Submitted to: Mr.

Shubbhendu vimal

Submitted by: Abhishek Chopra Chiranjeev Jemim Megha Singh Vindhyachal Kumar

 Dividend policy means that decision of the management

through which it is determined how much of net profits are to be distributed as dividend among the shareholders and how much

are to be retained in the business.

Reduction in Uncertainty: The distribution of retained earnings in future as dividend is

more uncertain than the distribution of dividend today. Firms may suffer losses in
future. As a result, the retained earnings may decline. To avoid this uncertainty, shareholders give more preference to present dividend. Indication of strength: By paying cash dividend, present and future investors get the

indication that the firm is strong and healthy. Dividend is also an indication of
liquidity of the firm. It also indicates better profitability which is likely to continue in future. Need for Current Income: Many shareholders want dividend on their investment in present times because they have to meet their living expenses. Such investors desire dividend income instead of selling their investments. Thus, cash dividend enables investors to get more income in the present and does not affect the original amount.

On the basis of mode of payments:

On the basis of time of payment:

Cash dividend
Stock dividend Scrip dividend Bond dividend Property dividend Composite dividend

Interm dividend Regular dividend

Special dividend

Relevance Theories

 Professor James E. Walter argues that the choice of dividend

policies almost always affect the value of firm.

It shows the importance of relationship between firms rate of

return (r) and its cost of capital (k).

 Internal Financing: - The firm finances all investments through retained

earnings; that is, debt or new equity is not issued.

Constant return & Cost of capital: - the firms rate of return, r, and its cost

of capital, k, is constant.
100% payout or retention: - All earnings are either distributed as dividends

or reinvested internally immediately.

Constant EPS & DPS: - The values of EPS and

DPS are assumed to

remain constant forever in determining a given value.

Infinite time: - the firm has a very long or infinite life.

Case1: Growth firm (r>k) r=20% k=15% E=Rs4 If D=Rs4

If D=Rs2

 Case2: Normal firm (r=k)

r=15% k=15%

E=Rs4

If D=Rs4

If D=Rs2

 Case3: Declining Firm (r<k)

r=10% k=15% E=Rs4 If D=Rs4

If D=Rs2

Case

If dividend payout ratio increase Market value of share decreases

If dividend payout ratio decreases Market value of share increases

In case of growing firm r>k

In case of declining firm r<k

Market value of share increases

Market value of share decreases

In case of normal firm r=k

No change in value of share

No change in value of share

 According to prof. Gordon, Dividend Policy always affects the

value of the firm. He showed how dividend policy can be used

to maximize the wealth of the shareholders.
It is based on following assumptions-

a) The firm is an all equity firm i.e., no external financing. b) r and ke are constant. c) Firm has perpetual life.

Contd
d) The retention ratio, once decided upon is constant. Thus the

growth rate (g=br) is also constant.

e) Ke>br It is similar to Walters model. As a result, over here the investors put a positive premium on the current incomes/ dividends.

 Formula:

P=

E(1-b) Ke - br

P=price of a share E=earning per share

b=retention ratio
1-b=D/P ratio ke= capitalization rate/cost of capital br = g = growth rate=rate of return on investment

 The following information is available in respect to the rate of

return on investment(r) and (ke) and E. r=12% E=Rs 20 Determine the value of shares, assuming
D/P Ratio (1-b) a b 10 20 Retention Ratio (b) 90 80 Ke(%)

20 19

c
d e f g

30
40 50 40 30

70
60 50 60 70

18
17 16 15 14

D/P Ratio
10 20 30 40 50 60 70

p
When b=90 P=(20(1-0.9))/(0.20-0.108)=21.74 When b=80 P=(20(1-0.8))/(0.19-0.096)=42.55 When b=70 P=(20(1-0.7))/(0.18-0.084)=62.56 When b=60 P=(20(1-0.6))/(0.17-0.072)=81.63 When b=50 P=(20(1-0.5))/(0.16-0.06)=100 When b=40 P=(20(1-0.4))/(0.15-0.048)=117.62 When b=30 P=(20(1-0.3))/(0.14-0.036)=134.62

br (g)
0.9*0.12=0.108 0.8*0.12=0.096 0.7*0.12=0.084 0.6*0.12=0.72 0.5*0.12=0.06 0.4*0.12=0.048 0.3*0.12=0.036

 Thus, the dividend decision has a bearing on the market price

of the share. The market price of the share is favorably affected

with the dividend.

 According to M-M, under a perfect market situation, the

dividend policy of a firm is irrelevant as it does not affect the

value of the firm. They argue that the value of the firm depends on firm earnings which results from its investment policy. Thus when investment decision of the firm is given, dividend decision is of no significance in determining the value of the

firm.

 Perfect Capital Markets: - The firm behaves in perfect capital

market where investors behave rationally, information is freely

available to all, and transaction and flotation cost do not exist. Perfect market capital also implies that no investor is large enough to affect the market price of the share.
No taxes: - Taxes do not exist; or there are no differences in the tax

rates applicable to capital gains and dividends. This means that

investors value a rupee of dividend as much as a rupee of capital gains

 Investment Policy: - The firm has fixed investment policy.

No risk: - Risk of uncertainty does not exist. That is, investors

are able to forecast future prices ad dividends with certainty, and one discount rate is appropriate for all the securities and all time periods

 Formula;

Po=(1/(1+p))*(D1+P1) Where, Po=market price per share at time 0 D1=dividend per share at time 1 P1=market price of share at time 1

 Question: A company belongs to risk class for which the

approximate capitalization rate is 10 percent. It currently has outstanding 25,000 shares selling at Rs100 each. The firm is

contemplating the declaration of a dividend Rs5 per share at

the end of the current financial year. It expects to have a net income of Rs2,50,000 and has a proposal of making new investments of Rs 5,00,000. show that under the MM assumptions, the payment of the dividend does not affect the value of the firm.

 Solution : (a) Value of the firm when dividend are paid:

(i)Price per share at the end of year , Po= 1/(1+ke)*(D1+P1) Rs100=1/1.10*(Rs5+P1) 110=5+P1 P1=105 (ii) Amount required to be raised from the issue of new shares,

 This theory regards dividend decision merely as a part of

financing decision becausea)

The earnings available may be retained in the business for reinvestment.

b)

Or if the funds are not required in the business they may be

distributed as dividend.

Thus the decision to pay the dividends or to 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 firms.

Thus, the firm should retain the earnings if it has profitable

investment opportunities otherwise it should pay then as dividend.