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A dividend policy is the policy a company uses to decide how much it will pay out to shareholders in
It is concerned with financial policies regarding paying cash dividend in the present or paying an increased
dividend at a later stage.
Whether to issue dividends and what amount, is determined mainly on the basis of the company's
inappropriate profit (excess cash) and influenced by the company's long-term earning power. When cash
surplus exists and is not needed by the firm, then management is expected to pay out some or all of those
surplus earnings in the form of cash dividends or to repurchase the company's stock through a share buyback
(Read summary IMPandey page 455)
Definition of Dividend
Dividend is a distribution of part of the earnings of the company to its equity shareholders. The board of directors of the
company decide the dividend amount to be paid out to the shareholders. Mostly, dividend is stated as an amount each
equity share gets. It can also be stated as a percentage of the current market price.
Different Forms / Types of Paying Dividends
There are various forms of dividends that are paid out to the shareholders:

Cash Dividend: Cash dividend is the most common form of dividend. The shareholders are paid in cash per
share. The board of directors announce the dividend payment on the date of declaration. The dividends are
assigned to the shareholders on the date of record. The dividends are issued on the date of payment. But for
distributing cash dividends, the company needs to have positive retained earnings and enough cash for the
payment of dividends.

Bonus Share: Bonus share is also called as stock dividend. Bonus shares are issued by the company when
they have low operating cash, but still want to keep the investors happy. Each equity shareholder receives a
certain number of additional shares depending on the number of shares originally owned by the shareholder.

Share Repurchase: Share repurchase occurs when a company buys back its own shares from the market and
reduces the number of shares outstanding. This is considered as an alternative to the dividend payment as
cash is returned to the investors through another way.

Property Dividend: The Company makes the payment in the form of assets in the property dividend. The
asset could be any of these- equipment, inventory, vehicle or any other asset. The value of the asset has to be
restated at the fair value while issuing a property dividend.

Scrip Dividend: Scrip dividend is a promissory note to pay the shareholders later. This type of dividend is used
when the company does not have sufficient funds for the issuance of dividends.

Liquidating Dividend: When the company returns the original capital contributed by the equity shareholders
as a dividend, it is termed as liquidating dividend. It is often seen as a sign of closing down the company.

Advantages of Paying Dividends

Paying dividends to investors has several advantages, both to the investors and the company:

Investor Preference for Dividends: The investors are more interested in a company that pays stable
dividends. This assures them of a reliable source of earnings, even if the market price of the share dips.

Bird-in-hand Fallacy: This theory states that the shareholders prefer the certainty of dividends in comparison
to the possibility of higher capital gains in future.

Stability: Investors prefer companies that have a track record of paying dividends as it reflects positively on its
stability. This indicates predictable earnings to investors and thus, makes the company a good investment.

Benefits without Selling: Investors invested in dividend-paying stocks do not have to sell their shares to
participate in the growth of the stock. They reap the monetary benefits without selling the stock.

Temporary Excess Cash: A mature company may not have attractive venues to reinvest the cash or may have
fewer expenses related to R&D and expansion. In such a scenario, investors prefer that a company distributes
the excess cash so that they can reinvest the money for higher returns.

Information Signalling: When a company announces the dividend payments, it gives a strong signal about
the future prospects of the company. Companies can also take advantage of the additional publicity they get
during this time.

Disadvantages of Paying Dividends

Paying dividends also has several disadvantages:

Clientele Effect: If a dividend-paying company is unable to pay dividends for a certain period of time, it may
result in loss of old clientele who preferred regular dividends. These investors may sell-off the stock in short

Decreased Retained Earnings: When a company pays dividends, it decreases its retained earnings. Debt
obligations and unexpected expenses can rise if the company does not have enough cash.

Limits Companys Growth: Paying dividends results in reduction of usable cash which may limit the
companys growth. The company will have less money to invest in the business growth.

Logistics: The payment of dividends requires lot of record-keeping at the companys end. The company has to
ensure that the right owner of the share receives the dividend.

Walter's model
Walter's model shows the relevance of dividend policy and its bearing on the value of the share.
Assumptions of the Walter model
1. Retained earnings are the only source of financing investments in the firm, there is no external finance
2. The cost of capital, k e and the rate of return on investment, r are constant i.e. even if new investments
decisions are taken, the risks of the business remains same.
3. The firm's life is endless i.e. there is no closing down.

Basically, the firm's decision to give or not give out dividends depends on whether it has enough opportunities
to invest the retained earnings i.e. a strong relationship between investment and dividend decisions is
Model description
Dividends paid to the shareholders are reinvested by the shareholder further, to get higher returns. This is
referred to as the opportunity cost of the firm or the cost of capital, ke for the firm. Another situation where the
firms do not pay out dividends, is when they invest the profits or retained earnings in profitable opportunities to
earn returns on such investments. This rate of return r, for the firm must at least be equal to ke. If this happens
then the returns of the firm is equal to the earnings of the shareholders if the dividends were paid. Thus, it's
clear that if r, is more than the cost of capital ke, then the returns from investments is more than returns
shareholders receive from further investments.
Walter's model says that if r<ke then the firm should distribute the profits in the form of dividends to give the
shareholders higher returns. However, if r>ke then the investment opportunities reap better returns for the firm
and thus, the firm should invest the retained earnings. The relationship between r and k are extremely important
to determine the dividend policy. It decides whether the firm should have zero payout or 100% payout.
In a nutshell:

If r>ke, the firm should have zero payout and make investments.

If r<ke, the firm should have 100% payouts and no investment of retained earnings.

If r=ke, the firm is indifferent between dividends and investments.

Mathematical representation
Mandar Mathkar has given a mathematical model for the above made statements :


P = Market price of the share

D = Dividend per share

r = Rate of return on the firm's investments

ke = Cost of equity

E = Earnings per share'

The market price of the share consists of the sum total of:

the present value of an infinite stream of dividends

the present value of an infinite stream of returns on investments made from retained earnings.

Therefore, the market value of a share is the result of expected dividends and capital gains according to Walter.
Although the model provides a simple framework to explain the relationship between the market value of the
share and the dividend policy, it has some unrealistic assumptions.
1. The assumption of no external financing apart from retained earnings, for the firm make further
investments is not really followed in the real world.
2. The constant r and ke are seldom found in real life, because as and when a firm invests more the business
risks change.

Gordon's Model

Myron J. Gordon has also supported dividend relevance and believes in regular dividends affecting the share
price of the firm.[2]
The Assumptions of the Gordon model
Gordon's assumptions are similar to the ones given by Walter. However, there are two additional assumptions
proposed by him:
1. The product of retention ratio b and the rate of return r gives us the growth rate of the firm g.
2. The cost of capital ke, is not only constant but greater than the growth rate i.e. ke>g.
Model description
Investors are risk averse and believe that incomes from dividends are certain rather than incomes from future
capital gains, therefore they predict future capital gains to be risky propositions. They discount the future capital
gains at a higher rate than the firm's earnings, thereby evaluating a higher value of the share. In short, when
retention rate increases, they require a higher discounting rate. Gordon has given a model similar to Walter
mathematical formula to determine price of the share.
Mathematical representation
The market prices of the share is calculated as follows:


P = Market price of the share

E = Earnings per share

b = Retention ratio (1 - payout ratio)

r = Rate of return on the firm's investments

ke = Cost of equity

br = Growth rate of the firm (g)

Therefore the model shows a relationship between the payout ratio, rate of return, cost of capital and the market
price of the share.
Conclusions on the Walter and Gordon Model
Gordon's ideas were similar to Walter's and therefore, the criticisms are also similar. Both of them clearly state
the relationship between dividend policies and market value of the firm.

Long-Term Financing
Businesses need long-term financing for acquiring new equipment, R&D, cash flow enhancement and
company expansion. Major methods for long-term financing are as follows:

Equity Financing
This includes preferred stocks and common stocks and is less risky with respect to cash flow
commitments. However, it does result in a dilution of share ownership, control and earnings . The
cost of equity is also typically higher than the cost of debt - which is, additionally, a deductible
expense - and so equity financing may result in an increased hurdle rate which may offset any
reduction in cash flow risk.

Corporate Bond
A corporate bond is a bond issued by a corporation to raise money effectively so as to expand its
business. The term is usually applied to longer-term debt instruments, generally with a maturity date
falling at least a year after their issue date.
Some corporate bonds have an embedded call option that allows the issuer to redeem the debt
before its maturity date. Other bonds, known as convertible bonds, allow investors to convert the bond
into equity.

Capital Notes
Capital notes are a form of convertible security exercisable into shares. They are equity vehicles.
Capital notes are similar to warrants, except that they often do not have an expiration date or an
exercise price (hence, the entire consideration the company expects to receive, for its future issue of
shares, is paid when the capital note is issued). Many times, capital notes are issued in connection
with a debt-for-equity swap restructuring: instead of issuing the shares (that replace debt) in the
present, the company gives creditors convertible securities capital notes so the dilution will occur

Short-Term Financing
Short-term financing can be used over a period of up to a year to help corporations increase inventory
orders, payrolls and daily supplies. Short-term financing includes the following financial instruments:

Commercial Paper
This is an unsecured promissory note with a fixed maturity of 1 to 364 days in the global money
market. It is issued by large corporations to get financing to meet short-term debt obligations. It is only
backed by an issuing bank or corporation's promise to pay the face amount on the maturity date
specified on the note. Since it is not backed by collateral, only firms with excellent credit ratings from a
recognized rating agency will be able to sell their commercial paper at a reasonable price.
Asset-backed commercial paper (ABCP) is a form of commercial paper that is collateralized by other
financial assets. ABCP is typically a short-term instrument that matures between 1 and 180 days from
issuance and is typically issued by a bank or other financial institution.

Promissory Note
This is a negotiable instrument, wherein one party (the maker or issuer) makes an unconditional
promise in writing to pay a determinate sum of money to the other (the payee), either at a fixed or
determinable future time or on demand of the payee, under specific terms.

Asset-based Loan
This type of loan, often short term, is secured by a company's assets. Real estate, accounts
receivable (A/R), inventory and equipment are typical assets used to back the loan. The loan may be
backed by a single category of assets or a combination of assets (for instance, a combination of A/R
and equipment).

Repurchase Agreements
These are short-term loans (normally for less than two weeks and frequently for just one day)
arranged by selling securities to an investor with an agreement to repurchase them at a fixed price on
a fixed date.

Letter of Credit
This is a document that a financial institution or similar party issues to a seller of goods or services
which provides that the issuer will pay the seller for goods or services the seller delivers to a thirdparty buyer. The issuer then seeks reimbursement from the buyer or from the buyer's bank. The
document serves essentially as a guarantee to the seller that it will be paid by the issuer of the letter
of credit, regardless of whether the buyer ultimately fails to pay.

Capital Structure and its Theories

Capital structure is the proportion of all types of capital viz. equity, debt, preference etc. It is synonymously used as
financial leverage or financing mix. Capital structure is also referred as the degree of debts in the financing or capital of a

business firm. It is believed that with the change in capital structure, the value of a firm can be influenced. There are four
approaches to this, viz. net income, net operating income, traditional and M&M approach.

Assumptions and Definitions:

In order to grasp the capital structure and the cost of capital controversy property, the following
assumptions are made:
Firms employ only two types of capital: debt and equity.
The total assets of the firm are given. The degree of average can be changed by selling debt to purchase
shares or selling shares to retire debt.
The firm has a policy of paying 100 per cent dividends.
The operating earnings of the firm are not expected to grow.
The business risk is assumed to be constant and independent of capital structure and financial risk. The
corporate income taxes do not exist. This assumption is relaxed later on.
David Durand views, Traditional view and MM Hypothesis are tine important theories on capital structure.
1. David Durand views:
The existence of an optimum capital structure is not accepted by all. There exist two extreme views and a
middle position. David Durand identified the two extreme views the Net income and net operating
a) Net income Approach (Nl):
Under the net income (Nl) approach, the cost of debt and cost of equity are assumed to be independent of the
capital structure. The weighted average cost of capital declines and the total value of the firm rise with
increased use of average.
b) Net Operating income Approach (NOI):
Under the net operating income (NOI) approach, the cost of equity is assumed to increase linearly with
average. As a result, the weighted average cost of capital remains constant and the total of the firm also
remains constant as average changed.

Thus, if the Nl approach is valid, average is a significant variable and financing decisions have an important
effect on the value of the firm, on the other hand, if the NOI approach is correct, then the financing decision
should not be of greater concern to the financial manager, as it does not matter in the valuation of the firm.
2. Traditional view:
The traditional view is a compromise between the net income approach and the net operating approach.
According to this view, the value of the firm can be increased or the cost, of capital can be reduced by the
judicious mix of debt and equity capital.
This approach very clearly implies that the cost of capital decreases within the reasonable limit of debt and
then increases with average. Thus an optimum capital structure exists and occurs when the cost of capital is
minimum or the value of the firm is maximum.
The cost of capital declines with leverage because debt capital is chipper than equity capital within reasonable,
or acceptable, limit of debt. The weighted average cost of capital will decrease with the use of debt. According
to the traditional position, the manner in which the overall cost of capital reacts to changes in capital structure
can be divided into three stages and this can be seen in the following figure.

1. The traditional view is criticised because it implies that totality of risk incurred by all security-holders of a firm
can be altered by changing the way in which this totality of risk is distributed among the various classes of

2. Modigliani and Miller also do not agree with the traditional view. They criticise the assumption that the cost of
equity remains unaffected by leverage up to some reasonable limit.
3. MM Hypothesis:
The Modigliani Miller Hypothesis is identical with the net operating income approach, Modigliani and Miller
(M.M) argue that, in the absence of taxes, a firms market value and the cost of capital remain invariant to the
capital structure changes.
The M.M. hypothesis can be best explained in terms of two propositions.
It should however, be noticed that their propositions are based on the following assumptions:
1. The securities are traded in the perfect market situation.
2. Firms can be grouped into homogeneous risk classes.
3. The expected NOI is a random variable
4. Firm distribute all net earnings to the shareholders.
5. No corporate income taxes exist.
Proposition I:
Given the above stated assumptions, M-M argue that, for firms in the same risk class, the total market value is
independent of the debt equity combination and is given by capitalizing the expected net operating income by
the rate appropriate to that risk class.
This is their proposition I and can be expressed as follows:

According to this proposition the average cost of capital is a constant and is not affected by leverage.

M-M opinion is that if two identical firms, except for the degree of leverage, have different market values or the
costs of capital, arbitrary will take place to enable investors to engage in personal leverage as against the
corporate leverage to restore equilibrium in the market.
Proposition II: It defines the cost of equity, follows from their proposition, and derived a formula as follows:
Ke = Ko + (Ko-Kd) D/S
The above equation states that, for any firm in a given risk class, the cost of equity (Ke) is equal to the constant
average cost of capital (Ko) plus a premium for the financial risk, which, is equal to debt-equity ratio times the
spread between the constant average of capita and the cost of debt, (Ko-Kd) D/S.
The crucial part of the M-M hypothesis is that Ke will not rise even if very excessive raise of leverage is made.
This conclusion could be valid if the cost of borrowings, Kd remains constant for any degree of leverage. But in
practice Kd increases with leverage beyond a certain acceptable, or reasonable, level of debt.
However, M-M maintain that even if the cost of debt, Kd, is increasing, the weighted average cost of capital,
Ko, will remain constant. They argue that when Kd increases, Ke will increase at a decreasing rate and may
even turn down eventually. This is illustrated in the following figure.

The shortcoming of the M-M hypothesis lies in the assumption of perfect capital market in which arbitrage is
expected to work. Due to the existence of imperfections in the capital market/arbitrage will fail to work and will
give rise to discrepancy between the market values of levered and unlevered firms