Dividend Theory

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Issues in Dividend Policy

Earnings to be Distributed High Vs. Low Payout. Objective Maximize Shareholders Return. Effects Taxes, Investment and Financing Decision.

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Walters Model

Assumptions Valuation Optimum Payout Ratio Criticism

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Assumptions

Internal Financing Constant Return and Cost of Capital 100% Payout or Retention Constant EPS and DIV Infinite Time

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Valuation

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.
P (DIV / k ) (r / k ) (EPS DIV) k

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Example
r 0.15, 0.10, 0.08 k 0.10 EPS Rs 10 DPS 40% (0.15 / 0.1) P (4 / 0.1) (10 4) Rs 130 0.1 (0.10 / 0.1) P (4 / 0.1) (10 4) Rs 100 0.1 (0.08 / 0.1) P (4 / 0.1) (10 4) Rs 88 0.1
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Optimum Payout Ratio

Growth Firms Retain all earnings Normal Firms No effect Declining Firms Distribute all earnings

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Criticism

No external Financing Constant Rate of Return Constant opportunity cost of capital

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Gordon's Model

Assumptions Valuation Optimum Payout Ratio Criticism

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

P EPS(1 b) /(k br )

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Example
r 0.15, 0.10, 0.08 k 0.10 EPS Rs 10 b 60% P (1 0.6) / 0.10 (0.15 * 0.6) = Rs 400 P 10(1 6) / 0.10 (0.10 * 0.6) = Rs 100 P 10(1 0.6) / 0.10 (0.08 * 0.6) = Rs 77

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Optimum Payout Ratio

Growth Firms Retain all earnings Normal Firms No effect Declining Firms Distribute all earnings

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Traditional Position

Graham and Dodd .the stock market is overwhelming in favour of liberal dividends as against niggardly dividends

P = m (D + E/3) PRICE = a + b DIVIDEND + c RE PRICE = a + b DIVIDEND + c RE + d RISK Measurement errors: earnings

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Miller and Modigliani Position

No advantage or disadvantage of tax associated with dividends Investment and Dividend decisions are independent No floatation or transaction cost

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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.
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1 Po ( D1 P ) 1 1 p 1 nPo {nD1 (n m) P mP } 1 1 1 p mP I1 ( X 1 nD1 ) 1 1 nPo {(n m) P I1 X 1} 1 1 p

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Dividend Policy
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Dividend Policy: Pay Out Ratio

Question

What should be the payout ratio? How stable should be the dividends over time?

Factors affecting payout

Funds requirement Liquidity Access to external sources of financing Shareholders preference Differences in cost of External and internal equity Control Taxes
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Dividend Policy: Stability

Stable dividend payout ratio Stable dividend Vs. steadily changing dividends

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Rational for Dividend Stability

Many individual investors depend on dividend income It has information content Steady dividend highly desirable feature by institutional investors

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Dividend as a Residual Payment

Pure residual dividend approach Fixed payout ratio approach Smoothed residual approach

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Corporate Dividend Behaviour

Most firms think primarily in terms the proportion of earnings that should be paid out as dividends rather than in terms the proportion of earnings that should be ploughed back in the firm Firm try to reach the target pay out over a period of time because stockholders prefer a steady progression of dividends
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Lintners Model

Dt crEPSt (1 c) Dt 1 Dt dividendpe rshare c adjustmentrate r t arg etpayoutrate

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Legal Aspect

Only cash dividend (except bonus) Out of profits only

Rate of dividend 10-12.5% reserves 2.5% Rate of dividend 12.5-15% reserves 5% Rate of dividend 15-20% reserves 7.5% Rate of dividend >20% reserves 10%

Out of accumulated profits

Average of 5 years or 10% of paid up capital Maximum reserve equal to 10% of paid up capital and free reserves can be drawn. First it should be utilised to set off losses Reserve should not fall below 15 % of its paid up capital

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No dividends for past years where accounts have been closed

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Procedural Aspect

Board resolution Shareholder approval Record date dividend payment

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