DIVIDEND THEORY & POLICY

DIVIDEND
Dividend refers to that portion of a firms net earnings (net profits)
which are paid to the shareholders, it is more related to public limited
companies as the dividend issue does not pose a major problem for
closely held private limited companies.
As the dividends are paid out of the profits, the alternative to the
payment of dividends is the retention of earnings/profits, retained
earnings constitute an easily accessible important source of financing
the investment requirement of the firms.
Hence there is a type of reverse relationship between retained
earnings and cash dividends : larger retentions, lesser dividends,
smaller retentions , larger dividends. Thus the alternative uses of the net
earnings dividends and retained earnings are competitive and
conflicting.

Dividend Implications
A Major decision of financial management is the dividend decision in the
sense that the firm has to choose between distributing the profits to the
shareholders and ploughing them back into the business. This choice would
obviously hinge on the effect of the decision on the maximization of
shareholders wealth.
There are conflicting opinions regarding the impact of dividends on the
valuation of a firm. According to one school of thought dividends are
irrelevant to the value of the firm measured in terms of the market price of
the shares.
On the other hand certain theories consider the dividend as relevant to the
value of the firm measured in terms of the marker price of the shares.

IRRELEVANCE OF DIVIDENDS
1. General
2. Modigliani & Miller Hypothesis

Relevance of Dividends
1. Walters Model
2. Gordon's Model

Residual Dividend (General) : The crux of the argument is that the dividend policy of
a firm is a part of its financing decision , the dividend policy of the firm is residual decision and
dividends are a passive residual.

If the dividend policy is strictly a financing decision whether dividends are paid out of profits or
earnings are retained, will depend upon the available investment opportunities , which means
that if a firm has sufficient investment opportunities it will retain the earnings to finance them.
Conversely , if acceptable investment opportunities are inadequate the implication is that the
earnings would be distributed to the shareholders.
The dividends are irrelevant or are a passive residual is based on the assumption that the
investors are indifferent between dividends and capital gains. So as 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 . In contrast if the return is less than the Ke, investors would prefer to
receive the earnings.

Modigliani & Miller Hypothesis

Dividend Irrelevance : It implies that the values of a firm is unaffected by the
distribution of dividends and Is determined solely by the earning power and
risk of its assets.
According to MM it is the investment policy through which the firm can
increase its earnings and thereby the value of the firm. Given the investment
decisions of the firm the dividend decision- splitting the earnings into
packages of retentions and dividends is a matter of detail and does not
matter.
Under conditions of perfect capital markets, rational investors, absence of
tax discrimination between dividend income and capital appreciation ,
given the firms investment policy its dividend policy may have no influence
on the market price of shares.

Assumptions
The MM approach has taken into consideration the following
assumptions:
There is a rational behavior by the investors and there exists perfect
capital markets. Which means Investors have free information available
for them, no investor is large enough to influence the market price of
securities, no time lag and transaction costs exist.
No taxes applicable to capital gains and dividends.
A firm has given investment policy which does not change, which
means financing of new investments out of retained earnings will no
change the business risk complexion of the firm and therefor no change
in the required rate of return.

CRUX OF THE ARGUMENT

Arbitrage Process : It involves a switching and balancing operation. In other words arbitrage refers to
entering simultaneously into two transactions which exactly balance or completely offset each other.
The two transactions here are the acts of paying out dividends and raising external funds either through
the sale of new shares or raising additional loans to finance investment programs.
Assume that a firm has an investment opportunity then it will have two alternatives :

1. It can retain its earnings to finance the investment program

2. It can distribute the earnings to the shareholders as dividend and raise an equal amount externally
through the sale of new shares/bonds for the purpose.

If the firm select the second alternative then arbitrage process is involved in that payment of
dividends is associated with raising funds through other means of financing . The effect of dividend
payment on shareholders wealth will be exactly offset by the effect of raising additional share
capital.

When dividends are paid to the shareholders the market price of shares will decrease, what is
gained by the investors is completely neutralized by the reduction in the market value of the shares.
The terminal value before and after the payment of dividend would be identical. The investors
according to MM would therefore be indifferent between dividend and retention of earnings, since
the shareholders are indifferent the wealth would not be affected by current and future dividend
decisions of the firm . It would depend entirely upon the expected future earningsof the firm.

Critique of MM Hypothesis
The validity of MM approach is open to question on two counts :

1. Imperfection of Capital Market

2. Resolution of Uncertainty

1. Imperfection of Capital Market : MM assumes capital markets are perfect, which

implies that there are no taxes , flotation costs do not exist and there is absence of transaction
costs. These assumptions are untenable in actual situations.

A. Tax Effect : It implies that retention of earnings (Internal Financing) & payment of dividends
(External Financing) are from the viewpoint of tax treatment on an equal footing. The investors
would find both forms of financing equally desirable.
Tax Differential : are the different rates of taxes applicable to dividend and capital gains.

The tax liability of investors is of two types :

1. Tax on dividend income (payable by the investors when the firms pays dividends)
2. Tax on capital gains(Applicable only when shares are actually sold, on operational basis it is
lower than the tax on dividend income)

The different tax treatment of dividend and capital gains means that with the retention of
earnings the shareholders tax liability would be lower or there would be tax saving for the
shareholders.

Flotation Costs : It is the capital cost involved in raising capital from the market. It includes
underwriting commission , brokerage and other expenses. The presence of flotation costs affects the
balancing nature of internal & External financing.
The introduction of flotation costs implies that the net proceeds from the sale of new shares would
be less than the face value of the shares depending upon their sizes.
For Eg : Suppose the cost of flotation is 10 % and the retained earnings are 900 . In case the
dividends are paid, the firm will have to sell shares worth Rs 1000 to raise funds equivalent to the
retained earnings.

Transaction & Inconvenience Cost : Transaction costs are the cost involved in selling securities by
the shareholders . MM assumption of no transaction cost . No transaction cost postulates implies
that if dividends are not paid the investors desirous of current income to meet consumption
needs can sell a part of their holdings without incurring any cost like brokerage and so on which
is an unrealistic assumption.

Institutional Restrictions : The dividend alternatives is also supported by legal restriction as to the type of
ordinary shares in which certain investors can invest. For instance the Life insurance companies are
permitted in terms of section 27-A (1) of the insurance act 1938 , to invest in only such equity shares on
which a dividend of not less than 4 percent including bonus has been paid for 7 years alleast.
These legal restrictions favors dividends to retention of earnings

Resolution of Uncertainty : Apart from the market imperfection the validity of the MM
hypothesis in so far as it
Argues that dividends are irrelevant is questionable under conditions of uncertainty.

1. Near Vs Distant Dividend : According to Gordon investors prefer near dividends than future or
distant dividends (Birds in hand argument its a belief that current dividend payment reduces
uncertainty and result in higher values of shares of a firm)
2. Informational Content : It is the information provided by dividends of a firm with respect to
future earnings which causes owners to bid up or down the prices of shares.
3. Preference for Current Income : In case dividends are not paid investors who prefer current
income can sell a part of their holdings in the firm for the purpose, but under uncertainty the
two alternatives wont be the same. Selling of shares to obtain income as an alternative to
dividend involves uncertain price and inconvenience implies that investors are likely to prefer
current dividend.
4. Underpricing : Implies sale of shares at prices lower than the current market prices. It implies that
the firm will have to sell more shares to replace the dividend. The firm would be better off by
retaining the profits as opposed to paying dividends.

RELEVANCE OF DIVIDENDS
Dividends relevance implies that shareholders prefer current dividends and there is direct relationship
between dividend policy and market values of a firm.
1. Walters Model : It supports the doctrine that dividends are relevant the investment policy of a firm
cannot be separated from its dividends policy and both are according to walter , interlinked . The
choice of an appropriate dividend policy affects the value of an enterprise.

The key argument in support of the relevance proposition of walters model is the relationship between
the return on a firms investment or its internal rate of return ( r ) and its cost of capital or the required
rate of return ( k ). The firm would have an optimum dividend policy which will be determined by the
relationship of r & k.
In other words if the rate on investments exceeds the cost of capital the firm should retain the earnings
whereas it should return on the firms investments.
The rational is that if r > k , the firm is able to earn more than what the shareholders could by
reinvesting. If the earnings are paid to them. The implication of r < k is that shareholders can earn a
higher return by investing elsewhere.

Walters 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 so that r > k. Such firms may be called growth firms.
For growth firms the optimum dividend policy would be given by a D/P ratio of Zero. That is to say
the firm should plough back the entire earnings within the firm. The market value of the shares will
be Maximised as a result.
In contrast a firm sodes not have profitable investment opportunities ( when r < k ) the shareholders
will be better off its earnings are paid out to them so as to enable them to 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 D?P ratio of 100 would give an optimum dividends
policy.
Finally when r = k (normal forms) it is a matter of indifference whether earnings are retained or
distributed. This is so because for all D/P ratios (ranging between 0 to 100) the market price of
shares will remain constant. For such firms there is no optimum dividend policy (D/P Ratio)

Assumptions
1. Retained earnings are the only source of financing investments in the firm, there is no
external finance involved.
2.The cost of capital, k e and the rate of return on investment, r are constant i.e. even if new
investments decisions are taken, the risks of the business remains same.
3. There is no change in the key variables namely beginning earnings per share, E and
dividends per share D, the value of D & E may be changed in the model to determine results ,
but any given value of E & D are assumed to remain constant in determining a given value.
4. The firm's life is endless i.e. there is no closing down.

Limitations
The Walters model assumes that the firms investments are financed exclusively by retained earnings no
external financing is used. The model would be only applicable to all equity firms.
Secondly the model assumes that r is constant this is not a realistic assumption because when increased
investments are made by the firm r also changes.
Finally as regard to constant Ke the risk complexion of the firm has a direct bearing on it. By assuming a
constant Ke walters model ignores the effect of risk on the value of the firm