DIVIDEND AND RETENTION

POLICY

By :Dr.Rajinder S.Aurora
Professor in Finance
IBS, Mumbai
Subject Facilitator: Financial Management
Introduction:

o What is Dividend?
o What is dividend policy?
o Theories of Dividend Policy
o Relevant Theory
• Walter’s Model
• Gordon’s Model
o Irrelevant Theory
• M-M’s Approach
• Traditional Approach
What is Dividend?

“A dividend is a distribution to shareholders out of

profit or reserve available for this purpose”.

- Institute of Chartered Accountants of India

Forms/Types of Dividend:

 On the basis of Types of Share

 Equity Dividend

 Preference Dividend

 On the basis of Mode of Payment

 Cash Dividend

 Stock Dividend

 Bond Dividend

 Property Dividend

 Composite Dividend
 Contd….

o On the basis of Time of Payment

o Interim Dividend
o Regular Dividend
o Special Dividend
What is Dividend Policy?

 “ Dividend policy determines the division of

earnings between payments to
shareholders and retained earnings”.

- Weston and Bringham

 Contd…

Dividend Policies involve the decisions, whether-

o To retain earnings for capital investment

and other purposes; or
o To distribute earnings in the form of
dividend among shareholders; or
o To retain some earning and to distribute
remaining earnings to shareholders.
Factors Affecting Dividend Policy

o Legal Restrictions
o Magnitude and trend of earnings
o Desire and type of Shareholders
o Nature of Industry
o Age of the company
o Future Financial Requirements
o Taxation Policy
o Stage of Business cycle
o Regularity
o Requirements of Institutional
Investors
Dimensions of Dividend Policy:

o Pay-out Ratio
o Funds requirement
o Liquidity
o Access to external sources of financing
o Shareholder preference
o Difference in the cost of External Equity
and Retained Earnings
o Control
o Taxes
 Contd
o Stability
 Stable dividend payout Ratio

 Stable Dividends or Steadily changing

Dividends
Types of Dividend Policy:

o Regular Dividend Policy

o Stable Dividend Policy
o Constant dividend per share
o Constant pay out ratio
o Stable rupee dividend + extra
dividend
o Irregular Dividend Policy
DIVIDEND THEORIES
 Dividend Theories

Irrelevance Theories
Relevance Theories
(i.e. which consider dividend
(i.e. which consider dividend
decision to be irrelevant as it
decision to be relevant as it
does not affects the value of the
affects the value of the
firm)
firm)

Walter’ Gordon’s
s Model
Model

Modigliani and Traditional

Miller’s Model Approach
RELEVANCE THEORY
Walter’s Model

 Prof. James E Walter argued that in the long- run

the share prices reflect only the present value of
expected dividends. Retentions influence stock
price only through their effect on future
dividends. Walter has formulated this and used
the dividend to optimize the wealth of the
equity shareholders.
 Assumptions of Walter’s Model:
 Internal Financing

 Constant Return in Cost of Capital

 100% payout or Retention

 Constant EPS and DPS

 Infinite time
 Formula of Walter’s Model

D+ r (E-D)
P = k
k
Where,
P = Current Market Price of equity
share E = Earning per share
D = Dividend per share
(E-D) = Retained earning per share
r = Rate of Return on firm’s investment or Internal
Rate of Return
k = Cost of Equity Capital
Illustration:

Growth Firm (r > k): r

= 20% k = 15% E = Rs. 4
If D = Rs. 4
P = 4+(0) 0.20 /0 .15 = Rs. 26.67
0.15
If D = Rs. 2
P = 2+(2) 0.20 / 0.15
0.15 = Rs. 31.11
Illustration:

Normal Firm (r = k): r

= 15% k = 15% E = Rs. 4
If D = Rs. 4
P = 4+(0) 0.15 / 0.15 = Rs. 26.67
0.15
If D = Rs. 2
P = 2+(2) 0.15 / 0.15
0.15 = Rs. 26.67
Illustration:

 Declining Firm (r < k):

r = 10% k = 15% E = Rs. 4
If D = Rs. 4
P = 4+(0) 0.10 / 0.15 = Rs. 26.67
0.15
If D = Rs. 2
P = 2+(2) 0.10 / 0.15
0.15 = Rs. 22.22
Effect of Dividend Policy on Value of Share

Case If Dividend Payout If Dividend Payout

ratio Increases Ration decreases
1. In case of Market Value of Market Value of
Growing firm Share a share
i.e. where r > decreases increases
k
2. In case of Market Value of Market Value of
Declining Share share
firm i.e. where r increases decreases
<k
3. In case of No change in No change in
normal firm value of Share value of Share
i.e. where r = k
Criticisms of Walter’s Model

 No External Financing
 Firm’s internal rate of return does not always
remain constant. In fact, r decreases as more
and more investment in made.
 Firm’s cost of capital does not always remain
constant. In fact, k changes directly with the
firm’s risk.
 Gordon’s Model

 According to Prof. Gordon, Dividend Policy almost

always affects the value of the firm. He Showed
how dividend policy can be used to maximize the
wealth of the shareholders.
 The main proposition of the model is that the
value of a share reflects the value of the future
dividends accruing to that share. Hence, the
dividend payment and its growth are relevant in
valuation of shares.
 The model holds that the share’s market price is
equal to the sum of share’s discounted future
dividend payment.
o Assumptions:
o All equity firm

o No external Financing

o Constant Returns

o Constant Cost of Capital

o Perpetual Earnings

o No taxes

o Constant Retention
o Cost of Capital is greater then growth rate

(k>br=g)
Formula of Gordon’s Model

E (1 – b)
P = K - br

 Where, P
= Price
E = Earning per Share
b = Retention Ratio
k = Cost of Capital br
= g = Growth Rate
Illustration:

 Growth Firm (r > k): r

= 20% k = 15% E = Rs. 4
If b = 0.25

P0 = (0.75) 4 = Rs. 30
0.15- (0.25)(0.20)
If b = 0.50
P0 = (0.50) 4 = Rs. 40
0.15- (0.5)(0.20)
Illustration
:
 Normal Firm (r = k):
r = 15% k = 15% E = Rs. 4
If b = 0.25
P0 = (0.75) 4 = Rs. 26.67
0.15- (0.25)(0.15)
If b = 0.50
P0 = (0.50) 4 = Rs. 26.67
0.15- (0.5)(0.15)
Illustration:

 Declining Firm (r < k):

r = 10% k = 15% E = Rs. 4
If b = 0.25
P0 = (0.75) 4 = Rs. 24
0.15- (0.25)(0.10)
If b = 0.50
P0 = (0.50) 4 = Rs. 20
0.15- (0.5)(0.10)
Criticisms of Gordon’s model

 As the assumptions of Walter’s Model and

Gordon’s Model are same so the Gordon’s
model suffers from the same limitations as the
Walter’s Model.
IRRELEVANCE THEORY
Modigliani & Miller’s
Irrelevance Model

Value of Firm (i.e. Wealth of

Shareholders)
Depends
on

Firm’s
Earnings
Depends
on

Firm’s Investment Policy and not on

dividend policy
Modigliani and Miller’s Approach

 Assumption
o Capital Markets are Perfect and people

are Rational
o No taxes

o Floating Costs are nil

o Investment opportunities and future profits

of firms are known with certainty (This

assumption was dropped later)
o Investment and Dividend Decisions

are independent
M-M’s Argument

 If a company retains earnings instead of giving it

out as dividends, the shareholder enjoy capital
appreciation equal to the amount of earnings
retained.
 If it distributes earnings by the way of
dividends instead of retaining it, shareholder
enjoys dividends equal in value to the amount
by which his capital would have appreciated
had the company chosen to retain its earning.
 Hence,
the division of earnings between dividends
and retained earnings is IRRELEVANT from
the point of view of shareholders.
Formula of M-M’s Approach

1 ( D1+P1 )
P = (1 + p)
o
Where,
Po = Market price per share at time 0,
D1 = Dividend per share at time 1,
P1 = Market price of share at time 1
Criticism of M-M Model

 No perfect Capital Market

 Existence of Transaction Cost
 Existence of Floatation Cost
 Lack of Relevant Information
 Differential rates of Taxes
 No fixed investment Policy
 Investor’s desire to
obtain current income
Traditional Approach

 This theory regards dividend decision merely

as a part of financing decision because
 The earnings available may be retained in

the business for re-investment

 Or if the funds are not required in the

business they may be distributed as

dividends.
 Thus the decision to pay the dividends or retain
the earnings may be taken as a residual
decision
 This theory assumes that the investors do
not differentiate between dividends and
retentions by the firm
 Thus, a firm should retain the earnings if it
has profitable investment opportunities
otherwise it should pay than as dividends.
Synopsis

o Dividend is the part of profit paid to

Shareholders.
o Firm decide, depending on the profit, the
percentage of paying dividend.
o Walter and Gordon says that a Dividend
Decision affects the valuation of the firm.
o While the Traditional Approach and MM’s
Approach says that Value of the Firm is
irrelevant to Dividend we pay.