DIVIDEND POLICY

BY ---------

SWETA

AGARWAL

1stYEAR PGDBM ; SEC - B

INTRODUCTION
The

term dividend refers to that portion of companys net earning that is to be paid out to the equity shareholders Dividend policy of a firm decides the same and the portion that is ploughed back in the firm for investment purpose

THEORY

The value of the firm can be maximised if the shareholders wealth is maximised. According to one school of thought, dividend decision does not affect the shareholders wealth and valuation of the firm. on the other hand, If the choice of the dividend policy affects the value of the firm, it is considered as relevant theory

WALTERS MODEL(RELEVANT)
Prof. Walter's model is based on the relationship between the firms: Return on investment, i.e. r The cost of capital or the required rate of return, i.e. k. Based on the following assumption: The firm finances its entire retained earning only. R and K of the firm remains constant. The firm earning are either distributed as dividend or reinvested internally.

 BEGINNING EARNING AND DIVIDEND OF THE FIRM WILL NEVER CHANGE WHILE DETERMING THE VALUE.

The firm has a very long or infinite life. P=D+ r(E- D)/Ke Ke Ke P = Market price per share D = Dividend per share E = Earning per share R = internal rate of return Ke = Cost of capital

CRITICISM OF WALTER'S MODEL

Investments are financed through retained earnings only is seldom true in real world. Firms do raise funds from external financing. The internal rate of return does not remain constant with the increased investment the rate of return also changes. The assumption that cost of capital remains constant does not hold good. As the firms risk pattern does not remain constant it is not proper to assume K remains constant.

WALTERS VIEW ON OPTIMUM DIVIDENED PAYOUT

Growth firms ( R>K ): Firms can naturally earn a return which is more than what shareholders could earn on their own. So OPR for growth is 0%. NORMAL FIRMS (R=K): Firms earn a rate of return which is equal to that of shareholders in that case dividend policy will not have any influence on the price per share. So all OPR are optimum. DECLINING FIRMS(R<K): Here company earns a return which is less than what the shareholders can earn on their investments ,it should not make any sense to retain earnings. So Entire earning OPR for a firm is 100%

PRACTICAL PROBLEMS
Question1 : EPS = RS 8 Assumed rate of return Cost of capital (K) = 12% a) 15% b) 10 % c) 12 %

Solution: To show the effect of dividend policy, let us consider 0%, 50%, 100%,

I WHEN R>K (15>12) At 0% payout ratio (dividend = 0) P = D + R(E D)/ Ke Ke = 0 + 0.15/0.12(8-0) = Rs 83.33 O.12 At 50% payout ratio = 4 + 0.15/0.12(8-4) = Rs 75 0.12 At 100% payout ratio = 8 + 0.15/0.12(8-8) = Rs 66.67 0.12 Price per share decreases as and when payout ratio is increased

II. WHEN R<K(10%<12%)

At 0% payout ratio P = 0 + 0.10/0.12(8-0) = Rs 55.55 0.12 At 50% payout ratio P = 4 + 0.10/0.12(8-4) = Rs 61.11 0.12 At 100% payout ratio P = 8 + 0.10/0.12(8-8) = Rs 66.66 0.12 Price per share increases as and when the payout ratio is increased

III. WHEN R=K (12% = 12%)

At 0% payout ratio P = 0 + 0.12/0.12(8-0) = Rs 66.66 0.12 At 50% payout ratio P = 4 + 0.12/0.12(8-4) = Rs 66.66 0.12 At 100% payout ratio P = 8 + 0.12/0.12(8-8) = Rs 66.66 0.12 Price per share remains the same at all payout ratios. So there is no one payout ratio, which is optimum.

2.GORDONS MODEL(RELEVANT)
ASSUMPTIONS: The firm is an all equity firm ( no debt) No outside financing and all investments are financed by retained earning (R) remains constant. K also remains constant Firm derives its earning in perpetuity. The retention ratio (b) once decided upon is constant thus, the growth rate (g ) is also constant (g=b) K>g A corporate tax does not exit.

FORMULA
P = E (1 b) Ke br P = Price per share K = cost of capital E = earning per share b = retention ratio (1 b) = payout ratio G = b growth rate. ( r = internal rate of return). According to Gordon, when R>K, The price per share increases as the dividend payout ratio decreases. When R<K the price per share increases as the dividend payout ratio increases. When R= K the price per share remains unchanged to the change in the payout ratio

If K= 11% and earning per share = Rs 15. calculate price per share. For r = 12%, 11%, 10% for the following levels of D/ P PROBLEMS: Ratios.
D/P RATIO RETENTION RATIO 90%

1.

10%

2.

50%

50%

SOLUTION:
If R>K(12>11) P = E( 1-b) Ke -br a). D/P ratio of 10%. Retention = 90% P = 15 ( 1- 0.9 ) = Rs 750 0.11-0.9*0.12

b). D/P RATIO OF 50%. b = 50%

P = 15 (1 0.5 ) = Rs 150 0.11- 0.5 *0.12 Price per share increases and the payout ratio decreases

R=K (11%=11%) a) D/P RATIO OF 10% . R = 90% P = 15(1 0.9) = Rs 136.6 0.110.9*0.11 b) D/P RATIO OF 50%. R = 50% P = 15(1-0.5) = Rs 136.6 0.11- 0.5 *0.11 Price per share remains same at all payout ratio

If R< K (10% <11%) a) d/p ratio of 10%. R = 90% P = 15(1-0.9) = Rs 75 0.11-0.9*0.10 b) d/p of 50% .R = 50% P= 15(1-0.5) = Rs 125 0.11-0.5*0.10 Hence price per share increases with the increases in the payout ratio

THE THEORY OF IRRELEVANCE

The theory of irrelevance says that the value of firm is independent of its dividend policy. A. Residual approach B. Modigliani and miller approach(MM model)

THE IRRELEVANCE CONCEPT OF DIVIDEND

RESIDUAL APPROACH According to this theory,
dividend decision has no affect on the wealth of the shareholders or the prices of the shares and hence it is irrelevant as far as the valuation of the firm is concerned. Dividend decision merely decision because the earnings available may be retained in the business for re-investment as a part of financing decision . Thus , decision to pay the dividend or retain the earnings may be taken as a residual decision. It assumes that investors do not differentiate between dividend and retentions by the firm. Their basic desire to earn a higher rate of return

But, if the funds are not required in the business they may be distributed as dividends. Thus, the decision to pay dividends or retain the earnings may be taken as residual decision. This theory assumes that investors do not differentiate between dividends and retention by the firm

MODIGLIANI MILLER MODEL (IRRELEVANCE THEORY)

According to MM, the dividend policy of the firm is irrelevant, as it has no effect on the market price of the shares and the value of the firm is determined by the earning capacity of the firm or its investment policy. Splitting of earning between retention and dividends may be in any manner the firm likes does not affect the value of the firm.

ASSUMPTIONS

There are perfect capital markets. Investors behave rationally Information about the company is available to all without any costs. There are no floatation(costs of printings, paying the underwriters, government fees) and transaction costs. No investor is large enough to affect the market price of shares. There are either no taxes or there are no differences in the tax rates applicable to dividends and capital gains.

The firm has a rigid investment policy. There is no risk or uncertainty in regard to future of the firm.

THE ARGUMENT OF MM
The argument given by MM in support of their hypothesis is that whatever increase in the value of the firm results from the payment of the dividend, will be exactly off set by the decline in the market price of shares because of external financing and there will no change in the total wealth of the shareholders. For e.g, if a co. having investment opportunities, distributes all its earnings among the shareholders,it will have to raise additional funds from external sources.

This will result in the increase in no. of shares or payment of interest charges, resulting in fall in the earnings per share in the future. Thus whatever a shareholder gains on account of dividend payment is neutralised completely by the fall in the market price of shares due to decline in expected future earnings per share.

This can be put in the form of the following: Po = D1 + P1 1 + Ke Where, Po = Market price per share at the beginning of the period, or prevailing market price of a share D1 = Dividend to be received at the end of the period

P1 = Market price per share at the end of the period. Ke = cost of equity capital . The value of P1 can be derived by the above equation as under: P1 = Po (1 + Ke ) D1

The MM hypothesis can be explained in another form also presuming that investment required by the firm on account of payment of dividends is financed out of the new issue of equity shares. In such case no of shares to be issued can be computed as: M = I ( E Nd1) P1

Further , the value of the firm can be ascertained with the help of the following formula: nPo = (n + m)P1 ( I E) 1 + Ke m = no of shares to be issued. I = investment required . E = total earning of the firm during the period. Ke = cost of equity capital. n = no of shares outstanding at the beginning of the period. D1 = dividend to be paid at the end of the period. npo = value of the firm

Q. ABC ltd belongs to a risk class for which the

appropriate capitalisation rate is 10%. It currently has outstanding 5000 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 Rs50,000 and has a proposal for making new investments of Rs 1,00,000. show that under the MM hypothesis the payment of dividend does not affect the value of the firm

(A)Value of the firm when dividend are paid : (1) Price of the share at the end of the current financial year P1 = Po (1 + Ke) D1 = 100 (1+.10) 6 = 100 * 1.10 6 = 110 -6 = RS 104

(2) No of the shares to be issued

m = I (E- nD1) P1 = 1,00,000 (50,000 5000 * 6) 104 = 80,000 = 769 104 3) Value of the firm nPo = (n+ m )P1 (I-E) I + Ke

3) Value of the firm nPo = (n+ m )P1 (I-E) I + Ke

= (5000+ 80,000/104 ) *104 (1,00,000 50000)

1
= 5,00,000

+ .10

( b) Value of the firm when dividend are not paid:

Price per share at the end of the financial year P1 = Po (1 + Ke) D1 = 100(1+.10)- 0 = 100 * 1.10 = RS 110 2) No of the shares to be issued m = I ( E- nD1) = 1,00,000-(50000-0) = 455 P1 110
1)

3) Value of the firm npo = (n+m)P1 (I-E) 1 + Ke = (5000+50000/110)110 (1,00,000-50,000) 1 + .10 = 5,00,000 Hence, whether dividends are paid or not the value of the firm remains the same Rs 5,00,000

CRITICISM OF MM APPROACH
Perfect capital market does not exist in reality. Information about the co. is not available to all the persons. The firms have to incur floatation costs while issuing securities. Taxes do exist and there is normally different tax treatment for dividends and capital gains. The firms do not follow a rigid investment policy. Shareholders may prefer current income as compared to further gains.