Dividend Policies and Theories

The Walter Model:

Walter (1963) postulated a model which holds that dividend policy is relevant in
determining the value of a firm. The model holds that when dividends are paid to
the shareholders, they are reinvested by the shareholder further, to get higher
returns. This cost of these dividends is referred to as the opportunity cost of the firm
(the cost of capital), ke for the firm, since the firm could use these dividends as
capital if they were not paid out to shareholders.
Another possible situation is where the firm does not pay out dividends, and they
invest the funds which could be paid out as dividends in profitable ventures to earn
returns. This rate of return, r, for the firm must at least be equal to ke . If this
happens then the returns of the firm is equal to the earnings of the shareholders if
the dividends were paid. Thus, its clear that if r, is more than the cost of capital ke,
then the returns from investments is more than returns shareholders receive from
further investments.
Walters model says that if r< ke then the firm should distribute the profits in the
form of dividends to give the shareholders higher returns. However, if r> ke then
the investment opportunities reap better returns for the firm and thus, the firm
should invest the retained earnings. The relationship between r and k e are
extremely important to determine the dividend policy. It decides whether the firm
should have zero payout or 100% payout.
In a nutshell, if D = the dividend payout ratio,
If r> ke , the firm should have zero payout and make investments. (D = 0)
If r< ke , the firm should have 100% payouts and no investment of retained
earnings. (D=E)
If r= ke , the firm is indifferent between dividends and investments.
Mathematical representation of Walters Model:
Where,
P = Market price of the share
D = Dividend per share
r = Rate of return on the firms investments
ke = Cost of equity
E = Earnings per share
The market price of the share consists of the sum total of the present value of an
infinite stream of dividends, the present value of an infinite stream of returns on
investments made from retained earnings. Therefore, the market value of a share is
the result of expected dividends and capital gains according to Walter.
Assumptions of Walters model
1. Retained earnings are the only source of financing investments in the firm,
there is no external finance involved.

2. The cost of capital, ke and the rate of return on investment, r are constant
i.e. even if new investments decisions are taken, the risks of the business
remains same.
3. The firms life runs to perpetuity.
Free cash flow theory of dividends: Under this theory, the dividend decision
involves the company paying out, as dividends, any cash that is surplus after it has
invested in all available positive net present value projects. A major 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.
Capital structure substitution theory & dividends: The capital structure
substitution theory (CSS) describes the relationship between earnings, stock price
and capital structure of public companies. The theory is based on one simple
hypothesis: company managements manipulate capital structure such that
earnings-per-share (EPS) are maximized. The resulting dynamic debt-equity target
explains why some companies use dividends and others do not. When redistributing
cash to shareholders, company managements can typically choose between
dividends and share repurchases. But as dividends are in most cases taxed higher
than capital gains, investors are expected to prefer capital gains. However, the CSS
theory shows that for some companies share repurchases lead to a reduction in
EPS. These companies typically prefer dividends over share repurchases.
Zero dividend policy: All surplus earnings are invested back into the business.
Such a policy is common during the growth phase and should be reflected in
increased share price. When growth opportunities are exhausted (no further positive
NPV projects are available):
cash will start to accumulate
new distribution policy will be required.
Irregular dividend policy: as the name suggests here the company does not pay
regular dividend to the shareholders. The company uses this practice due to
following reasons:
Due to uncertain earning of the company.
Due to lack of liquid resources.
The company sometime afraid of giving regular dividend.
Due to not so much successful business.
Payment proceduresdividends are usually paid quarterly. The following dates
are important when establishing a dividend policy:
Declaration date: the date the board of directors states that a dividend will be paid
to stockholders. A dividend is not a liability to the firm until it is declared.
Holder of record date: the date the firm opens its ownership books to determine
who will receive dividends. Persons whose names appear in the ownership books
after the holder-of-record date, which is also termed the date of record, but prior to
the date the dividend is paid will not receive a dividend payment.

Ex-dividend date: two working days before the holder-of-record date. Ex dividend
means without dividend; so, on the ex-dividend date, the stock begins to sell
without the right to receive the next dividend payment.
Payment date: the date the firm mails the dividend checks.
Dividend reinvestment plans: plans that permit stockholders to have dividend
payments automatically reinvested in the firms stock. Dividend reinvestment plans,
which are referred to as DRIPs, allow stockholders to buy additional shares of a
firms stock on a pro rata basis using the cash dividend paid by the firm. Often there
are little or no brokerage fees involved with DRIPs.
Stock Splits and Stock Dividends
Stock splits: an action taken by a firm to change the number of outstanding shares
of stock. Many firms believe their stock has an optimal price range within which
their stock should trade. If the price of the stock exceeds the price range, then the
firm will execute a stock split. If a firm initiates a 2-for-1 stock split, each existing
stockholder will receive two shares of stock for each one share he or she now owns.
This action should cut the market price of the stock exactly in half.
Stock dividends: dividends paid in the form of stock rather than cash. Like stock
splits, a stock dividend does not have specific economic value; rather, it increases
the total number of shares of stock each stockholder owns. At the same time, the
stock price per share decreases because investors have not provided any funds for
the additional shares of stock.
Balance sheet effects: for stock splits, the only effect on the balance sheet is that
the number of shares outstanding changes relative to the split, which also changes
the stated par value of the stock (if there is one). If a firm executes a 2-for-1 split,
for example, it would double the number of shares outstanding and halve the par
value of the stock reported on the balance sheet. The total dollar values in each
common equity account would not change. When a stock dividend is paid, on the
other hand, the firm must transfer capital from retained earnings to the Common
stock account and the Additional paid-in capital account to reflect the fact that a
dividend was paid.
Price effects: even though both stock splits and stock dividends only increase the
number of outstanding shares of stock, studies have shown that the market price of
the stock affected by such actions might change, if investors expect future earnings
and cash dividends to increase (decrease), then the price will increase (decrease)
above the relative price associated with the stock split or the stock dividend. For
example, if investors believe a firm initiated a 2-for-1 stock split because its future
earnings will cause the price of the stock to increase well above its optimal range,
then their reaction to the split will cause the post-split price of the stock to be
greater than one half the pre-split price. If the future expectations do not pan out,
however, the price of the stock will eventually settle at about one half the pre-split
price.

https://laiboni.wordpress.com/2013/08/02/dividend-policy-theories/
http://www.baitshepi-tebogo.com/SCB.docx
https://en.wikipedia.org/wiki/Dividend_policy http://kfknowledgebank.kaplan.co.uk/KFKB/Wiki
%20Pages/The%20Dividend%20Decision.aspx?mode=none
http://managementation.com/4-types-of-dividend-policy/

http://www2.fiu.edu/~keysj/CFIN_13.pdf