Dividend Decisions in Financial Management

Dividend DecisionsPloughing back of prof its , forms of div idends, factors affecting dividend pol icy, Retained Earning Vs. Dividend Decis ion; Walter Model; Gordon Model; MM hypothesis . Contemporary issues in f inancial management

05-04-2016 BCH 505 PROJECT FINANCE BY DR N R KIDWAI, INTEGRAL UNIVERSITY 1

Dividend policy: Ploughing back of ProfitsThe ‘Ploughing Back of Profits’ is a management policy under which all profits are not distributed among shareholders, but a part of profit is ‘Ploughed back’ or retained .

Retained earnings are utilised in future for financing investment needs and for meeting the fixed or working capital needs. It is also called ‘Internal Financing’ or ‘Self Financing’.

Internal financing is an ideal method of financing expansion schemes as there is no pressure to pay any return on this. It is an adjunct of sound financial management.

It requires no legal formalities as do borrowing from the public or from the banks. This Policy is a sound method of funding the projects without disturbing capital structure.

Under this method, a reasonable part of the earnings is transferred to various reserves like General Reserve Fund, Repairs and Renewal or Depreciation Fund, etc. The practice of retained earnings is appreciated because it helps in stabilizing the economic health of firm.


Does Dividend rate Matter?The value of the stock is based on the present value of expected future dividends

Why might a low dividend payout be desirable?

◦ Individuals in upper income tax brackets might prefer low dividend, due to immediate tax liability,

◦ Flotation costs – low payouts results in lower capital requirement thereby lower flotation costs

◦ Dividend restrictions – debt contracts might limit the dividend payout

Why might a high payout be desirable?

◦ Desire for current income :Individuals that need current income, i.e. retirees and Groups that are prohibited from spending principal (trusts and endowments)

◦ Uncertainty resolution – no guarantee that the higher future dividends will materialize

◦ Taxes : Tax-exempt investors don’t have to worry about differential treatment between dividends and capital gains


Forms of paying Dividends


•Cash Dividend: The shareholders are paid in cash per share.

•Bonus Share or stock dividend: Bonus shares are issued by the company when they have low operating cash, but still want to keep the investors happy.

•Stock Split: essentially the same as a stock dividend except expressed as a ratio

•Share Repurchase or share buyback: It occurs when a company buys back its own shares from the market. This is an alternative to the dividend as cash is returned to the investors.

•Property Dividend: The company makes the payment in the form of assets. The value of the asset has to be restated at the fair value while issuing a property dividend.

•Scrip Dividend: Scrip dividend is a promissory note to pay the shareholders later. It is used when the company does not have sufficient funds for the issuance of dividends.

•Liquidating Dividend: When the company returns the original capital contributed by the shareholders as a dividend, it is said as liquidating dividend. It is seen as a sign of closure.

Dividend PaymentDeclaration Date – Board declares the dividend and it becomes a liability of the firm

Ex-dividend Date◦ Occurs two business days before date of record◦ If you buy stock on or after this date, you will not receive the dividend◦ Stock price generally drops by about the amount of the dividend

Date of Record – Holders of record are determined and they will receive the dividend payment

Date of Payment – checks are mailed


Figure showing effect of dividend on share price

The share price will fall by the amount of dividend on the Ex date (time 0). If the dividend is Rs 5 per share, the share price will be Rs 100-5=Rs 95/- on the ex date.Before Ex date share price (time -1) = Rs 100/-On Ex date ( dividend of Rs 5/-) share price (time 0)= Rs 95/-

Share price= Rs 100/-

Share price= Rs 95/-

Ex date-t ……….-2 -1 0 1 2 ----------

Ex dividend price drop of Rs 5/-


Theories of DividendDividend irrelevance Approach: (profound by Miller and Modigliani)

Payment or otherwise of the dividend has same impact on firm’s value and shareholders are indifferent on dividend payments and retained earnings.

Dividend irrelevance approach : This approach prefers retention of earning.residual theory of dividend comes under the group

Dividend relevance approach: dividend payment influences the shareholder’s wealth.

◦ Smoothed residual theory, Walter theory, Group theory etc


Dividend irrelevance: M & M ApproachPayment or otherwise of the dividend has same impact on firm’s value and shareholders are indifferent on dividend payments and retained earnings. This approach assumes perfect market conditions

In all four situations shareholder’s wealth remain same.

1. Firm retains entire earnings and does not declare dividend.

2. The firm declares cash dividend and is paid. Share holder wealth is share price plus dividend

3. Firm declares dividend and issues shares in lieu of dividend, shareholders wealth remain same.

4. Firm issues new shares in lieu of dividend, shareholder may sell new shares to earn cash. The shareholder wealth remains same. The type of transaction is referred as homemade divided.

The value of shares during t+1 taking into account the capitalization rate for a specific class of risk𝑃𝑡+1 = 𝑃𝑡 1 + 𝜌 − 𝐷𝑡+1

Where 𝜌 is capitalization rate


Dividend irrelevance: IllustrationEx. If a firms share is selling at Rs 100/- and the firm was planning to declare dividend of Rs 5/- per share at the end of the year. The value of share at the end of the year if the capitalization rate is 10%.

A share holder holds 21 shares of the firm. Calculate share value & Share holder wealth if (i) firm does not declare dividend (ii) firm declares cash dividend of Rs 5/- (iii) If firm issue new shares in lieu of dividend of Rs 5/- (iv) if share holder sells extra share allotted in lieu of dividend of Rs 5/-

1. 𝑆ℎ𝑎𝑟𝑒 𝑉𝑎𝑙𝑢𝑒 = 100 1 + 0.1 − 0 = 110 𝑆ℎ𝑎𝑟𝑒 ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝑤𝑒𝑎𝑙𝑡ℎ = 110𝑥21 = 2310

2. 𝑆ℎ𝑎𝑟𝑒 𝑉𝑙𝑎𝑢𝑒 = 100 1 + 0.1 − 5 = 105

Wealth of share holder= Cost of shares + Cash dividend = 105𝑥21 + 21𝑥5 = 2310

3. 𝑆ℎ𝑎𝑟𝑒 𝑉𝑙𝑎𝑢𝑒 = 105 𝑆ℎ𝑎𝑟𝑒 ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝑤𝑒𝑎𝑙𝑡ℎ = 105𝑥22 = 2310

4. 𝑆ℎ𝑎𝑟𝑒 𝑉𝑙𝑎𝑢𝑒 = 105

𝑆ℎ𝑎𝑟𝑒 ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝑤𝑒𝑎𝑙𝑡ℎ = 𝑠ℎ𝑎𝑟𝑒𝑠 𝑉𝑎𝑙𝑢𝑒 + 𝑠𝑎𝑙𝑒 𝑝𝑟𝑜𝑐𝑒𝑒𝑑 = 105𝑥21 + 105𝑥1 = 2310


Residual theory of dividends

05-04-2016 BCH 505 PROJECT FINANCE BY DR N R KIDWAI, INTEGRAL UNIVERSITY

It says that dividend decision is primarily a financing decision.

i.e. profits should be first retained for meeting investment needs. If any amount remains after that (residual) it may be distributed in form of divided

The theory assumes that dividend decision is not relevant to the maximization of shareholder’s wealth.

Smoothened residual theory of dividend

The amount of dividend will be volatile as per residual theory. If market does not like this volatility, it will affect share prices.

The smoothened residual theory suggest that the amount of dividend should be set at a constant value plus a growth element. The set dividend represent an amount equal to earnings minus new investment.

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Walter’s model of dividend policy


It says that dividend decision is relevant to the investors. This theory states that the retention of earnings and dividend payment influence shareholder’s wealth differently. The model assumes three cases

1. When ROI on new investment > market capitalization rate; retention of earnings and their investment that will raise the value of shares.

2. When ROI on new investment = market capitalization rate; both the dividend and retention of earnings will have same impact on the value of shares.

3. When ROI on new investment < market capitalization rate; dividend raise the value of shares.

Share price 𝑃 = 𝐷 + 𝐴/𝜌(𝐸 − 𝐷) /𝜌

D= Dividend per share, E = earning per share, A= ROI on new investment, 𝜌 = market capitalization rate

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Gordon’s model of dividend policy


Assuming no financial leverage, absence of taxes, no external financing, constant return, constant cost of capital and constant retention ratio, Gordon model says that the market price of a share is equal to the present value of a infinite stream of dividends to b received by the shareholder.

𝑃𝑜 =𝐷 1+𝑔

(1+𝑘)+ 𝐷

(1+𝑔)2

(1+𝑘)2+ … . . +𝐷

(1+𝑔)𝑛

(1+𝑘)𝑛

It may be expressed simply as

𝑃𝑜 =𝐷1

(𝑘−𝑔)=

𝐸𝑃𝑆1(1−𝑏)

(𝑘−𝑏𝑟)Where b is retention ratio, k is ROI, r is discount rate

If r>k, increase in retention ratio leads to increase in share prices

If r<k, increase in retention ratio leads to decrease in share prices

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Factors affecting dividend policy Stability of Earnings. Firms with stable earnings may have a more consistent dividend policy than those having an less stable earnings as they can predict easily their earnings.

Age of corporation. A new company require much of its earnings for expansion and may adopt a rigid dividend policy while, an older company may have a consistent dividend policy.

Liquidity of Funds. greater the liquidity of the firm the better the ability to pay dividend. If less liquidity, stock dividend may be given and if good liquidity, cash dividend may be paid.

Extent of share Distribution. A closely held company may adopt conservative dividend policy. While a firm having a large shareholder base, would adopt a liberal dividend policy.

Needs for Additional Capital. Small companies find difficulties in raising finance for Investment needs. In the situation ploughing back of profits is good alternative and low dividend are paid.

Trade Cycles. Business cycles also influence dividend Policy. During the boom, earnings are retained for investments and low dividend is paid. While Higher dividend is used to market the securities in an otherwise depressed market.


Factors affecting dividend policy Government Policies. The earnings capacity of the firm is widely affected by the change in government policies. The dividend policy has to be modified accordingly in those firms.

Taxation Policy. High taxation reduces the earnings of firm leading to low dividends. Dividend-tax levied by government affects the capital formation. In India, dividends beyond 10 % of paid-up capital are subject to dividend tax at 7.5 %.

Legal Requirements. In order to protect the interests of creditors, the companies Act 1956 prescribes guidelines in respect of the payment of dividend. Also dividend can be declared after depreciation on its fixed and tangible assets. Also, contractual obligation like, payment of dividend on preference shares should be fulfilled over ordinary dividend.

Past dividend Rates. Dividend pay-out history of the firm and of rival firms must be considered in formulating the dividend Policy. The current rate should be around the average past rate. If it has been abnormally increased the shares will be subjected to speculation.


Factors affecting dividend policy Ability to Borrow. Established firms have better access to the capital market than new Companies and may have a better dividend pay-out ratio. Whereas smaller firms have limited borrowing ability therefore a large portion of earnings may be retained for investment.

Policy of Control. For better control, management may declare a dividend at low rate and retained earnings may be used for investment needs. As addition of new shareholders may lead to fear of dilution of control and diversion of policies of the existing management.

Repayments of Loan. A company having loan indebtedness are vowed to a high rate of retention earnings, thereby lowering down of dividend rate. Formal loan contracts provide a certain standard of liquidity and solvency to be maintained thereby limiting dividend rate.

Regularity and stability in Dividend Payment. Investor are interested in the regularity and stability of dividend. For this purpose sometimes companies maintain dividend equalization Fund.


Managements’ View of Dividend PolicyAgree or Strongly Agree◦ 93.8% Try to avoid reducing dividends per share

◦ 89.6% Try to maintain a smooth dividend from year to year

◦ 41.7% pay dividends to attract investors subject to “prudent man” restrictions

Important or Very Important◦ 84.1% Maintaining consistency with historic dividend policy

◦ 71.9% Stability of future earnings

◦ 9.3% Flotation costs to issue new equity


Dividend Decisions in Financial Management

Economy & Finance

Transcript of Dividend Decisions in Financial Management