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i
Ii
Dividend
Decisions
A
dividend
is a payment
made
by
a
corporation to its
shareholders
usually
as
a
distribution
of
profits
When a corporation earns a
profit
or a surplus the
dividend
netprofits
distributed
corporation is
able to
reinvest
the profit in
the
business retained
earnings
among and
shareholders
pay
a proportion
of
the
profit
as
dividend to
shareholders
High
Payout
ratio
Janis ationtigion Thisdisposition
of
earnings
is a fundamentalproblem in
financial
management
lowPayout
ratio can
dividends
morefunds
the management
of
an enterprise has an
important financial
decision
to
decide
for
enpansion growth
about the
disposition
of
income after meeting all
business
expenses
of
the
total
business
profits
a
portion
is
retained
for
reinvestment
in the
vidend policy
decisions involve
aimportantquestions
business
andthe
rest is
distributed
to
shareholders
as
dividend
what
fraction
of
earnings
should
bepaidoutovertime
hould the firm
maintain
asteady
stable
vigand
growth
Dividend
Policy it is
the
decision concerned with
paying
dividends
to the
shareholders
of
the
business
itsaimis to
maximise
shareholders
return which in turn
lea
to
manimisation
of
value
of
investment
it
indicates
the performance
of
the
firm
to the
investors lende
bankers
society
in general
yardstickthrough
which
market value
of
shares is
measured
highly
sensitive to behavior
of
investors
itsobjective
should be to divert
fundsfrom
the less
productive operations
to more productive
ones
of
the management
finds
itself
in a declining industry they
want to
retain more
funds
for
the
business operations and
pay
out
less so as to
conserve
funds
Which
isnotbeneficial
for
shareholders
They
may
also
try
to
retain
fu
for
other profitable
investments
so continuity
of
the corporation can be
Forms
of
dividend
cash
dividend flow
of
funds
reduces
net
worth
of
company
requiresliquid
resources
Scrip
Bonddividend promise to
pay
at
afuture
date
issues notes or
bonds
Property
dividend
paid
in
form
of
assets
stock
dividend
inue
of
bonusshares
through
capitalization
of
earnings
doesn't affect cashposition
maintained
Determinants
of
Dividend decisions
stability
of Earnings
stable
and
growing
earnings
allow companies to
maintain
a
high
dividend
payout
consistently supporting a
reliabledividend
policy
andbuild in
shareholder confidence Firms with
volatile
earnings
keeppayoutlow
FinancingPolicy
of
Company theapproach a company
takestowards
financing
suc
as
whether
it
prefers
equity
or
debt
influences
dividend decisions Firms
relying
m
internal
financingusually
retain more earnings
While
firms
with
easier acc
financing
pay
higher
dividends
liquidity
of
Funds sufficient cash andliquid
assets
are necessary
for
paying
cas
dividends Even profitable
companies
may
limit
dividends
if
liquidityislow
Otherwise
they
may
resort
to other
forms
of
dividend
Dividend
Policy
of
Competitive
Concerns companies often
observedividend
policies
of
i
competitors which
may
push high payout
or low payout strategies
depending
plaitdidEnd pites
firms
with a history
of
paying
stable
or rising
dividends
ten
to
maintain
orgradually
increase
highpayout
ratios
to
sustain
investor
trust
Changing
payout
ratios drastically
may
hurt
marketperception so
companies
often
match
payou
policiesto
historicaltrends
Debt
Obligation Heavy
debtloads leadto
lower
payout
ratios as earnings
ar
retained
to
meetinterests andprincipal payments
Cow or manageable
debt
levels enable
high
payout
ratios as
lesscashneeds
to
bepreserved
for
financing
costs
Growth
needs
of
Company
High
growth
firms
require
more
retained
earnings
for
expansion
usually
adopting
low
payout
ratios Mature
companies
with
few
growth
opportunities
often
distribute
more earnings as
dividends
Profit
position
of
Company
firmsearning
more
profit
distribute more
dividends
kind
of
dividend
Typeof
Security
Timings
Mode
of
Payment
Preference Equity
Interim
Regular cash
stock
script
Bond
and
others
A
dividend
cannotbe
paid
unless
sufficient
profit
enists Irregular
Dividend
Policy
companies facing
constraints
of
earnings
and
recommended
by
BOD
unsuccessful
business
operations
may
follow
irregular
dividend
policy
It is
acceptance
by
shareholders
in AGM
temporary
arrangement to
meet
financial
problems
No
Dividend
policy
companies
may
follow
no
dividend
policy
due
to unfavoura
workingcapital
position
of
the
amount required
for
future growth
of
the
concerns
Procedural
legal
aspects
of
Dividend
1
Legal
aspects
of
dividend
Sources mode
of
payment
dividends
can
only
be
paid
in
cash
They
may
be
remitte
by
cheque
warrant
or
electronic
transferto
bank
account
provided
by
shareholders
Issue
bonusshares
is an
exception as
they
are not
considered
cash
dividends
Profits
available
for
dividend dividends
can
only
be
declared
from
current
year
profits
afterdepreciation
profits
after transferring
prescribed
percentage
to
reserves
accumulated
profits
of
previous
years
subjectto
conditions
Newly
incorporatedcompanies
cannot transfer
morethan 10
of
their
profits
to
reserves
Dividend
out
of
reserves
if
inadequate profits
exist
in
a
year
dividend
may
be
declar
out
of
accumulated
profits
under the following
conditions
dividend
rate
cannotexceed
avg
of
last
Syrs
dividend
or 10
of
paid
up
capital
whichever
lower
withdrawls
from
reserves
must not
exceed 10 ᵗʰ
of
paid
up
capital
free
reserves
interimdividendcannot
be
revoked
post
withdrawl reservesmustremain at
least 10
ofpaid
up
capital
Final
dividend
canbe
revoked
only
with
shareholderconsent
Restrictions dividend cannot
be
declared
for
past
accounting years
where
accounts
are
already
adopted Dividend once
declared
becomes
a
debt
of
the company
Timelimits compliance
declared
dividendmust be
deposited in
a separate
bank
account within 5
days
of
declaration
Paymentmustbe
made within 30
days
if
not
transferred company
pays
12
annual interest on unpaidsumto
shareholders
An
unpaid
dividends
lying
in the Unpaid
Dividend
Accounts
for
years
must be
transferred to
InvestorEducation
Protection
Fund
Procedural
aspects
of
dividend
Board
Resolution
BOD
decides whether
to
declare dividend
interim
dividend
canbe
declared
solely
by
board
shareholders
approval
AUM
final
dividend
requires
shareholders
approval
shareholders cannotincreasedividend
beyond
what
board
recommends
but they
can
reduce it
Record
Date
dividend
will
be
paid
to
those
shareholders whose namesare
listed in the
register
of
members as on
record date
Mode
of
Payment paidthrough
cheque
warrant
or
electronic
transfer
joint
shareholders
paid
to
first
named holder
fractional
amounts
so paise
rounded tonext so
paiseignored
dematerialized shares
paid
as
per
list from
depository
Unpaid
Dividend unclaimed
fundsafter
years
are transferredtoIEPF
Thevalue
of
the
firm
canbe
maximised when the
shareholders wealth is
maximised There are 2
schools
of
thought
regarding
theimpact
of
dividend
decision
on
shareholders wealth
Irrelevance
Theory
Relevance
Theory
firm
manimises
value
by
paying
all earnings
as
dividend
criticisms
pain illiterate
Earnings
thus
if
rake
100 payouts no
investment
of
retained
earnings
asines
constant
rek
disregarding
Walter
concludes
theoptimum payout
ratio is nil
in case
of
a growth
firm
payout
ratio
I
Y
É
militia
constant
firm
is
irrelevant
anddeclining
firm
is
100
p
D r ke
E D
where P
market
price
of
share
D
dividend
per
share D eps
l b
wherebis
tage
retained
r rate
of
return
Ke
cost
of
equity
E
earnings
per
share
Gordon's Model
Theory
according to
Gordon's model
dividend
per
share is
expected
to
grow
when
earnings
are
retained The
dividend
per
share is equal
to the
payout
ftp
jn
l
ilfn
f
I
p
in
p
naggin
ratio multiplied
by
earnings
D Eps
1 b To
determine
thevalue
of
the
firm
thus
based
on
dividend
growth
model the value
of
the
firm
willbe
fi
Ii i
iiaim
so
i
where Po
intrinsic
price
per
share
K
cost
of
equity
D
dividend
per
share D
EPS 1 b
g
growth
rate
b
T.pgtti.mn
The
conclusions
of
Gordon's
model are
similar to
Walters model
dueto the
fact
tha
their set
of
assumptions are
similar
when r k
market value
of
Po
increases with
retention
ratio b
for
firms
with
growth
opportunities
when r k
market value
of
Po
increases
with payout
ratio 1 b
for
declining firms
when
r k
marketvalue is not
affected
by
dividend
policy
11 Irrelevance Theories
Thepropagators
of
this
school
of
thought
were
France
Modiglianiand
Merton
Mill
They
state thatthe
dividend
policy
employed
by
a
firm
does not
affect thevalue
of
the
firm
They
argue
that the
value
of
the
firm
is dependent on the firm's
earnings
whichresult
from
its
investment
policy
such thatwhen the
policy
is
given
the
dividend
policy
is
of
no consequence
MMHypothesis As
per
thismodel under
conditions
of
a perfect capital
dividen
decisions
and
retained
earnings
donot
affect marketvalue
of
shares
umption
li i
Fini
iint i
case 1
firm
has
sufficient
earnings surplus
to
pay
dividends
III
Estette investment
policy
int
iEt ieiaieipi no
effect
on
firm
value since
investmentneeds
arealreadymet
I
toilet
jaith
In.at
cf
Case
2
firm
doesn't have
sufficient
funds
so it
issues
newequityto
pay
dividends
firm
wants
to
pay
dividends
but
lacks
fundsafter
meeting
investment needs
raisesadditional
capital
by
inning
new
shares
cash
given
as
dividend
is
effectivelyreplaced
by
capital
raised
from
shareholders
shareholderswealth
is unchangedastheir
proportionalownership
investment
value is
const
no change
in
value
of
the
firm
Case 3
firm
does not
pay
dividend
but
shareholders need cash
earningsare
retained
for
investment
shareholders
who require
liquidity sella portion
of
their
shares to generate
cash
act
of
selling
shares replicates
same
cash
flow
effect
of
dividend
investors are notworse off
whether
firmpays
dividend
or not
of
ownershipandthe
bonus shares are
treated no differently than
the
normal shares
Theissue
of
bonussharesleads to
decrease
in
accumulated
profits
of
the
year
with
simultaneous increase in
paid
up
share
capital
It is
known as capitalization
of
profits
and
reserves It is generally
usedwhen companies
have
accumulated
reserves
and wantto
capitalize them
Bonus shares
increase
thetotal
number
of
outstanding
shares however net
earnings
EPS
NfqgÉT
of
the
company
remainthesame andas a
result theEPS
decreases dilutes
proportionally to
increase
in
shares
Thus
it
shows
financialstrength
or rewards
shareholders
but
dilutes
EPS whi
may
reduce
perceived
profitability
per
share
Advantages
rewards
shareholders without
distributing
cash
company
confidence
by
investors
makes shares more
affordable
Disadvantages
dilutes EPS
no
actualincrease in
shareholder wealthsince no cashis
given
stock
split
A
stock
split
is
done
by
reducing
the
par
value
of
the
shares
by
increasingthe
number
of
shares
proportionately It
increases the number
of
shares
outstanding
by
dividing
existing
shares
reducing
the
nominal value
per
share
without
changing
the
company's
overall market capitalization
Itis
different
from
bones inue as the
totalvalue
of
the paid
share capital remains
the
sameandthe
par
value
of
the
shares is
reduced
as
opposed tothat
of
bonusissue
It isgenerally
usedwhenshare
price
becomes
too high limiting
accessibility
for
small
investors
and
helps
maintain a
desirable
tradingprice range
and liquidity
A
stock
split
decreases
a
company's EPS
because
the
total
earnings
are
divided amon
a
larger
number
of
shares while
the
company's net
income
stays
thesame Thus
helping
improving liquidity
affordability
Advantages
makes
sharesaffordable attractive
to
retail
investors
more
shares available
for
trading
increases
liquidity
psychologically
boost demand
for
shares
Disadvantages
does
notadd
intrinsic value purely
cosmetic
change
may
leadto
increased
volatilitydue
to more
shares
trading
Buy
Back
of
Shares
A Buyback
of
shares is
also known
as
stockRepurchase It
occurswhen a company
repurchases itsown
shares
from
the
marketplace usually higher
thanthe
market
price
to
reduce the
number
of
shares available
in the open
market The
motive couldalso incl
increasing
the
value
of
remaining
values and thereby prevent
other
shareholders
fro
having
a controlling factor
over
the
company
improve
EPs support
share
price
during
difficult marketconditions
It is
used to
signal
undervaluation
or
return excess cash to
shareholders
It is
employedwhen growth
opportunities
are
limited
or to adjust
capital
structure
Sometime
to
offsetdilution
or defend against
hostiletakeovers
Buyback
reduces
the
number
of
01s shares as the company
repurchases and
retiresshares
since net earnings
stay
the
same but the
denominator decreases
theEPS
increases I
may
improve financial
ratios but
reduces
cash
reserves
Advantages
increases
EPS
boosts share price
signals managements confidence in company's
undervaluation
provides tan
efficient returns
to
shareholders
ascompared to
dividends
flexible
way
to
return cash
without
committing toongoing
dividend payments
PracticalProblems
Compute
the
market
price
of
XY
td's share
underWalters model
EPS
ES
DPS 3
Cost
of
capital
InternalRate
of
Return 16
As
per
Walters model
P
r ke
E D
01st
1016100
s 3
The
cost
of
capital
andrate
of
return on
investment
of
R'Ltd are 10 181
respectively The
company
has 5
lakh equity
shares
of
each
outstanding andEPS
is 20 Compute
market
price
of
share value
of
the
firm
in the following
situation
i
No
retention
ii
retention
iii
retention
Use
Walters model
comment
on
results
As
per
Walters model P
r
k
E D
ke
r
D
EPS 1 b
a
D
b
p
c
D 20
AlsoValue
of
the
firm
P
xNumber
of
Shares
Scenario
Retention
Payout
Formula Price value
a 0 100
20 20
00,
b 40
12 264 13, 00,
c 80 20
4
0
120 4
328 16, 00,
The
EPS
of
ABCompany Ltd is 10 andrate
of
capitalization applicable is
12 The
company
has the
option
of
adopting
i so ii
iii 100
dividend
payout
ratio
Calculate
the
market
priceof
the
company's quoted
shar
as
per
walters model
if
it can earn a
return
of
i
ii
iii
on its
retained
earnings
As
per
Walters model
P
D
v
E D
10
ke
D EPS
1 b
a
10
g
b
10
1 0.
c
10
1 0 10
If
EPSis
and Equity
capitalization rate is
20 internal rate
of
return is
16 Findthe
market
price
of
a
share
using
Gordons Model
if
retention
ratio is
a
b
As
per
Gordonsmodel
Po D
k
g
D
ensure
is
i
3
k 0.
g
or
is
Thus
a Retention
ratio is
Po
b
Retention Ratio
is 251
Po
If
EPS 10
Equity
capitalizationrate 16 and
InternalRate
of
return is
Findthe
market
price
of
a
share
using
Gordons
model
if
retention
ratio is
40 What isthe impact
on
share
price
if
equity
capitalizationrate IRR are
reversed
As
per
Gordon's model Po
1g
D EPs
1 b 1011 0.
k 0.
g
br
1
i
Po
7S
of
Equitycapitalization rate is
and
internal Rate
of
Return
is
16 then
D
G
k
g
br
1 0. 0.16 0.
Po
1176
share
price
decreases
if
IRR K are
reversed
The
information
given
belowshows the
rate
of
return on an
investment cost and
earnings
per
share
of
Tata Itd
cost
of
capital
12 EPs EIS
andrate
of
return i 1st ii 121
iii at
Determine
the
value
of
share
using
Gordons
model
assuming
dividend
payout
ratio
is a 100
b
c
so t
d
As
per
Gordon'smodel Po
11g
k 0.
EPS EIS
D EPs
l b
a
is
is
b
is
c
is
1 o s
d
is
1 1 0
g
br
therefore
The
capital
structure
of
a
company
is as
follows
Equity
share
capital
100 sh 100 lakh
Earnings
for
Eq
Shareholders
Price
of
share in beginning
Equity
capitalizationrate
a calculate theoretical market
price
of
equity
share under MMmodel
the
company
is considering payout
of
i
b
calculate value
of
firm
using
MM
model The
company proposes
to
mal
a new
investment
of
12,20 000
a
EPs
198988s
Po
Pi Politke Di
Po 100 ke
odito
8
110
Payout
P
Payout
Pi 100
1,
b
calculation
of
value
of
firm
v
nD
Intan
P
itke
Particulars Dividend
not
declared
Dividend
is
declared
1
Ke
n no
of
shares
1
00,000 1,
total
earning
for
eq.sn
10,
10 00,
NDI total
dividend
O
i
1100,000 0
nDi
retained
earnings
10,001000 2
00,
new
investment
12 20,000 12 20,
entg
financing
2,201000 10
20,
12 20,
10
00,
12 20,000 2,
000
Dn
sharestobe
inued
2
20,
no
20
8
102
Value
of
firm
1110,
8
0 2.
8,
119,0 1,
10.20.
100 lakhs 100
lakhs
The
Agro
chemical
company
belongs
to a risk
class
for
which
appropriate
capitalisation is
10 It currently
has 1,
000 shares
selling
at 100 each
The company
is contemplating
declaration
of
dividend at 5
per
share
theend
of
current
fiscal
year
which has
just
begun
What willbe the
priceof
the share at the
end
of
the
year
if
dividendis not
declared
What will it
be
if
one is
declared Answer on basis
of
MMModel
assuming
no taxes
As
per
MM
Model
P
Po Itke DI
1
If
no
dividend
is
declared
Di
0 ke 0.
Po 100
Pi 100 1 0.
0
110
if
dividend is
declared
Di
5 ke 0.1 Po 100
p
s
10s
