CHAPTER - 18

Dividend Policy

2

PRACTICAL CONSIDERATION IN PAYING DIVIDENDS Financial Need of company. Shareholders Expectations. Closely / Widely Held Company. Constraints on Paying Dividends.

Legal Restrictions Liquidity Borrowing Capacity Access to the Capital Markets Restrictions in Loan Agreements

3

STABILITY OF DIVIDENDS

Constant Dividend per Share or Dividend Rate.

Constant Payout. Constant Dividend per Share Plus

Extra Dividend.

4

SIGNIFICANCE OF STABILITY OF DIVIDENDS Resolutions of investors

uncertainty. Investors’ desire for current

income. Institutional Investors’

Requirement. Raising Additional Finances.

5

FORMS OF DIVIDENDS

Cash Dividends Bonus Shares (Stock Dividend).

Advantages for Shareholders and Company. Limitations of Bonus Issue. Conditions for Issue of Bonus Shares.

CORPORATE DIVIDEND BEHAVIOUR

Lintners Model

1DIV * * EPS (1 )DIVtt t ta+b p b e

7

CHAPTER - 17

Dividend Theory

8

ISSUES IN DIVIDEND POLICY

Earnings to be Distributed – High Vs. Low Payout.

Objective – Maximize Shareholders Return.

Effects – Taxes, Investment and Financing Decision.

9

RELEVANCE VS. IRRELEVANCE

Walter's Model Gordon's Model Modigliani and Miller Hypothesis The Bird in the Hand Argument Informational Content Market Imperfections

10

WALTERS MODEL

Assumptions Valuation Optimum Payout Ratio Criticism

11

ASSUMPTIONS

Internal Financing Constant Return and Cost of

Capital 100% Payout or Retention Constant EPS and DIV Infinite Time

12

Market price per share is the sum of the present value of the infinite stream of constant dividends and present value of the infinite stream of capital gains.

VALUATION

( / )(DIV / ) (EPS – DIV)

r kP k

k

13

EXAMPLE

0.15, 0.10, 0.08

0.10

EPS Rs 10

DPS 40%

(0.15 / 0.1)(4 / 0.1) (10 4) Rs 130

0.1(0.10 / 0.1)

(4 / 0.1) (10 4) Rs 1000.1

(0.08 / 0.1)(4 / 0.1) (10 4) Rs 88

0.1

r

k

P

P

P

14

OPTIMUM PAYOUT RATIO

Growth Firms – Retain all earnings Normal Firms – Distribute all

earnings Declining Firms – No effect

15

CRITICISM

No external Financing Constant Rate of Return Constant opportunity cost of

capital

16

GORDON'S MODEL

Assumptions Valuation Optimum Payout Ratio Criticism

17

ASSUMPTIONS

All Equity Firm No External Financing Constant Return and Cost of

Capital Perpetual Earnings No Taxes Constant Retention Cost of Capital greater than

Growth Rate

VALUATION

Market value of a share is equal to the present value of an infinite stream of dividends to be received by shareholders

EPS(1 ) /( )P b k br

19

EXAMPLE

0.15, 0.10, 0.08

0.10

EPS Rs 10

60%

(1 – 0.6) / 0.10 – (0.15 * 0.6) = Rs 400

10(1 – 6) / 0.10 – (0.10 * 0.6) = Rs 100

10(1 – 0.6) / 0.10 – (0.08 * 0.6) = Rs 77

r

k

b

P

P

P

20

Financial Management, Ninth Edition © I M Pandey

Vikas Publishing House Pvt. Ltd.

OPTIMUM PAYOUT RATIO

Growth Firms – Retain all earnings Normal Firms – Distribute all

earnings Declining Firms – No effect

THE BIRD IN THE HAND

Argument put forward, first of all, by Kirshman

Investors are risk averters. They consider distant dividends as less certain than near dividends. Rate at which an investor discounts his dividend stream from a given firm increases with the futurity of dividend stream and hence lowering share prices.

MODIGLIANI AND MILLER

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.

23

MARKET IMPERFECTIONS

Tax Differential – Low Payout Clientele Flotation Cost Transaction and Agency Cost Information Asymmetry Diversification Uncertainty – High Payout Clientele Desire for Steady Income No or Low Tax on Dividends

INFORMATIONAL CONTENT OF DIVIDEND

…. In an uncertain world in which verbal statements can be ignored or misinterpreted, dividend action does provide a clear cut means of ‘making a statement’ that speaks louder than a thousand words. — Solomon