DIVIDEND POLICY

The term dividend refers to that part of profits of a company which is distributed by the
company among its shareholders. It is the reward of the shareholders for investments made by them in
the shares of the company. The investors are interested in earning the maximum return on their
investments and to maximise their wealth.

Dividend Decision and valuation of firms

The value of the firm can be maximised if the shareholders wealth is maximised. There are
conflicting views regarding the impact of dividend decision on the valuation of the firm. According to
one school of thought, dividend decision does not affect the shareholders wealth and hence the valuation
of the firm.

1) The Irrelevance concept of dividend or the Theory of Irrelevance and

2) The Relevance Concept of Dividend or the Theory of Relevance.

1. THE IRRELEVANCE CONCEPT OF DIVIDEND OR THE THEORY OF

IRRELEVANCE:

A. RESIDUAL APPROACH

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 earnings 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 dividends. Thus, the decision to pay dividends or retain the earnings may be taken as a
residual decision. This theory assumes that investors do not differentiate between dividends and
retentions by the firm. Their basic desire is to earn higher return on their investment.

B.MODIGLIANI AND MILLER APPROACH (MM MODEL)

Modigliani and Miller have expressed in the most comprehensive manner in support of the theory of
irrelevance. They maintain that 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. The splitting
of earnings between retentions and dividends, may be in any manner the firm likes, does not affect the
value of the firm. As observed by MM.”Under conditions of perfect capital markets’’.
Assumptions of MM hypothesis

i. There are perfect capital markets.

ii. Investors behave rationally.
iii. Information about the company is available to all without any cost.
iv. There are no floatation and transaction costs.
v. No investor is large enough to effect the market price of shares.
vi. There are either no taxes or there are no differences in the tax rates applicable to
dividends and capital gains.
vii. The firm has a rigid investment policy.
viii. There is no risk or uncertainty in regard to the future of the firm.(MM dropped this
assumption later)

The argument of MM

Po = D1+P1

1 + Ke

Po=Market price per share at the beginning of the period, or prevailing market price of share

D1 =Dividend to be received at the end of the period.

P1 =Market price per share at the end of the period.

Ke =Cost of equity capital or rate of capitalism

P1 = Po(1+Ke)-D1

m = I (E-nD1)

P1

nPo = (n+m)P1- (I - E)

1+Ke

m =Number of shares to be issued

I =Investment required

E =Total earnings of the firm during the period

P1=Market price per share at the end of the period

Ke =Cost of equity capital

n = Number of shares outstanding at the beginning of the period

D1 =Dividend to be paid at the end of the period

nPo = Value of the firm

Illustration 1.ABC Ltd.belongs to a risk class for which the appropriate capitalization rate is 10%.It
currently has outstanding 5000 shares selling at Rs.100 each. The firm is contemplating the declaration
of dividend of Rs 6 per share at the end of the current financial year. The company expects to have a net
income of Rs 50000 and has a proposal for making new investments of Rs 100000.Show that under the
MM hypothesis, the payment of dividend does not effect the value of the firm.

Illustration 2.Expandent Ltd had 50,000 equity shares of Rs 10 each outstanding on January
1.The shares are currently being quoted at par in the market. In the wake of the removal of dividend
restraint, the company now intends to pay a dividend of Rs 2 per share for the current calendar year. It
belongs to a risk-class whose appropriate capitalization rate is 15%.Using MM model and assuming no
taxes, ascertain the price of the company’s share as it is likely to prevail at the end of the year

.i) When dividend is declared, and ii) When no dividend is declared. Also find out the number of new
equity shares that the company must issue to meet its investment needs of Rs 2 lakhs, assuming a net
income of Rs 1.1 lakhs and also assuming that the dividend is paid.

Criticism of MM Approach

MM hypothesis has been criticized on account of various unrealistic assumptions as given below.

1. Perfect capital market does not exist in reality

2. Information about the company is not available to all the persons
3. The firms have no incur flotation costs while issuing securities
4. Taxes do exit and there is normally different tax treatment for dividends and capital gains.
5. The firms do not follow a rigid investment policy.
6. The investors have to pay brokerage, fees, etc while doing any transaction.
7. Shareholders may prefer current income as compared to further gains.
2)THE RELEVANCE CONCEPT OF DIVIDEND OR THE THEORY OF RELEVANCE

The other school of thought on dividend decision holds that the dividend decisions considerably
affect and value of the firm. The advocates of this school of thought include Myron Gordon, Jone Linter,
James Walter and Richardson. According to them dividends communicate information to the investors
about the firm’s profitability and hence dividend decision becomes relevant.

i. WALTER’S APPROACH

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 subserve the ultimate goal of
maximizing the wealth of the share holders.Prof.Walter’s model is based on the relationship between the
firms i) return on investment ie, r and ii) the cost of capital or the required rate of return,ie,k

If r ˃K ie,if the firm earns a higher rate of return on its investment than the required rate of return, the
firm should retain the earnings. Such firms are termed as growth firm’s and the optimum pay out would
be zero in their case. This would maximise the value of shares.

In case of declining firms which do not have profitable investments, ie, where r ˂ k, the shareholders
would stand to gain if the firm distributes its earnings. For such firms, the optimum pay-out would be
100%and the firms should distribute the entire earnings as dividends.

In case of normal firms where r=k,the dividend policy will not affect the market value of shares as the
shareholders will get the same return from the firm as expected by them. For such firms, there is no
optimum dividend payout and the value of the firm would not change with the change in dividend rate.

Assumptions

i. The investments of the firm are financed through retained earnings only and the firm does not
use external sources of funds.
ii. The internal rate of return (r) and the cost of capital (k) of the firm are constant.
iii. Earnings and dividends do not change while determining the value
iv. The firm has a very long life
WALTER’S Formula for determining the value of a share

P= D

Ke-g

P=Price of equity share

D=Initial dividend per share

Ke=cost of equity capital

g = Expected growth rate of earnings /dividend

or P= D + r (E-D) /Ke

Ke Ke

P= Market price per share

D=Dividend per share

r = Internal rate of return

E=Earnings per share

Ke=Cost of equity capital

Illustration 3

The following information is available for Awadh Corporation:

Earnings per share Rs.4.00

Rate of return on investment Rs.18 per cent

Rate of return required by shareholder Rs.15 per cent

What will be the price of share as per the Walter’s Model if the payout ratio is 40 per cent?50 per cent?
60 per cent?

Illustration 4

The following information is available in respect of a firm :

Capitalisation rate : 10%

Earnings per share :Rs.50

Assumed rate of return on investment :

i )12% ii)8% iii)10%

show the effect of dividend policy on market price of shares applying Walter’s formula when dividend
payout ratio is a)0% b)20% c)40% d)80% e)100%

Criticism of Walter’s model

Walter’s model has been criticized on account of various assumptions made by Prof. Walter in
formulating his hypothesis:

 The basic assumption that investments are financed through retained earnings only is
seldom true in real world. Firms do raise funds by external financing.
 The internal rate of return, i.e., r, also does not, remain constant. As a matter of fact, with
increased investment the rate of return also changes.
 The assumption that cost of capital (k) will remain constant also does not hold good. As a
firm’s risk pattern does not remain constant, it is not proper to assume that k will always
remain constant.

(ii) GORDON’S APPROACH

Myron Gordon has also developed a model on the lines of Prof. Walter suggesting that dividends
are relevant and the dividend decision of the firm affects its value. His basic valuation model is based on
the following assumptions:

(i) The firm is an all equity firm

(ii) No external financing is available or used. Retained earnings represent the only source of
financing investment programmes
(iii) The rate of return on the firm’s investment r, is constant
(iv) The retention ratio, b, once decided upon is constant. Thus, growth rate of the firm g=br, is also
constant.
(v) The cost of capital for the firm’s remains constant and it is greater than the growth rate, i.e.,
k>br.
 (vi) The firm has perpetual life
(vii) Corporate taxes do not exist.
(viii) Gordon’s basic valuation formula can be simplified as under:

p = E(1-b)

Ke-br

or, P0 = D1 = D0(1+g)

Ke-g Ke-g

Where,

P = Price of shares

E = Earnings per share

b= Retention ratio

Ke = Cost of equity capital

br = g= growth rate in r, i.e., rate of return on investment of an all equity firm

D0 = Dividend per share

D1 = Expected dividend at the end of year

DETERMINANTS OF DIVIDEND POLICY

The payment of dividend involves some leant gal as well as financial considerations. It is difficult to
determine a general dividend policy which can be followed by different firms at different times because
they dividend decision has to be taken.

1.Legal restriction

Legal provisions relating to dividends as laid down in section 93,205, 205 A,206, and 207 of the
companies act, 1956 are significant because they lay down a framework within which dividend policy is
formulated. These provisions require that dividend can be paid only out of the moneys provided by Govt
for the payment of dividends in pursuance of a guarantee given by the government.
2.Magnitude and trend of earning

The amount and trend of earnings is an important aspect of dividend policy. It is rather the starting point
of the dividend policy. As dividends can be paid only out of present or past years profits, earning of a
company fix the upper limits on dividends. The dividend should, generally be paid out of current years
earnings only as the retained earnings of the previous year become more or less a part of permanent
investment in the business to earn current profits.

3.Desire and type of shareholder

Although, legally, the discretion as to whether to declare dividend or not has been left with the board of
directors, the directors should give the importance to the desires of shareholders in the declaration of the
dividends as they are the representative of shareholder. Desires of shareholders for dividends depend
upon their economic status. Investors, such as retired persons, widows and other economically weaker
persons view dividends as a source of funds to meet their day to day living expenses.

4.Nature of industry

Nature of industry to which the company is engaged also considerably affects the dividend policy.
Certain industries shave a comparatively steady and stable demand irrespective of the prevailing
economic conditions. For instance, people used to drink liquor both in boom as well as in recession,
such firms expect regular earnings and hence can follow a consistent dividend policy.

5.Age of the company

The age of the company also influences the dividend decision f a company. A newly established concern
has to limit payment of dividend and retain substantial part of earning for financing is future growth and
development, while older companies which have established n sufficient reserves can afford to pay
liberal dividends

6. Future financial requirements- It is not only the desires of the shareholders but also future financial
requirements of the company that have to be taken into consideration while making a dividend decision.
The management of a concern has to reconcile the conflicting interests of shareholders and those of the
company’s financial needs. If a company has highly profitable investment opportunities it can convince
the shareholders of the need for limitation of dividend to increase the future earnings and stabilize its
financial position.

7.Government’s economic policy - the dividend policy of firm has also to be adjusted to the economic
policy of the government as was the case when the temporary restrictions on payment of dividend
ordinance was in force .In 1974 and 1975 ,companies were allowed to pay dividends not more than 33
percent of their profits or 12 per cent on the paid –up value of the shares ,whichever was lower.

8. Taxation policy-The taxation policy of the government also affects the dividend decisions of a firm.
A high or low rate of business taxation affects the net earnings of company (after tax) and thereby is
dividend policy. Similarly, a firm’s dividends policy may be dictated by the income-tax being in high
income bracket.

9.Inflation –Inflation acts as a constraint in the payment of dividends. Profits as arrived from the profit
and loss account on the basis of historical cost have a tendency to be overstated in times of rise in prices
due to over valuation of stock –in-trade and writing of depreciation on fixed assets at lower rates.As a
result, when prices rise, funds generated by depreciation would not be adequate to replace fixed assets
and capital intact, substantial part of the current earnings would be retained.

10.Control objectives –When a company pays high dividends out of its earnings, it may result in the
dilution of both control and earnings for the existing shareholders. As in case of a high dividend pay-out
ratio, retained earnings are insignificant and the company will have to issue new shares to raise funds to
finance its future requirements. The control of the existing shareholders will be diluted if they cannot
buy the additional shares issued by the company.

11.Requirements of Institutional Investors – Dividend policy of a company can be affected by the

requirements of institutional investors such as financial institutions,banks, insurance cooperations,etc.

These investors usually favour a policy of regular payment of cash dividends and stipulate their own
terms with regard to payment of dividend on equity shares.

12.Stability of dividends –Stability of dividends is another form of dividend policy.Stability of

dividend simply refers to the payment of dividend regularly and shareholders ,generally, prefer payment
of such regular dividends. Some companies follow a policy of constant dividend per share while others
follow a policy of constant payout ratio and while there are some other who follows a policy of constant
low dividend per share plus an extra dividend in the years of high profits.

13.Liquid Resources-The dividend policy of a firm is also influenced by the availability of liquid
resources. Although a firm may have sufficient available profits to declare dividends, yet it may not be
desirable to pay dividends if it does not have sufficient liquid resources.

TYPES OF DIVIDEND POLICY

1) Regular dividend policy

Payment of dividend at the usual rate is termed as regular dividend. The investors such as retired
persons, widows and other economically weaker persons prefer to get regular dividends.

2) Stable dividend policy

The term stability of dividends means consistency or lack of variability in stream of dividend payments.
In more precise terms, it means payment of certain minimum amount of dividend regularly. A stable
dividend policy may be established in any of the following three forms:

a) Constant dividend per share

b) Constant payout ratio
c) Stable rupee dividend plus extra dividend

Advantages of stable dividend policy

A stable dividend policy is advantageous to both the investors and the company on account of the
following:

1. It is sign of continued normal operations of the company.

2. It stabilizes the market value of shares.
3. It creates confidence among the investors.
4. It provides a source of livelihood to those investors who view dividends as a source of funds
to meet day-to-day expenses.
5. It meets the requirements of industrial investors who prefer companies with stable dividends.
Dangers of stable dividend policy

In spite of many advantages, the stable dividend policy suffers from certain limitations. Once a
stable dividend policy is followed by a company, it is not easier to change it. If the stable dividends are
not paid to the shareholders on any account including insufficient profits, the financing standing of the
company in the minds of the investors is damaged and they may like to dispose off their holdings.It
adversely affects the market price of shares of the company.

3) Irregular dividend policy

Some companies follow irregular dividend payments on account of the following:

a) Uncertainty of earnings
b) Unsuccessful business operations
c) Lack of liquid resources

4)No dividend policy

A company may follow a policy of paying no dividends presently because of its unfavorable working
capital positions or on account of requirements of funds for future expansion and growth.

5)Cash dividend

A cash dividend is a usual method of paying dividends. Payment of dividend in cash results in outflow
of funds and reduces the company’s net worth, though the shareholders get an opportunity to invest the
cash in any manner they desire. This is why the ordinary shareholders prefer to receive dividends in
cash. But the firm must have adequate liquid resources at its disposal or provide for such resources so
that its liquidity position is not adversely affected on account of cash dividends.

6)Scrip or Bond dividend

A scrip dividend promises to pay the shareholders at a future specific date. In case a company does not
have sufficient funds to pay dividends in cash, it may issue notes or bonds for amounts due to the
shareholders. The objective of scrip dividend is to postpone the immediate payment of cash. A scrip
dividend bears interest and is accepted as a collateral security.
7) Property dividend

Property dividend property dividends are paid in the form of some assets other than cash. They are
distributed under exceptional circumstances and are not popular in India.

8)Stock dividend.

Stock dividend means the issue of bonus shares to the existing shareholders. If a company doesn’t have
liquid resources it is better to declare stock dividend .stock dividend amounts to capitalization of
earnings and distribution of profits among the existing shareholders without affecting the cash position
of a firm. This has been discussed in detail under “bonus issue.”

Bonus issue

A company can pay bonus to its shareholders either in cash or in the form of shares .many a times ,a
company is not in a position to pay bonus in cash inspire of sufficient profits because of unsatisfactory
cash position or because of its adverse effects on the working capital of the company so desires and the
articles of association of the company provide ,it can pay bonus to its shareholders in the form of
shares by making partly paid shares as fully paid or by the issue of fully paid bonus shares .

A bonus shares is neither dividend nor a gift .it is governed by so any regulations that it can be neither
be declared like a dividend nor gifted away.issue of bonus shares in lieu of dividend is not allowed as
according to sec 205 of the companies act ,1956,no dividend can be paid except in cash .it cannot be
termed as a gift also because it only represents the past sacrifice of the shareholders.

Advantages of issue of bonus shares

(a) Advantages from the view point of the company

1.it makes available capital to carry on a larger and more profitable business.
2.it is felt that financing helps the company to get rid of market influences.
3.when a company pays bonus to its shareholders in the value of shares and not in cash ,its liquid
resources are maintained and the working capital of a company is not affected .
4.it enables a company to make use of its profits on a permanent basis and increases
creditworthiness of the company .
5.it is the cheapest method of raising additional capitalfor the expansion of the business.
 6.abnormally high rate of dividend can be reduced by issuing bonus shares which enables a
company to restrict entry of new entrepreneurs into the business and thereby reduces
competition.
7.the balance sheet of the company will reveal a more realistc picture of the capital structure
and the capacity of the company.

Disadvantages of issue of bonus shares

1. The issue of bonus shares leads to a drastic fall in the future rate of divided as it is only the
capital that increases and not the actual resources of the company. The earnings do not usually
increase with the issue of bonus shares. Thus, if a company earns a profit of rs. 200000 against
the share capital of rs.500000 and the capital of the company is raised by the issue of bonus
shares to rs.800000, the rate of dividend falls from 40% to 25%.
2. The fall in the future rate of dividend results in the fall of the market price of shares
considerably. This may cause unhappiness among the shareholders.
3. The reserves of the company after the bonus issue decline and leave lesser security to investors.

GUIDELINES FOR THE ISSUE OF BONUS SHARES

New guidelines for bonus shares have been issued by the primary market department of SEBI
vide press release dated 13.4.94 modifying the earlier guidelines issued by the SEBI on 11.6.92. SEBI
believes that, while deciding on bonus issues, the Board of Directors of the companies wishing to make
bonus issues will take into consideration the relevant financial factors and observe the following
modified guidelines:

1)Issue of bonus shares after any public rights issue is subject to the condition that no bonus issue shall
be made which will dilute the value or rights of debentures convertible fully or partly

2)The bonus issue is made out of free reserves built out of the genuine profits or share premium
collected in cash only.

3)Reserves created by revaluation of fixed asset are not capitalized.

4)The declaration of bonus issue, in lieu of dividend, is not made.

5)The bonus issue is not made unless the partly paid shares, if any existing are made fully paid.

6)The company :

i. has not defaulted in payment of interest or principal in respect of fixed deposits and interest on
existing debentures or principal on redemption there of and

ii.Has sufficient reason to believe that it has not defaulted in respect of payment of statutory dues of the
employees such as contribution to provident fund, gratuity, bonus etc

7)A company which announces its bonus issue after the approval of the Board of Directors must
implement the proposals within a period of six months from the date of such approval and shall not have
the option of changing the decision.

8)There should be a provision in the Articles of Association of the company for capitalization of
resources,etc,and if not ,the company shall pass a resolution at its general body meeting making
provision in the Articles of Association for capitalization.

Sources of Bonus issue

The bonus shares can be issued out of the following :

1.Balance in the profits and loss Account

2.General Reserve

3.Capital reserve

4.Balance in the sinking fund reserve for redemption of debentures after the debentures have been
redeemed

5.Development Rebate Reserve ,Development Allowance Reserve,etc.allowed under the Income Tax
Act ,1961,after the expiry of the specified period(8 years)

6.Capital Redemption Reserve Account

7.Premium received in cash