Dividend Policy

LEARNING OBJECTIVES
Highlight the issues of dividend policy
Critically evaluate why some experts feel that dividend policy
matters
Discuss the bird-in-the-hand argument for paying current
dividends
Explain the logic of the dividend irrelevance
Identify the market imperfections that make dividend policy
relevant
Understand information content of dividend policy
Dividend & Dividend Policy
A firm earns for its shareholders.

The income generated after meeting all obligations by the
firm belongs to the shareholders.

The part of earning that is distributed is called dividend.
The optimum dividend policy would be one that maximizes
the value of the firm.

The question of in what ratio to retain or distribute the
earned income, is referred as dividend decision or policy.
Theories of Dividend
The irrelevance concept of dividend or the theory of
irrelevance
Modigliani and Miller Approach
The relevance concept of dividend or the theory of relevance
Walters Approach
Gordons Approach
Irrelevance concept- M & M
It is based on the following assumptions:-
Perfect capital markets
No taxes
Rigid Investment policy
No risk
Investors are rational


Irrelevance concept- M & M
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.

Argument of M&M
The argument is that whatever increase in the value of the
firm results from the payment of dividends, will be exactly
offset by decline in the market price per because of external
financing and there will be no change in the total wealth of
the shareholders.

For Eg: If a company, having investment opportunities,
distributes all its earnings among the shareholders, it will have
to raise additional funds from external sources. This will result
in increase in no. of shares or payment of interest charges,
resulting in fall in the EPS in the future.
Argument of M&M
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 EPS.

To be more specific, the MP of share in the beginning of a
period is equal to the Present value of dividends paid at the
end of the period plus the market price of the shares at the
end of the period.

Walters Approach
As per this approach dividend decisions are relevant and
effect the value of the firm. The relationship between the
internal rate of return earned by the firm and its cost of
capital is very significant.

The relationship is based on the relationship between the
firms
Return on investment (r)
Cost of capital or required rate of return (K)
Walters Approach- Assumptions
The investment of the firm are financed through retained
earnings.
The r and k are constant
Firm has a very long life
Walters Approach
1. If r>k i.e., if the firm earns a higher rate of return on its
investment than required rate of return, the firm should
retain the earnings. Such firms are termed as growth firm
and optimum pay-out ratio would be zero in their case.

2. Where r< k, the shareholders would stand to gain if the firm
distributes its earnings. Decline firms, optimum pay out ratio
would be 100%.

3. If r=k, the dividend policy does not affect the value of the
firm.
Problem
The following information is available in respect of the firm:
Capitalisation rate = 10%, EPS =50
Assumed rate of return on investment: a) 12%, b) 8%, c) 10%
Show the effect of dividend policy on market price of share
applying Walters formula when dividend pay out ratio is a) 0%,
b) 20%, c) 40%, d) 80%, e) 100%.

P= D/Ke + [r(E-D)/Ke]/ke
E= EPS
D= Dividend per share
Gordons Approach- Assumptions
All-equity firm
No external financing
Constant return
Constant cost of capital
Perpetual earnings
No taxes
Constant retention

Gordons Model
Problem
The following information is available in respect of the rate of
return and the cost of capital and EPS of ABC ltd.
Rate of return = 1) 15%, 2) 12%, 3) 10%
Cost of capital = 12%
EPS= 10
Determine the value of its share using Gordons Model when
dividend pay-out ratio a) 90, b) 80, c) 40
P= E(1-b)/ Ke- br

Br=g = Growth rate


DIVIDEND AND UNCERTAINTY:
THE BIRD-IN-THE-HAND ARGUMENT
According to Gordons model, dividend policy is irrelevant
where r= k, when all assumptions are valid.

But when the assumptions are conform more closely to reality
Gordon concludes that dividend policy does affect the value
of the firm even when r=k.

This view is based on the assumption that under conditions of
uncertainty, investors tend to discount distant
dividends(Capital gains) at a higher rate than they discount
near dividends.
DIVIDEND AND UNCERTAINTY:
THE BIRD-IN-THE-HAND ARGUMENT
Investors, behaving rationally, are risk averse and, therefore,
have a preference for near dividends to future dividends. The
logic underlying the effect on the share value can be
described as the BIRD-IN-THE-HAND ARGUMENT.


Types of Dividend
Stock Split
Bonus issue
Cash
Right issue