DEVIDEND POLICY

By CPA Robert Vedastus

MEANING OF DIVIDEND

❖ A dividend is the share of profits that

is distributed to shareholders in the
company and the return that
shareholders receive for their
investment in the company.
❖ Dividend refers to the net profits of
the company distributed among the
shareholders.
❖ It is the part of the profit of a business
concern which is distributed among
its shareholders.
Form of Dividend
Dividends are classified into:
1. Cash dividend
2. Stock dividend
3. Bond dividend
4. Property dividend
1. Cash Dividend

❖ It is paid in the form of cash to the

shareholders.
❖ It is paid periodically out the business
concerns earnings after interest and
tax.
❖ Cash dividends are common and
popular types followed by majority of
the business concerns.
2. Stock Dividend

❖ Stock dividend is paid in the form of

the company stock due to raising of
more finance.
❖ Cash is retained by the business
concern.
❖ Stock dividend may be bonus issue.

❖ This issue is given only to the existing

shareholders.
3. Bond Dividend

❖ Bond dividend is also known as script

dividend.
❖ If the company does not have
sufficient funds to pay cash
dividend, it promises to pay at a
future specific date with the help of
issue of bond or notes.
4. Property Dividend

❖ Property dividends are paid in the

form of some assets other than cash.

❖ It will be distributed under the

exceptional circumstance.
MEANING OF DIVIDEND POLICY

Dividend policy is the policy a company

uses to structure its dividend payout to
shareholders.
❖ Dividend policy depends upon the
nature of the firm, type of shareholder
and profitable position.
❖ A company’s dividend policy
dictates the amount of dividends
paid out by the company to its
shareholders and the frequency with
which the dividends are paid out.
❖ Some researchers suggest that
dividend policy is irrelevant in theory
because investors can sell a portion
of their shares or portfolio if they need
funds.
Types of Dividend Policy

The following are the types dividend

policy based on the dividend
declaration by the firm:
1. Stable dividend policy

2. Regular dividend policy

3. Irregular dividend policy and

4. No dividend policy.
1. Stable Dividend Policy

Under the stable dividend policy, the

percentage of profits paid out as
dividends is fixed.
❖ For example, if a company sets the
payout rate at 6%, it is the
percentage of profits that will be
paid out regardless of the amount of
profits earned for the financial year.
Three Forms of Stable Dividend Policy

1. Constant dividend per share

2. Constant payout ratio

3. Stable amount of dividend plus extra

dividend.
Constant Dividend Per Share

It is the policy of a company to pay fixed

amount per share or fixed rate on paid-up
capital as dividend every year, irrespective
of fluctuations in the earnings.
Constant Payout

The ratio of dividend to earnings is known

as payout ratio.
❖ The amount of dividend will fluctuate in
direct proportion to earnings.

❖ Internal financing with retained

earnings is automatic when this policy
is followed.
Constant Dividend Per Share Plus Extra

Dividend

The policy to pay a minimum dividend per

share with step-up feature is desirable.

❖ The small amount of dividend is fixed to

reduce the possibility of ever missing a

dividend payment.
❖ The extra dividend may be paid as an

interim dividend in periods of

prosperity.
2. Regular Dividend Policy
Under the regular dividend policy, the
company pays out dividends to its
shareholders every year.
❖ If the company makes abnormal
profits, the excess profits will not be
distributed to the shareholders but are
withheld by the company as retained
earnings.
❖ If the company makes a loss, the
shareholders will still be paid a
dividend under the policy.
3. Irregular Dividend Policy

Under the irregular dividend policy, the

company is under no obligation to pay its

shareholders and the board of directors

can decide what to do with the profits.

❖ If the company makes an abnormal
profit, can decide to distribute it to the
shareholders or not pay out any
dividends at all and instead keep the
profits for business expansion and
future projects.
4. No Dividend Policy

Under the no dividend policy, the

company doesn’t distribute dividends to
shareholders.
❖ It is because any profits earned is
retained and reinvested into the
business for future growth.
Factors Determining Dividend Policy
1. Profitable Position of the Firm

When the firm earns more profit, they

can distribute more dividends to the
shareholders.
2. Uncertainty of Future Income

When the shareholder needs regular

income, the firm should maintain
regular dividend policy.
3. Legal Constrains

The Companies Act 2002 has put

several restrictions regarding payments
and declaration of dividends.
❖ Similarly, Income Tax Act, 2004 also lays
down certain restrictions on payment of
dividends.
4. Liquidity Position

❖ If the firms have high liquidity, the firms

can provide cash dividend otherwise,
they have to pay stock dividend.
5. Sources of Finance

❖ Financial institutions and banks may

generally put restrictions on dividend
payments to protect their interests
when the firm is experiencing low
liquidity or low profitability, etc.
6. Growth Rate of the Firm

❖ High growth rate implies that the firm

can distribute more dividend to its
shareholders.
7. Tax Policy
❖ Tax policy of the government also
affects the dividend policy of the firm.
❖ When the government gives tax
incentives; the company pays more
dividend.
8. Capital Market Conditions

❖ Due to the capital market conditions,

dividend policy may be affected.

❖ If the capital market is prefect, it leads

to improve the higher dividend.
Passive and Active Dividend Policy
The difference between a passive and an
active dividend policy lies in the amount of
time between dividend disbursement.
❑ In a passive dividend policy, dividends
are given when the company decides
it is time.
❑ With an active dividend policy,
dividends are disbursed at regular
intervals.
DIVIDEND SIGNALING

Dividend signaling is a theory that suggests

that a company's announcement of an
increase in dividend payouts is an
indication of positive future prospects.
❑ The dividend signaling theory suggests
that companies that pay the highest
dividends are, or should be, more
profitable than those paying smaller
dividends.
❑ Increasing a company's dividend
payout may predict favorable
performance of the company's stock in
the future.
❑ This is a theory which asserts that
announcement of increased dividend
payments by a company gives strong
signals about the bright future
prospects of the company.
IRRELEVANCE OF DIVIDEND

The concept of the irrelevance of

dividends was popularised by the
Modigliani-Miller theorem (M&M.
❑ M&M challenges traditional views on
the impact of dividend policy on a
firm's value.
According to M&M theory, dividend policy
has no bearing on a firm's valuation under
certain idealized assumptions.

❑ Dividend policy has no effect on the

share price of the company.
❑ There is no relation between the
dividend rate and value of the firm.

❑ Dividend decision is irrelevant of the

value of the firm.
❑ Modigliani and Miller contributed a
major approach to prove the
irrelevance dividend concept.
Modigliani and Miller Approach

According to M&M, under a perfect

market condition, the dividend policy of

the company is irrelevant and it does not

affect the value of the firm.

Assumptions of M&M Approach

❖ The Modigliani-Miller (M&M) approach

to capital structure and dividend
policy is based on several key
assumptions which form the foundation
of its theoretical framework.
❖ These assumptions provide the basis for
the conclusions drawn by the M&M
theorem regarding the irrelevance of
capital structure and dividend policy
under certain idealized conditions.
1. Perfect Capital Markets

The M&M theorem assumes the existence

of perfect capital markets, where:

❑ Investors can buy and sell securities

without transaction costs.
❑ There are no taxes or other market
frictions.

❑ Information is freely available and

equally accessible to all market
participants.
❑ There are no restrictions on borrowing
or lending, and interest rates are the
same for all firms and investors.
2. Investor Rationality

The M&M approach assumes that investors

are rational and make decisions based on
maximizing their own utility or wealth.
❑ This implies that investors have
homogeneous preferences and can
accurately assess the risk and return
characteristics of different investment
opportunities.
3. No Agency Costs

The M&M theorem assumes the absence of

agency costs arising from conflicts of
interest between shareholders and
management.
❑ Managers always act in the best
interests of shareholders, and there are
no agency problems or costs
associated with monitoring and
controlling management behavior.
4. Information Symmetry

The M&M approach assumes that there is

no asymmetry of information between
managers and shareholders.
❑ This means that all relevant information
about the firm and its prospects is
known and incorporated into stock
prices efficiently.
5. Risk Neutrality

The M&M theorem assumes that investors

are risk-neutral or that they can diversify
away all firm-specific risk through well-
diversified portfolios.
❑ This implies that investors are only
concerned with the overall risk-return
trade-off of their investment portfolios
rather than the risk characteristics of
individual securities.
6. Single Period Analysis

The M&M approach typically employs a

single-period analysis, where decisions are
made based on the expected outcomes
within a single time period.
❑ This simplifies the analysis but may not
fully capture the dynamics of long-term
investment decisions.
 Proof of M&M Approach

The market value of a share at the

beginning of a period is equal to the
present value of dividends paid at the end
of the period plus the share price at the
end of the period.
This means that:

If one year period of holding is taken, the

value of share (Po) will be equal to PV of
dividend paid at the end of one year (D1)
plus PV of share price at the end of one
year (P1)
Where:
Po = Prevailing market price of a share.
Ke = Cost of equity capital.
D1 = Dividend to be received at the
end of period one.
P1 = Market price of the share at the end of
period one.
The Price of New Issue (P1)
Computation of New Shares to be Issued

The Investment programme of a company

in a given period of time can be financed,
either by retained earning or by new
shares or both.
Where:

❖ M= Number of new shares to be

issued.

❖ P1 = Price at which new issue is to be

made.
❖ I = Amount of investment required.

❖ X = Total net profit of the firm during

the period.

❖ nD1 = Total dividend paid during the

period.
Example 1

AB Company Ltd., has 100,000 shares

outstanding. The current market price of
the shares TZS 15 each. The company
expects the net profit of TZS 200,000 during
the year and it belongs to a rich class for
which the appropriate capitalisation rate
has been estimated to be 20%. The
company is considering dividend of TZS
2.50 per share for the current year.
Required:

What will be the price of the share at the

end of the year:

i) If the dividend is paid and

ii) If the dividend is not paid.

Example 2

Z Ltd. has 1,000 share at TZS 100 per share.

The company is contemplating a TZS 10
per share dividend at the end of the year.
It expects a net income of TZS 25,000.
Required:

Calculate the company's share price

under the following conditions:

a) Dividend declared

b) Dividend not declared

Also, assuming that the company pays
dividends and makes a new investment of
TZS 48,000 in the coming period, how many
new shares will need to be issued to the
Finance Investment Programme (as per
the MM) approach with a 20% risk factor?
Criticism of M&M Approach

1. MM approach assumes that tax does

not exist. It is not applicable in the

practical life of the firm.

2. M&M approach assumes that, there is

no risk and uncertain of the investment.

It is also not applicable in present day

business life.
3. MM approach does not consider
floatation cost and transaction cost. It
leads to affect the value of the firm.
4. MM approach considers only single
decrement rate, it does not exist in real
practice.
5. MM approach assumes that, investor
behaves rationally. But we cannot give
assurance that all the investors will
behave rationally.
RELEVANCE OF DIVIDEND

The relevance dividend theories support

the view that the dividend policy has
profound impact on the value of a firm.
Dividend relevance implies that
shareholders prefer current dividend and
there is no direct relationship between
dividend policy and value of the firm.
There are three theories under this school
of thought.

1. Traditional Theory

2. Walter’s Model

3. Gordon’s Model
 Traditional Theory
The traditional theory was expounded by
B. Graham and D.L. Dodd.
❑ According to them, the stock market is
overwhelmingly in favour of liberal
dividends as against niggardly
dividends.
❑ As per this model the importance
attached to liberal current dividends
by the shareholder is more.
❑ The shareholders give less importance
to capital gains that may arise in future.

❑ Firms which pay more current

dividends will have higher market
value than the firms which pay less
dividends.
❑ The weight attached to dividends is
equal to four times the weight
attached to retained earnings (R).
❑ These weights provided by Graham
and Dodd are based on their
subjective judgement and not derived
from objective analysis.
❑ According to their view the liberal
payout policy has favourable impact
on stock prices.
WALTER’S MODEL

Prof. James E. Walter argues that the

dividend policy is a critical factor
affecting the value of the firm.
Walter model is based in the relationship
between the following important factors:

❖ Rate of return (r)

❖ Cost of capital (k)

According to the Walter’s model:

❖ If r > k, the firm is able to earn more

than what the shareholders could be
reinvesting, if the earnings are paid to
them.
The implication of r > k is that the
shareholders can earn a higher return
by investing elsewhere.
❖ If the firm has r = k, it is a matter of
indifferent whether earnings are
retained or distributed.
Assumptions of Walter’s Model

1. The firm finances new investments

through retained earnings only.

2. The firm does not use debt or equity

finance.
3. The firm’s internal rate of return, and
cost of capital are constant.

4. 100 % of earnings is either distributed as

dividends or reinvested internally.

5. The firm has a very long infinite life.

5. The initial earnings and dividends
remain constant forever.

Any given values of EPS and DPS

assumed to remain constant forever in
determining a given value.
❑ The above equation gives the sum of
the PV of future stream of dividends
(D/Ke), and capital gains resulted by
reinvestment of retained earnings (E-D)
at the firm’s internal rate of return (r).
❑ The discount value is equal to the
firm’s cost of capital (Ke).
Where:
❖ P = Market price of an equity share (MPS)
❖ D = Dividend per share (DPS)
❖ r = Rate of return on investment
❖ E = Earnings per share (EPS)
❖ Ke = Cost of equity capital
❖ (E - D) = Retained earnings
❖ (E – D)r = Return on retained earnings invested
Criticism of Walter’s Model

1. Walter’s model assuming that

investment will be financed only with
retained earnings, without resorting to
either debt or new equity.

This is not practically applicable.

2. Walter’s Model assumes a constant
rate of return which is in the real life
may not hold true.

Return may increase or decrease,

depending upon the business situation.
3. Walter’s model assume constant cost
of capital which may not hold true in
the real life of the business.
The firm’s cost of capital changes with
its risk, and with the macro-economic
changes in the economy.
Example 1

a) From the following details, calculate

the market value of equity shares of
a firm by using Walter’s model:

Earnings per share (E) = TZS 5; Dividend

per share (D) = TZS 3;
 Rate of return on Investment (r) = 10%;
Cost of capital (k) = 10%.

b) Will there be any change in the market

value of equity share if the dividend
payout ratio is 100% in the place of
present rate of 60%?
Example 2

From the following information supplied to

you, ascertain whether the firm is following

an optional dividend policy as per Walter’s

Model.
• Total Earnings TZS 200,000
• No. of equity shares 20,000 each TZS
100
• Dividend paid TZS 100,000
• P/E Ratio 10
• Return Investment 15%
The firm is expected to maintain its rate on
return on fresh investments. Find out what
should be the E/P ratio at which the
dividend policy will have no effect on the
value of the share.
Example 3

The earnings per share of a company are

TZS 10 and the rate of capitalization
applicable to the company is 12%. The
company has before it an option of
adopting a payment ratio of 25%.
Required:

Using Walter’s formula of dividend payout,

compute the market value of the
company’s share of the productivity of
retained earnings12%
GORDON’S MODEL

Myron Gordon suggests one of the popular

model which assume that dividend policy
of a firm affects its value.
❑ He proposed a model of stock
valuation which is supporting the
dividend relevance decision in case of
a growth firm (when r > k)

❑ In case of a declining firm (when r < k)

❑ Dividend irrelevance decision in case
of a normal firm (when r = k)

❑ The theory relating dividend policy and

the firm’s value.
Assumptions of Gordon’s Model
1. The firm has only equity capital, and
no debt.
2. The firm has no external finance.
3. Cost of capital and return are
constant.
4. The firm has perpetual life.

5. There are no taxes.

6. Constant retention ratio (g=br).

7. Cost of capital is greater than growth

rate (Ke>br)
Where:
❖ Po = Current market price of a share
❖ E = Earnings per share at the end of
year one
❖ b= Retention ratio (% of earnings
retained by the firm)
❖ 1 – b = Dividend payout ratio
❖ Ke = Capitalization rate
❖ r= Return on investment
❖ br = g= Growth rate of earnings and
dividends
Criticism of Gordon’s Model

1. Gordon model assumes that there is no

debt and equity finance used by the
firm. It is not applicable to present day
business.
2. Ke and r cannot be constant in the real
practice.

3. According to Gordon’s model, there

are no tax paid by the firm. It is not
practically applicable.
Example 1
Raja company earns a rate of 12% on its total
investment of TZS 600,000 in assets. It has
600,000 outstanding common shares at TZS 10
per share. Discount rate of the firm is 10% and
it has a policy of retaining 40% of the earnings.
Required:

a) Determine the price of its share using

Gordon’s Model.

b) What shall happen to the price of the

share if the company has payout of 80%
Example 2
A company earns TZS 120 per share at an
internal rate of 15 per cent. The firm has a
policy of paying 40 per cent of earnings as
dividends. If the required rate of return is 12 per
cent, determine the price of the share under
Gordon’s model.
 THE END

THANK YOU

By CPA Robert Vedastus