CHAPTER -10:Dividend Policy

Dividend policy: Policies related to declaration and

payment of firm’s earnings to stockholders as
financial benefit whether those earnings were
generated in the current period or in previous
periods.
Optimal dividend policy: The dividend policy that
strikes a balance between current dividends and
future growth and maximizes firm’s stock price.
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 Dividend irrelevance theory- The theory
that a firm’s dividend policy has no effect on
either its value or its cost of capital.
 Dividend relevance theory – The value of
a firm is affected by its dividend policy.
 Information content hypothesis- The theory
that investors regard dividend changes as signals
of management’s earnings forecasts.
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 Clientele effect – The tendency of a firm to
attract the type of investor who likes its dividend
policy.
 Free cash flow hypothesis – Cash flows
are remaining for declaring and paying dividend
after meeting up the fund requirement for
implementing all reinvestment plans.

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 Types of Dividend Payments
 Residual dividend policy
 Stable dividends
 Constant payout ratio
 Extra dividend

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Dividend Payment Procedures
 Declaration date
 Holder of record date
 Ex-dividend date
 Payment date

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Factors Influencing Dividend Policy

1. Investment opportunities
2. Alternative sources of capital
3. Ownership dilution
4. Effects of dividend policy of cost of equity
5. Legal constraints
6. Control issues
7. Investment and financing considerations
8. Stability of the earnings
9. Liquidity
10. Access to external sources of financing
11. Taxes

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 Dividend Models: Walter

James Walter has proposed a model for share valuation

based on the following assumptions:
a) Retained earnings represents the only source of
financing for the firm
b) The return on firm’s investment remains constant
c) The cost of capital for the firm remains constant
d) The firm has an infinite life.
Valuation formula is: p = D + (E-D)(r/k)
k

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p = price per equity share D = Dividend per share
E = Earnings per share (E-D) = Retained earnings per share
r = internal rate of return on
investments
k = cost of capital
Implications:
r>k, the price per share increases as dividend payout ratio
decreases
r=k, the price per share does not vary with changes in payout
ratio
r<k, the price per share increases as dividend payout ratio
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increases
 Gorden Model

Myron Gordon proposed a model of stock valuation

using the capitalization approach based on the
following assumptions:
The rate of return on the firm’s investment is
constant.The growth rate of the firm is the product
of its retention ratio and its rate of return.The cost
of capital for the firm remains constant. The firm has
a perpetual life. Tax does not exist.
Gordon’s basic valuation formula is:
Po = Yo(1-b)/(k-br) 10-9
Po = Beginning price per share
Yo = Ending earnings per share
1-b = Fraction of earnings distributes as dividends
b = Fraction of earnings the firm ploughs back
k = rate of return required by shareholders
r = rate of return earned on investment made by the
firm
br = Growth rate of earnings and dividends
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Implications:
r>k, the price per share increases as the
dividend payout ratio decreases
r = k, the price per share remains unchanged in
response to variations in the dividend payout
ratio
r<k, the price per share increases as the
dividend payout ratio increase.
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 MM Model

Miller and Modigliani have advanced the view that the value
of a firm depends solely on the earnings power and is not
influenced by the manner in which its earnings are split
between dividends and retained earnings. They have
stated that if a company retains earnings instead of
giving it out as dividends, the shareholder enjoys capital
appreciation equal to the amount of earnings retained. If
it distributes earnings by way of dividends instead of
retaining it, the shareholder enjoys dividends equal in
value to the amount by which his capital would have
appreciated had the company chosen to retain earnings.
Hence the division of earnings between dividends and
retained earnings is irrelevant from the point of view of
shareholders. 10-12
 Problems

1. Calculate the price of the share

according to Traditional model, Walter
model and Gordon model from the
following information: dividend per share
is Tk.35, earnings per share are Tk.90,
internal rate of return is 10%, cost of
capital is 18% and multiplier is 14X.

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 Problems

Future Net income Capital expenditure

years (Dollars) Budget (Dollars)
1 1000000 500000
2 800000 600000
3 1200000 1200000
4 1300000 500000
5 1300000 320000
6 500000 100000
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 Problems
 In year zero, the company earned $1 million and
paid dividends of $1 per share on the 500,000
shares outstanding.
 Determine the company’s dividend per share for
each year (i) using a residual dividend policy,
assuming that the capital budget will be financed
using internal equity; (ii) using a constant payout
ratio of 0.6.
 Which policy would result in the higher average
dividend over the six-year period? 10-15
H.W.
Problems:
From 13-1 to 13-5

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