DIVIDEND POLICY

Dividend decisions
y 2 options of a firm to utilize profit after tax  

plough back the earnings distribute to shareholders

y Dividend policy is important due to unambiguous relationship

between the dividend policy and the equity returns.

y Models based on above relationship and dividend policies:  Traditional position  Walter model  Gordon model  Miller & Modigliani model  Rational expectations

TRADITIONAL POSITION
y Given by B GRAHAM & DL DODD y Lays emphasis on relationship between dividends and the stock

market y Stock value responds positively to higher dividends and negatively when there are low dividends y Relationship between the market price and dividends using a multiplier  P=m(D+E/3) P=market price m=multiplier D=dividend per share E=earning per share

Limitations Of the Traditional Approach

y This approach states that P/E ratios are directly

related to the dividend payout ratio. However this might not be true always.
y Also, Only a few investors of the company who would

prefer dividends to the uncertain capital gains and a few who would prefer lower taxed capital gains

WALTER MODEL

WALTER MODEL
y The dividend policy given by James E Walter also

considers that dividends are relevant and they do affect the share price. y In this model, he studied the relationship between internal rate of return(r) and the cost of capital of the firm(ke). y The model studies the relevance of dividend policy in 3 situations: 1) r>ke, 2) r=ke 3) r<ke and

Assumptions of the model

y Retained earnings is the only source of finance

available to the firm

y r and k are assumed to be constant y Firm has an infinite life y For a given value of the firm, the dividend per share

and the earnings per share remain constant

y According to Walter, the market price of the share is

taken as the sum of present value of future cash dividends and capital gains.
y Market price of the share is given as

P = D + r(E-D)/ke ke ke Where P = Market price per share D = Dividend per share E = Earnings per share r = Internal rate of return ke = Cost of equity capital

Q: Show the effect of the dividend policy on the market price of Zed Ltds shares, using Walters model: Equity capitalization rate(ke) = 12% Earnings per share (E) = Rs. 8 Assumed return on investments(r) are as follows: i. r = 15% ii. r = 10% iii. r = 12%

r > ke (r = 15%, ke = 12%) a. D/P ratio= 0 P = 0 + (0.15/0.12)(8-0) 0.12 = Rs.83

1. b.

D/P ratio= 50% P= 4 + (0.15/0.12)(8-4) 0.12 = Rs. 75

D/P ratio= 25% P= 2 + (0.15/0.12)(8-2) 0.12 = Rs. 79 D/P ratio = 100% P= 8 + (0.15/0.12)(8-8) 0.12 = Rs. 67

D/P ratio= 75% P= 6 + (0.15/0.12)(8-6) 0.12 = Rs. 70.83

c.

2. r < ke (r = 10%, ke = 12%)

a.

D/P ratio= 0 P = 0 + (0.10/0.12)(8-0) 0.12 = Rs.56 D/P ratio= 25% P= 2 + (0.10/0.12)(8-2) 0.12 = Rs. 58 D/P ratio = 100% P= 8 + (0.10/0.12)(8-8) 0.12 = Rs. 67

b.

c.

3. r = ke (r = 12%, ke = 12%)
a.

D/P ratio= 0 P = 0 + (0.12/0.12)(8-0) 0.12 = Rs.67 D/P ratio= 25% P= 2 + (0.12/0.12)(8-2) 0.12 = Rs. 67 D/P ratio = 100% P= 8 + (0.12/0.12)(8-8) 0.12 = Rs. 67

b.

c.

Limitations
y The assumption of exclusive financing by retained

earnings make the model suitable only for all-equity firms.

y The assumption of constant return on investment is

not true for firms making high investments.

y This model ignores the business risk of the firm which

has a direct impact on the value of the firm. Thus, k cannot be assumed to be constant

Gordons Dividend Capitalization Model

y The firm will be an all-equity firm with the new

investment proposals being financed solely by the retained earnings. remain constant.

y Return on investment(r) and the cost of equity (ke)

y Firm has an infinite life. y The retention ratio remains constant and hence the

growth rate is constant(g = br) rate.

y K > br i.e cost of equity capital is greater than growth

Gordons Dividend Capitalization model gave the value of the stock as:
P = E(1 b) ke br

P = Share Price E = Earnings per share b = Retention Ratio (1-b) = Dividend pay-out ratio Ke = Cost of equity capital br = Growth rate(g) in the rate of return on investment

i)

r > ke Share price decreases with the increase in Dividend Pay Out Ratio( D/P)

ii)

r < ke Share price increases with the increase in Dividend Pay Out Ratio.

INTERPRETATION
y RATE OR RETURN > COST OF CAPITAL

Growth firms should have higher retention ratio

RATE OR RETURN < COST OF CAPITAL

Firms should have lower retention ratio and high dividend pay out ratio.

Miller and Modigliani Model

MILLER AND MODIGLANI MODEL

y Argument given by M&M was Dividend irrelevance. y Dividend policy has no effect on the share price of the firm. y What matters is the investment policy through which the

firm can increase its earnings and thereby the value of the firm.
y An increase in value of the firm caused by payment of

dividend is exactly set off by the decline in the market price of shares because of external financing. Hence no change in the total wealth of the shareholders.

ASSUMPTIONS OF M&M MODEL

y There are perfect capital markets in which all

investors are rational.

y There are no taxes , implying that there are no

differential tax rates for the dividend income and the capital gains.
y Constant investment policy of the firm. y Investors are able to forecast future prices and

dividends with certainity.

QUESTION
A company belongs to a risk class for which the approximate capitalisation rate is 10 %.It currently has outstanding 25,000 shares selling at Rs.100 each. The firm is contemplating the declaration of a dividend of Rs. 5 per share at the end of the current financial year. It expects to have a net income of Rs. 2,50,000 and has a proposal for making new investments of Rs. 5,00,000. Show that under the MM Assumptions, the payment of dividend does not affect the value of the firm.

Solution :
Value of the firm when dividends are paid : y P= 1 (D1+P1) (1+ ke) 100 = 1 (5+P1) 1.10 P1 = 105 y Amount required to be raised from the issue of new shares :nP1 = I-(E-nD1) = Rs. 5,00,000-(2,50,000-1,25,000) = Rs. 3,75,000
a)

CONTD.
y Number of additional shares to be issued

n = Rs.3,75,000 = 75,000 Shares Rs.105 21 y Value of the firm nP = (n+ n)P1-I+E = (1+ke) 25,000 + 75,000 (Rs.105)-Rs.5,00,000+Rs.2,50,000 1 21
1. 1

=Rs. 25,00,000

CONTD.
b ) Value of the firm when dividends are not paid y Rs.100 = P1 So , P1 = Rs. 110 1.10 y nP1 = (Rs. 5,00,000-Rs.2,50,000) = Rs. 2,50,000 y n = Rs.2,50,000 = 25,000 shares Rs.110 11
y

nP=25,000 + 25,000 (Rs110)-Rs5,00,000+Rs2,50,000 1 11 1.1

= Rs. 25,00,000

ANALYSIS OF ASSUMPTIONS
 Tax effect  Floatation costs  Transaction costs  Market conditions  Underpricing of

shares

RATIONAL EXPECTATIONS MODEL

y No impact of dividend declaration on the market

price of share until it is at the expected rate.