GROUP MEMBERS: Mithu Dhanuki Austin Fernandes Pramod Gupta Suryakant Gupta Jitendra Alamzeb Khan 14 16 18 20 22 24

Introduction
Net earning has two parts- Retained earning and Dividends Retained earning used for further investment External source of financing- issue of debt or equity Dividends are paid in cash Dividend increases the value of share Should be paid to maintain the value of share

Objectives of Dividend Policy

Firms need for fund Shareholders need for income

Firms need for fund

When dividend decision is treated as financing decision, dividend should be paid only when firm does not have profitable investment opportunities. Retained earnings are preferred than external equity as they does not involve floatation costs. Growing firm generally keep major proportion of net earning.

Shareholders need for income

Some shareholders may prefer near dividends than future dividend or capital gain. High dividend may increase the value of share while low dividend may reduce it. Management should properly trade off between dividend and retained earning. Shareholders income may go against companys investment and long term growth.

Practical consideration in Dividend Policy

Generally firm retain one-third to half of the net earning. Depend upon firms financial needs, growth plans and investment opportunity. Preferences of firms shareholders. Risk taking capability of firm Firms constraints- financial and legal. Following of stable dividend policy.

Firms investment opportunity and financial needs

Growth firms have large number of investment opportunity hence they should give precedence to retention of earning. Matured firms have infrequent investment opportunity hence they should distribute most of their earning. It is argued that when IRR is greater than cost of capital, it is profitable to reinvest the net earning or most of it. Some companies prefer to raise external equity for financing investment decision.

Firms investment opportunity and financial needs

Director should retain some earnings to maintain the company as sound and solvent enterprise. Mature companies generally have fewer investment opportunity may have high payout ratio. Growth companies may have plenty of investment opportunity may have low payout ratio.

Shareholders expectation
Depends upon economic status, the effect of tax differential on dividends and capital gains. In closely held companies, director knows shareholders expectations well and frame dividend policy accordingly. Widely held companies Small investors. Retired or old person. Wealthy investors. Institutional investors avoid speculation.

Constraints on paying dividends

Legal restrictions. Like, Indian Companys act provides that dividend shall be declared or paid out of the current profits or the past profits after providing for depreciation. Greater the liquidity, greater ability to pay dividend. Mature firms are generally more liquid. Financial condition and borrowing capacity

Constraints on paying dividends

A high leveraged firm expected to retain more to strengthen its position. Raising much external equity will adversely affect the firms financial flexibility. Financial flexibility includes the firms ability to access external funds at later date. Access to capital market. Restriction in loan agreements. Lenders may put restrictions on dividend payment until some conditions met.

Control
If dividends are paid, cash may affected. As a result, company have to issue new share, The control of existing shareholders will be diluted if they do not want or cannot buy new shares. Hence payment of dividend may withheld and earning may be retained.

Stability of dividends
It has the positive effect on market price of the share. It also mean regularity in paying some dividend annually. Three forms of dividend stability -Constant dividend per share (dividend rate) -Constant payout -Constant dividend per share + extra dividend.

Constant dividend per share

In India, companies announces dividend as a percent of the paid-up capital per share. Dividend rate may increase.

EPS EPS & DPS

DPS

Time

Constant dividend per share

Easy to follow when earnings are stable. Company generally have reserves known as dividend equalization reserve It put ordinary shareholder at par with preference shareholder.

Constant Payout
The rate of dividend to earning is known as payout ratio. Some company may follow a policy of constant payout ratio. Paying a fixed percentage of earning per year. Amount of dividend fluctuates in direct proportion to earning. In losses, no dividend shall be paid.

Constant Payout
EPS EPS and DPS

DPS

Time

Constant Dividend per Share plus Extra Dividend

Generally adopted by companies with fluctuating earnings. Policy to pay a minimum dividend per share with a step up feature. Paying extra in period of prosperity. Known as interim dividend with final dividend. It helps in paying dividend without a default.

Issues in dividend policy

Maximizing shareholders return Dividend & Capital gain Payout ratio = dividend as a percentage of earning Retention ratio = 100 percent minus payout percent Growth = ROE * Retention ratio High payout companies will hove low growth rate for same ROE

Issues in dividend policy

Low policy payout may produce higher share price but not always Dividend is a current earning while capital gain is a future earning Dividend yield = dividend per share/ market price per share Dividend are generally taxed more than capital gain Dividend decision affected by dividend decision

Forms of dividends
Cash Dividends Bonus Shares (Stock Dividend)

Advantages of Bonus Shares

To shareholders:
y Tax benefit y Indication of higher future profits y Future dividends may increase y Psychological value

To company:
y Conservation of cash y Only means to pay dividend under financial

difficulty and contractual restrictions y More attractive share price

Limitations of Bonus Shares

Shareholders wealth remains unaffected Costly to administer Problem of adjusting EPS and P/E ratio

Conditions for the Issue of Bonus Shares

Residual reserve criterion Profitability criterion

Theories
On the relationship between dividend policy and value of firms Theories that consider dividend decision irrelevant Theories that consider dividend decision affects value of firm, It may affect positively or negatively

Walters model
Dividend policy affects value of firms Gives relationship between firms rate of return r, and cost of capital k. Assumptions Internal financing r and k is constant 100 percent payout or retention Constant EPS and DIV Infinite life

Walters Model
P = DIV + r ( EPS DIV ) / k k k P= infinite stream of (dividend + capital gain) For growth firm ( r > k ), retaining all earning will give max. market price per share. For normal firm ( r =k ), dividend policy has no effect. For declining firm ( r < k ), all earning should be distributed.

Criticism to Walters model

No external financing
r=k r>k r<k

Returns and Costs %

k = ka = km

E1

I*

Investment & Earning

Constant return, r Const. opportunity cost of capital

Gordons Model
Assumptions All equity firm, no debt. No external financing Constant return, r Constant cost of capital, k Perpetual income No corporate taxes Constant retention, const. growth rate g = r.b Cost of capital is greater than growth rate

Gordons Model
Po = EPS(1-b) / (k-b.r) Market value of share is equal to the present value of infinite stream of dividends. Since retained earnings are reinvested, earning will grow at g=b.r per period. If r=k; EPS=rA, (A=asset per share), Po=A If r<k; b=0, Po = rA/k If r>k; b=1, Po<0, hence b< k/r

MM Model
Miller-Modigliani Model (Dividend Irrelevance) Under perfect market situation, Dividend policy is irrelevant. Value of the firm depends upon firms earning from investment policy. Assumption Perfect capital market No taxes Fixed investment policy No risk of uncertainty

Three situations
Firm has sufficient cash to pay dividend Firm does not have sufficient cash to pay dividend so it issues new shares Firm does not pay dividend but shareholder need cash.

When firm has cash

Firm pays dividend Shareholder get cash Asset of the company reduced Its just a transfer of wealth No net gain or loss Firms value remained unaffected.

When firm doesn't have cash

Company issues new share Shareholder get cash They lose value of their claim as asset reduced New share holder gain Existing shareholder transfer a part of their claim to new shareholder No net gain or loss

Firm doesnt pay dividend

Shareholder sell a part of their share He exchanged a part of his claim on the firm to new shareholder for cash No net gain or loss

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