Define dividend policy? A company's stance on whether it will pay out profits as dividends or keep them as retained earnings.

If the company decides to issue dividends, the policy will outline whether or not the dividends will be issued on an ongoing basis, or if the dividend payout will be infrequent.

theory of dividend policy Walter's model Walter's model shows the relevance of dividend policy and its bearing on the value of the share.[2] Assumptions of the Walter model 1. Retained earnings are the only source of financing investments in the firm, there is no external finance involved. 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. Model description 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. 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 Walter has given a mathematical model for the above made statements:

Where,

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'

Criticism 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. 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 Investor's 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. Gordon has given a model similar to Walter's where he has given a mathematical formula to determine price of the share. Mathematical representation The market price of the share is calculated as follows:

Where,

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.

Modigliani-Miller theorem The ModiglianiMiller theorem states that the division of retained earnings between new investment and dividends do not influence the value of the firm. It is the investment pattern and consequently the earnings of the firm which affect the share price or the value of the firm. Assumptions of the MM theorem The MM approach has taken into consideration the following assumptions: 1. 2. 3. 4. 5. 6. There is a rational behavior by the investors and there exists perfect capital markets. Investors have free information available for them. No time lag and transaction costs exist. Securities can be split into any parts i.e. they are divisible No taxes and floatation costs. The investment decisions are taken firmly and the profits are therefore known with certainty. The dividend policy does not affect these decisions.

Determinants of Dividend Policy Dividend refers to the corporate net profits distributed among shareholders. Dividends can be both preference dividends and equity dividends. Preference dividends are fixed dividends paid as a percentage every year to the preference shareholders if net earnings are positive. After the payment of preference dividends, the remaining net profits are paid or retained or both depending upon the decision taken by the management. Determinants of Dividend Policy 1. 2. 3. 4. 5. 6. The main determinants of dividend policy of a firm can be classified into: Dividend payout ratio Stability of dividends Legal, contractual and internal constraints and restrictions Owner's considerations Capital market considerations and Inflation.

Write down the factors that influence the dividend decision of a corporate firm? Factors Affecting Dividend Policy: 1. External Factors 2. Internal Factors External Factors Affecting Dividend Policy 1. General State of Economy:

2. State of Capital Market: Favorable Market: liberal dividend policy. Unfavorable market: Conservative dividend policy. 3. Legal Restrictions: Companies Act has laid down various restrictions regarding the declaration of dividend: Dividends can only be paid out of: Payment of dividend out of capital is illegal. A company cannot declare dividends unless: 4. Contractual Restrictions: Lenders sometimes may put restrictions on the dividend payments to protect their interests (especially when the firm is experiencing liquidity problems) Internal Factors affecting dividend decisions 1. Desire of the Shareholders: [i] Capital Gains: i.e., an increase in the market value of shares. [ii] Dividends: regular return on their investment. [i] It reduces uncertainty (capital gains are uncertain). [iii] Need for income: Some invest in shares so as to get regular income to meet their living expenses. 2. Financial Needs of the Company: If the company has profitable projects and it is costly to raise funds, it may decide to retain the earnings. 3. Nature of earnings: A company which has stable earnings can afford to have an higher divided payout ratio 4. Desire to retain the control of management: Additional public issue of share will dilute the control of management. 5. Liquidity position: Payment of dividend results in cash outflow. A company may have adequate earning but it may not have sufficient funds to pay dividends Capital Structure' Definition of 'Optimal Capital Structure' The best debt-to-equity ratio for a firm that maximizes its value. The optimal capital structure for a company is one which offers a balance between the ideal debt-to-equity ranges and minimizes the firm's cost of capital. Factors that influence the optimal capital structure of a firm The primary factors that influence a company's capital-structure decision are: 1.Business risk 2.Company's tax exposure 3.Financial flexibility 4. Management style

5.Growth rate 6.Market Conditions

1. Business Risk Excluding debt, business risk is the basic risk of the company's operations. The greater the business risk, the lower the optimal debt ratio. 2.Company's Tax Exposure Debt payments are tax deductible. As such, if a company's tax rate is high, using debt as a means of financing a project is attractive because the tax deductibility of the debt payments protects some income from taxes. 3. Financial Flexibility This is essentially the firm's ability to raise capital in bad times. It should come as no surprise that companies typically have no problem raising capital when sales are growing and earnings are strong. 4.Management Style Management styles range from aggressive to conservative. The more conservative a management's approach is, the less inclined it is to use debt to increase profits. An aggressive management may try to grow the firm quickly, using significant amounts of debt to ramp up the growth of the company's earnings per share (EPS). 5.Growth Rate Firms that are in the growth stage of their cycle typically finance that growth through debt, borrowing money to grow faster. The conflict that arises with this method is that the revenues of growth firms are typically unstable and unproven. As such, a high debt load is usually not appropriate. 6.Market Conditions Market conditions can have a significant impact on a company's capital-structure condition. Suppose a firm needs to borrow funds for a new plant. Assumptions of of capital structure The capital structure theories have the following assumptions: There are no corporate taxes (this assumption has been removed later).The firms use only 2 sources of financing namely perpetual debts ad equity sharesThe firms pay 100% of the earnings as dividend. This means that the dividend pay-out ratio is 100% and there are no earnings that are retained by the firms.The total assets are given which do not change and the investment decisions areassumed to be constant.Business risk is constant over time and it is assumed that it is independent ofthe capital structure.The firm has a perpetual life.The firms earnings before interest and taxes are not expected to grow.The firms total financing remains constant. The firms degree of leverage can be altered either by selling shares and to retire the debt using the proceeds or by raising more debt and reduce the equity financing.All the investors are assumed to have the same subjective probability distribution of the future expected operating profits for a given firm.

1st Theory of Capital Structure

Name of Theory = Net Income Theory of Capital Structure This theory gives the idea for increasing market value of firm and decreasing overall cost of capital. A firm can choose a degree of capital structure in which debt is more than equity share capital. It will be helpful to increase the market value of firm and decrease the value of overall cost of capital. Debt is cheap source of finance because its interest is deductible from net profit before taxes. After deduction of interest company has to pay less tax and thus, it will decrease the weighted average cost of capital. For example if you have equity debt mix is 50:50 but if you increase it as 20: 80, it will increase the market value of firm and its positive effect on the value of per share. High debt content mixture of equity debt mix ratio is also called financial leverage. Increasing of financial leverage will be helpful to for maximize the firm's value.

2nd Theory of Capital Structure Name of Theory = Net Operating income Theory of Capital Structure Net operating income theory or approach does not accept the idea of increasing the financial leverage under NI approach. It means to change the capital structure does not affect overall cost of capital and market value of firm. At each and every level of capital structure, market value of firm will be same.

3rd Theory of Capital Structure Name of Theory = Traditional Theory of Capital Structure This theory or approach of capital structure is mix of net income approach and net operating income approach of capital structure. It has three stages which you should understand:

Ist Stage In the first stage which is also initial stage, company should increase debt contents in its equity debt mix for increasing the market value of firm. 2nd Stage

In second stage, after increasing debt in equity debt mix, company gets the

position of optimum capital structure, where weighted cost of capital is minimum and market value of firm is maximum. So, no need to further increase in debt in capital structure. 3rd Stage

Company can gets loss in its market value because increasing the amount of debt

in capital structure after its optimum level will definitely increase the cost of debt and overall cost of capital.

MM theory MM Proposition 1 with Zero Taxes The value of a firm is independent of its capital structure. Value depends solely on the level and risk of the firms cash flow V U = value of unlevered firm (no debt) V L = value of levered firm (has debt) and V L = V U = EBIT capitalized at WACC, since with zero growth reinvestment is zero; r su and r sL are the returns to the stock of an unlevered and levered firm, respectively

6. MM Proposition 2 with Zero Taxes The cost of equity of a levered firm is equal to the cost of equity of an unleveled firm plus a risk premium which depends on the degree of financial leverage. Reductions in capital costs as a result of using more lower cost debt are exactly offset by increases in the cost of levered equity due to added financial risk.