250
New face value = 4 x 10 = Rs.40
Market price = 20 x 4 = Rs.80
g) Cum dividend market price = Rs. 20
(-) dividend = 2
Ex-dividend market price Rs. 18
Illustration 7
Following is the capital structure of Progressive Co. Ltd. as on 31st March, 2009.
Equity Share Capital (1,00,000 shares of Rs. 10 each) 10,00,000
Share premium 15,00,000
Reserves & Surpluses 5,00,000
Net worth 30,00,000
On 1st April, 2007, the company made a bonus issue of two shares for every five
held. The market price at the time of bonus issue was Rs. 40 per share. X holds
100 shares of the Progressive Co. Ltd. purchased on 1st April, 2003 a market price
of Rs. 30. He sold these shares on 31st March, 2009 at Rs. 50 per share. The
income tax rate for X is 20% and capital gain tax is 15% for him. If the company
pays a regular dividend of 10% on par before transferring earnings to reserves and
surpluses, state whether X was able to earn his required rate of return of 10% on
his investment? (The PV at 10% 1st year 0.91; 2nd year 0.83; 3rd year 0.75; 4th
year 0.68; 5th year 0.62 and 6th year 0.56)
Appraisal of Investment decision: [NPV method ]
1) Initial Investment (out flow): 100 shares @ 30 each = 3000
2) Present value recurring cash inflows

3) Present value of terminal cash inflow:
Sale proceeds 140shares @ 50 each = 7000
(-) capital gain tax 4000@ 15% = 600
Its present value = 6400 x 0.56 = 3584
Present value of cash inflow (407.52+3584) = 3,991.52
(-) outflow 3,000
Net present value 991.52
The investment yields more than 10 % return to the investor.
1) The earnings per share of a Company are Rs. 8 and the rate of capitalization
applicable to the company is 10%. The company has before it an option of
adopting a payment ratio of 25% or 50% or 75%. Using Walter's formula of
dividend payout compute the market value of the company's share if the
productivity of retained earnings is (i) 15%, (ii) 10%, and (iii) 5%.
2) The earnings per share of a company are Rs. 10. It has rate of return of 15%
and the capitalization rate of risk class is 12.5%. If Walter's model is used (i)
what should be the optimum payout ratio of the firm? (ii) What would be the
price of the share at this payout? (iii) How shall the price of the share be
affected if a different payout was employed?
3) The earnings per share of a share of the face value of Rs. 100 of PQR Ltd. is Rs.
20. It has rate of return of 25%. Capitalization rate of its risk class is 12.5%. If
Walter's model is used:
a) What should be the optimum payout ratio?
b) What should be the market price per share if the payout ratio is zero?
c) Suppose, the company has a payout of 25% of EPS, what would be the
per share?
4) The earning per share of ABC Ltd. is Rs. 10 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 Walters formula, compute the market value of the
company's share if the productivity of retained earnings is (i) 20% (ii) 10%, or (iii)
5) Determine market value of equity shares of the company from the following
information as per Walter's Model :
Earnings of the company Rs.5,00,000
Dividend paid Rs. 3,00,000
Number of shares outstanding 1,00,000
Price-earning ratio 8
Rate of return on investment 15%
Are you satisfied with the current dividend policy of the firm? If not what
shoul d be the optimal dividend payout ratio?
6) ABC and Co. has been following a dividend policy which can maximize the
market value of the firm as per Waller's model. Accordingly, each year, at
dividend time the capital budget is reviewed in conjunction with the earnings
for the periods and alternative investment opportunities for the shareholders.
In the current year, the firm expects earnings of Rs. 5,00,000. It is estimated
that the firm can earn Rs. 1,00,000 if the profits are retained. The investors
have alternative investment opportuni ty that will yield them 10% return. The
firm has 50,000 shares outstanding. What shoul d he the di vi dend payout
rati o in order to maximize the weal th of the shareholders? Also find out the
current market price of the share.
7) 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
yi el d a return of 10%. The company is considering a pay-out of 25%, 50% and
75%. Which of these would maximize the wealth of shareholder?
8) Calculate the market price of a share of ABC Ltd. under (i) Walter' s
formula; and (ii) dividend growth the model from the following data :
Earnings per share Rs.5
Dividend per share Rs.3
Cost of capital 16%
IRR on investment 20%
Retention ratio 40%
9) A Company has a total i nvestment of Rs. 5,00,000 in assets, and 50,000
outstandi ng common share at Rs. 10 per shares (par val ue) . It earns a
rate of 15% on its investment, and has a policy of retaining 50% of the
earnings, if the appropriate discount rate of the firm is 10 percent,
determine the price of its share using Gordon's model. What will happen to
the price of the share if the company has payout of 80% or 20%?
10) The following information is available in respect of ABC 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%.