FINANCIAL

MANAGEME
NT
M O D U L E :- 4

Dividend
Decision

Syllabus M O D U L E - 1
Understanding Dividend Decisions
Theory and Practices
Contemporary Issues and Projects by
Students
Various Models of Relevance and
Irrelevance Approaches towards Dividend
Theory

M O D U L E :- C O N T E N T s

DIVIDEND
MODELS
DIVIDEND
DECISION
3

DIVIDEN
D
MODELS
4

C O N T E N Ts
RELEVANCE CONCEPT OF
DIVIDEND THEORY
WALTERS MODEL
GORDERS GROWTH MODEL

IRRELEVANCE CONCEPT OF
DIVIDEND POLICY
MODIGLIANI AND MILLER
APPROACH (MM MODEL)

RELEVANCE CONCEPT OF
DIVIDEND THEORY
Dividend relevance theory proposes that
dividend policy affect the share price.
According to this theory, optimal dividend
policy should be determined which will
ensure maximization of the wealth of the
shareholders.

WALTERS
MODEL

MEANING OF WALTERS MODEL

ASSUMPTIONS OF WALTERS MODEL
FORMULA FOR DETERMINING THE VALUE
OF A SHARE OF WALTERS MODEL
CRITICISMS OF WALTERS MODEL
7

MEANING OF WALTERS MODEL

Prof. Walters approach supports the
doctrine that dividend decisions are
relevant and affect 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 in
determining the dividend policy to sub
serve the ultimate goal of maximizing the
wealth of the share holders.
Prof. Walter model is based on the
relationship between the firms i) return
on investment and ii) the cost of capital.
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ASSUMPTIONS OF WALTERS MODEL

Internal Financing
Constant Return and Cost of Capital
100 percent payout or retention
Constant EPS and DPS
Infinite Time

FORMULA FOR DETERMINING THE VALUE OF A

SHARE OF WALTERS MODEL
Growth

Company
= (r > Ke)
D+
r (E - D)
Normal
P = Ke
Company
Ke
= (r = Ke)
where,
Declining
E = Earning
Company = (r
P = Market Value of Share
< Ke)
D = Dividend
r = return on investment
Ke = Cost of equity or capital or
capitalization rate
10

Cost of capital
Cost of capital refers to the
opportunity cost of making a specific
investment. It is the rate of return
that could have been earned by
putting the same money into a
different investment with equal risk.
Thus, the cost of capital is the rate
of return required to persuade the
investor to make a given investment.
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CRITICISMS OF WALTERS MODEL

Constant Return
Constant Opportunity Cost of Capital

12

GORDANS
GROWTH
MODEL

MEANING OF GORDANS GROWTH MODEL

ASSUMPTIONS OF GORDANS GROWTH
MODEL
FORMULA FOR DETERMINING THE VALUE
OF A SHARE OF GORDANS GROWTH
MODEL
13

MEANING OF GORDONS GROWTH MODEL

Myrion Gordon contended that dividends
are relevant.
He proposed a model of stock valuation
using the dividend capitalization
approach.
According to Gordon, Dividend policy of a
firm is based on few following
assumptions:

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ASSUMPTIONS OF GORDONS
GROWTH MODEL

All equity firm

No external Financing
Constant Return
Constant Cost of Capital
Perpetual Earning
No Taxes
Constant Retention
Cost of Capital greater than Growth Rate

15

FORMULA FOR DETERMINING THE

VALUE OF A SHARE OF GORDONS
GROWTH MODEL
E (1 b)
P =
Ke br
where,
P = Price of Share
E = Earning
b = Retention Ratio or % of earning
br = g = growth rate
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CRITICISMS OF GORDONS GROWTH MODEL

Gordons models conclusions about

dividend policy are similar to that of
walters model.
This similarity is due to the similarities of
assumptions which underlines both
models.
Thus the Gordon model suffers from the
same limitations as the Walter model.

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IRRELEVANCE CONCEPT OF
DIVIDEND POLICY

Dividend irrelevance theory suggests

that, in a perfect world, dividends are
irrelevant and it has no effect on the
wealth of the shareholders or the prices
of the shares.
Irrelevance Policy perceive dividend as a
signal as,
Increase = Positive Signal and earns in
future
Decrease = Negative Signal and decrease in
earning
capacity in future
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 According to this theory, dividend decision

has no effect on the wealth of the
shareholders or the prices of the shares, and
hence it is irrelevant so far as the valuation of
the firm is concerned.
This theory regards dividend decision merely
as a part of financing decision because the
earning available may be retained in the
business for re investment.
But if the funds are not required in the
business they may be distributed as dividend.
Thus, a firm should retain the earnings if it
has profitable investment opportunities
otherwise it should pay them as dividend. 19

MODIGLIANI AND
MILLER APPROACH
(MM MODEL)
MEANING OF MM MODEL
ASSUMPTIONS OF MM MODEL
FORMULA FOR DETERMINING THE VALUE
OF A SHARE OF MM MODEL
CRITICISMS OF MM MODEL
20

MEANING OF MM MODEL
MM has expressed in the most comprehensive
manner in support of the theory of irrelevance.
According to this theory dividend policy 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.
As observed by M.M. 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 the
shares.
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ASSUMPTIONS OF MM MODEL
No Taxes
Investment Policy given
No Risks

22

FORMULA FOR DETERMINING THE VALUE OF

A SHARE OF MM MODEL

P0 = (D1 + P1)/(1 + Ke)

nP1 = I (E nD1)
Delta n = Delta n*P1 / P1
nP0 = (n + Delta n)P1 (I-E)/ 1 + Ke
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CRITICISMS OF MM MODEL
Information about the company 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.
The investors have to pay brokerage, fees,
etc. while doing any transaction.
Shareholders may prefer current income as
compared to further gains.
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Residual Theory of
Dividend
It suggest that the dividends paid by
a corporate should be the amount
left over after meeting the financial
requirements of all the acceptable /
profitable investment projects.
Dividend will be paid after investing
in all new projects.

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DIVIDEND
DECISION
26

C O N T E N Ts
MEANING AND DEFINITION OF
DIVIDEND
TYPES OF DIVIDEND
RELEVANCE OF DIVIDEND DECISION
MEANING OF DIVIDEND POLICY
FORMULATING / FACTORS AFFECTING
DIVIDEND POLICY
CONTEMPORARY ISSUES ON
DIVIDEND POLICY
BONUS SHARES AND STOCK SPLITS
27

MEANING AND DEFINITION OF DIVIDEND

According to ICAI, A dividend is a

distribution to shareholders out of profit
or reserves available for this purpose.
The term dividend refers to that part of
profit of a company which is distributed
by the company among its shareholders
after execution retained earning.
It is reward of the shareholders for
investments made by them in the shares
of the company.
It is the return that a shareholder gets
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TYPES OF DIVIDEND
On the Basis of Types of Shares
Equity Dividend
Preference Dividend

On the Basis of Modes of Payment

Cash Dividend
Bonus Shares / Stock Dividend
Scrip or Bond Dividend
Property Dividend
Composite Dividend

On the Basis of Time of Payment

Interim Dividend
Regular Dividend
Special Dividend

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RELEVANCE OF DIVIDEND DECISION

The firm has to balance between the growth of
the company and the distribution to the
shareholders.
It plays an important role in determining the
value of a firm.
Dividends are important component for
calculating the value of a stock.
A large number of analyst employ dividends to
calculate the intrinsic value of stock.
Dividends can indirectly influence the external
financing plans of financial managers
Retained earning helps the firm to concentrate
on the growth, expansion and modernization. 30

MEANING OF DIVIDEND POLICY

It refers to the policy concerning quantum
of profit to be distributed as dividend.
The concept of dividend policies implies
that companies through their Board of
Directors evolve a pattern of dividend
payment which has a bearing on future
action.
According to Weston and Brigham,
Dividend policy determines the division
of earning between payments to
shareholders and retained earning.
31

FORMULATING / FACTORS AFFECTING

DIVIDEND POLICY

Size of the Earnings

Investment Opportunities and
Shareholders Preferences
Liquidity Position
Managements Attitude towards Control
State of Capital Market and Access to it
Contractual Restrictions
Profit Rate and Stability of Earnings
Inflation
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CONTEMPORARY ISSUES ON DIVIDEND

POLICY
Dividend follows earning.
The market seems to react positively to the
announcement of dividend increases and
penalize the dividend decrease.
Factors such as ownership structure,
management control and other market
imperfections seem to make the dividend
decisions more complex.
The challenge to financial economists is
therefore to determine the link of such factors
with payout policies so that firms maximize
shareholders wealth and investors maximize
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their utility.

BONUS SHARES AND STOCK

SPLITS

Bonus Shares:

A company very often distributes dividend

in cash. But in certain circumstances
where cash is not available or company
wants to capitalize its profits, it may
distribute dividend in the form of shares
known as Bonus Shares.
Thus Bonus shares represents a
distribution of shares in lieu of or in
addition to the cash dividend to the
existing shareholders. If the articles so
permit.
34

BONUS SHARES AND STOCK

SPLITS

Stock Split:

It is the process of splitting shares with

high face value into shares of a lower
face value.
Its like getting an Rs. 20 note changed
for two Rs. 10
A stock split simply involves a company
altering the number of its shares
outstanding and proportionally
adjusting the share price to
compensate.
35

Bonus Shares v/s Stock Split

Bonus Shares

Meaning

Additional Free
share

Face Value

It is not changed

Share Capital
It is increased from
issue

Dividend

More dividend are

to be paid

Reserves
Reserved are to be

Stock Split
Meaning
Process dividing the
face value

Face Value
It is chnaged

Share Capital
Capital is not changed
but no. of shares
changed

Dividend
There is no difference
in dividend

Reserves
No use of Reserve

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