Dividend Theory

Objectives to understand
the issues of dividend policy
does dividend policy matters
bird-in-the-hand argument for paying current
dividends
the logic of the dividend irrelevance
Identify the market imperfections that make dividend
policy relevant
information content of dividend policy
 Dividend Theory
Dividend policy involves the balancing of the
shareholders desire for current dividends and
the firms needs for funds for growth.
 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
Walter's Model
Gordon's Model
Modigliani and Miller Hypothesis
The Bird in the Hand Argument
Informational Content
Market Imperfections
 DIVIDEND RELEVANCE: WALTERS MODEL
Walters model is based on the following assumptions:
Internal financing
Constant return and cost of capital
100 per cent payout or retention
Constant EPS and DIV
Infinite time
Walters formula to determine the market price per share:
 Optimum Payout Ratio

Growth Firms Retain all earnings

Normal Firms Distribute all earnings
Declining Firms No effect
Dividend Policy: Application of Walters Model
 Criticism of Walters Model
No external financing
Constant return, r
Constant opportunity cost of capital, k
 DIVIDEND RELEVANCE: GORDONS MODEL
Gordons model is based on the following assumptions:
All-equity firm
No external financing
Constant return
Constant cost of capital
Perpetual earnings
No taxes
Constant retention
Cost of capital greater than growth rate
 GORDONS MODEL : Valuation
Market value of a share is equal to the present
value of an infinite stream of dividends to be
received by shareholders.
Application of Gordons Dividend Model
 Under Gordons model it is revealed that :
The market value of the share, P0, increases with
the retention ratio, b, for firms with growth
opportunities , i.e., when r > k.

The market value of the share, P0, increases with

the payout ratio, (1-b), for declining firms with r
< k.

The market value of the share is not affected by

dividend policy when r = k.
 DIVIDEND AND UNCERTAINTY:
THE BIRD-IN-THE-HAND ARGUMENT
Argument was put forward 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 price.
 DIVIDEND IRRELEVANCE:
THE MILLERMODIGLIANI (MM) HYPOTHESIS
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.
It is based on the following assumptions:-
Perfect capital markets
No taxes
Investment policy
No risk
 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
 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
 Dividend Policy and Determinants

To understand;
Objectives of dividend policy in practice
Factors that influence a firms dividend policy
Importance of the stability of dividend
Significance and implications of bonus shares and
stock splits and the share buyback
Lintner's model of corporate behaviour of dividends
 OBJECTIVES OF DIVIDEND POLICY

Firms Need for Funds

Shareholders Need for Income

 Stable dividend policy
Regularity in paying some dividend annually,
The amount paid out regularly. This policy should be
followed, because by and large, shareholders favour this policy
and value stable dividends higher than the fluctuating ones.
The stable dividend may have a positive impact as the market
price of the share. This policy resolves uncertainty in the
minds of investors about future earnings, and satisfies the
desire of many investors, such as old, retired persons, etc.
If the companies change from the stable dividend policy to an
irregular or fluctuating dividend policy, it gives an
unfavourable signal to shareholders about the stability of the
firms operations.
 Significance of Stability of Dividends

Resolutions of investors uncertainty.

Investors desire for current income.
Institutional Investors Requirement.
Raising Additional Finances.
Factors affecting dividend decision (determinants)
a) Dividend payout ratio
i. EPS = PAT/Number of Shares,
ii. DPS = Profit distributed/ Number of Shares
iii. Dividend Payout ratio = DPS/EPS
 PRACTICAL CONSIDERATIONS IN DIVIDEND POLICY
b) Firms Investment Opportunities and Financial
Needs
c) Shareholders Expectations
d) Constraints on Paying Dividends
Legal restrictions
Liquidity
Financial condition and borrowing capacity
Access to the capital market
Restrictions in loan agreements
Inflation
Control
 STABILITY OF DIVIDENDS
When companies have consistency of payments of
dividends, market price of share P0 is stable and risk is
less.
Stability of dividend through
i. Constant Dividend per Share or Dividend Rate.
ii. Constant Payout.
iii. Constant Dividend per Share Plus Extra Dividend.
Factor affecting

i. Constant dividend per share i.e. what

ever be the EPS, you pay constant dividend
hence in case of higher EPS you may have
higher buildup reserves which could be
utilized in case of low EPS.
The policy of a company to pay fixed amount per
share or fixed rate on paid-up capital as dividend
every year, irrespective of fluctuations in the
earnings.
 Factor affecting

ii.Constant dividend payout ratio (ratio of

dividend to earnings) i.e. fixed percentage of net
earnings. What ever is the EPS you decide to pay
50% and retain 50%. So it depends on the EPS or
profit i.e. dividend fluctuate in direct proportion
to earnings.

with this policy, the amount of dividend will fluctuate

in direct proportion to earnings. Internal financing
with retained earnings is automatic when this policy is
followed
Factor affecting
iii. Constant dividend per share plus extra dividend The
policy to pay a minimum dividend per share with step-up
feature is desirable. The small amount of dividend is fixed to
reduce the possibility of ever missing dividend payment.

The extra dividend may be paid as an interim dividend in

periods of prosperity. Certain shareholders like this policy
because of the certain cash flow in the form of the regular
dividend and the option of earning extra dividend occasionally
i. Constant dividend per share policy
ii. Dividend policy of constant payout ratio
Factor affecting

Legal, contractual obligation

If you have taken some loan, out of operating
profits, you will have to pay interest, redemption
of debenture, payment of rent on lease, litigation
expenses, repayment of loan etc.

These obligations are to be met before the

payment of dividend. Some percentage of
debenture amounts has to be kept aside in
debenture redemption reserve a/c before
payment of dividend.
Factor affecting

Owner consideration
Look into the overall composition of shareholders.
They may want regular income out of their shares.
In a closely held company number of share
ownership is very limited. The profit in these cases
may be retained for future growth. For them
dividend policy is irrelevant.
In a widely held company where the number of
shareholders is very large, wants regular income,
retention of earning may not be an appropriate
step.
Factor affecting

Capital market consideration i.e. its reaction

Inflation rate/ PLR (prime lending rate)

If the risk-free rate of return (RFR) = 10% and
with more risk expected return (ER) will be
increases
ER= RFR + p ( p = risk premium)

Faith in management
Factor affecting

Liquidity position The overall liquidity of a company

has an effect on the dividend decision of a firm. In
the absence of sufficient cash, a firm may be unable
to pay dividends even if it has profits.
Capital Market Accessibility
The Financial Condition A high levered firm is
expected to retain more profits and distribute less
dividends in order to strengthen its equity base.
Factor affecting

Tax position of shareholder: Shareholders

expectation relating to dividends or capital gains
depends on their economic status, effect of
differential tax system, need for regular income,
etc
Factor affecting

Dividend Tax
Dividend tax is levied on the amount, which is paid,
and dividend tax is not paid on the profit retained.
Suppose, 12.5% is dividend tax payable on Rs 100
crore profit. If Rs 50 crore is retained and Rs 50
crore is paid out then,
Rs 50 crore tax-free (retained and used for
capitalization)
Rest Rs 50 crore Rs 6.25 crore = 43.75 crore
(which is paid and is taxed to the extent of 12.5%)
 Factor affecting

U/S 205 and 205-A, when dividend is declared it becomes a

current liability on part of the company to pay out with in a
period of 14 days. If the company fails to pay dividend after
elapse of one week after 14 days the company has to open a
scheduled bank a/c and transfer the unpaid amount to that
account.
If with in three years that amount remains unpaid
that then that bank a/c is transferred to general
account of central govt. i.e. central govt becomes the
custodial of the amount of shareholders. Thus cash
availability is the major factor in dividend decisions
whether to pay or not to pay dividend.
 FORMS OF DIVIDENDS
a. Cash Dividends
b. Bonus Shares (Stock Dividend)

Dividend in the form of share- Bonus share is

a way of distributing profit.
 BONUS ISSUE
XYZ Ltd. declares a 1:2 bonus issue, i.e. for every 2 shares held,
the shareholders receive 1 additional share.
Pre and Post Bonus Issue Balance Sheet (in Rs. million)

Liabilities Assets Liabilities Assets

Share capital 100 - Share capital 150 -
(10 million ( 15 million
shares of shares of
Rs. 10 each) Rs. 10 each)

Reserves 200 - Reserves 150 -

300 300

A shareholder who earlier had 2 shares will have 3 shares now.

Implications
- A bonus issue is merely a book entry.

No real change in the No change in the

fortune of the business value of the company

Earnings are same but number of shares increase EPS&MPS

 Advantages of Bonus Shares
To shareholders:
Tax benefit
Indication of higher future profits
Future dividends may increase
Psychological value
To company:
Conservation of cash
Only means to pay dividend under financial
difficulty and contractual restrictions
Shareholders satisfaction
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