Dividend Definition, Theories, Forms

By, Poornima Vijayakumar Lakshmi Suresh

Definition
A sum of money paid regularly by a company to its shareholders out of its profits (or reserves). Typically, when a company is making a profit, it distributes those profits to its owners (the shareholders) by way of a dividend.
When a company makes a profit, some of this money is typically reinvested in the business and called retained earnings, and some of it can be paid to its shareholders as a dividend. Paying dividends reduces the amount of cash available to the business.

DIVIDEND DECISION
One of the three basic decisions of a financial manager, the other two being investment decision and financing decision. Decision as to whether the firms profits should be paid as dividend or retained and in what amount. Objective : -Maximize wealth of shareholders, -Increase the goodwill of the firm, -Satisfy the obligations to shareholders.

Dividend Policy
Dividend Policy refers to the decision of the Board of Directors regarding the amount of residual earnings (past or present) that should be distributed to the shareholders of the corporation. This decision is considered a financing decision because the profits of the corporation are an important source of financing available to the firm.

Factors influencing dividend policy : Past dividend rate Age of company Liquidity of funds Stability in earning Expectations of shareholders Legal restrictions

Dividend Theories Relevance Theories Irrelevance Theories

RELEVANCE THEORYby Myron J. Gordon and John Lintner

Dividend policy is very important for any business firm as it affects the overall value of the firm. Dividend relevance theory suggests that investors are generally risk averse and would rather have dividends today than possible share appreciation and dividends tomorrow. According to this theory, optimal dividend policy should be determined which will ensure maximization of the wealth of the shareholders. Shareholders prefer current dividends & hence there is a direct relationships between the dividend policy & the market value of the firm.

IRRELEVANCE THEORYby Merton H. Miller and Franco Modigliani, (M&M)

Dividend policy is irrelevant to maximizing the shareholders wealth. The theory implies that retained earnings belong to the shareholders of the company and shareholders are not concerned whether money is used to pay out dividends or for investment purposes because they benefit either way by receiving dividends or via share price appreciation. If investors will require cash, they can always sell a few of the shares which increased in value due to investments. Value of the firm is affected by the earning capacity of the firm i.e., the investment policy and not the dividend policy. Whether the firm retains its earnings or pays dividend, the market price of the share is indifferent towards it.

WALTER MODEL :
Dividend policy affects the value of the firm. Together, the cost of capital ( k ) and rate of return ( r) determine the dividend policy that will maximize the shareholders wealth.

RATE OF RETURN(r) VALUE OF THE FIRM DIVIDEND POLICY COST OF CAPITAL(k)

WALTER MODEL -- assumptions :

The firm finances all investment through retained earnings while debt and new equity is not used. Business risk remains constant i.e., r & k are also constant. The firm has infinite life. The firm either goes for a 100% pay-out or a 100% retention

WALTER MODEL DECISIONS

CONDITION

r >k
EVALUATION TYPE OF FIRM Growth firm PAY-OUT RATIO

r<k
Declining firm

r=k
Normal firm

Zero
INVESTMENT OPPORTUNITIES DECISION Abundant Company should retain all earnings for investment.

100%
Very few Company should distribute all earnings in form of dividends.

Discretion
Optimal Dividend does not affect market price of share

WALTER MODEL -- criticisms :

It ignores the benefit of optimal capital structure. Assumption that k remains constant does not hold good in practice. It ignores that market price is affected by many factors.

GORDONS MODEL
Dividend policy is relevant to the value of the company. Also known as the bird in hand argument Dividend policy is relevant as the investors prefer current dividends as against the future uncertain capital gains. Gordon and Lintner argued that investors value dividends more than capital gains when making decisions related to stocks. The bird-in-the-hand may sound familiar as it is taken from an old saying: "a bird in the hand is worth two in the bush." In this theory "the bird in the hand' is referring to dividends and "the bush" is referring to capital gains.

GORDONS MODEL -- assumptions :

No external financing is available. The firm has infinite life. Investors are basically risk-averse. The growth rate of firm g is the product of its retention ratio b and its rate of return r, i.e., g = br. The cost of capital is constant and also more than growth rate, i.e., k > g Corporate tax does not exist.

GORDONS MODEL -- decisions :

If r > k >g company should distribute less dividend and retain high profit If r < k company should distribute more profits as dividend

If r = k payout ratio is not affected by retention ratio.

MODIGILANI & MILLER MODEL

.Modigilani and Miller were two staunch supporters of the irrelevance concept. The value of the firm is not affected by the decision of pay-out or plough-back. Firms dividend policy have no influence on the market price of the shares

M& Ms Model CRUX

MM's dividend-irrelevance theory says that investors can affect their return on a stock regardless of the stock's dividend. For example, suppose, from an investor's perspective, that a company's dividend is too big. That investor could then buy more stock with the dividend that is over the investor's expectations. Likewise, if, from an investor's perspective, a company's dividend is too small, an investor could sell some of the company's stock to replicate the cash flow he or she expected. As such, the dividend is irrelevant to investors, meaning investors care little about a company's dividend policy since they can simulate their own.

M-M MODEL -- assumptions :

Perfect capital market. There are no taxes. Investment policy is fixed. No flotation cost on issue of shares. Investors behave rationally.

M-M MODEL -- criticisms :

There is perfect capital market condition is not always true. It is wrong to assume that there are no taxes, flotation costs do not exist