DIVIDEND THEORY & POLICY

The idea behind adoption of any dividend policy should be ideally --- maximization of shareholders wealth. The returns to the shareholders consist of two parts viz. Dividends and Capital gains. The dividend policy adopted by the firm directly influences both of these components of returns to shareholders.

DIVIDEND THEORY & POLICY

That percentage of the total return on equity which is allowed by the firm to be distributed in the form of dividends is called the Pay out ratio. Say, the PAT is 100 and 60 is allowed to be distributed as dividend then Pay out ratio would be 60% and 100-60=40% would be the Retention ratio. Recall : ROE = PAT/NET WORTH NET WORTH = SHARE CAPITAL + RESERVES GROWTH RATE = ROE X RETENTION RATIO

DIVIDEND THEORY & POLICY

Assume there are two companies namely LPC & HPC. ROE of both the companies is 20% and both the companies have one share of Rs.100/-. DP ratio of HPC is 80% while LPCs DP ratio is 20%.

HIGH PAYOUT COMPANY

YEAR
1 2 3 4 5 10 15 20

CAPITAL/EQUIT ROE @ 20% Y

100 104 108.16 112.48 116.98 142.33 173.17 210.68 20 20.80 21.63 22.50 23.40 28.47 34.63 42.14

DIVIDEN DS @ 80%
16 16.64 17.31 18 18.72 22.77 27.71 33.71

RETAINED EARNINGS
4 4.16 4.32 4.50 4.68 5.69 6.92 8.43

LOW PAYOUT COMPANY

YEAR
1 2 3 4 5 10 15 20

CAPITAL/EQUIT ROE @ 20% Y

100 116 134.56 156.09 181.07 380.30 798.75 1677.65 20 23.20 26.91 31.22 36.21 76.06 159.75 335.53

DIVIDEN DS @ 20%
4 4.64 5.38 6.24 7.24 15.21 31.95 67.11

RETAINED EARNINGS
16 18.56 21.53 24.98 28.97 60.85 127.80 268.42

COMPARISON HPC VRS. LPC

YEAR 1 2 DIVIDEND HPC 16 16.64 DIVIDEND LPC 4 4.64 REMARKS

3
4 5 10 15

17.31
18 18.72 22.77 27.71

5.38
6.24 7.24 15.21 31.95 HIGHER THAN HPC

20

33.71

67.11

HIGHER THAN HPC

 LPCs policy produces higher returns in the long run because of accelerated earnings growth. Growth = ROE x Retention ratio For LPC : Growth = 20% x 80% = 16%(GROWTH COMPANY) For HPC : Growth = 20% x 20% = 4%

 If Growth is supposed to be a leading factor for deciding the market price of shares of a company then LPCs shares will command higher market prices and thus the shareholders will get the advantage of capital gains.

But, market price of shares also depend on the demand of the shares in the market. Low dividend in the initial years and Capital gains in the distant future may also reduce the demand of such shares thereby adversely affecting the market value of these shares.

 HPCs policy means more current dividends and less retained earnings which leads to a slow growth rate. This slow growth rate may in turn reduce the market price of shares.

Moreover, taxation policy of dividends and capital gains may also play a major role in deciding the demand for the shares of the firms.

COMPARISON HPC VRS. LPC

YEAR 1 RETAINED EARNINGS HPC 4 RETAINED EARNINGS LPC 16 REMARKS

2
3 4 5 10

4.16
4.32 4.50 4.68 5.69

18.56
21.53 24.98 28.97 60.85

15
20

6.92
8.43

127.80
268.42

High pay out companies will have lesser funds at their disposal for further expansions and new projects. This means that expansion and new projects will be more difficult than Low payout companies. However, for new projects and expansions the company can always go for fresh capital issues. Moreover, the market price of shares actually depends on many other factors other than the dividend policy or growth rate or expansion schemes for that matter.

WALTERS MODEL OF RELEVANCE OF DIVIDENDS

BASIC THEORY : Choice of dividend policy always affects the market price of the shares. ASSUMPTIONS : The firms finances all investments through retained earnings, i.e., debt or new equity is not issued. The firms rate of return and cost of capital remain constant. 100% of the earnings are either distributed as dividends or are reinvested internally immediately. The firm has a very long or infinite life.

WALTERS MODEL OF RELEVANCE OF DIVIDENDS Walter gave the following formula for determining the market price of shares. DIV + (r/k) ( EPS-DIV) P= -----------------------------Where, k P = Market Price of Share DIV = Dividend per share EPS = Earnings per share r = Firms average rate of return k = Firms cost of capital walters model.xlsx

WALTERS MODEL OF RELEVANCE OF DIVIDENDS CRITICISM : The criticism of Walters model are all of its assumptions viz. No external financing Constant rate of return

Constant cost of capital

GORDONS MODEL( A BIRD IN HAND ARGUMENT)

Comparing two stocks of equal earnings record and prospects, the one which pays a larger dividend than the other, will naturally command a higher price merely because shareholders prefer the present to the future values. The equation forwarded by Gordon is : P = EPS ( 1 b ) DIVIDED BY (k g) WHERE, b= retention ratio, k = Cost of capital, g=growth rate, AND g = br gordon's model.xlsx

MILLER MODIGLIANI HYPOTHESIS Under a perfect market situation the dividend policy of a firm is irrelevant as it does not affect the value of a firm. (Here Value means the wealth in the hands of the shareholders). The argument is based on the hypothesis that the value of a firm is primarily decided by the firms investment policy. Thus it is argued that the value of a firm will improve with a good investment decision and dividend policies will have no significance.

MILLER MODIGLIANI HYPOTHESIS There can be three situations for a firm operating in a perfect market condition. A) The firm has sufficient funds to pay dividends. B) The firm does not have sufficient funds to pay dividends, given new investment plans and hence issues new shares to finance the payment of dividends. C) The firm does not pay any dividends BUT the shareholders need cash.

MILLER MODIGLIANI HYPOTHESIS First case : Shareholders get cash in the form of dividends BUT the assets of the firm reduce (cash). The gain of the shareholders in the form of dividends is offset by reduction of their claims on the assets of the firm. The value of the firm remains unaffected. Second case : Increase in the capital base of the firm through issue of new shares is set off by decrease in the assets through payment of dividends. Hence, here also there is no change in the value of the firm.

MILLER MODIGLIANI HYPOTHESIS Third case: When the firm does not pay any dividend and the shareholders require cash, the MM hypothesis suggests that the shareholders will create HOME MADE DIVIDEND by selling a part of his shareholding( at fair market value) and thus obtain cash. Now the shareholder has less number of shares with him BUT the number of shares of the company has not changed. Hence, the situation is as before and there is no change in the value of the firm.

MILLER MODIGLIANI HYPOTHESIS The decision of whether or not to pay dividends is a financing decision as per MM. It considers the earnings of a firm to be a source of long term funds. Hence, dividends will only be paid when the firm has no profitable investment opportunities. Further, the assumption of MM is that new projects and operations can be funded by fresh capital issues only and only when there are no floatation costs.

MILLER MODIGLIANI HYPOTHESIS Further, another assumption of MM is that since the ability of the shareholders to earn returns is less than that of the firm, the shareholders will be indifferent as between current dividends and retained earnings. Hence, payment of dividends will not affect the market price of the firm BUT the plans of the firm for dealing with the retained earnings will definitely increase the demand of the shares.