MODULE 6 DIVIDEND MODELS, DECISIONS & POLICY & FIRM VALUATION Dividend Models Dividend policy of a firm decides

es what portion of earnings is paid as dividends to ordinary shareholders and what portion is ploughed back in the firm for investment purpose. The alternative uses of earnings or net profit dividend pay-out and retention are competitive and conflicting, since it affects the value of the firm. Payment of dividends has two opposing effects: i! it increases current income to shareholders, thereby stock price, and, ii! it reduces the funds available for investment, which reduces growth rate, thereby stock price. Therefore, the firm"s optimal dividend policy must strike a balance between current dividends payout! and future growth retention!. There are two schools of thought regarding dividend decision and value of shares. #ne school comprising of $.%. &alter, '.$. (ordon, %)ra *olomon and (itman! believes that dividend decision relevant to value of shares, while other school comprising mainly of 'odigliani + 'iller! emphasi)es on its irrelevance. A. Dividend Relev n!e T"eo#ies $ l%e#&s Model $ames %. &alter has proposed a model of share valuation that supports the view that the dividend policy of a firm has a bearing on its market value. The model is based on: i! ii! ,eturn on -nvestment or -nternal ,ate of ,eturn r !, and .ost of .apital or ,e/uired ,ate of ,eturn k!

0 firm"s optimal dividend policy is determined, based on the relationship between internal rate of return r !, and cost of capital

k!. -n other words, if 1 r " e2ceeds 1k 1, the firm should retain the earnings, whereas it should distribute the earnings as dividends, when 1 r " is less than 1k 1. -t indicates that when r3k, the firm will be able to earn more than what shareholders could by investing elsewhere, if earnings are paid to them. Thus, the model relates the payment of earnings as dividend or retention of earnings to available capital budgeting or investment pro4ects. 5or the above purpose, the model classifies firms into three groups, namely, 6! (rowth firms, 7! 8ormal firms, and 9! Declining firms. 6. (rowth 5irms: (rowth firms are those firms, which have profitable investment pro4ects which provide a return that is greater than k i.e., r3k!. 5or such firms, the optimum dividend policy is 6:: per cent retention or dividend payout is ;)ero<. -n other words, the firm should retain all e/uity earnings, by which the value of share price increases, thereby the value of the firm increases. 7. 8ormal 5irms: 8ormal firms are those firms, which have investment pro4ects whose rate of return is e/ual to cost of capital i.e., r=k!. 5or such firms, the optimum dividend ratio ranges between ;)ero and 6::<. -n this situation, the value of share price remains constant for any level of dividend payout ratio. 9. Declining 5irms: Declining firms are those firms, which do not have profitable investment pro4ects. -n other words, investment pro4ects" return is less than cost of capital r>k!. 5or such firms, the optimal dividend payout ratio is 6:: per cent or retention ratio is ;)ero<. 0ssumptions: assumptions: &alter"s 'odel is based on the following

i. 0ll profitable investments are financed through retained earnings -nternal financing!, i.e., e2ternal sources of funds like debt or fresh e/uity are not issued. ii. The firm"s return on investment r! and cost of capital k! are constant. iii. 0ll earnings are either distributed as dividends or reinvested internally immediately 6:: per cent payout or retention!. iv. ?eginning earnings and dividends never change. %P* and DP* may be changed in the model to determine its effect on share price, but any given change in %P* and DP* remain constant forever .onstant %P* and DP*!. v. The firm has a perpetual infinite! life. 'arket Price Per *hare &alter has given the following formula for determining the market price or value of share:

P= -----------------P= 'arket price per e/uity share D= Dividend per share DP*! %= %arnings per share %P*! %-D!= ,etained earnings per share r= ,eturn on investment k= .ost of capital or market capitali)ation rate The above formula indicates that the market price per e/uity share is e/ual to the present value of an infinite stream of dividends plus the present value of an infinite stream of returns from retained earnings. .riticism of &alter"s 'odel

6. -t assumes that all investments are being financed through retained earnings. Thus, it ignores the benefits of optimal capital structure. 7. 0ctual share price in practice are likely to be different from those determined by the &alter"s formula. 9. -t assumes that 1r" is constant. ?ut 1r" is generally declined when more and more investments are taken up. @. 0ssumption that cost of capital k! remains constant may not hold trueAgood in practice. B. -t ignores the fact that market prices are affected by many factors and the present value of future e2pected dividend is only one of them. 'o#den&s Model 'yron $. (ordon also holds the view that dividend is relevant to the value of the company and dividend policy certainly affects the value of the company, i.e., market price of shares. The model uses stock valuation using dividend capitali)ation approach. 0ssumptions i. The company is an all-e/uity company. #nly retained earnings are used for financing acceptable investment opportunities. 8o e2ternal financing is available. ii. The internal rate of return r! and cost of capital k! are constant. iii. The company has infinite or perpetual life. iv. .orporate ta2 does not e2ist. v. The retention ratio b!, once decided, is taken as constant. Thus growth rate, i.e., g=br is also constant.

vi. .ost of capital k! is greater than growth rate g=br!. -n other words, k3br = g 0ccording to (ordon, the market value of a share is e/ual to the present value of an infinite future stream of dividends. Thus, P=

P= 'arket price per e/uity share %= %arnings per share %P*! b-r!= (rowth rate, i.e., 1g" r= ,ate of return on investment k= .ost of capital or market capitali)ation rate b= ,etention ratio -n his model also, dividend policy is dependent on the availability of investment opportunities and relationship between r and k. This can be e2plained as under: a! &hen r3k .ase of growth firms! : P increases with the increase in retention ratio b!. Thus, when r3k, the company should distribute lesser dividend and retain higher amount of profits. b! &hen r>k .ase of declining firms! : P decreases with the increase in retention ratio b!. Thus, when r>k, retention becomes undesirable and more and more profits should be distributed as dividends. c! &hen r=k .ase of normal firms! : P is not affected by the retention ratio b!. Thus, dividend becomes irrelevant in such cases. (ordon"s model is based on arguments: i! that investors are riskaverse and ii! that they put a premium on certain returns than uncertain returns.

(. Dividend I##elev n!e T"eo#ies

Modi)li ni*Mille# +,-o%"esis 5ranco 'odigliani and '.C. 'iller are the principal proponents of Dividend -rrelevance Theory. They maintain that dividend policy has no effect on the market price of share and the value of the firm. Dalue of a firm is determined by its basic earning power and its business risk. -n other words, they argue that the value of the firm depends solely on its earning power and is not influenced by the manner in which it splits its earnings between dividends and retained earnings. 0ssumptions: assumptions: '' hypothesis is based on the following

i. There are perfect capital marketsE where investors behave rationally, information is available to all investors free of cost, there are no transaction costs, securities are infinitely divisible, and there is no single investor large enough to affect the market price of a share. ii. There are no ta2es, and there are no differences in ta2 rates applicable to capital gains and dividends. iii. The firm has a fi2ed investment policy. iv. There is no risk, i.e., risk or uncertainty does not e2ist. -n other words, investors are able to forecast future of a share and dividends, with certainty and one discount rate is appropriate for all of securities at all times. '' 0rgument: '' hypothesis is based on the arbitrage argument. The term arbitrage refers to involving simultaneously into two transactions which e2actly balance each other. Cere the two transactions are a! paying out dividends, and b! raising funds e2ternally to finance a profitable investment pro4ect. %2ternal funds may be raised by issue of fresh e/uity shares or some other debt.

5or e2ample, a firm has an investment pro4ect, and has earnings available to shareholders. Cere, the firm has two alternatives: a! it can distribute earnings to the e/uity shareholders as dividend and rise an e/ual amount e2ternally by issue of fresh e/uity shares, or b! retain its earnings to finance the investment pro4ect. This arbitrage process is involved only when the firm opts for the first alternative. &ith the dividend payment share price increases, and it will be e2actly balanced by issue of fresh e/uity shares of the same amount. The market price of shares before and after the dividend payment remains the same and hence the wealth of the shareholders does not change. Therefore, investors will be indifferent between dividend and retention of earnings. *o, payment of dividend becomes irrelevant. The value of the firm depends solely on the firm"s future earnings power and not the manner in which its earnings are split between dividend and retained earnings. Proof for '' Cypothesis : '' have proved their argument in the following way: 6. 'arket Price of *hare at the end of Period 6 : The market price per share P:! in the beginning of the period s e/ual to the present value of dividends paid at the end of the period plus market price of share at the end of the period.

P: = &here, P: = 'arket price per share at period 1 :" D6 = Dividend per share at the end of period 1 6" P6 = 'arket price per share at the end of period 1 6" k which = Discount rate applicable to the risk class to

the firm belongs cost of e/uity capital! Therefore, P6 = P: 6Fk! - D6

7. The total capitali)ation value of outstanding e/uity share of the firm at period 1:" is obtained by the following formula:

9. 0mount needed to be raised by the issue of new shares! GnP6 = - % nD6! &here, GnP6 = 0mount raised by issue of new shares - = Total funds re/uired for investment % = Total earnings of the firm during the period nD6 = Total dividends paid % nD6 = ,etained earnings @. 8o. of 0dditionalA8ew *hares to be -ssued: Gn = GnP6 H P6 B. Dalue of the 5irm: GnP: = .riticism of '' Cypothesis: '' argue that dividend decision of a firm is irrelevant, based on some simple and unrealistic nature of

assumptions. -n other words, '' approach is alleged to lack practical relevance, as under: i. There is no capital market. ii. Ta2 differential between dividend and capital gains e2ist. iii. 5loatation costs e2ist, making e2ternal financing costly iv. Transaction costs e2ist, making dividend more desirable than capital gains through sale of security. v. -nformational value of dividend payout ignored. vi. -nstitutional investors preferring dividend. vii. ,esolution of uncertainty by dividend payout not considered. viii. -nvestors" general preference for current dividend to future dividend.

Dividend Poli!ies & P# !%i!es There are different types of dividend policies: *table dividend policy: *table dividend means payment of a certain amount or rate of dividend regularly. There are three distinct forms of stability. They are: a! .onstant dividend per share 0 company that follows this policy will pay a fi2ed amount per share as dividend. The level of earnings would not affect this policy or the dividend payments. This type of dividend policy is suitable for companies, whose earnings are stable over a number of years. *tability of dividend does not mean stagnation in dividend payout.

b! .onstant payout ratio Inder this policy, a fi2ed percentage of earnings are paid out as dividends each year. This policy is suitable for a company that is not confident enough in getting stable earnings. c! *table rupee dividend plus e2tra dividend Inder this policy, the management fi2es the minimum dividend per share, to reduce the possibility of not paying dividend. 0n e2tra dividend is paid in the years of prosperity. This type of policy is more suitable to companies having minimum earnings and over that level, earnings may fluctuate. 0 stable dividend policy is advantageous for both the company and the shareholders. i. ?uilds confidence among investors ii. %nsures current income to investors iii. Provides information about firm"s profitability and resolves uncertainty in the minds of investors iv. 'eets institutional investors" re/uirements for regular return v. ,aising additional finances made easy, because of investors" loyalty and goodwill towards the firm vi. %nsures stability in market price of shares vii. %asy availability of debt funds, due to assurance of profitability and regularity in firm"s revenues. -n spite of the above advantages, the stable dividend policy suffers from certain limitations. They are: i. Difficult to change ii. 0dverse effect on market price of shares, in lean years

iii. ?orrowing to maintain dividends, in lean years, may be dangerous in the ling run. There is a positive relationship between dividend policy of a firm and its market value. The dividend payout ratio of a firm should be determined with reference to two ob4ectives one ma2imi)ation of shareholders" wealth and second providing sufficient funds to finance growth. There is a need to consider the factors that affect dividend policy. They are: 8ature of earnings 0ge of the company Ji/uidity position of the company %/uity shareholders" preference for current income ,e/uirements of institutional investors Jegal rules .apital impairment rule, .ompanies 0ct, -nsolvency ,ule, ! .ontractual re/uirements 5inancial needs of the company 0ccess to capital market e2ternal sources! .ontrol ob4ective -nflation Dividend policy of competitors Past dividend rates of the company #thers trade cycles, corporate ta2ation policy, attitude of investors groups and repayment of loan

5orms of Dividends: 5irms may declare dividends in the form of: a! .ash dividend paid in the form of cash b! *crip payment of dividend in the form of promissory note c! ?ond - payment of dividend in the form of long-term bonds d! *tock bonus shares! issue of additional shares of common stock to the ordinary shareholders

e! Property payment of dividend in the form of assets Payment of dividend through issue of bonus shares is a financial gimmick, since it does not affect the owners" wealth. The reasons for payment of dividend in the form of shares are to: ?ring the market price per share within more popular range Promote more active trading in company"s shares ,educe the nominal rate of dividend -ncrease the paid up share capital -ndicate the better prospects of the firm -mprove prospects of raising additional funds

*tock dividend issue of bonus shares! is advantageous for the company and the owners. 0dvantages en4oyed by the issuing company are: 'aintenance of li/uidity position 'anage financial difficulties 0ttractive share price %nhances prestige &idening the share for market 0vailability of funds for e2pansion programme. *tock dividend is also beneficial to owners by way of: ta2 savings, indication of future benefits, psychological value. ?ut stock dividend has certain limitations, like: 0dministrative costs of issuing new shares ,educes %P* and PA% ratio Prevents new investors from becoming shareholders of the firm 'isuse of management power, since there is no dilution of control

Disadvantages to owners are: disappointment to shareholders preferring current income, shareholders" wealth remains remain unaffected, lowers market value of e2isting shares, less security to investors due to reduction in reserves. The company law governs the amount of dividend that can be distributed. The important provisions of company law pertaining to dividends are: Jegal 0spects: 6. .ompanies can pay only cash dividends with the e2ception of bonus shares! 7. Dividend should be paid out of profits. 9. Dividends can be paid out of profits earned during the financial year after providing for depreciation and after transferring to reserves such percentage of profits as prescribed by law. @. Due to inade/uacy or absence of profits in any year, dividend may be paid out of the accumulated profits of the previous years. B. Dividends cannot be declared for the past years for which accounts have not been closed. Procedural 0spects: 6. 7. 9. @. B. ?oard resolution *hareholders" approval ,ecord date Dividend payment InpaidAunclaimed dividend

Ta2 0spects: 6. Presently, dividend income from domestic companies and mutual funds is e2empt from income ta2 in the hands of the shareholders unit holders in case of '5s!.

7. Cowever, domestic companies are liable to pay ta2 on dividend distribution K 67.B percent plus surcharge. *tock split is the action of a firm to increase the number of shares by splitting the e2isting shares into different proportions. The primary ob4ective behind stock split is to make shares more affordable to small investors, without changing the issued and paid up share capital and the value of the company. -t is done to make share trading attractive, indicate higher profits in the future, and give higher dividends to shareholders. 5rom economic point of view, stock split and stock dividend are similar to each other, but there are some differences from accounting point of view. They differ with respect to par value of share, capitali)ation of reserves, shareholders" proportion, book value, earnings and market price per share. ,everse split is the opposite of stock split, under which the number of outstanding shares will be reduced, to increase the market price of shares.

Revie. /0es%ions 6. &hat is meant by dividendL %2plain the different forms of dividends. 7. %2plain the meaning of the concept 1dividend policy". .ritically e2amine the essentials of a sound dividend policy. 9. %2plain the various factors determining the dividend policy of a company. @. %2plain the different types of dividend policies. &hat are the advantages of a stable dividend policyL B. #utline and analyse the fundamental issues concerning corporate dividend policy. &hat should be the dividend policy goalsL M. *tate the legal, procedural and ta2 aspects pertaining to declaration and payment of dividend in -ndia. N. %2amine the Dividend ,elevance 'odels of &alter and (ordon, with respect to their propositions and assumptions.

O. %2plain 'odigliani-'iller irrelevance theory of dividend distribution. *how how shareholders" wealth remains the same whether dividend is paid or not. P. &rite notes on the following: a! 0lternative dividend policies b! *tock dividend c! *tock split d! .onstant percentage of %arnings as Dividend

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