DIVIDEND POLICY Dividend is the return on equity share holders which is the result of earnings after tax.

Dividend distribution policy for a firm depends on various factors which are elaborated in various theories divided into two parts. 1) The dividend decisions of a firm relevance / irrelevance 2) Models explaining relevance / irrelevance of dividend policy Dividend decisions: Based on the relevance of dividend to the current market price of the share or the value of the share the theories are classified as follows Relevant Models 1) Traditional position 2) Walter model 3) Gordon model Irrelevant Model 1) Miller & Modigliani position 2) Rational expectations model 1) Traditional position : B Graham and D L Dodd: P/E ratios are directly related to D/P ratios High D/P increases P/E ratio Market price of a share (P) = m (D + E/3)

Where P = Market place, m = multiplier, D = DPS and E = EPS 2) Walter Model: James E Walter: It gives the relationship between IRR (r) and Cost of capital of the firm which gives a dividend policy to maximize wealth. It gives in 3 ways.

Assumptions 1) Retained earnings are the only source of finance 2) r and k constant 3) Infinite companies firms life 4) DPS and EPS remain constant Propositions a) r > ke : Market value decreases as the DP ratio increases. b) r < ke : Market value increases as the DP ratio increases. c) r = ke : Market value remains same at any DP ratio. P = D + Ke r(E-D)/ke ke

3) GORDONS DIVIDEND CAPITALIZATION MODEL: Given by Myron Gordon. Similar to walter model but considers current dividends Assumptions 1) 100% equity firm 2) Retention ratio and growth rates are constant 3) Investors are rational and risk averse 4) Investors prefer certain to uncertain returns 5) Ke > br (Cost of equity is greater than growth = E (1-b) Ke br Propositions a) r > ke : Market value decreases as the DP ratio increases. b) r < ke : Market value increases as the DP ratio increases. P

c) r = ke : Market value remains same at any DP ratio. 4) Modigliani and Miller Model: Irrelevant Model a) Rational investors and perfect market b) No taxes c) Investment policy will not change the risk complexion d) Rate of return not influenced by source of finance (Retained earnings) Formulas 1) Price Current price (P0) = D1+ P1 (1+Ke) Expected price (P1) = P0(1+ke) D1

2) Amount to be raised for new capital requirements n1 P1 = I(E- nD1) 3) No of shares to be issued n1 = n1P1 P1 4) Value of the firm

nP0

= (n+n1)P1 I + E (1+ ke)

Where n n1 = Number of existing shares = Number of additional shares

P0 P1 I nD1 E

= Current price = Price after 1 year = Total investment required = Total Dividends paid = Earnings during the period

E-nD1= Retained earnings Critics 1) Tax effect 2) Floatation cost 3) Transaction cost 4) Market conditions 5) Under pricing of shares 5) RATIONAL EXPECTATIONS MODEL Proposition As long as the dividend rate is up to the expectations there is no impact of dividend declaration on market price. a) If dividends are above the expectations, price goes up b) If dividends are below the expectations, price goes up DIVIDEND MODELS It has two basic models as follows 1) Relevant Models a. Traditional position b. Walter model

c. Gordon model 2) Irrelevant Model a. Miller & Modigliani position b. Rational expectations model Relevant models a) TRADITIONAL MODEL: B Graham and D L Dodd P/E ratios are directly related to D/P ratios High D/P increases P/E ratio

E P = m D + 3 Where P = Market Price m = multiplier D = DPS E = EPS

b) WALTER MODEL: James E Walter It gives the relationship between IRR (r) and Cost of capital of the firm which gives a dividend policy to maximize wealth. It gives in 3 ways Assumptions 5) Retained earnings are the only source of finance 6) r and k constant 7) Infinite companies firms life 8) DPS and EPS remain constant

Propositions d) r > ke : Market value decreases as the DP ratio increases. e) r < ke : Market value increases as the DP ratio increases. f) r = ke : Market value remains same at any DP ratio.

PO =

D r ( E D) k e + ke ke

c) GORDONS DIVIDEND CAPITALIZATION MODEL: Myron Gordon Similar to Walter model but considers current dividends Assumptions 6) 100% equity firm 7) Retention ratio and growth rates are constant 8) Investors are rational and risk averse 9) Investors prefer certain to uncertain returns 10) Ke > br (Cost of equity is greater than growth

= E (1-b) Ke br

Propositions a) r > ke : Market value decreases as the DP ratio increases. b) r < ke : Market value increases as the DP ratio increases. c) r = ke : Market value remains same at any DP ratio.

Irrelevant Model a) MODIGLIANI AND MILLER MODEL: Irrelevant Model e) Rational investors and perfect market f) No taxes g) Investment policy will not change the risk complexion h) Rate of return not influenced by source of finance (Retained earnings) Formulas Current Price PO = D1 + P1 (1 + k e )

Expected Price P1 = P0 (1 + k e ) D1 Amount to be raised for new capital requirements n1 P1 = I ( E nD1 ) No of shares to be issued n1 = n1 P1 P1

Value of the firm nPo =

( n + n1 ) P1 I + E
(1 + k e )

Where n n1 P0 P1 I nD1 E = Number of existing shares = Number of additional shares = Current price = Price after 1 year = Total investment required = Total Dividends paid = Earnings during the period

E-nD1 = Retained earnings

Critics 1) Tax effect 2) Floatation cost 3) Transaction costs 4) Market conditions 5) Under pricing of shares

b) RATIONAL EXPECTATIONS MODEL Proposition As long as the dividend rate is up to the expectations there is no impact of dividend declaration on market price. a) If dividends are above the expectations, price goes up b) If dividends are below the expectations, price goes up

DIVIDEND DECISIONS These are the decisions made by the directors of a company which are related to the amount and timing of any cash payments made to the company's stockholders. It is an important decision to make as it may influence its capital structure and stock price. In addition, the decision may determine the amount of taxation that stockholders pay. Following are the important factors influencing dividend decision 1) Free-cash flow

2) Dividend clienteles 3) Information signalling

Free cash flow theory of dividends Under this theory, the dividend decision is very simple. The firm simply pays out, as dividends, any cash that is surplus after it invests in all available positive net present value projects. A key criticism of this theory is that it does not explain the observed dividend policies of real-world companies. Most companies pay relatively consistent dividends from one year to the next and managers tend to prefer to pay a steadily increasing dividend rather than paying a dividend that fluctuates dramatically from one year to the next. These criticisms have led to the development of other models that seek to explain the dividend decision.

Dividend clienteles A particular pattern of dividend payments may suit one type of stock holder more than another. A retiree may prefer to invest in a firm that provides a consistently high dividend yield, whereas a person with a high income from employment may prefer to avoid dividends due to their high marginal tax rate on income. If clienteles exist for particular patterns of dividend payments, a firm may be able to maximise its stock price and minimise its cost of capital by catering to a particular clientele. This model may help to explain the relatively consistent dividend policies followed by most listed companies.

A key criticism of the idea of dividend clienteles is that investors do not need to rely upon the firm to provide the pattern of cash flows that they desire. An investor who would like to receive some cash from their investment always has the option of selling a portion of their holding. This argument is even more cogent in recent times, with the advent of very low-cost discount stockbrokers. It remains possible that there are taxationbased clienteles for certain types of dividend policies.

Information signaling A model developed by Merton Miller and Kevin Rock in 1985 suggests that dividend announcements convey information to investors regarding the firm's future prospects. Many earlier studies had shown that stock prices tend to increase when an increase in dividends is announced and tend to decrease when a decrease or omission is announced. Miller and Rock pointed out that this is likely due to the information content of dividends. When investors have incomplete information about the firm (perhaps due to opaque accounting practices) they will look for other information that may provide a clue as to the firm's future prospects. Managers have more information than investors about the firm, and such information may inform their dividend decisions. When managers lack confidence in the firm's ability to generate cash flows in the future they may keep dividends constant, or possibly even reduce the amount of dividends paid out. Conversely, managers that have access to information that indicates very good future prospects for the firm (e.g. a full order book) are more likely to increase dividends.

Investors can use this knowledge about managers' behaviour to inform their decision to buy or sell the firm's stock, bidding the price up in the case of a positive dividend surprise, or selling it down when dividends do not meet expectations. This, in turn, may influence the dividend decision as managers know that stock holders closely watch dividend announcements looking for good or bad news. As managers tend to avoid sending a negative signal to the market about the future prospects of their firm, this also tends to lead to a dividend policy of a steady, gradually increasing payment.

Conclusion In a fully informed, efficient market with no taxes and no transaction costs, the free cash flow model of the dividend decision would prevail and firms would simply pay as a dividend any excess cash available. The observed behaviours of firm differs markedly from such a pattern. Most firms pay a dividend that is relatively constant over time. This pattern of behavior is likely explained by the existence of clienteles for certain dividend policies and the information effects of announcements of changes to dividends. The dividend decision is usually taken by considering at least the three questions of: how much excess cash is available? What do our investors prefer? and What will be the effect on our stock price of announcing the amount of the dividend? The result for most firms tends to be a payment that steadily increases over time, as opposed to varying wildly with year-to-year changes in free cash flow.

Buy Back offers in India Amount Year (Rs.crore) Issues No. of

_________ 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 (as on 31/12/11)

_________ 1 300 1,297 2,154 1,011 52 3,600 363 295 2,004 4,221 824 4,295 2,738 ________ 23,155

_________ 1 12 14 27 31 8 11 10 7 10 46 20 20 23 ________ 240