Dividend Policy

Meaning and Types of Dividend

The word dividend is derived from the word dividendum which means total divisible sum. It is that share of profit which is distributed among shareholders. It provides information about company. As 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 Types: 1. Cash Dividend 2. Stock Dividend 3. Scrip or Bond Dividend 4. Property Dividend

Dividend Policy
Dividend Policy is the policy which concerns quantum of profits to be distributed by way of dividend. Dividend Policy determines the division of earnings between payments to shareholders and retained earnings Types of Dividend Policy: 1. Conservative or Strict Dividend Policy 2. Liberal Dividend Policy 3. Irregular Dividend Policy 4. Sound or Stable Dividend Policy

Sound or Stable Dividend Policy

Patterns: 1. Constant Dividend per share 2. Constant Pay-out ratio 3. Constant Dividend per share plus extra dividend Advantages: 1. Sign of continued normal operations of company. 2. Stablise the market value of shares. 3. Creates confidence among shareholders. 4. Improves credit standing of company. 5. Resolutions of investors uncertainty. 6. Institutional Investors Requirement. Limitations: 1. Difficult to make changes in the policy. 2. Difficult to be followed in case of insufficient profits.

Practical Consideration in Paying Dividends or Factors affecting (determinants) of Dividend Policy

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. Financial Need of company Magnitude and trend of earning Liquidity position Shareholders Expectations Nature of the industry Cyclical Variation Age of the company Structure of ownership (Closely / Widely Held Company) Legal Restrictions Restriction by lending institutions State of Capital Market Taxation Policy

Issues in Dividend Policy

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

Relevance Vs. Irrelevance

Relevance concept of Dividend: this hold that there is a direct relationship between dividend policy and the value in terms of market price of shares. It is represented by following two theories: a. Walter's Model b. Gordon's Model Irrelevance concept of Dividend: According to this concept dividend are irrelevant or are a passive residual. As per this concept, investors are indifferent between capital; gains and dividend. The ultimate desire of investor is to earn higher return. It is explained through Modigliani and Miller apprach.

Walters Model
Assumptions: 1. Internal Financing 2. Constant Return and Cost of Capital 3. 100% Payout or Retention 4. Constant EPS and DIV 5. Infinite Time 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

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

Cont.

Optimum Payout Ratio: Growth Firms Retain all earnings Normal Firms Distribute all earnings Declining Firms No effect Criticism: No external Financing Constant Rate of Return Constant opportunity cost of capital

Gordon's Model
Assumptions: 1. All Equity Firm 2. No External Financing 3. Constant Return and Cost of Capital 4. Perpetual Earnings 5. No Taxes 6. Constant Retention 7. Cost of Capital greater than Growth Rate 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 )

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

Cont. Optimum Payout Ratio Growth Firms Retain all earnings Normal Firms Distribute all earnings Declining Firms No effect The Bird in the Hand: Argument put forward, first of all, by Kirshman Investors are risk averters. They consider distant dividends as less certain than near dividends. Rate at which an investor discounts his dividend stream from a given firm increases with the futurity of dividend stream and hence lowering share prices.

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.

Market Imperfections
Tax Differential Low Payout Clientele Flotation Cost Transaction and Agency Cost Information Asymmetry Diversification Uncertainty High Payout Clientele Desire for Steady Income No or Low Tax on Dividends