Dividend Policy
Ananta Kumar Sahoo
P.G. Department of Commerce
Berhampur University
Introduction
• Dividend? “Dividendum”
• Section 123(5)
• Types of Dividend
– A. Sources
• Retained earnings
• Current profit
– B. Medium
• Cash dividend
• Share dividend
• Bond dividend
• Scrip dividend
• Extra dividend
• Composite dividend
– Timing
• Interim dividend
• Annual/Final dividend
Determinants of Dividend Policy
External Factors Internal Factors
• General state of economy • Dividend pay-out ratio
• Access to capital market • Owner’s contribution
• Legal/Contractual Constraints • Nature of earnings
• Tax policy • Liquidity position
• Inflation • Rate of return
• Stability of earnings • Divisible profit
• Stability of dividend • Degree of control
– Constant dividend per share • Dividend clientele
– Constant % Earnings
• Cost of financing
Types of dividend policy
• Steady dividend policy
• Regular+ Extra dividend
• Fluctuating with earning policy
• No dividend policy
Dividend Theories
Irrelevance Concept
• M M hypothesis
• Residual theory of Solomon and Pringle
Relevance concept
• Walter’s Model
• Gordon’s Model
• Dividend under Uncertainty
M M Theory
Assumptions:
• Perfect capital market
• Symmetry of information without any cost
• No transaction cost
• No investor can influence the market
• No floatation cost
• No tax
• Investment policy don’t change
• Risk and uncertianty do not exist
M M Theory
• Firm value is based on earnings power of the assets not on
the dividend decision of how such earning is being split.
Where:
– P0=Market price of share at time 0
– D1= Dividend per share to be received at time 1
– P1= Market price of the share at time 1
– K= Cost of equity capital
Example
• XYZ Ltd company has a cost of equity capital of 10%, the
current market price of the firm is Rs. 20,00,000 (1,00,000
shares@Rs.20). Firm’s current earning is Rs. 1,50,000 and the
firm plans to declare the Rs. 1 per share as dividend.
• Further, assume the value of the new investment is Rs.
6,80,000 which can be financed from the earnings available
for dividend payment.
• Calculate the value of the firm, if dividend is paid and
dividend is not paid.
Criticism of MM Hypothesis
• Tax Differential
• Existence of floatation cost (for companies issuing securities)
• Existence of transaction cost (for investor in selling the
securities)
• Diversification
• Uncertainty
Walter’s Model
• Developed by Prof. James E. Walter
• He opined that dividend policy and investment policy are
interlinked.
• The optimal dividend is determined by establishing a relationship
between internal rate of return and the cost of capital
• He proposed 3 types of situation
– When r>k (Growth firm)
– When r<k (Declining firm)
– When r=k (Normal firm)
Example
• Cost of Capital (k)= 10%
• EPS (E)= Rs 10
• IRR (r) = 15%, 10% and 8% respectively
• Calculate the value of shares under Walter Model assuming
that the D/P ratios are 0% , 40%, 75% and 100%.
Criticism of Watler’s Model
• All investments are financed by retained earnings
• Internal rate of return remains remain constant
• Cost of capital remains constant
Gordon’s Model
• Developed by Myron Gordon
Assumptions:
• All equity firm
• All investments are financed by retained earnings
• IRR and cost of capital remain constant
• Firm has perpetual life
• Corporate tax don’t exist
• Retention ratio once decided remains constant
• K>br=g
– Where
– P= Price of share
– E= Earnings per share
– B= Retention ratio
– Br=g= Growth rate in return
– R= Internal Rate of Return
Gordon’s Model
• He proposed 3 types of situation
– When r>k (Growth firm)
– When r<k (Declining firm)
– When r=k (Normal firm)
• Solve the example as given in case of Walter’s Model
• Interpretation
– For growth firm market value increases with retention ratio and
decreases with payout ratio
– For declining firm market value will decrease with retention ratio
and increases with payout ratio
– For normal firm market value is not affected by payout retio
Dividend under Uncertainty
• “Birds-in-the-hand” approach
• Extension of Gordon’s approach to incorporate two
additional assumption for normal firm (r=k). Even when r=k,
dividends matter under the condition of uncertainty as
investors tend to discount distant dividend than near
dividend because of two assumptions:
– Investors are risk-averse
– They put premium on certain return discount uncertain return
Residual Dividend theory
• Developed by Solomon and Pringle
• Dividend is paid only when earning are available after
meeting investment needs
Linter’s Dividend Model
• It is a dividend model that provides for determination of
expected dividend for future to reach a certain level of
dividend in long-run.
