DIVIDEND POLICY

13
CHAPTER OBJECTIVES
. Understandthe impact of dividend decision on valuation ofa firm.
MM, Walter and Gordon's Approach.
Determinants of dividend policy.
Types of dividend policy.
Efects and objects of bonus issue.
SEBI Guidelines for the issue of bonus shares.
Accounting for bonus issue.
Bonus issue vs. stock split.
Legal and procedural aspects of payment of dividend.

NTRODUCTION
The term dividend refers to that part of profits of a company which is distributed by the company
nong 1ts shareholders. It is the reward of the shareholders for investments made by them in the shares of the
any. The investors are interested in earning the maximum return on their investments and to maximise their
A company, on the other hand, needs to provide funds to finance its long-term growth. If a company
d a s dividend most of what it earns, then for business requirements and further expansion it will have
h upon outside resources such as issue of debt or new shares. Dividend policy of a firnm, thus aftects
Bid ongterm financing and the wealth of shareholders. As a result, the firm's decision to pay dividends
c h e d in such a manner so as to equitably apportion the distributed profits and retained earnings.
Vidend is a right of shareholders to participate in the profits and surplus of the company for their
hould hthe share capital of the company, they should receive fair amount of the profits. The company
lue relore, distribute a reasonable amount as dividends (which should include a nornmal rate of interest
1or the risks assumed) to its members and retain the rest for its growth and survival.

BIVIDENDDEDECISION AND VALUATION OF FIRMS

vioughd
ews ueof the firm can be maximised if the shareholders' wealth is maximised. There are contlieting
the impact of dividend decision on the valuation of the firm. According to one school of
De
other n a decision does not affect the share-holders' wealth and hence the valuation of the
hand, accordin ticm. On
hand also the ding to the other school of thought, dividend decision materially atfects the
shareholders
We valuation of the firm.
ave discussed below
the views of the two schools of thought under two
groups
he Irrelevance Concept of Dividend or the Theory of lrrelevanee, and
ne
Relevance Concept of Dividend or the Theory of Relevance.
 5.3
aendPoic

132 Dividend Policy Market price per share at

Where
a share
the beginning of the period, or
prevailing market price of
1. THE IRRELEVANCE CONCEPT OF DIViDEND OR THE THEORY OF IRRELEVANCE:
D, Dividend to be
received at the end of the period
A RESIDUAL APPROACH Market price per share at the end of the period.
Acoonding to this theory. dividend docision has no eflect on the wealth of the shareholders or P Ke Cost of equity apital or rate of capitalisation
the
pies of the shares and hence it is imelevant so far as thc valuation of the firm is concerned. This theoryreoard. be derived by the above equation
can as under
dividend decision merely as a part of financing decision because the may be retained in value of P,
business for re-investment. But. if the funds are not requircd in the
earnings available the The P=P,(1+ke) -D
they may be distributed as
business a an be explained in another form also
dividends. Thus thc decision to pay dividends or retain the carnings may be taken as a residual decision. This presuming that investment required y
theo asumes that investors do not ditterentiate between divIdends and retentions by the firm. Their basic The MM ent of dividends is financed out of the new issue of the
account
equity shares
desire is to eam higher return on their investment. In case the firm has investment opportunities
prolitable giving case, the number of shares to be issued can be cornputed with the help of the llowing
In such
a
of reurn than the of retaincd carn1ngs. the investors would be with the firm
ahigher rate cost
content retaining
the eamings to finance the same. However. if the firm is not in a position to lind profitable investment
opportunities the investors would prefer to receive the earnings in the form of dividends. Thus, a firm should
m
1(E-nD
retain e a r n i n g s if it has profitable investment opportunities otherwise it should pay them as dividends.

B4ODIGLLANI AND MILLER APPROACH MM MODEL) iher. the value of the firm can be ascertained with the help of the following iomula
Modigliani and Miller have expressed in the most comprchensive manner in support of the theory of (n+m) Pj - ( - E)
irelevance. They main tain that dividend policy has no market nP,
on effect the
oftheirmisetermined by the earning capacity of the firm or its investment policy. The splitting of earnings
price of the shares and thevalue 1+ke
number of shares to be issued
firm does the of the Where,
between retentions and dividends. may be in any manner not the affect
likes, value firm. Investment required.
As obser ed byM.M. -Lnder conditions of perfect capitalmarkets. rational
investors,
discrimination berween dividend income and capitai appreciation. given the firm's investment policy, its dividend
absence of tax Total earnings of the firm during the period.
Market price per share at the end of the period.
no miuence on the market price of the shares. Cost of equity capital.
policy m2y have Ke
Assumptions of MM Hypothesis n number of shares Outstanding at the beginning of the period
The MM hypothesis of irelevance of dividends is based on the following assumptions D = Dividend to be paid at the end of the period.
nP
=Value firm of the
i ) h e e are períect capital markets.
illustration to 1llustrate MM hypothesis of irrelevance of dividend to the
javesturs behave rationally. Let us take the following
(ii
(i Information about the company is available to all without any cost dision of firm.
iv There are no ioatztion 2nid ransacti on costs. Hustration 1. ABC LId. belongs to a risk classfor which the appropriatecapitalisation rate is10
(v)oinvesor i15 2rge enough to ettect the market price of shares. shares selling at R100 each. The firm is contemplating the declaration of
either no z r e s there are no diffeTences in the tax rates applicable to dividends and tamently has outstanding 5,000
of the current financial year. The company expects to have a net income
TnTe are r
(vi) of 6 share the end
idend per at
apitai g2irns. that under the MM hypoth e s s ,
tE000 and has a proposal for mak1ng new investments of KI,00,000. Show
(iiy The frm has a rigid invesimert policy. does effect the value of the firm.
(iiy ThaE 1s no isk run ceTainty in regard to the future of the firm. (MM dropped this assumption payment of dividend not

The Argumeat d MM
of
is that whatever increase in the valuc 419Value of the firm when dividends are paid :
T e argunent givn by MM in support of their hypoahesis
of
t e firm reuis fron the ayITt of dividaid, vill be eracaly off set by
the decline in the market price shares Price of the share at the end of the current financial year
P, = P, ((+ke) - DP
For exampie,
will be n o change in the uaal wealth of the shareholders.
t E n a n a l finarcinz and there = 100 (1+.10
a
y. 121Tg i v e n r n t opprurities.
disiributes all its carnings among the sharehol deTs, it will nave
r in number of shares or pa yinen == 100 1.10-6
a i r z l funds frorn enenal v u r v e . This vill result in the increase
rai the future. Thus whatever a shareholdeT gains
1 10-6 =* 104
T at2e, Tevitun in fall in the arnings per share in a NumbeT of shares to be issucd
T. aiIrirt dividad peynat is rautraliel cnpleely by the fall in the market priCe of shares due o ue

T E a 1 g pa hare fo
te mnre spgeific, the mnarket price of a share in the beginning or
a
m -E-nD)
B u tre revait valut i dividnds paid at the end of the period plus the market price
of tne
snai P
PA g a
a the e d A the peaus This an tn put in the fiam of the following tormula 1,00,000-(50,000-5,000x6)

104
, +P 80,000
, . 104
Tay Value of the firmn

nP (n+m)P-(1-E)
1+ke
 13.4 Dividend Polig pitndPoliy
when dividends are not paid:
Priceper share
s.000 x104-(1.00.000 -50.000) P P, (1ke) -D
104 19(115
711.5
shares to be issued if dividend is pad
Number of new equity
s.20.00080.0001-(50,000
x
m E-nD)
104 P
I.10

6.0000-50.00 2.00,00-(1,10,00-50.012
9.5

5.50.00=z 5.00.000. 1,90.0 20,000 shares

9.5
BVane te im
-ten dnideads are not paid
P P (1e)-DP. Criticism of MM Approach
1 0(1-10
100.10 = 110
MM hypothesis has been criticised
on account
of various unrealistic assumptions as gven belz
Prefect capital market does not exist in reality
Nonber of s s be isei is not available to all the peTsons.
2 Information about the company
have incur flotation costs while issuing securities.
3. The firms to
tax treatment for dividends and capital gains
4. Taxes do exit and there is normally different
1.00.000-50. 00-0 5. The firms do not follow a rigid investment policy.
110 while doing any transacticn
6. The in vestors have to pay brokerage, fees, etc.
50.000 7. Shareholders may prefer current income as compared to further gains.

110 OR THE THEORY OF RELEVANCE

2 THE RELEVANCE CONCEPT OF DIVIDEND

decision holds that the dividend decisions considerably afie

The other school of thought on dividend
Jone Linter, lams wa
of this school of thought include Myron Gordon,
1e ne value of the firm. The advocates communicate information to the investors about
the tirms

5.000 chardson. According to them dividends

5,0001101.10-(1.00.009-50,09)
dividends, *il
Those firms which pay higher a
POtability and hence dividend decision becomes relevant.
10 cater value as compared to those which do not pay dividends or have a lower dividend
pay Out rato
1ave examined below two theories representing this notion:
5.50.00+50.000, 10 s0.000 Walter's Approach, and (i) Gordon's Approach
110 1
LI0 i) WALTER'S APPROACH
6.00,000-50.000 are relevant and anect une va
1.10 Prot. Walter's approach supports the doctrine that dividend decisions
the firm and its cost of apid
ignificant in1he relationship between the internal rate of return earned by
5.50.069? 5.00,000.
1.10
determining the dividend policy to subserve the ultimate goal of maximising tne
haders Praf. Water's modd is basad an therdaianship batwean the fim's
t
return on investmen
Hence, whetha dividends are paid or not, the value of the firm remains the same 5,00,U0 and(i) the cost of capital or the required rate of return, i.e.k.
According to Prof. Walter, I f r > ki.e., i f the firm earns a higher rate of return on i s n vestment
A than
the
ary 1. TD
THastration 2. Expandent Lid. had 50,000 equity shares of T10 each outstanding on Januan t stra u i r e d rate ofreturn, the firm should retain the earnings. Such firms are termed as growu u
shares are curentiy being qured at par in the market. In the wake of the removal of dividend re nsr payout would be zero in their case. This would maximise the value of shares.
company now intends to pay a dividend of 2 per share for the current calendar year. It belong
toa
belongs tie pmunn case ofdecining firms which do not have profitable investments, i.e., where r<E.tnes
class whose is MM model and assuming no taxes,
appropriate capitalisaticn rate 159%. Using ascertd and
of the company's share as it is likely to prevail at the end stand to gain if the firm distributes its earnings.
For such firms, the optimum pay-u
of the year (i) when dividend is d musti and the firms should distribute the entire
earnings as dividends.
when no dividend is declared. Also find out the number
to meet its investment needs of 2 lakhs,
of new equity shares that the couing
thal h c s e or normal firms where r = k, the dividend policy will not atect the market vaiue or s
assuming a net income of 1.1 lakhs and also a3 1um
as expected by them. For such firms, there
the is o
dividend is paid. dividend
dividend nav
pay out andget same
the value of
return fom the firm
the firm would not change with the change in
aiv
Solution: Assumption of Walter's Model
( The investments of the firm are afinanced not
firm
earnings only and the
docs
i) Price per share when dividends are paid (Gi) The Iemal sources of finde
nced
through retained earmingo
P C n t e r n a l rate of retum
P (1tke)- D (r) and the cost
of capital (k) of the firm are co1 stant.
10 (1+.15)-2
1.5-2 7 9.5
 13.6 13.7

Dividend Po
r i d e n dP o l i c y

(iii) Earnings and dividends do not change while determining the value. 48 = 100+320 = 100 + 400
(iv) The firm has a very long life.
10010 420 =
500
Walter's Formula for Determining the Value of a Share 7
Walter has developed a mathematical When
58dend pay o
dividend pay o u t
is 400%

equation to ascertain 08 50-20)

a firm to arrive at the
appropriate dividend decision. His equation
the market price of a
is based on the
share which
following
enaki
)
12
P _2010 P 20
+
10(50-20)
model: share valuatin P 1 0 5 0 - 2 0 )
.10 .10 10 10
D
P-ke-g 200+ 10
= 200 +240 200+ 300
Where, P = Price of equity share
-7 440 =7 500
D = 7 560
=
Initial dividend per sharee dividend p a - o u t
is 80%
When
ke =
Cost of equity
capital d)
.12 08 50-40) 10
10(5040) )
Expected growth rate of earnings/dividend
g
P
4 1 0 ~ 4 0 )

P -
Prof. Walter has given the following formula to ascertain the market price P0 (50 40)
.10 .10 10 .10
of a share P1010 = 400+80 400+100
D+r D) 400+1 20
=480 500
P ke_ =75520
is 100%
When dividend pay-out
ke (e)
P = + (E-D)/Ke .250 50 so 5 0 50) 501050-50)

ke ke
P 1 o 0 - 5 0 )

.10
5010.10
10
=

10 .10
where, P = Market price per share .10
500+0 S00+
D =Dividend per share 500+0
= T 500 S00
500
lnternal rate ofreturn
E =
Earnings per share Conclusion : From the above analysis we can draw the conclusion that when,
ke =
Cost of equity capital
Let take the
(i) r>k, the company should retain the profits, i.e., when r=12%. ke=10%;
us following illustration to understand the above equation.
r is 8%, i.e., r<k, the pay-out should be high; and
Illustration 3. The following information is available in respect of a firm (ii)
Capitalisation rate = 10% (ii) r is 10%; ie., =k; the dividend pay-out does not affect the price of the share.
Earnings per share 50 Criticism of Walter's Model
Assumed rate of return on investments Walter's model has been criticised on account of various assumptions made by Prof. Walter in
(i) 12% formulating his hypothesis
(ii) 8% i) The basic assumption that investments are financed through retained earnings only is seldom true
(iii) 10% in real world. Firms do raise funds by external financing.
Show the effect of dividend policy on market price of shares applying Walter's formula when dividend (i) The internal rate of return, i.e., r, also does not , remain constant. As a matter of fact, with
pay out ratio is (a) 0% (b) 20%, (c) 40%, (d) 80%, and (e) 100% inereased investment the rate of return also changes.
Solution: (ui)
The assumption that cost of capital (k) will remain constant also does not hold As a
good. firm's
risk pattern does not remain constant, it is not proper to assume that k will always remain
constant.
P
D r(E-D)/ i) GORDONS APPROACH
e
Effect of dividend policy on market price of shares
VYron Gordon has also developed a model on the lines of Prof. Walter suggesting that dividends
)-12% (ii) r=8% (iin) 10%
followin nd the dividend decision of the firm affects its value. His basic valuation model is based on the
(a) When dividend pay-out ratio is 0
0.10(50-0)/.10
1Ollowing assumptions:
p , .12(50 -0)/.10 008(50-0/.10 P 10
(i) The firm is
10 P10 10 .10
(i)
an all
equity firm.
0S(50) 10 50) external financing is available or used. Retained earnings represent the only source of
=0+
50) = 0+10 =0+ inancing investment programmes.
600
.10
400
.10
= 500
.10 (iv) Tate of retum on th firm's investment r, is constant. firm g= br,
(b) When dividend pay-out is 20% is al
is ron ratio, b, once decided upon is constant. Thus, the growth rate of the
also constant.
.12 08 50-10)
10) P .a0-10)
capital for the firn remains constant and it is greater than the growth rate, i.e. k> br.
The sfirm or
vi) The
J0-
P 0 10 (50-10) P 0 vi has
10.10 10 10 .10 (i)
Corporate perpetual life
taxes do not exist.
 thtilend
Pohey

13.8
Dividend Policy 10
According to Gordon, the market value of a share is cqual to the prescnt valuc of
of tuun future stream 0.12
dividends. Thus, of 12
0.12 83.33 33.3
D
D + 2+ 89%or
b=
= { 83.33

r a o
1s
P *** *****

(1 k) (1+k) (b)
tb)
Whem Dp
10(1-0.20) P F
100-0.20) 101-92
Dt PO.12-(0.20) (0.15) 0.12-0.20 (0.12) 12-029) (0.19)
(1+ =
0.096
Gordon's basic valuation formula can be simplified as under 0.09 =7 83.33
=788.89
PE-b) h=60
ratio is 40% or

ke--br When Dp
c)
10(1-0.60)
10(1-0.6) 101-96
Po D_ Dal+g) PO.12-(0.60)(0.15) 0.12-(0.60) (0.12) '012-(9.660,19.1
or,
ke- ke-g 4
P= Price ofshares 4
where 0.03
0.048
66.67
E=Earnings per share =7 83.33
-7 133.33
b=Retention ratio
ke =Cost of equity capital
Gordon's Revised Model
br=g=Growth rate in r,i.e., rate ofreturn on investment all-equity firm
ofan of capital (k) r e m a i n s consant for
in Gordon's Basic Valuation Model that cost
D-Dividend per share The basic assumption in the
Gordon revised his basiC model to consider risk and uncertanty.
not true in practice.
Thus,
D,=Expected dividend at the end 1.
ofyear a firm is
that even when r = k, dividend policy affects the value of shares on account of

The implications of Gordon's basic valuation model may be summarised as below: revised model, he suggested rate than they discount n e a r dividends
of future, shareholders discount future dividends at a higher
1. When the rate of return of firm on its investment is greater than the required rateofreturn, ie uncertainty on a certain
viz. (1) investors a r e risk averse, and (1) they put premium
a

when r k . the price per share increases as the dividend payout ratio decreases. Thus, growth That is there is a two fold assumption, investors are rational and they want
to avoid risk.
returns. Because the
return and discount/penalise uncertain
firm should distribute smaller dividends and should retain maximum earnings. dividends. This argument is described
as bird-in-the hand argument,
2 When the rate of return is equal to the required rate of return, i.e.,
when r k, the price per =
they prefer near dividends than future the value of rupee of capital gain. In the words of
for a normal firm there dividend income is m o r e than
share remains unchanged and is not affected by dividend policy. Thus,
Le. value of a rupee of
the identical earnings, record, prospects,
but the one pay1ng a larger devidend
is no optimum dividend payout. Anshnan, John, E. "of two stocks with merely because shareholders prefer present
return is less than the required rate of return, i.e.,
when r < k, the price per share
an the other, the former will undoubtedly command a higher price
3.
When the rate ofdividend increases. Thus, the shareholders of declining firm stand in the price-making process.
Stockholders often act on the principle
i n c r e a s e s as the payout ratio
For such firms, the optimum pay out
would be 100%. r e values. Mypoic vision plays partthe bushes and for this reason a r e willing to pay a premium or the
to gain if the fim distributes its earnings.
the rate of return on
investmeun d n hand is worth than two in wih the lower rate." Thus,
if dividend poircy
The following information is available in respect of the higher dividend rate, just as they discount the one firm
Illustration 4 .

n be assumed to be constant and

so

the cost of capital (k) and earning per share (E) of ABC
Ltd. the cost of capital cannot
(r), s l r in the context of uncertainty, offer a high dividend yield
in order to minimise its cost capital.
of
Rate of return on investment (r)
=

(1) 15% ; (i) 12%; and (iii) 10% g n dividend payout ratio
and the cos
= (k) 12% available in respect of return on investment (T),
Cost of capital 5. The following information is
= 10
ration
Earning per share (E) 1 a l (ke) and earning per share (E) of XYZ Ltd.
Gordon's Model assuining the followIng
Determine the value of its shares using r 10 percent
Retention ratio (b)
D/p ratio (1-b) E =740 tollowing
Model, assuming the
100 Determ value of its shares using Gordon's
80
20 ne Retention raito (b)
Cost ofequiy (ke)
b) 60 D/p ratio (1-b)
40 (a)
(C) 80
(b) 20
Solution3 40
0
(d) 20
S0
P=E(1-b)
ke-tbr
Solution :
Dividend Policy and the Value of Shares
( i i ) r = 1 2 % (r = k) (tüi) =10% (r < k)
r = 15% (r k) P b)
(a) When Dip ratio is 100%or b=0 10(1-0) CTe, P
ke-br
10 (1-0 P
1 0 (1-0) P
=

Price of shares
0.12-(0) (0. 10)
P=
0.12-0) (0.15) 0.12-(0)(0.12) EEarnings per share
13.10
phldend
Poltey

b Retention Ratio Dividend Polley 5

13.11

ke =Cost of equity capital

br =ggrowth rate in r,i.e., rate
12-9.19
of retum on investment of an
all-cquity firm 5 - 7 250
Dividend Policy and Value of Shares of XYZ 0.02
(a) D/p ratio = 20
Ltd.
(b) D/p ratio =40 (c) Dip ratio = 60
Retention ratio = 80
Retention ratio = 60 (d) D/p ratia 80 A st h e value
F the share 250) is more than its current
Retention ratio = 40 price of ? 200, the investor should buy thee
br =0.8
x 0.10=0.08 br = 0.6 x 0.10=0.06
br 0.4 x 0.10=0.04
=
Retention ratio 20
=

br =0.2
P 40 (10.8) P 40(1-0.6) x 0.10=0.02 share. n 9. The book value per share of a
conpany is 145.50 and its rate of return on
P 40(-0.4) equity is
0.20-0.08 0.18-0.06 0.16-0.04 p 40(1-0.2) company
1 0percent. The
follows a dividend policy of 607%
pay out. What is the price of its share if the
0.14-0.02 is 12 percent ?
rate
italisation
40 (0.2) 40(0.4) 40 (0.6)
E-
0.12 0.12 (0.8) Solution.
0.12
24 0.12
10 0
(EPS)= 145.50 x
2 Rs. 14.55
0.12 0.12 Eaming per share
0.12 0.12 100
=66.67 R 133.33 =R200 =R 266.67 60
Dividend per share
(D) =14.55 0 0 Rs. 8.73
Illustration 6. A company is
expected to paydividend of R 6 per share next year. The
a
are
expected to grow perpetually at a rate of 9 per cent. What is the value of its share if the dividends
(g)=0.10x = Rs. 0.04
return is 15%? required rate of Growth in dividend
100
Solution :
Price of the Share
P K-s
D 8.7
P Ke- 0.12 - 0.04
6 6 8.73
0-15-09 06 0.08
= 100 109.13

the dividend
Theifcurrent
Illustration 7.rate, its
price ofarate
company's share is 75 and dividend per share is 5. Calculate
ustration 10. A company decides that it will notshare
pay any dividends for 20 years. Ater that timeit

growth capitalisationis 12 percent. 15 per indefinitely. However, the company aa present

the company could pay dividend of
Solution: cted that shareholders is 10 percent. What is the loss to
a y 3 per share. The required rate of this company's
? Calculate the value of the equity share.
D1 Do(l+8 O l d e r as a result of the policy of the company
Solution:
P Ke Ke-8
75 + g ) n e value of the share at the end o f 20 years shall be

0-12-g D 15
9.0-75 g = 5 +

-80 g = 4
5 g

The curent
P20K 0.10 =
150
value of the share 1s.

.05 or 5%%
150
-80

Ilustration 8. The current price of a company's share is 200. The company is expected ed pay a
Fo.1
=22.29
v a u e of share i f the company at present could pay dividend of R 3 per share torever
rate o

dividend 5 per investor's

of R share
next year an annual growth rate of 10
return is 12%, should he buy the share ?
with per cent. If an
requl
Po=
Solution 0.10
30
t h e loss per share to each shareholder is: 7 3 0 2 2 . 2 9 = 7.71
Value of the share,
tor the
grow at
14% per year
D
P Ke-8 EeKt4 lustration 11. A large
sized chemical compa has been expected to
i.e. 5%. Therequired rate
years and then as the national
economy,
n d e f i n i t e l y at the
same rate
 13.12 dPolley

of return the
Dividend Policy aena.

of market value of Share at the end of

13.13

on equity shares is 12% Assume that the company paid a dividend of R 2 year 4
per share lao
Calculat.

P, =
2). Determine the market price
of the shares today. You may use the following table: last ycar
Year K.
Discount Factor at 12%
2 3 4
O.893 0.797 0.712 P=D,1+)
0.636
Solution:
2.28(1 +0.08) 2.462
Calculation of Present Value of 0.16-0.08 3073
Expected Dividends During Supernormal Growth Period of 4 O.03
ycars
Year value of market price of share
Expected Dividend ( P.V Factor at 12% P.V. of Calculation of present
2(1+0.14) = 2.28 0.893
Dividends ()| = 7 30.78 0.55

2 2(1+0.14) = 2.5992 2.0360 16.929

0.797
2.0715 intrinsic value per share = Present value o , drvidends + Present v a l e of market prica

=R 5.419 + 16.929
2(1+0.14)3 =2.9631 0.7
0.636 2.1097
2(1+0.144 = 3.3779 722.348 or say 22.35
2.1483
8.3655
Calculation of market price of share at the end of Ycar 4
DETERMINANTS OF DIVIDEND POLICY
Pa
Dn+L involves financial considerations. it is diffcuit to
well
ke En The payment of dividend
some legal as as

which can be followed different ffrms

at different times because the
by
determine a general
dividend policy
D4(1+8) 3.377910.05) special circumstan of an individua! case.
P ke n 0.12-0.05 dividend decision has to be
taken considering the ces

which determine the dividend poBicy of a frm

.5468 The following are the important factors
to dividends as laid down in sections 123 to 127
50.67 of
0.07 1. Legal Restrictions. Legal provisions relating dividend poiicy is
because they lay dowm a framework within which
Calculatioa of present value of market price of share at the end of year 4 (at 12%)
theCompanies Act, 2013 are significant cut of current profits or past profts ater
formulated. These provisions require that dividend can be paid only
by Government for the paymeniReserves o dividends n
Po (+ke providing for depreciation or out of the moneys provided (Transfer of Proits to Rules
the Government. The Companies
PATSuance ofa guarantee given bymore than ten per cent dividend to transfer
certain percentage ot the current

= Pa require a company providing that dividends cannot be pad out ot caprtai.

provides
(1+0.12)] S profits to reserves. Companies Act, further, the security of its reitors.
L W i l l amount to reduction of capital adversely affecting
50.67x 0.636 T 32.23
The amount and trend of earnings
is an important aspext ot
Present Value of Dividends P.V. of Market Price of Share 4. of
agnitude and Trend Earnings. be paid ony of
+
Market Price of the share today =

of the dividend policy. As dividends can divIdends

Dtesentoey. It is rather the starting point
=8.3655 + 32.23
fix the upper limits on dividends.
The stoui
40.60 Eertast year's profits, earnings ofa company the previous years
berome
éne
only as the retained earnings of
Or current year's earnings
ue
current proits.
The past trend ot
ustration 12. X Ltd. is foreseeing a growth rate of 12% per annum in the next 2 years. The grow hore or less business to e a r n
ot permanent investment in the
10% for the third and fourth year. After that the growth rate is expected
to
stabiisc Pat the dividend decisio
likely to fall in consideration while making
rate n g s should also be kept
is to
1s whether to deciare any
If the last dividend paid was1.50 share and the investor's required rate of return 10 the discretion as to
870 per per of Shareholders. Although, legally,
annum.
Type to the
desures
o
has been and
the following table of not the importance
find out the intrinsic value per share of X Ltd. as of date. You may use
leit the directors should give Desires of
the Board of Directors, sharehoBders.
of
uers in the n
4 the representatives
Years 1 2 3 declaration of dividends they are

0.64 0.55
0.43
areholders for status. Investors,
such as retired persens, wCo
P.V. Factor at 16% 0.86 0.74
Oner co depend upon their economic meet their
day-tO-day vn
ucnas as a source of funds to

Solution: persons view dividends

dker the puic
, 3 af
not exceat
10% but does
dividend excards
Calculation of Present value of Expected Dividends During Supernormal Growth eriu
P.V. of Dividends )
Ser
of at least 2% of profits to reserves if proposed 13> or
iep
not e x c d
Year P.v. Factor at 16% (b) capital. but does
Expected Dividend 1.449
*"
Ieast 5% of the profits to reserves if proposed
dividend
excends 12
50(1+0.12)y = 168 0.86 1.391 PCapital. of he

1.50 (1+0.12 1.33 I5% but

does ax exrd 20%
0.74 e)
1.88 (1+0.10)' = 2.07 0.64
1.325
Transfer of at least the protits to proposed
dividend
excerds

1.88 (1+0.10 2.28 0.55

L254
Ghd-up capital 7,0 or C protits to

pertendge
excecds 2 0 s at n y
5.419 e r of dividend tor
riskr

Howeve orese
a least 10% of the profits
resnoted
n e profits to
to if proposed no
that under the Companies Act
ot 2013,
reserves
conditions are
presnbed

Ots
to
 13.14
13.15
ridtna Potio

expenses. To benefit such investors, the companies should Dividen Policy Requirements of Institutional Investors. Dividend policy of a unzany can be affectei by the
investors suchaas financial institutins, tanks insuranc
pay regular dividends. On the
investor in a high income tax bracket may not benefit by high other han. of
institution

onponatins, ec. Theve

be interested in lower current current dividend incomes. Such ahand, awealthy a
policy of regular payment of cash dividemds and stipulate their gwn terms with reyard
dividends and high S a l y favour
interests of the different type of sharehol ders, but a capital gains. It is difficult to reconcile theestor
investor may on equityshares.
dividend
of
consideration the interests of its various groups of company should adopt its dividend
shareholders. policy after taling an t
0eymentahility of Dividends. Stability of dividends anaher imprrant guiding principie in the
is

4. Nature of into dividend policy. Stability

div
of
dividend simply refers to the payment of dividend regularly and
Industry. Nature of industry to which the company is engaged also o fa
ally, prefer payment of such regular dividends. Some companies olion a phej ofon tant
the dividend policy. Certain industries have
irmulation

a
comparatively and stable demand considerablv: ffects ratio and while there aher zho
prevailing economic conditions. For instance. people used to steady arehol hare while others follow a policy payout of constant are wme
irrespective o the dividend per share plus an extra dividend in the years of high profits. A policy
Such firms expect regular earnings and drink liquor both in boom as well as
in recesicn videnuv idend
of con stant low
hence can follow a consistent dividend policy. On the other SIOn. a per share is most suitable to concerns whose earnings are enpected to remai sable Ver
luxury goods, conservative policy should be followed. hnand, if
the earnings are uncertain. as in the case of ofconstant d i v i
the years of low profits.
suiticient reserves to pay dividends in
who have buil-up
should retain a substantial part of their current
earnings during boom period in order to provide Such firm
firms r of vears or those net earnings eveTY a r may te supported
adequate dividends in the recession periods. Thus, industries with steady funds to pa licy of constant payout ratio, 1.e., paying a percentage oi nxta

demand of their to pay dividends. Ihe policy of constant iow dividend per
products can follow related to the firms ability
a higher dividend
payout ratio while
cyclical industries
should follow a lower payout ratio. em because it is of high proiits is Suitable to the firms having fluctuating earnings
from
dividend
in years
5. Age of the some extra
Company.
The age of the company also in tluences the dividend
decision of a company hare
A newly established concern has to limit
payment of dividend and retain substantial part of jear to year.

earnings for
financing its future growth and development, while older companies which have established sufficient DETERMINANTS OF DIVIDEND POLICY
can afford to pay liberal dividen ds. reserves
1 . Legal Restrictions
6. Future Financial Requirements. It is not
only the desires of the shareholders but also future
financial requirements of the company that have to be taken into consideration while Trend of Earnings
making a dividend decision. 2 Magnitude and
The management of a concern has to reconcile the Shareholders
conflicting interests of shareholders and those of the Desire and Type of
company's inancial needs. If a company has highly profitable investment opportunities it can convince the 3.
shareholders of the nead for limitation of dividend to increase the future 4. Nature of Industry
earnings and stabilise its financial
pOsition. But when profitable investment opportunities, do not exist then the company may not be justified in 5.| Age of the Company
retaining substantial part ofits current earnings. Thus, a concern having few internal investment opportunities Future Financial Requirements
should tollow high payout ratio as
6
compared to one having more profitable investment opportunities. Government's Economic Policy
7. Economic
7.
Government's Policy. The dividend policy of a firm has also to be adjusted to the
economic policy of the Government as was the case when the Temporary Restriction on Payment of Dividend
8. Taxation Policy
Ordinance was in force. In 1974 and 1975, companies were allowed to pay dividends not more than 33per cent 9. Inflation
of their profits or 12 per cent on the whichever was lower.
paid-up
value of the shares, 10. Control Objectives
8. Taxation Policy. The taxation policy of the Government also affects the dividend decision ofa irm Investors
idend 1. Requirements of Institutional
Ahigh orlouw of business
rate taxation afects the net earnings of company (ater tax) and therebyits
policy. Similarly, a firm's dividend policy may be dictated by the income-tax status of its shareholders. 12 Stability of Dividends
dividend income of shareholders is heavily taxed being in high income bracket, the shareholders may forego 13. Liquid Resources
cash dividend and bonus
prefer shares and capital gains. the availab1lity of lhquid
policy of a firm is also
influenced by
. Inilation. acts as a constraint in the payment of dividends. Profits as arrived Resources. The dividend it may De
desiraole not
Inflation from tne p
andlossaccunt on the basis of historical cost have a tendency to be overstated in times of rise in pricesn esources. A ud
a firm may have sufficient
available profits to
declare dividends. yet
or d c o a u y
the liquidity position
lo pay diviaugh, Hence
to suficient liquid
resources.
over valuation of stock-in-trade and writing off depreciation on fixed assets at lower rates. AS a ce to imn ds if it does not have
prices rise, funds generated by depreciation would not be adequate to hence
in paying dividends. s t o c k - d i v i d e n d i.e.
issue of bonus
maintain the same assets and replace nxed a dOtherwise, Consideration is better to
declare
capital intact, substantial part of the current earnings woula be r e s o u r c e s , it
s earnings

shares toIft a company does not

of firm
have liquid distribution
imaginary and inflated book
profits in the days of rising prices would amount to payment or av dends much shares also
amounts to
The issue of bonus
shareholders.
more than warranted
by the real profits, out of the equity among th av g
capital resulting in erosion
10. Control Objectives. When a company pays high dividends out of its earnings, t y
of
caplta t in
ratio,
the
e
Sting shareholders without affecting its cash position.
dilution of both control and
earnings for the existing shareholders. As in case of a high YPES OF DIVIDEEND POLICY
the retained earnings are
insignificant and the company will have to issue new shares todividenu p nance
The various types of dividend policies are discusseu
its future requirements. The control of the
existing shareholders will be diluted ifthey
raise u dditional
shares issued by the company. Similarly, issue of new shares shall cause increase in thecannotD o niy shares retired
(a) Regular Di: idend Poliey The investors
Such as

and ultimately cause a lower

earnings per share and their price in the market. Thus, undernumber stances regular
dividend. dividend

ESOns, Payment of divic n a is termed as dividends. A regular

the usual rate
to maintain control
of the existing shareholders, it may be desirable to declare these d retain widows and other
at
weaker persons preter to get regular
earnings to finance the firm's future requirements.
lower dividendsa offers S
the tollai
Oomically
following advantages
 3.17
It establishes a proitable record otf the
phidendPolliy

(a)
(b) It creates confidence amongst the company. Dividend Policy i s sign of continued normal operations of the company.
shareholders. the market valuc of shares.
c) It aids in long-term financing and renders t stabilises
(d) It stabilises the market value of shares. financing easier. It creates
conidence among the investors.
(c) ides a source of livelihood
to those investors who dividends
(o) The ordinary shareholders view dividends (
pr view as a snrce of funds
as a source of funds to meet meet day-1o day expenses.
expenses. mect their vets the requirements of institutional investors who prefer cornpanies with stable dividends
I f profits are not
rate of tax in the
distributed regularly and are retained, the shareholders day-to-day living
i
0improves the
creait standingand makes financing easier.
year when
accumulated profits are may have. r e s u l t s in a continuous flow to the national income stream and thus helps in the stabslisation
distributed.
However, it must be remembered that regular dividends can
be maintained higher (8 of national economy.
standing and stable earnings. A company should establish the only by
to the average earnings of the company. regular dividend at a lower companies of long of Stable
Dividend Policy
rate a Dangers
2. Stable Dividend compared advantages, the stable dividend policy suffers from certain limitations. Once a stable
iocnite of many
Policy
The term 'stability of dividends
olicy is followed by a company, it is not easier to change it. If the stable dividends are not paid to
payments. In more
means
consisteney or lack ot variability in the dividenlders on any account including insufficient profits, the financial standing of the company in the
precise terms, it means payment ot certain minmum amount of dividend stream of divided
idend eshrthe investors is damagedAnd
andifthey may like to dispose off their holdings. It adversely affects the market
dividend policy may be established in any of
the following three forms: regularly
gula . A
stable mins shuares of the company. the company pays stable dividends in spite of incapacity. will be
its it

(a) Constant dividend per share. Sonme companies follow a the long-run.
suicidal in
irrespective of the level of earnings year after year. Such firms, policy create
of paying fixed dividend D share
3. Irregular
Dividend Policy
Equalisation' to enable them pay the fixed dividend even in the yearusually,
when the
a
'Reserve for Dividend follow irregular dividend payments
companies on account
of the following
when there are losses. A policy of constant dividend earnings are not
suficient on
Some
per share IS most suitable to concerns whose (a) Uncertainty of carnings.
are expected to
remain stable over a number of years. earninos Unsuccessful business operations.
(b)
(b) Constant pay out ratio. Constat pay-out ratio means payment of a fixed (c) Lack of liquid resources.
as dividends every
year. The amount of dividend in such a policy fluctuates in direct
percentage of net earnings Fear of adverse effects of regular dividends on the financial standing of the company.
(d)
of the company. The policy of constant pay-out is proportion to the earnings 4. No Dividend A company may follow a policy of paying no dividends presently because of
Policy.
preterred by the firms because it is related to their
ability to and growth.
pay dividends. Figure given below shows the behaviour of dividends when such a
policy is followed. its unfavourable working capital position or on account of requirements of funds for future expansion
c) Stable rupee dividend plus extra dividend. Some companies follow a policy of
low dividend per share plus an extra dividend in the years of paying constant DIVIDEND POLICY IN PRACTICE
high profits. Such a policy is most suitable to the
the firm having fluctuating earnings trom year to year. We have observed earlier that the main consideration in determining dividend policy is the
objetive of maximisation of wealth of shareholders. Thus, a firm should retain the earnings ifit has proftable
Advantages of Stable Dividend Policy
retained earnings, otherwise it should
A stable dividend policy is advantageous to both the investors and the company on account of the nvestment opportunities, giving a higher rate of return than the cost of
treat retained earnings as the active decision variable, and
following : Pay them as dividends.It implies
the dividends as the
that a firm should
passive residual.
In actual practice, however, find that most firms determine the amount of dividends first,
we
active as an

and the residue constitutes the retained earnings. In fact, there is choice with the no
variable ,

companies between paying dividends and not paying dividends Most of the companies believe that by
the market value of shares.
Mr Stable dividend policy with a high pay-out ratio, they can maximise
in the market and the investors also favour
such
CO ne image of such companies is also improved
companie "c r m s following this policy can, thus, successtully approach the market
for raising additional
nds f
lheor future expansion and growth, as and when required. It has, therefore, been righty sa ht
EPS
decision variable, and dividends passive as

residual tained earnings should be treated as the active

, b u t the practice does not con form to this in m0St ses.
believe that dividend policy
conveys
informati Deen observed that the managements of Indian firmsthus affects its market value. They do
EPS and future prospects of the firm and
onsider the in Current while designing the divicend poliey.
ney also have prererence for dividends and shareholder profiledividends with growth.
r g e t dividend payout-ratio but want to pay stable of capitalisation apPplicable too
nartion 13. The earnings per share of company are 78 and the rate ratio of
Sing Walte The company has before it an option of adopting payout a
25o or S0o or o
share it the
of dividend payout, compute the market value of the company's
TIME (YEARS)- Oductivitv
VIy of ac mula
retained earnings is (i) 15% (11) 107o and (ii) 5%.
13.18 13.19
e n dPolig

Solution:
Diidend Polie required to
to find out
find out whether the caompany's dividend pay n t ratin is crirmai. using Haiter's
You are required
According to Water's formula
Mdel

P r(E-D)/ke
ke ke stion:

the market price of the share is

where, P Market price per share Walter's Model,
D Dividend per share
Asper
D r(ED)k
Intermal rate P
E
r
of retum or productivty of retained
Eamings per share, and camings. ke
k Cost of cquty capial or capitalisation rate.
P Market price per share
D = Dividend per share
Whert
Computation of Market Value of Company's Shares =
Internal rate of return
Earnings per share
i) 15% (i)=10% (iüi) =5% Cost of equity capital
fa) When dividend payout ratio is 25%
Total Earnings2,0,000 710
share (E)
P 215(8-2)/.10 P 21008-2)/.10 P 8-2)/.10 Earnings per No. of Shares 20.00
10 .10 .JO

(6) Amount of Dividend Paid1.60,000 _z

J0 10 Dividend per share (D) 20,000
.10 .10 10 10 .10 10
No. of Shares

=-
Internal rate ofreturn (r) Total Earnings, 100 2.00.0 100 =1P
10 .10 10 10 1010 Total Equity 20,00,0O
- Z 1i0 =
.10
80 10 50

Price- Earning Ratio 12.5%

(b) When dividend payout ratio is
50%
P =40.10010-8)/.08
4158-4)/.10 P
108-4)/.10
10 .10 P
405(8-4)/.10 08 08
.10 .10

10A) P = 084
10 (2)
4 10) 44
.10 10 10 .10 10 .10 08 08

10 10
4 ,4
10 10 .10 .10
8+2510.-7
08 08
131.25
10- z 100 8 0 760
.J0 10 1,60.000x 100.Since this is agrowth im na
Atpresent, the dividend payout ratio is 80702.00.00o
When dividend payout ratio is 75%
(c)
ofcapital (ke), i.e. r(10%)>k(8%). The firm's pay out ratio of 80% not optiomalasand
te
of is per
P 6.15(8-6)/.10 .10(8 6)/.10
D(8-6)/.10
nr)>cost
The market price of the company's share shall be maximum ifit retains I00% of the pronts
0 .10 .10 .10 divid del.
05 dend payout ratio is zero. This can be proved as below
(2) .J02
D,*r(E-D)/ke0, .10(10-0)/.08 0+12.5
6
410 _O 1 0
10 .10 .10 10 10 .10 P
D
08
Ke 08 08
6
Re
.10 .10 P -T156.25
10 10 1010
=7 70 156.25 by inereasing the reiention rato
10 90 80 ]0
100%, s, the firm
the optimal
can increase the market price of the share upto 7
pay out ratio for the firm is zero
TCnytration 15. ABC Lid. has a capital of 10 lakhs in equity shares of R100 each. The sharesar
Tlustration 14. The following information relates to XYZ Ltd.
20,00,000
fen ina at par. The company proposes declaration of a dividend of R 10 per share at theend 0t
which the company belongs Is

he capitalisation rate for the risk class to

00,000
Paid-up equity capia a
Earnings of the company
Dividend paid
be the market price of the share at the end ot the yea, t

)a dividend is not
declared ?
20,000

Price-caming rati0 i) a
Number of shares dividend is declared ?
outsianding
 13.21
13.20
Assuming that the company pays the dividend and has net profits of s.o0 oo Dividend Poliy phidenaPolicy

Dividend. promises to pay the sharehoiders at a future specific date

dividend
Serip or Bond A
scrip dividends in cash, it may issue notes or bonds for
investments of 710 lakhs during the period, how many new shares must be issued. Use and makes new any does not have sufficient funds to pay
the M.M. model. The objective of scrip dividend is to postpome the immediate Payment of cash.
eholders.
Case a compa

shareho
Solution : the
amounts
due to and is accepted as a collateral security.
Property dividends are paid in the form of sone assets ther than cash. They
According to the M.M. model, the price ot the share at the end of the
current financial AScripDeonerty Dividend. in India.
be calculated as below; tributed u n d e r e x c e p t ional
on:
circumstances and are not popular
shares to the existing sharehoiders. If
P, Po (1+k)-D Stock Dividend. Stock
dividend of bonus
means the
issue
amounts to
PP, Prevailing market price of the share it is better to declare stock dividend. Stock dividend
where,
= Market price per share at the end of the year des not have liquid resources the existing shareholders without affecting the cash
D, = Dividend to be received at the end of the year compaon ofearnings and distribution of profits among
capitalisation discussed in detail under "Bonus Issue".
This has been
firm.
k Cost of cquity capital or rate of capitalisation of the
position
Substituting the values in the above equation:
BONUS I S S U E
dividend is not declared
(a) When a
bonus to its shareholders either in
cash or in the form of shares. Many a times,
P, Po (1+k)-D, company can pay
A
of sufficient profits because of unsatisfactory cash
100 (1+.12)-0
a company
is not in a position
to
pay bonusthein cash inspite of the company. In such cases, if the company
adverse eftects on working capital
100 (1.12)=7 112
sition or because of its of asSsoCiation of the company provide, it c a n pay bonus to ts sharehoider in the
and the articles
co desires shares as fully paid or by the issue of fully paid
bonus shares.
(b) When a dividend is declared R10 per share)
orm of shares by
making partly paid
of stock, by a corporation to
bonus shares is: 'a premiumstockgift, usuallyfrom surplus profit." Howevr
or
P, Po (1+k-D, The dictionary meaning of
100 (1+.12-10 dividend paid to shareholders in a joint company
100 (1.12)-10=7 102 shareholders' o r "an extra neither dividend n o r a gift. It is governed by
context the meaning is not the same. A bonus share is
in legal shares in lieu
Number of shares to be issued assuming that the company pays the dividend : declared like a dividend n o r gifted away. Issue of bonus
soany regulations that it c a n neither be 1956, no dividend can be paid
_-(E-nD2 is not allowed as according to Section 205 of the Companies Act,
of dividend it only represents the past sacrifice of the shareholdeTs
Cxcept in cash. It cannot be termed as a gift also because
m = Number of shares to be issued
where,
I Investment required. BFFECTS AND OBJECTS OF BONUS ISSUE
and reserves, its balance sheet does not reveal a true
E = Total earnings of the firm during the period
When a company accumulates huge profits
n Number of shares outstanding at the beginning of the period. shareholders do not get fair return o n their capital
about the capital of the and the
D = Dividend to be paid at the end of the period. DIcnaure structure company
amount can be distributed among
P, =
Market price per share at the end of the period. Thus, if the Articles of Association of the company
so permit, the
ne existing shareholders of the company by way of issue of bonus shares.
excess
Substituting the values
The effect of bonus issue is two-fold,viz.,
10,00,000-(5,00,000-10,000x10)
i) It amounts to reduction in the amount of accumulated profits and reserves.
102
(i) There is a corresponding increase in the paid up share capital of the company.
10,00,000-4,00,000) By the issue of bonus shares, the accumulated profits and reserves of the company are converted
102
Frore which is used permanently in the business and hence it is also known as Capitalisation of
6,00,00055882 shares (appx). Profits andcapital
Reserves.
102
e following circumstances warrant the issue of bonus shares.
when company has accumulated huge profits and reserves and it desires to capitalise these
a
FORMS OF DIVIDEND
course of business
a
protits them on permanent basis in the business.
so as use

Dividends can be classified in various forms. Dividendsknown paid cours is

ordinary
in theordinary dividend
6When the company is not able to declare higher rate of dividend on its capital, in spite of suticient
as Liquidation aivurend which
nOWn 1sas Profit dividends, while dividends paid out of capital areinterim dividend, t s , due to restrictions imposed by the Government in regard to payment of dividend.
wcn declared between two annual general meeting is called while tne
vidend.
hen higher rate of dividend is not advisable for the reason that the shareholder may expect the
recommended to the shareholders at the annual general meeting is known as 1inal a same higher rate of dividend in future also.
Dividends may also be classified on the basis of medium in which they are paid edividend
the company cannot declare a cash bonus because of unsatistactory cash pasition and its
dividends.
r e h o l d e r s g e tn
Payment (S) W efects on the working capital of the company.
(a) Cash Dividend. A cash dividend is a usual method of paying receve
COthere is a large diference in the nominal value and market value of the shares of the
cash results in outflow of funds and reduces the company's net
worth n holders prefer tCe ompany.
oPportunity to invest the cash in any manner they desire. This is why the ordinarysnnrovidefor suchree (1)
) To Donus issue is made to achieve the following objects:
dividends in cash. But the firm must have adequate liquid resources at its dispos1 To
so that its
ds. bring the
amount of issued and paid up capital in line with the capital employed so as to depict
liquidity position is not adversely affected on account of cash diviac ore realistic earning capacity of the
company.
13.22
13.23
Dividend Polig
phidendPolicy

) To bring down the abnormally high rate of

such as demand for higher wages and to dividend the on its capital so as to avoie Mr.
Mr, A shall own I,000+5091,509 shares. His propertiomate wnership prior to the onus
abo which

attraction of abnormal profits, as illustratedrestrict entry of new of

below entreprenewrurs dueProblem 10

each

Balance Sheet of X Co. to the 1.000100=10%

Was
10,000
(Prior to bonus isue) sue

Liabilities ASsets the bonus Issuc, his proportionate ownership shail te td6-tfe!
Share capital S,00,000 And after 15.0
Fixed Assets
Reserve 15,00,000 Current Asscts e the proportionate ownership remains the same and on this accrAunt, he does not gain anything
Creditors 2.00.000 15,00,000 he owns 1,500 shares now against 1,09 shares rwned prior to bonus
7,00,000 he should be happy as
ce
22.00,0000 u inaeisthe gainer by s00 shares received free of cost, which he should be able to seil in the market
22,00,000 sue 35anpens is
that generally, a company is able to
notsame maintain the cm
rate of drvidend its shares
the the
Assume that the company earns a profit of R4,00,000 in the year. It will mean , 00x1 Ru whatd the of the shares fall
prices in marketissue.
as a result of bonus Therefcre. practically.
foilowing example.
holder gains nothing.
This can be illustrated with the help ofthe
80% returns its capital and it may attract many new
on
5,00.000e,
entrepreneurs into the business and may alsa qTests Equity Share Capital
other problems from labour. But in reality the profit of R4,00,000 has been earned Shares of R10 each
= 7 1,00,000
not on a capital of
but on the actual investment ofR20,00,00, 1.e. 7 5.00 10,000 Equity
5,00,000 capital plus R 15,00,000 Reserves, making a profit prior to bonus issue is 7 20,000
its actual investments to returnhono s
Say, the company average
20,000x 100-20%o
4,00.000x100
20.00.000
20% only That income return on capital is
1,00,000
Afer the bonus issue of 5,000 equity shares, the capital of the company shall be 15.000 shares of
Hence. to bring down abnormally high rate of dividend, it is advisable that the
company should issue T10 each i.e. 7 1,50,000.
shares. because the assets of the company remain
But the earning capacity of the company does not increase
) To Pay bonus to the shareholders of the
company without affecting its liquidity and the carning the average profit shall remain the same.20.000 making
capacity of the company. thesame. And hence there is every possibility that
4) To make the nominal value and the market value of the shares of the has fallen from 20% to 13.33%. So the
) To correct the balance sheet so as to give a realistic view of the
company comparable. return On =13.33%.
1,50,000
It is clear that the return on capital
capital structure ofthecompany prices of the shares in the market shall fall accordingly. making the value of 1.500 shares nearly the same as
ADVANTAGES OF ISSUE OF BONUS SHARES
(A) Advantages from the viewpoint of the company
i was for 1,000 shares prior to bonus issue, which proves that there is no gain the investor. But in case
to
the company is able to maintain or increase the rate of dividend on its shares ater the issues of bonus shar
une prices of its shares will not fall and the investor will gain substantially.
I t makes available capital to carry an a larger and more profitable business.
I t is felt that financing helps the company to get rid of market influences.
Tosum up, the
advantages to the shareholders a r e :
G) When company pays bonus to its shareholders in the value of shares and not in
a
cash, 15 ug T h e bonus shares are a permanent source of income to the investors.

2 Even if the rate of dividend falls,the total amount of dividend may increase as the invester gets
resources are maintained and the working capital of the company is not
affected, ness
4) It enables a company to make use of its profits on a permanent basis and increases
creai dividend on a larger
number of shares.
G) The investors can easily sell these shares and get immediate cash, if they so desire.
of the company.
6) It is the cheapest method of additional capital for the expansion of the
raising bustn enables a DISADVANTAGES OF ISSUE OF BONUS SHARES
6) Abnornmally high rate of dividend can be reduced by issuing
bonus shares e nspite of many advantages, the issue of bonus shares suffers frorm the following disadyantages
COmpany to restrict entry of new entrepreneurs into the business and thereby reduces competition.
is only the
cture an
1 s s u e of bonus shares leads to a drastic fall in the future rate The of dividend a s it not
7) The balance sheet of the company will reveala more realistic picture ofthe capital u and the actual resources of the company. earmings do usuaily
d n a t increases not
the capacity of the company.
se With the issue of bonus shares. Thus, if a company earns a proit of 7 2 0,0 against

(B) Advantages from the viewpoint of investors or shareholders a share capital ofT 5,00,000 and the capital of the company is raised by the issue of bnus shares
8,00,000, the rate of dividend falls from 40% to 25 o.
mpact bonus issue
otf proportionate ownership, earnings per share and share price
on of shares considerabiy.
shares.
ership in thi t
n the future rate
of dividend results in the fall of the market price
said that an investor gains nothing from the issue of bonus
1s generally Tmay cause unhappiness among the shareholders
tne shareholder receives nothing except some additional share certificates. But his propo decline and leave lesser security to invesiors
V e s of the
company after the bonus issue
the company remains unchanged.
For
which
Mr. A
owns

uUIDELINES FOR THE ISSUE OF BONUS SHARES

say, a company has 10,000 cquity shares
example, of 10 cach, Out 2 shares heldares o The llo
,000 shares. Now the company issues bonus shares at the rate of I share
ulations, regulations have been provided by the SEBI (sue of Capital and Disclosure Roqurements)
every
tor eve n-15.000shar
5,000= aons, 2009 for the
Company. After the bonus issue, the total share capital company shall be
of the l,000 issue of bonu hares
 ividend Policy boius shares
13.24
For
the issuc of
Sharcholders
A/c
Bonus to
1. Conditions for bonus issue Share
Capilal AWc
To
Subject to the provisions of the Companies Act, 1956 or any other applicable law for the time beinng Premium Ac (if shares are issued at premnum)
To Sharc
in force, a listed issuer may 1ssue bonus shares to its members if:
TA When the existing
partly paid shares are converted into fully paid
(a) it is authorisod by its articles of association fir isue of bonus shares, capitalisation of reserwes (Dssue, the following Journal entries shall be made shares as a reuit of rui
Cic
Provided that if there is no such provision in the articles of association, the issuer shall nace
For the
declaration of bonus:
resolution at its general body meeting makimg provisions in the articles of a
Loss Appropriation A/c
associations for dProfit and Dr
capitalisation of reserve: or
(b) it has not defaulted in payment of interest or principal m respect of fixed deposits Respective Reserve AVc
securnies issued
or deht
b t To Bonus
to Shareholders A/c
(C)
it has suficient reason tobelieve that it has not defaulted in
dues of he employees such as contribution to provident fund,
respect of the payment of atutorys (2) For
making the final call on shares due;

gratuity and bonus: Share Final

Call A/c
(d) the partly paid shares. if any outstanding on the date of allotment, are made
fully paid un To Share Capital
A/c
2. Restriction on bonus issue: issue of Bonus shares
the
0) For
(1) No issuer shall make a bonus issue of equity shares if has Shareholders A/C
it outstanding fully or Bonus to
debt instruments at the time of making the bonus issue, unless it has made reservation of partly convertible To Share Final Call Ac
same class in favour of the holders of such
equity shares of the
outstanding convertible debt instruments in proportion to the Jllustration 16. The following are the extracts from the draft Balance Sheet ofA Ltd. 15 n Decemter
convertible part thereof.
(2) The equity shares reserved for the holders of fully or 31, 2007
partly convertible debt instruments shall be
issued at the time of conversion of such convertible debt instruments on the same
terms or same
on which the bonus shares were issued. proportion Authorised Capital
Equity shares of R10 each 2.00.00
3. Bonus shares only against reserves, etc. if capitalised in cash: 20,000
Issued and Subscribed Capital 10,000 Equity Share of R10/-each
(1) The bonus issue shall be made out of free reserves built out of the genuine Reserve Fund
profits or securities
premium collected in cash only and reserves created by revaluation of fixed assets shall not be
capitalised for Profit and Loss Account
the purpose of issuing bonus shares.
A resolution was passed by the company declaring bonus of 25% on equity shares to e rovide
(2) Without prejudice the provisions of The bonus was to e satished
to
sub-regulation (1), the bonus share shall not be issued in
,U0 out of fund and the balance out of profit and loss
reserve
account.
lieu of dividend. y issuing fully paid equity shares.
4. Completion of bonus issue: the Balance Sheet of the

journal entries and show the effect

on
.are required to make necessary
(1) An issuer, annourncing a bonus issue after the approval of its board of irectors and not ompany.
requiring shareholders' approval for capitalisation of profits or reserves for making the bonus issue, shal Solution:
implement the bonus issue within fifteen days from the date of
approval of the issue by its board of
directors. Journal Entries
Provided that where the issuer is required to seek shareholders' approval for capitalisation ot prou 2007
or reserves for making the bonus issue, the bonus issue shall be implemented within two months from tne Dec.31 Reserve Dr..
of the meeting of its board of directors wherein the decision to announce the bonus issue was takn Fund A/c 0,000
du Profit and loss Appropriation
Dr..
to shareholders' approval. o Bonus to shareholders Ac Ac
1,00,000) on
ie., 25%
(2) Once the decision to make a bonus issue is announced, the issue can not be withdraw the declaration of bonus 2 5 % on equity shares,
Bonus to ShareholderS Dr.
( To uity AVC A/c
Share Capital
ACCOUNTING TREATMENT FOR THE ISsUE OF BONUS
(a) When the unissued shares of the company are issued to its existing shareholders as u
SHARES pald h e issue of bonus shares in the rato o1 4
sheet of ALtd.
Extracts ofThe Balance
bonus shares, the following journal entries should be recorded : as at 31 st Dec. 2007

(1) For the declaration of bonus

Dr..
Liabilities
Profit and Loss Appropriation Alc
Author 5,000
or
Share Capital 20,000 equity shares ot 1 0 each
Share Premium A/c Dr..
(Of theubscribed Capital 12,500 equity shares or tully pa
or
ne above shares 2,500 share
share
*°U0
are
aure allotted as tfully paid
bonus share)
a5,000
Dr.. Surplus
Respective Reserve Ac Reserve
Frofit
Fund
To Bonus to Shareholders A/c and Loss
AC
 ustration 19..A company has a share capital of I 13.27
Dividend Policy
13.26 reserve fund of 0,00,000 and declares a bonus,000 equity shares « 19 each
fully paid. The
per share. Shares are4,50,000. This bonus to te paid by issue
anpanyh a s
shares of 10 each, 6 per share premium of 5
lllustration 17. A company has a share capital of 5,00,000 cquity
shares at a
has decided to equity quoted at 20 per share on the date of
paid. It has a balance in the Reserve Fund Account amounting
to R 50,00,000. The company llypaid bonus
issue.

as fully paid. Make necessary Journal entries to

of
shareholders by making the partly paid share
pay bonus to lotment
record the same. Shution:

Solution
Journal Entries
Journal Entries

Reserve Fund A/c

Reserve Fund A/c Dr 20,00,000 ..Dr. 4 50,0M
Shareholders A/c
Bonus Sharcholders A/c Bonus to
To to
20,00,000 To
bonus) 450SA
(Being the declaration of bonus @ 4 per.share, i.c., the amount unpaidDr..
Share Final Call A/c
on shares)
20,00,000 (Beingthe declaration of A/c
to
Shareholders
.Dr.
To Share Capital A/c Bonus Share Capital A/c 450,000
To Equity 3.0.000
(For making the final call due on shares) P r e m i u m A/c
20,00,000 To Share
Bonus to Shareholders A/c Dr... 20,00,000 (Being the issue of 0 , 0 0 0 equty shares as rully paid bonus shares at a premium of
I5009
To Share Final Cal Ac
20,00,000 S-per share)
(Being the bonus to shareholders applied towards meeting the call due on share)

Tlustration 18. The extracts are given from the draft Balance Sheet of Bharat Gears Lid. as on 31st Note: The market price of shares, i.e., { 20/- per share is not to be taken into consideration.
December 2007 lustration 20. A company has a share capital of 10,00,000 equity shares of ? 10 sach. & per share
pidup It has a reserve fund ofT 80,00,000. Ifis decided to utilise the whole of the reserve fiund in the foilowing
Authorised Capital: manner
20,000 Equity Shares of R10 each
2,00,000 a) existing shares to be made fully paid up without the shareholders having to pay anything
lssued and Subseribed Capital :
7,000 Equity Shares of R10 each fully called up and
Reserve Fund
70,000
36,000 (b) Each shareholder is to be given proportionate to his holdings, bonus shares for the remaining
Profit and Loss Account
29,000 amount in the Reserve Fund, the shares to be valued at 12 each.
The Board of Directors pass a resolution to capitalise a
part of existing reserves and profits by issuing Pass the necessary journal entries to record the above deal.
Bonus Shares. One bonus share is being issued for every 4
equity shares held at present. For this purpose, Solution:
10,000 are to be provided out of Reserve Fund and the balance out of Profit and Loss Account.
Set out the journal entries to give effect to the resolution and show how
they would affect the Balance
Sheet of the Company. Journal Entries
Solution
Reserve Fund Account Dr.. 80,00,000
Journal Enters To Bonus to s0,00.000
2007 Shareholders A/c
Dec.31 Reserve Fund A/c
Ron
Bonus to amount of reserve fund to be capitalised transferredto)-
Profit and Loss Appropriation Account
Dr.. 10,000 Share FinalShareholders A/c
Call Account Dr.. 20,00,000
Dr... 7,500 20,00,000
To Bonus to Shareholders AWc 17,500 To Share
(Being the declaration of bonus to share- holders at the rate of Capital Account
g the final call due on 10,00,000 shares @2 Per sina 20,00,000
one hare for every four shared
held) Bonus to Dr.
Bonus to Shareholders A/c
Dr.. 17,500 To Share Shareholders
A/c 20,00,000
To Equity Share Capital A/c Final Call A/c
(Being the issue of shares in the ratio of I:4) shareholders applied towards meeting the call due)Dr. 60,00,000
nus tto
17,500 Bonus s0,00,000
o Shareholders A/c
Share Capital A/c 10,00,000
Extractsofthe Balance Sheet of Bharat Gears Ltd.
To Share Premium alc
as on December 31, 2007
Liabilities Amount
g 1Ssue of 5,00,000 bonus shares of 10 each at 12 each)

Authorised Share Capital 20,000

ISSUE (STOCK DIVIDEND )Vs. STOCK SPLT
200.000

Issued & Subscribed Capital Equity Shares of 10 each 87,500 It

8,750 Equity of R10 each fully called up of the company.
Reserve Fund 26,000 St existing
shareholders
wthout
shares to the
Profit and Loss Account 21,500
to capitalisationmeans
to of dividend
issue of bonus
the issue
the the existing
shareholder

ti s o of profits among value ot the shares

ting the arnings and

distribution

other hand,
means reducing the par
Position on the
Ue irm. Stock split,
13.28 13.29
pididendP'olly

by increasing
the number of shares
Dividend Polhey where the dividend propoSed exceers 15 per cent ht does not exceed 20 per cent
proportionately, the amount to be transferred to reserves shail not be less than 7.5 of the paid
up cApital,
each Thus, the two viz; a share ofR 100 may be
terms are quite diferent from cach other split into 10 shares of R. 1 per cent, and
The effet of bonus
the proposed dividend exceeds 29 per cent of the paid up capital. the amount to be
issue is that it amounts to
stock split does not affect the reduction in the amount of ransferred trans
to reserves shall not be less than 19
per cent of the current years profits.
accumulated profits at all. Further.in profits and reserves,
remains unchangei. whereas. it bonus issues, the par value of whereas, Itmay, however,
be noted that that a company may
voiuntarily transfer a higher percentaye of profits
is reduced in the However, according to Cor
Companies Act of 2013, no conditions are preseribed for trasfer of any
per share, earnings per share and the
case of stock
split. However, in both the cases, the book stock
market price per share declines. That is reserves.
However,
value o
of profits to
reserves.
very much like a stock split. The distinction why a stock dividend is considered ercentage
in the balance sheet between the two is of technical nature. A Dividend out of Past Profits Reservi
stock dividend is
LDeclaration of
or
by way of transfer from retained reflected
a reduction in
par valuc of each share.
earnings to cquity
capital whereas a
split is shown as Ifa company wants to teclare dividend out of acumulated profits or reserves, it has tn compiy with
gains anvthing Although. it is generally said that neither an investor nor the
from stock dividend or stock
split. yet there may be a positive effect of informationalcompany
thefollowing c o n d i t i o n s

of bonus'split announcement rate of not exceed the average of the rates at which dividend was declared
of shares thereby
The prices of shares
may not fall in direct proportion to the increase
content
in number
) The dividend should
increasing the wealth of the shareholders. The prospects by it in five years immediately predeeding that jear or ten per cent of its paid up capitai, whichever
additional funds may also improve. Hindustan Lever of the firm in
regard to
Limited, a well known company in the Indian raising
Is less.
sector. recentiy announced stock corporate ) The total amount to be drawn for the declaration of dividend from the ccumulated profits should
split in the month of February 2000 and there has been a not exceed an amount equal to one-tenth of the sum of its paid up capital and free reserves and
on the value of its shares in the favourable impact
market. the amount so drawn should first be utilised to set-off the losses incurred in the financal year
LEGAL AND PROCEDURAL ASPECTS OF PAYMENT (ii) The balance of reserves after such drawl should not fali below fiteen per cent of ts paid up
OF DIVIDEND
capital
The term dividend refers to that
part of profits of a company which is distributed by the 4.0ther Provisions and Aspects of Payment of Dividend
among its shareholders. It is the periodical payment made by a company
company to its sharcholders out of divisible ) The decision in regard to the payment of final dividend is taken at the annual zeneral meeting
profits. Divisible profits are those profits which are legally available for distribution of dividend to its The shareholders themselves
shareholders. Usually. capital profits such as profits
arising from revaluation or sale of fixcd assets or redemption
of the shareholders only on the recommendation of the directors
cannot declare dividend. However, interim dividend is declared by the directors and therTe is no
of fixed assets or redemption of fixed liabilities are not available for distribution as
dividend amongst need for of the shareholders to
a meeting a
sanction the payment of such divdend
shareholders. Legal provisions relating to declaration of dividend laid down in sections 123 to 128 of the
are
Companies Act 2013. Some of the Companies Act. Some of the important provisions and procedural aspects
() Dividend shares can be paid only after
onequity of
the
on
deciaration dividend
within 30 days of
preierence shares
(1) When dividend is declared by company,
a it must be paid by company
arereproduced below declaration of dividend.
no dividend shall be payable except in cash
1. Source of Deciaring Dividend ) According to section 205 of the Companies Act,
of proits or reserves of a
Provided that nothing in this section prohibits the capitalisation
(a) Out of current profits. Dividend can be declared by a company out of prolits for the current year benus shares.
COmpany for the purpose issuing fully
of paid up
arrived at after providing depreciation. or warrant sent through the post directed
A n y dividend payable in cash may be paid by cheque
(b) Out of past profits. Dividend can also be declared out ofthe undistributed profits of the company shareholder entitled to the payment or the dividend
registered address of the
o the
for any previous financial year or years arrived at after providing depreciation in accordance with the provisions in the Articles ot Associatton
of the company, d:vidend
(vi) the absence of any specific provision
of the Ac It there are calls in arrears davidend is paid on

(c) Out of moneys provided by the Government. A company may also declare dividend out of the paid on the paid up capital of the company.
shareholders.
the ne amount actually paid by the
for the payment of dividend in pursuance of a guarantee by ) No dividend can be paid on calls in advanee
moneys provided by the Central Government
AS
per Finance Act, 1997 dividends paid
or deciared are subject to corporate devdend tax Ai
govermment.
the rate of corporate divdend
ta f>pius appiicabie
s

dividend can be declared o r paid by a company unless 2015-16)

t may, however, be noted that no PI Csent (Assessment Year
(0) Depreciation has been provided for in respect
of the current linancial year. Surcharge and 3% education ces.
commencement of n e
respect of the previous years falling afler the REVIEW QUESTIONS
( Arrears of deprecialion Act,
in

1960 have ben set oll against profils ol the company A

Companies (Amendment)
(1) LosSes, if any incurred by
the company in previous years falling after 28th
December, 1960 havc
to be declarca
Objective Type Questions
of the company for which dividend is proposed . Fill in the
been written off against profits blanks compuny ameng
s sharehoiders
) distribution of prolits of a
2. Transfer to Reserves. is the annemg and
. .
atlects both the long-tern
to Reserves) Rules, 1975 require
a
company providing more Dividend policy of a
firn at a future date
The companies (Transler of Prolits
sharenutdes
the
of the current year's prolits to r e s e r v e s us specificd eo ) *******.. dividend promises
to pay
lvidend.
transfer a ertain percentage methed ot payng
10 per cent dividend to exceed 12.5 per cent of
the
pau is a usual
excceds 10 per cent but dos not dividend d e c i s o n is
uTelevant.

(a) where the dividend proposed the r e s e r v e s shall not be

less than 2.5 per cen *****.
model, the divtdend
MM}
amount to be ransierred o (v) According to (iv} CLsh,
up capital, the ot ne
l weulth, (uuSrip
,

exceed 15 per cent shareholders'

excceds 12.5 per cent but does not Dividend; (ii)
(b) where the dividend proposed Faise
*

transierred o I e s e r v e s shall not be less tlhan 5 per Cent, () statements are

Irue or
the anount to
wiether the following involves legal as well s
be tinaneat coistukera{kns
up capital,
T a y n n e n t of dividend
 13.30 phidendPotley
13.31

(i) Stock dividend affects liquidity

Dividend Policy What do you understand by bonus issue ? Mention the circurnstances that warrant the issue o
9
position of the company.
(iii) MM model suggests that dividend decision
bonus shares.

atffects the value of the firm. A/hat are the sources of bonus issue ? Write
(v) In the opinion of Prof. Walter, the dividend detailed note on the issue of bonus shares.
ifr=k. policy will not atfect the market price of
10.
investor gains nothing frorn "bonus shares".
Exarnine the statement critically.
share
ares
(v) A
company should follow an ad-hoc dividend policy. Enumerate the guidelines issued by SEBI for the issue of bonus shares.
[Ans.
(i) True; (ii) False: (ii) False:
(iv) True: (v) False] Theoretically, retained earnings should be treated as the active decision variable and dividends as
3. State whether the the passive residual but tne practice does not con form to this in most cases." Examine this staternent.
following statements are true or false:
i) The issue of bonus shares amounts to a 14 Discuss the legal and procedural aspects of the payment of dividend.
the company. corresponding increase in the paid up capital of
(ii) Reserves created by revaluation of EXERCISES
fixed assets are permitted to be
of bonus shares. capitalised for the issue
(iii) The declaration of bonus issue in lieu of 1 , The Asbestors Company belongs toa risk class
of which the appropriate capitalisation rate1s
dividend is allowed. has at The firm is contemplating the declaration of Z6
(iv) Bonus shares are not permitted unless the
partly paid shares, if any, are made fully paid. It currently 1,00,000 shares
current
selling K100 each.
which has
a

(v) Premium received in cash is a

source of Aidend at the end of the fiscal year, just begun. Answer the following questions based
bonus
[Ans.i) True; (ii) False: (iii) False;(v) True; () True]
issue
m the MM model assumption of no taxes
and the

4. Fill in the gaps : (a) What will be the price of the shares at the end of the year if fiy dividend is not declared: and
() Bonus issue amounts to . . .
in the amount of accumulated
(ii) if it is declared ?
(ii) The residual
reserves after the
profits and reserves. (b) Assuming that the firm pays dividend, has net income of 10,00,000 and makes new investment
proposed capitalisation should be at least
20,00,000 during the period, how many new shares must be issued?
of
the.... paid up capital of the company.
*****....
.
per cent
ofT
(ii) The bonus issue is
permitted to be made out [Ans. (a) i) 7110,(iR 104;/6)15,385 shares ]
(iv) Bonus issue is made to make the
of.. and. . .

Ex. 2. Omega Company has a cost of equity capital of 10%, the current value of the firm (v) is
.... value and the
.... value of, the shares of
the company comparable. 20,00,000 @7 20 per share). Assume value for I (new investment), Y (earnings) and D (dividends ) at the emd
Ans. (i) Reduction: (i) 40 increased; (iüi) Free Reserves, premium collected in
cash; (iv) Nominal, market.] ofthe year as I T 6,80,000, Y= 7 1,50,000 and D- R1 per share. Show that under the MM assumptions, the
=

B. Short Answer Type Questions payment of D does not affect the value of the firm.
1. Name the two main theories of dividend. [Ans. Value of Firm remains 20,00,000]
2. Enlist the factors that influence the dividend policy of a firm. Ex. 3. The Apex Company which earns 5 per share, is capitalised at 10% and has a return on
3. What is the significance of stable dividends ? Ivestment of 12 %. Using Walter's model, determine:
(i) the optimum pay-out, and
4. What is 'scrip dividend' ?
(ii) the price of share at this pay-out.
5. What is dividend pay-out ratio ?
6. What do you mean by bonus issue ?
[Ans. (i) 0% (ii) T60]
a risk class for which the appropriate capitalisation
7. Give sources of bonus issue. N 4. The Agro-Chemicals Company belongs
Tate is 0%. It currently has 1,00,000 shares selling at
to
100 each The firm is contemplating thedeclaration of
8. Bonus issue Vs. stock split.
the end of the current financial year, which has just begun. What will be the price of the
9. Write a note on dividend policy in practice. nn
Share e ddatof the year, if a dividend is not declared? What will be the price if it is declarad ? Answer
On the
C. Essay Type Questions basis of MM model and assume no taxes.
1. How far do you agree that dividends are irrelevant? [Ans. (iR 110; (iiR 105]
2. There is strong view prevalent among financial experts that the irrelevant
the MM theory of dividend distribution is out-dated and unsuited to present conditions. Do you
hypothesisunderiy AS.The details regarding three companies are given oeto
Z Lad
XLid. YLd.
agree with this view? Discuss.
3. In Walter's approach, the dividend policy of a firm depends on availability of invesin 12% 6/0

or
ke=8% 70
and the relationship between the firm's internal rate of return and its cost coP E=F10
Opportunity T10
Discuss what are the shortcomings of this view. euation when walter s
C the value of of these companies appiying
equity share of each
Explain the various factors which influence the dividend decision of a firm. not 7
VIdend n le an
and () T00Yo.
60%;
5. A firm should follow a policy of very high dividend pay-out." Do you agree ? Why or wuy Out ratio is (a) 0%; (b) 20%;(c) (6) R 100 (c) 12.5(d)
(d) 7 125;Y Ltd. (a)* 93.75
6. What do you understand by a stable dividend policy ? Why should it be followed 125, Ltd.
5ZL ^Ltd. (a) F 187.5 (b) 7 175 (c) 7 150125
7 125 (a) ]
7. DiscuSs the various forms of dividends ofIndia lor (b) R 125(c) 125 (d) f discount applicable to th
16. The market rate
pany Ex.
6. The earnings
8. Define 'bonus shares' and enumerate the guidelines laid down by the Government Gompan is
12.5%.
earnings per share of a company
per share
are
to yield a return
or
he compuny
la. shareholders
is considering
the issue of bonus shares. Payout of 25 %, Retained
etained earnings can be employed
would maximise
the wealth of
50% and
and 75%. Which of these
75
Ans.75 %o
13.32 usiE
Dldend
Poliy
its share
the price of
Divide Policy discount rate of the firm is 10%, deterrmine or
Ex. 7. The earnings per share of a company are 10 and the rate of i n u s . If
the appropriate
to the price of the share, if the company
has a payout dV70
10%. The company has before it the options capitalisation to tit is
W h a t shall happen
shall
of adopting payout of 20% or 40% or 80% Using applicable
What
a to a the eadel.
model.
compute the market value of the company's share it the productivity of retained Walter'ss formula, Gordon's
3 0 , and
? 17.14]
and has a share price of
25.D
and (ii ) 8% earnings is (i) 20%, n 10 [Ans.
presentuy pays a
dividend
of Re. 1.00 per sharefirm's expected or required return
10%, Ex. 12.
A company rate of T5% p.a. forever, what is
the
What inference can be drawn trom the above exercise. grow at amodel
vidend is expected todiscount approach ?
using a dividend
[Ans. 180, 160, and 120; 7 100, 100, and 100; 84, 88, and F96]
3 paid up
shares of 7 19 each
on
Ex. 8. Two companies- Alpha Ltd. and Beta Ltd. are in the same [Ans. 19.6%]
industry with identical earninos has a share capital of 40,000 Equity
Ratan manulacturing Co. shares and partly paid shares
per share for the last five years. The Alpha Ltd. has a policy of paying 40% of earnings as Ex. 13. 1,00,000. It w a s decided to
issue bonus
the Beta Ltd. pays a constant amount of dividend per share. There is a disparity between the dividends, while company has a
Reserve F u n d of
market prices of he
the shares of the two companies. The price of thee Alpha's share is generally lower than that of the made fully paid.
Beta, even were
Journal entries. 31-3-2008.
though in some years Alpha paid more dividends than Beta. The data on earnings, dividends and market price
of ABC Company Lid
necessary as on
Pass
the extracts from the draft Balance Sheet
for the two are as under: following are
companies Ex. 14. The
AlphaLtd. Authorised Capital : 3.00,000
Year EPS DPS Market Price 15,000 Equity
share of 7 20 each
160,000
Issued& Subscribed Capital
90.000
8,000 Equity
Shares
ofR 20 each
2004 4.00 1.60 12.00 Reserve Fund 60,000
2005 1.50 0.60 8.50 Account
Profit and Loss 5 shares
shares for every
2006 5.00 2.00 13.50
the determining bonus of 2 equity
2007 4.00 1.60 11.50 A resolution was passed by company
of Reserve Fund and the balan c e out-of
Profit
this ? 35,000 are to provided out
2008 8.00 3.20 14.50 held at present. For purpose,

and Loss Account. and shown how they would affect the
Beta Ltd.L entries to give effect to the
resolution

Make necessary journal

Year EPD Market Price balance sheet. has a r e s e r v e fund of
8,00,000
has share Capital of 5,00,000. The company
shares of 1 0 each
Ex. 15. X Company Ltd
a
13.50 issue of fully paid equity
4.00 80
bonus of R 3,60,000. The
bonus is to be paid by Make
2004 a allotment of bonus shares.
2005 1.50 80 12.50 and aeclares Shares are quoted at 18 each o n the date of

5.00 80 12.50 premium of 2 per share.

atJournal
a
2006 entries to record the above.
12.50 Dec. 31. 2007.
2007 4.00 1.80
1.80 15.00 Ex. 16. The following is the summarised Balance
Sheet of Pragti Ltd. as on

2008 8.00 Balance Sheet

Required: both the companies. Liabilities ASSes

(a) Calculate (i) payout ratio (ii) dividend yield ; (iii) earnings yield for Fixed Assets
i6,00,0000
What are the r e a s o n s for the difference in market prices of these two companies shares Share Capital 5,00,00
(b) shares. 3,00,000 share of T10 each fully paid 30,00,000 Investment
be done by Alpha Ltd. to increase the market price
of its Current assets 24,50,00
(c) What can Share premium 1,00,000
[Ans. Alpha Ltd. Beta Ltd. General Reserve 8,00,000
(i) 0.40 for all 5 years 0.45, 1.20, 0.36, 0.45, 0.23 Debentures 1,50,000

(i) 0.13, 0.7, 0.15, 0.14, 0.22 0.13, 0.14, 0.14, 0.14, 0.12 Current Liabilities 5,00,000
0.30, 0.12, 0.40, 0.32, 0.53] 4550.000
(ii) 0.33, 0.18, 0.37, 0.35, 0.35 ected 45.50,000
to pay a dividend of 2 per equity share. The dividends
are
expE bonus share for every 5 share held and a
EX. 9. A company is expected Board of Directors decided to issue one fülly paid
dividend at 30%.
to grow at the rate of 10%. Find out the share price today, if market capitalises
necessaryne
will
wl approval was received from the Government.
The share premium iIS to be used fully and the balance

[Ans.7 10] be taken

share now. Its dividends
are
expee up from General Reserve
is expected to pay a dividend of 4 per equity O Revised Balance Sheet.
A company
EX. 10. for 5 years and then at the rate of 19% indefinitely. Find out the present va ass necessary Journal entries and prepare
a

to grow at 15% the next

table may be used [Ans B/STotal 7 45,50,000]
equity share if the capitalisation rate is 12%. The following Dec. 31, 2007
Year 4 0.507 Ex. 7. The following is the Balance Sheet Nadia Coal Ltd.
of as on

0.567
0.797 0.712 0.636 Balance Sheet
P.V. Factor at 0.893
1270 As on De. 31, 2007
dinary
[Ans. 272.75]
Ex. 11. A company has a total investment of 7 5,00,000
in assets, and 50,000 outstanding 0% Liabilities
10 per share (par value). It e a r n s a rate of 15% on
its in vestment, and has a policy
ol
retan Issued
and Subscribed
Sundry Assets 38.00,000
shares at
0,000 shares capita
of 100 each fully paid 20,00,000
13.34
idend Policy
15,00,000
General Reserve 3,00,000
Current Liabilities
38,00,000

Capital ior raising share capital by t0 e0 shares

38,0M
from Controller ol of
The company got permission use general reserve for issuing additionol
neral reserve additional capital at
100 each at par. The
Board of Directors
decided to 0ital at the
held.
rate of one share
for every two share
accounts incorporating above mentioned changes and give a
Revised Balance Shee
Revised Ral.

Prepare ledger
Dec. 31, 2007.
as on of K 50,00,000 in 50,000 equity shares . c 7.
Simla, had, a paid up share capital
Ex. 18. Grover Ltd, balance of 10,00,000 and 7 Ao
Premium Account had a
Fund Account and Share
each. The Reserve four share held. Pass necescam
bonus share at par for every urnal
It was decided to issue one
respectively.
entries to record the issue of bonus shares.
Sheet of Rohini Ltd. as at 3 1st December. 2
Ex. 19. The following are the extracts from the Balance

Authorised Capital
5.00.000
1,00,000 Equity Shares of T 5 each
Issuedand Subscribed Capital
paid 2,50,000
50,000 Equity Shares of 7 5 each fully called up and up
1,00,000
Reserve Fund
25,000
Profit and Loss Account
to 40,00
A resolution was bonus of 20% on equity shares to be provided as
passed declaring a
account. The bonus was to be satistied by
ssuing
out of Reserve Fund and the balance out of Profit and Loss
one fully paid equity share for every five shares held.
balance
Pass entries in the books
journal the company and show how these entries will effèct
of