Unit 4 Dividend Relevance

Factor Affecting Dividend Policy

FACTORS AFFECTING DIVIDEND POLICY
A company needs to analyze certain factors before framing their dividend policy.

The following are the various factors/determinants that impact the dividend policy of a company:

(i) Type of Industry

The nature of the industry to which the company belongs has an important effect on the dividend
policy. Industries, where earnings are stable, may adopt a consistent dividend policy as opposed
to the industries where earnings are uncertain and uneven. They are better off in having a
conservative approach to dividend payout.

(ii) Ownership Structure

The ownership structure of a company also impacts the policy. A company with a higher promoter’
holdings will prefer a low dividend payout as paying out dividends may cause a decline in the
value of the stock. Whereas, a high institutional ownership Determinants of Dividend Decisions will
favor a high dividend payout as it helps them to increase the control over the management.

(iii) Age of Corporation

Newly formed companies will have to retain major part of their earnings for further growth and
expansion. Thus, they have to follow a conservative policy unlike established companies, which
can pay higher dividends from their reserves.

(iv) The Extent of Share Distribution

A company with a large number of shareholders will have a difficult time in getting them to agree
to a conservative policy. On the other hand, a closely held company has more chances of
succeeding to finalize conservative dividend payouts.

(v) Different Shareholders’ Expectations

Another factor that impacts the policy is the diversity in the type of shareholders a company has. A
different group of shareholders will have different expectations. A retired shareholder will have a
different requirement vis-a-vis a wealthy investor. The company needs to clearly understand the
different expectations and formulate a successful dividend policy. Psychologically, cash dividend
will give more satisfaction to shareholder in comparison to capital appreciation.

(vi) Leverage

A company having more leverage in their financial structure and consequently, more interest
payments may to decide for a low dividend payout, so as to increase their net worth and to make
sure that it can make payment of financial charges even in case of earning of the company is
falling. Whereas a company utilizing more of own financing will prefer high dividends.

(vii) Future Financial Requirements / Reinvestment Opportunity

Dividend payout will also depend on the future requirements for the additional capital. A company
having profitable investment opportunities is justified in retaining the earnings. However, a
company with no capital requirements should opt for a higher dividend.

(viii) Business Cycles

When the company experiences a boom, it is prudent to save up and make reserves for dips.
Such reserves will help a company to maintain dividend even in depressing markets to retain and
attract more shareholders.

(ix) Changes in Government Policies

There could be the change in the dividend policy of a company due to the imposed changes by the
government. The Indian government had put temporary restrictions on companies to pay
dividends during 1974-75.

(x) Profitability

The profitability of a firm is reflected in net profit ratio and ratio of profit to total assets. A highly
profitable company have a capacity to pays higher dividends and a company with less profits will
adopt a conservative dividend policy.

(xi) Taxation Policy

The corporate taxes will affect dividend policy, either directly or indirectly. The taxes directly
reduce the residual earnings after tax available for the shareholders. If dividend income is taxable
in the hands of investor and capital gain is exempt, then company may retain its earning so as to
increase price per share, which ultimately gives higher return to investors’ and vice versa. Further
if it is possible that bifurcate all shareholders into high tax bracket or low tax bracket, accordingly
dividend policy can be framed. Finally, objective is to give maximum return to shareholders.

(xii) Trends of Profits

Even if the company has been profitable over the years, the trend should be properly analyzed to
find the average earnings of the company. This average number should be then studied in relation
to the general economic conditions. This will help in opting for a conservative policy if a depression
is approaching.

(xiii) Liquidity

Liquidity has a direct relation with the dividend policy. Many a times, company having high profit,
may have majority of profit blocked in working capital or it may acquired assets. In that case its
liquidity is poor. In that case company should pay less dividend. High dividend payment is possible
only if company has good earning and sound liquidity.

(xiv) Legal Rules

There are certain legal restrictions on the companies for dividend payments. It is legal to pay a
dividend only if the capital is not reduced post payment. These rules are in place to protect
creditors’ interest. Most importantly providing depreciation is mandatory before making payment of
dividend. Depreciation is to be provided at minimum rates provided. Providing depreciation is very
important because with that company is able to retain an amount of profit for replacement of fixed
assets in future.

(xv) Inflation

Inflationary environments compel companies to retain major part of their earnings and indulge in
lower dividends. As the prices rise, the companies need to increase their capital reserves for their
purchases of fixed assets. In case of inflationary situation, same quantity of closing stock will have
more valuation, so payment of tax also increase.

(xvi) Control Objectives

The firms aiming for more control in the hands of current shareholders prefer a conservative
dividend payout policy. It is imperative to pay fewer dividends to retain more control and the
earnings in the company.

In a nutshell, the management of a company is completely free to frame the required dividend
policy. There are no obligations to be adhered to. So, the company needs to judiciously weight all
the above-mentioned factors and formulate a balanced dividend policy. A dividend policy can also
be revised in the wake of changes in any of the factors.

Forms of Dividends
A dividend is generally considered to be a cash payment issued to the holders of company stock.
However, there are several types of dividends, some of which do not involve the payment of cash
to shareholders. These dividend types are:

1. Cash Dividend
The cash dividend is by far the most common of the dividend types used. On the date of
declaration, the board of directors resolves to pay a certain dividend amount in cash to those
investors holding the company’s stock on a specific date. The date of record is the date on which
dividends are assigned to the holders of the company’s stock. On the date of payment, the
company issues dividend payments.

2. Stock Dividend
A stock dividend is the issuance by a company of its common stock to its common shareholders
without any consideration. If the company issues less than 25 percent of the total number of
previously outstanding shares, then treat the transaction as a stock dividend. If the transaction is
for a greater proportion of the previously outstanding shares, then treat the transaction as a stock
split. To record a stock dividend, transfer from retained earnings to the capital stock and
additional paid-in capital accounts an amount equal to the fair value of the additional shares
issued. The fair value of the additional shares issued is based on their fair market value when the
dividend is declared.

3. Property Dividend
A company may issue a non-monetary dividend to investors, rather than making a cash or stock
payment. Record this distribution at the fair market value of the assets distributed. Since the fair
market value is likely to vary somewhat from the book value of the assets, the company will likely
record the variance as a gain or loss. This accounting rule can sometimes lead a business to
deliberately issue property dividends in order to alter their taxable and/or reported income.

4. Scrip Dividend
A company may not have sufficient funds to issue dividends in the near future, so instead it issues
a scrip dividend, which is essentially a promissory note (which may or may not include interest) to
pay shareholders at a later date. This dividend creates a note payable.

5. Liquidating Dividend
When the board of directors wishes to return the capital originally contributed by shareholders as a
dividend, it is called a liquidating dividend, and may be a precursor to shutting down the business.
The accounting for a liquidating dividend is similar to the entries for a cash dividend, except that
the funds are considered to come from the additional paid-in capital account.

Types of Dividend Policy

Four types of dividend policy
There are basically 4 types of dividend policy. Let us discuss them on by one:

1. Regular dividend policy

In this type of dividend policy the investors get dividend at usual rate. Here the investors are
generally retired persons or weaker section of the society who want to get regular income. This
type of dividend payment can be maintained only if the company has regular earning.

Merits of Regular dividend policy:

 It helps in creating confidence among the shareholders.

 It stabilizes the market value of shares.
 It helps in marinating the goodwill of the company.
 It helps in giving regular income to the shareholders.

2. Stable dividend policy

The payment of certain sum of money is regularly paid to the shareholders. It is of three types-

(a) Constant dividend per share: here reserve fund is created to pay fixed amount of dividend in
the year when the earning of the company is not enough. It is suitable for the firms having stable
earning.

(b) Constant pay out ratio: it means the payment of fixed percentage of earning as dividend every
year.

(c) Stable rupee dividend + extra dividend: it means the payment of low dividend per share
constantly + extra dividend in the year when the company earns high profit.

Merits of stable dividend policy:

 It helps in creating confidence among the shareholders.

 It stabilizes the market value of shares.
 It helps in marinating the goodwill of the company.
 It helps in giving regular income to the shareholders.

3. Irregular dividend
As the name suggests here the company does not pay regular dividend to the shareholders. The
company uses this practice due to following reasons:

 Due to uncertain earning of the company.

 Due to lack of liquid resources.
 The company sometime afraid of giving regular dividend.
 Due to not so much successful business.

4. No dividend
The company may use this type of dividend policy due to requirement of funds for the growth of
the company or for the working capital requirement.

Dividend Models: Walter and Gordon’s Model

Walter’s Model
Professor James E. Walterargues that the choice of dividend policies almost always affects the
value of the enterprise. His model shows clearly the importance of the relationship between the
firm’s internal rate of return (r) and its cost of capital (k) in determining the dividend policy that will
maximize the wealth of shareholders.

Walter’s model is based on the following assumptions:-

1. The firm finances all investment through retained earnings; that is debt or new
equity is not issued;
2. The firm’s internal rate of return (r), and its cost of capital (k) are constant;
3. All earnings are either distributed as dividend or reinvested internally
immediately.
4. Beginning earnings and dividends never change. The values of the earnings
pershare (E), and the divided per share (D) may be changed in the model to
determine results, but any given values of E and D are assumed to remain
constant forever in determining a given value.
5. The firm has a very long or infinite life.

Walter’s formula to determine the market price per share (P) is as follows:

P = D/K +r(E-D)/K/K

The above equation clearly reveals that the market price per share is the sum of the present value
of two sources of income-

(i) The present value of an infinite stream of constant dividends, (D/K) and

(ii) The present value of the infinite stream of stream gains.

[r (E-D)/K/K]

Criticism
Walter’s model is quite useful to show the effects of dividend policy on an all equity firm under
different assumptions about the rate of return. However, the simplified nature of the model can
lead to conclusions which are net true in general, though true for Walter’s model.

The criticisms on the model are as follows:

1. Walter’s model of share valuation mixes dividend policy with investment policy of
the firm. The model assumes that the investment opportunities of the firm are
financed by retained earnings only and no external financing debt or equity is
used for the purpose when such a situation exists either the firm’s investment or
its dividend policy or both will be sub-optimum. The wealth of the owners will
maximize only when this optimum investment in made.
2. Walter’s model is based on the assumption that r is constant. In fact decreases
as more investment occurs. This reflects the assumption that the most profitable
investments are made first and then the poorer investments are made.
The firm should step at a point where r = k. This is clearly an erroneous policy and fall to optimize
the wealth of the owners.

3. A firm’s cost of capital or discount rate, K, does not remain constant; it changes
directly with the firm’s risk. Thus, the present value of the firm’s income moves
inversely with the cost of capital. By assuming that the discount rate, K is
constant, Walter’s model abstracts from the effect of risk on the value of the firm.

Gordon’s Model
One very popular model explicitly relating the market value of the firm to dividend policy is
developed by Myron Gordon.

Assumptions of Gordon’s model

Gordon’s model is based on the following assumptions.

1. The firm is an all Equity firm

2. No external financing is available
3. The internal rate of return (r) of the firm is constant.
4. The appropriate discount rate (K) of the firm remains constant.
5. The firm and its stream of earnings are perpetual
6. The corporate taxes do not exist.
7. The retention ratio (b), once decided upon, is constant. Thus, the growth rate (g)
= br is constant forever.
8. K >br = g if this condition is not fulfilled, we cannot get a meaningful value for the
share.

Miller- Modigliani (MM) Hypothesis

The MM, in their first paper (in 1958) advocated that the relationship between leverage and the
cost of capital is explained by the net operating income approach. They argued that in the
absence of taxes, a firm’s market value and the cost of capital remains invariant to the capital
structure changes. The arguments are based on the following assumptions:-

(a) Capital markets are perfect and thus there are no transaction costs.

(b) The average expected future operating earnings of a firm are represented by subjective
random variables.

(c) Firms can be categorized into “equivalent return” classes and that all firms within a class have
the same degree of business risk.

(d) They also assumed that debt, both firm’s and individual’s is riskless.(e) Corporate taxes are
ignored.

Proposition I
The value of any firm is established by capitalizing its expected net operating income (If Tax = 0)
VL = VU = EBIT

1. The value of a firm is independent of its leverage.

2. The weighted cost of capital to any firm, levered or not is

(a) Completely independent of its capital structure and

(b) Equal to the cost of equity to an unlevered firm in the same risk class.

Proposition II
The cost of equity to a levered firm is equal to

(a) The cost of equity to an unlevered firm in the same risk class plus

(b) A risk premium whose size depends on both the differential between the cost of equity and
debt to an unlevered firm and the amount of leverage used.

As a firm’s use of debt increases, its cost of equity also rises. The MM showed that a firm’s value
is determined by its real assets, not the individual securities and thus capital structure decisions
are irrelevant as long as the firm’s investment decisions are taken as given. This proposition
allows for complete separation of the investment and financial decisions. It implies that any firm
could use the capital budgeting procedures without worrying where the money for capital
expenditure comes from. The proposition is based on the fact that, if we have two streams of
cash, A and B, then the present value of A +B is equal to the present value of A plus the present
value of B. This is the principle of value additivity. The value of an asset is therefore preserved
regardless of the nature of the claim against it. The value of the firm therefore is determined by
the assets of the firm and not the proportion of debt and equity issued by the firm.

The MM further supported their arguments by the idea that investors are able to substitute
personal for corporate leverage, thereby replicating any capital structure the firm might undertake.
They used the arbitrage process to show that two firms alike in every respect except for capital
structure must have the same total value. If they don’t, arbitrage process will drive the total value
of the two firms together.