semester (Financ Man IS (Mustule-tth MBA Second 8.1.1. Meaning and Definition of Dividend ‘Retained Earning’) The term dividend denotes that part of company’s balance of profi (after the execution of is Het neN, Nt available for equal distribution amongst the shareholders (investors) of the company: Dividends jade by a compar the shareholders for having invested in the company’s shares, This is the return out of the profit made DY 4 year. for its shareholders (beneficiaries) According to the Institute of Chartered Accountant of India, “A dividend is a distribution to shareholders out OF reserves available for this purpose” 8.1.2. Fi ‘orms/Types of Dividend 4 idends’ ividends may be classified into diferent categories on the basis of various parameters, eg. “Profit Dividends dividends paid out of the profit in the normal conduct of business, and ‘Liquidation Dividends’ are those which Out ofthe capital ofa company. Other categories of dividends and the underlying parameters are described inthe fo eae Forms/Types of Dividend t + On the Basis of On the Batis of Mode ON the Basis of Time of Types of Shares of Payment Payment Interim Regular Special Equity Preference Divicend Dividend Dividend Dividend Dividend Cash Stock Scrip Bond Property ‘Composite Dividend Dividend Dividend Dividend Dividend Dividend 1) On the Basis of Types of Shares ') Equity Dividend: Dividends distributed to the equity shareholders of a company are known as equity divic Their quantum and timing is decided on the' recommendation of Board of Directors. Rate of equity dividen not fixed (unlike in the case of dividends on preference shares, which are fixed) and depends upon the | eamed by the company during a particular year and the company's need of funds in future Preference Dividend: Preference Dividends, as the nomenclature indicates, are the dividends distributed amc the preference shareholders. The rate of preference dividen¢ is fixed (pre-decided) and does not depend upo Profits eared by a company during a particular year. However, the decision with regard to the distributic preference dividends is taken on the basis of the recommendation of the Board of Directors. If the Boar Directors believes it to be fit, they recommend a higher rate on preference dividends; although, they do not | the power to reduce the pre-decided rate of interest on preference dividends. Dividend payment to prefer. shareholders gets primacy over the dividend payment to equity shareholders; in fact dividend payment on eq shares is considered only after the payment of dividends on preference shares, 2) On the Basis of Modes of Payment i) Cash Dividend: The decision teeing delarton of dividends ake na Board Meeting, wherein the voting consideration onthe subject ke lace among the Board of Dec (BoD) Afr the declaration the pom immediate; asthe process of transfer of stock between the holders takes time and an up-to-date Int of kronds required forthe purpose. Tiss precisely the reson the dts for following activites ae fixed in aha a) Date of the meeting of Board of Directors for the declaration of dividend ) Date of the closure of record for shareholder’ register. ©) Date of the payment on which cheques are mailed to the shareholdersSt cera, Dav nlondl OG tstans (Chapter NP Thus, durmy the Annual General Meeting, the iwvommendation of ROD is approved: by. the Shareholders and the process of “declaration of cash dividends” is finished. A declared cash shiviclend iy patt of shareholder's equity (and not a hatility of the company), ax decision inthe matter may be reversed On Treasury Stocks, no cash payments are made: 0) Bonus Share/Stock Dividend: Sometimes, when the profits made by a company are substantial, it may decide to retain a part thereof by capitalising and retaining it in the business perpetually. by issuing stock dividends (additional or bonus stocks/shares in liew of cash) to the existing stockholders. Under this process, assets distribution is not involved and — each shareholder's interest in the company remains unchanged. The total shareholder's equity also remains unaffected. Stock dividend is beneficial for a company as it has a positive effect on its ‘Liquidity Management’, due to absence of cash- outflow. Shareholders also stand to gain, as there is an increase in the number of shares in proportion to the shares held by them without any payment. Consequences of Bonus Share/Issue Bonus shares may be issued due to several reasons as enumerated below: a) If a company has accumulated a large quantity of profits and it wants to capitalise such profits for future use. The company may be under legal restrictions and may not be able to declare higher dividends despite its profits. c) A company may refrain from paying high rate of dividend so as not to create unnecessary high expectations in the future. d) A company may have profit reserves but not enough liquid cash to declare regular dividend. ¢) Ina company, nominal and market value of the shares may show a big difference. b) Comparison between Bonus Shares/Issue and Stock Split Basis of Bonus Shares/Issue| Stock Split Difference 1) Face Value |The face value of] The face value the bonus shares! of the stock remains the same. _| split decreases. 2) Transfer of |The declaration of] In stock split, Reserve | bonus shares take|there is no place with the| transfer. of transferring reserves. | reserve done. 3)Dividend |The dividend pay-| The — dividend Pay-out | out of the company| pay-out does increases. not change with the stock split. w5 Wy) Totut Pald-| the tal paid-up! the wut pad up al increases| up capital dues Capital with the isste of nat change with homus shar the stock split 5) tnnue The ise of bonus] The stock split shares is when the| tikes place company hax the) when the price large accumulated) of the share is | reserves high iii) Serip Dividend: In a situation, where in a company 1s a) Suffering from a temporary liquidity crunch, and b) Has an adequate level of retained earnings. IL may decide to issue ‘Scrip Dividends’ in lieu of ‘Cash Dividends’. ‘Scrip Dividends’ may be issued either as ‘Promissory Notes’ (which may be discounted before its ‘due date’) or ‘Ordinary Shares’. Issue of ‘Scrip Dividends’ may result in increase in the number of shares of the company, but there will be no increase in the value of the company, Issue of ‘Scrip dividends’ is, sometimes, opted by a company due to temporary liquidity problems. However, investors do not favour this type of dividend, as it may lead to reduction in the market value of the company’s shares. Bond Dividends: “Bond Dividends’ may be defined as ‘dividend distribution that is paid to shareholders in the form of a bond or debenture (debt instruments) instead of cash’. It has fixed rate of interest for long duration. Issue of “Bond Dividends’ is opted by a company under the same situation as that of issue of “Scrip Dividends’, and have the same impact. Property Dividend: ‘Property Dividend’ is an alternative to ‘Cash Dividend’, ‘Scrip Dividend” or ‘Bond Dividend’. It is rather an uncommon payout structure, in which there is transfer of non- monetary asset. between a company and its shareholders on a non-reciprocal basis. The non- monetary asset may be in the form of a) Inventory of the company, b) Shares of a subsidiary company, and c) Real estate (land or building), ete ‘The dividend is recorded at the markev/fair value of the asset provided. This mode of payout is employed by a company, when it does not want to dilute its existing share position or when it suffers trom liquidity problems. Composite Dividend: When dividend payment involves two or more types mentioned in the foregoing paragraphs, it is known as ‘Composite Dividend’. For example, a company may decide to distribute dividend partly in the form of cash and partly in other forms, i.e., scrip, bond or property. iv) v) Vieo MIA Secu Seneter Hu Many 1 Eye (Mastute Ub) 0 Oa the Basis of Time of Payment v pet Dividend: Dividend is hormully declared MN the Annual General Meeting (AGM) of at Sema’ attet the finalisation af the balance sheet a the endl of a financial year, However, at ties the shvitend is declare and pid bet the finalisation al the balance sheet or before AGM of a company. Such divide is rightly tenet ay “erin Divicend” and is paid when the Managemen/Boant OF the company has wasons to believe that the company has already eamed enough profits and ot the year end the level of profit would be maintained! oF tnereased, AL times the projections of a ty may prove fo be wrong; as Nuch the Management needs to be extra catitious it declaring the interim dividend, Interim Dividend is declared by the Board and Paid before the approval of “Annual General Meeting of a company. Subsequently, when the AGM takes place and final dividend is declared in the normal course, the amount of Interim Dividend, already paid, is adjusted and approval of ‘Interim Dividend’ is also granted spontaneously. Interim Dividend is something like a part of dividend paid in advance. 4) Regular Dividend: The dividend declared in the Annual General Meeting, in the normal course of business, is known as ‘Regular Dividend’. Regular Dividend is declared and paid after the finalisation of a company’s balance sheet every year. iii) Special Dividend: A well-founded ‘Dividend Policy’ needs to be framed with a provision to ensure that frequency in change of the dividend rate is kept at the minimum from year to year and the level of profitability is not same every year. Even during a year of huge profit, the company may consider declaring a ‘Special Dividend’ instead of declaring an extraordinary rate of dividend for that particular year. This would check the expectation of shareholders to get a high rate of dividend during the subsequent years. Declaration of ‘Special Dividend’ by a Company express to its shareholders that this is a ‘One-Time’ affair and may not necessarily be repeated during succeeding years. 8.1.3. Meaning and Definition of Dividend Policy The vision of a company regarding the part (amount) of profit (remaining afier the retained eamings are kept aside) to be declared as dividend, is referred to as its ‘Dividend Policy’. Dividend Policy of a company is developed and implemented through its “Board of Directors’. It defines the pattem of dividend declarations to be followed in the long-term. According to Weston and Brigham, “Dividend policy determines the division of earings between payments to shareholders and retained earnings”. the by its manager split into "Rel safiey’ of a company HEA I, spividend Poliey YH Pave ent in suc a way ADE Net Fained zarnings’ aM DIV, appropriate manner This framed policy SH 1) Business growth, 2» The two 1) 2) pould also micet bot the obje and 7 Hin of wealth for its shareholders Mani decision of breaking the "Net PrOME (Post, . company m0 rcholders as ‘Dividend Distributing to share 8.1.4. Objective of Dividend Polic, The firms dividend pol icy represents a plan of action, follow whenever the dividend decision must be p,.* Following are th \ 1) Wealth Maximization: Th 2 3 4) objectives of dividend policy ¢ firm's dividend py, should be one that supports the general objectiy, maximizing the wealth of the firm's owners o, Tong run, It must be design not merely to marin, the share price in the coming year but to maxim, wealth in the long run, since the firm is assume, have an infinite life. Of course the theoretically ,, except that shareholders and prospective investor yy recognize the long run 45 effect of a dividend poy on their ownership and that this recognition will reflected in the level of future return they forecast Providing for Sufficient Financing: Making provisin for sufficient financing can be considered a second) objective of dividend policy. Without _suffcen financing to implement acceptable project, the weilh maximization process cannot be carried out. The fim must forecast its future funds needs and taken in account the extemal availability of fund and ceria market consideration, determine both the amount and retained earnings financings needed and the amouni of retained earnings available after the minimum dividends have been paid. The important point paid to remember here is that the amount of retained earnings financing available must be forecast on an after dividend basis since the market can be expected to react adversely to tht non-payment of the cash dividend Future Prospects: Dividend policy is a financing decision and leads to cash outflows and also leads 10 decrease in availability of cash for financing of Profitable projects. If sufficient funds are no! available, a firm has to depend on external financing. Therefore the dividend policy needs to be devised in such a manner that prospective projects may be financed through retained earnings. Degree of Control: Issue of new shares of dependence on extemal financing will dilute the degree of control of the existing shareholders Therefore, a more conservative dividend policy should be followed in order that the interest of existing shareholders is not hampered.\ ( hapto 8) SOLS. Policy Vy pes/Classification of Dividend Ay alo one of the following types af vd Dohoes depending: pon the snitability UypewChasifieation of Divider ees ke Divndemnt Daten | - = | | Sable Dividend Policy une | = Regular Dividend Policy: A company having a am of income may prefer this category of Policy”. It means payment of dividends on basis. even if the rate of dividend is low. In other words, the focus is on the regularity of dividend ssyout rather than on its rate. It suits the investors, Retired persons, and Persons belonging to low income group. This category of dividend lar payment of a fixed percentage 1 of a company’s annual income to its shareholders. nree sub-categories: Constant Dividend per Share: Under this sub- egory. a ‘Reserve Fund’ is created to take care payment of fixed dividends to the shareholders during a year when the company is adequate 10 generate revenue. Companies having stable annual income find this policy suitable, Constant Payout Ratio: In this sub-category, a fixed percentage of a company’s annual earning s paid to the shareholders as dividend. i) Stable Plus Extra Dividend: Low rate of dividend per share is paid to the shareholders on a regular basis. However, in the year of higher profit plus extra dividend is paid. 3) Irregular Dividend Policy: As the name itself suggests under this type of policy, a company does not pay dividends to its shareholders on a regular basis. because of certain reasons, some of which are as follows: 1) Annual revenue generation by a company may be unpredictable ii) A company may be facing liquidity crisis. iii) A company may be scared of giving regular payouts, due to certain reasons of the company. iv) The business carried out by a company may not be a success or profitable. 4) No Dividend Policy: At times, a company may like to keep its entire net profit as ‘Retained Earnings’ to be utilised for its business growth or for meeting its working capital needs. 197 ee 8.1.6. Factors Determining Dividend Policy The guiding factors in determination of particu! Policy’ to be adopted by a company are as follows: 1) Legal Bounding: This is the foremost deciding factor responsible for a company adopting a specific ‘Dividend Policy’, which needs to be compliant with various statutory provisions, especially those contained in’ the Companies Act, 1956. These provisions relate to distribution and payment of dividends and include following: i) Protection of interest of the creditors (outsiders). ii) Providing for the depreciation on the company’s fixed and tangible assets. iii) Dividends are not distributed from capital funds. iv) Payment of preference dividend needs to get precedence over the payment of ordinary dividends. “Dividend of the Earnings: Eaming of a business organisation is the basis for deciding the upper limit of dividends to be distributed amongst the shareholders. If the earning of a company is adequate and stable, it is capable to forecast future earnings, and the percentage of its dividends declared would be at a higher level. An optimum dividend policy should look upon the quantum and type of a company’s earning over a long period of time. 3) Investment Opportunities and Shareholder’s Preferences: Management of a company needs to develop a ‘Dividend Policy’, which must be able to maintain a balance between: i) Shareholders expectations with regard to rate of dividend, and ii) Utilisation of retained earnings for investment in available profitable avenues. If a good number of profitable projects are on the horizon of a company, logically preference should be given to the retention of earnings over the dividend payout. However, the shareholders interest with regard to the better rate of dividend and capital gains also needs to be protected, The financial status and the lax slab of a shareholder is the determinant of his/her preference. As the rate of capital gains is lower than the rate of dividend tax, preference of a financially sound shareholder would be for capital gains as against dividends. All these aspects need to be taken into account while formulating an ideal/optimal dividend policy. 4) Liquidity Position: As dividend payout to the shareholders involves cash outflow; it is necessary at the time of formulating a ‘Dividend Policy’ to make a provision for the liquidity status prevailing in the company. A company facing liquidity constraint may not be able to declare dividend payout at a better rate, even if it would have earned well. Therefore, need to have cash funds/liquidity is given top position in the company and hence it may not prefer to pay cash dividend to its shareholders.— Txs (Maatale HD 6) Company tnteation fowards Control: cmpay"® iweterernee to depoadt apon the “retained earnings’ £04 tts business ghetty, expansion oF diversifte ation my. te appreciated, tC the underlying: Tele 1s properly understood Ranstngs finds (for the above purposes) tim other sowie than the retained carmings like anny asalitional stares would resell in dilution ol the contol over the company. Puither, debentte fea woul angryase the chances oF Hctention the oomnpany 'S earmings, which may not hye considered in A company's 7) 8) the favour of existing: shareholders continue having control over its al 4 decision to reduce the rate of intention 1 wouk! result in dividend and increase in the retained earnings fal Market and Access to it: In case cate of Capit the hguidity position of a country’s capital market is got and a company's camings are, high, the jer raising finds through the company may consid capital market, rather t for the same, provided han using its retained earings the market is easily accessible for the company. The result under the above situation, company would follow a “liberal dividend policy’ (ie., the dividend rate will be higher). However, in the absence of any of the above conditions, vic.: i) Adequate liquidity in the capital market, ii) Company’s earnings being at a comfortable level, and iii) Easy access for the company to the capital market, The company is likely to follow a ‘conservative dividend policy” (i.e. the dividend rate will be lower). Contractual Restrictions: When a company borrows funds from external sources, certain restrictive clauses may be imposed by the lenders. Such clauses / conditions are laid down in the loan documents by the lenders in order to protect their interests. Such restrictive clauses, sometimes, may relate to dividend distribution. These clauses need to be Kept in view at the time of framing the ‘dividend policy’ of a company, so as 10 ensure that the loans are not recalled by the creditors on account of breach of any of the restrictive clauses. Profit Rate and Stability of Earnings: A company's investment in high-yielding instruments would fetch huge profit for the company. Such a company would be in a position to pay better rate of dividend, when compared with a company having investment in low- yielding instruments, which in turn would result in poor profit and pay poor rate of dividend. Another factor influencing the dividend paying capability of a company relates to stability of its earning. Stable earning of a company would enable it to forecast its future earings and thereby pay a higher rate of dividend. On the other hand, a company with unstable earnings would not be in a position to project its future earnings and thereby may be compelled to have a higher level of retained earings, resulting in payment of lower rate of dividend. = oo 9) In brief, famed according declare a high ral which would compe its shareholders. WI broad parameters S! Hy ey due inflation, the og | Dt Inf 5 increases aNd 88 yey | replecing xed end the deprectallan Policy op 8. necounting Pe re depreciated year after year y 4) Th companys eT im ccurnulated depreciation fynq 1) hook value le the rising COM of replacemen, supposed ie ssc! Howevel when inflation rate i: saat assets HOTTY not be sUlfcen Wey the depreciation JM Ty yh silo, may De COMPelleg 4, Pi the replace’ meet the rep! company | in order t0 maintain the anagement of rede the rate of dividend, iy financial health of the company: o have its ‘Dividend Policy ich company ions tinder which it woulg 10 gividend and als the conditions 1 it to reduce the rate of dividend for ‘hile framing 2 «dividend policy’, the hould be taken into account ina judicious manner. Policy/Reaso! Importance of the * following - 1) An optimal ‘Dividend Policy’ ¢ 2) 3) 4) 6) 7) Importance of Dividend ns for Paying Dividend Dividend Policy’ can be summarised as an maintain a balance (retained earnings) and Ider’s wealth (dividend 7. between the business growth maximisation of its sharehol pByment). It is a decisive force in shaping the market value of a company. Rate of dividend payout symbolises a company’s competence to do business effectively and generate revenues. Professional analysts use the rate of dividend as a tool to assess the inherent value of shares. ‘Dividend Yields’ is one of the inputs to compute ‘Beta (measure of the volatility) of a stock’. While computing the value of a stock also, dividends have significant role. Decision regarding dividend payment may impact a company’s external financing plans in an indirect manner. Payment of dividends at a higher rate would result in shrinking of intemal funds for reinvestment. ‘Through share/bond issues, bringing about changes in its capital structure as well as cost of capital. Maintaining a balance between the objective of ‘maximisation of shareholder's wealth’ and the decision relating to long-term financing (distribution of dividends due to lack of better investment avenues) is ‘one of the most important goal of ‘Dividend Policy’. Market value of the share price is impacted in a negative manner if the rate of dividend distributed by company is low. An adequate level of ‘Retained Barings’ is necessary for a company with a view to focus on improvement s financial health, implementation of its growth, ae ah ample pansion, modernisation, diversification plans, etcSt HUN vais (tater 8 Issues in Dividend policy Ts vanows Haves mn dividend decistons ane as follows 4 5) Anformation Signalling: Che nnanay ment cannot Hischose any anformation ot the company te the sestors Due to this, coMMUniCALION pap atises ttween management ant shareholders and this: will crease the price of Swock whieh is less than ander the conxhbions of information svinmetty toy the signalling theaty, the firms take actions whieh canons De easily done by the finns which donot have any promising proets. Paying more dividends is one sesh action, The increase it dividends shows the market that the fim ty an the position of eaming prospects whch will help to maintain the higher dividend for ruture. It will ead to buoying effect on stock prices and ‘sy have the positive sign for the market same way, decrease in the dividends shows the Ve signal to the market as the firms are not able o decrease the dividends. Thus, these actions will rease the stock prices, The practical evidence about the market reaction can be seen with the increase and decrease in the dividend which depends on the situation. Clientele Effect: The investors have different types of demand. There are some which require more dividends while other wants more capital gains or the other requires the balance of both dividend income and capital gains. As the time passes the investors invest in the firm which offer the dividend policy as per their requirements. The clientele effect refers to the preference of the investors of the company according to the demand. The presence of a clientele effects suggest that: Firm will get investors according to their demand; and ii) The firm cannot change its regular dividend policy. Cost of Capital: This helps to decide whether the distribution of capital is to be done or not. The Board will estimate the profits which the firm assumes to acquire (Ra) to the rupee profits that the shareholders will assume to earn outside (Rc), i.e., Ra/Re. The firm will distribute the dividend if the ratio is less than one and the firm will distribute dividend if the dividend is more. Objectives Realisation: The dividend policy formulated by the firm should follow the objective of the firm of shareholder's wealth maximisation which consists of current rate of dividend. It is also consider for the formulation of dividend. Shareholders’ Members: These members are also get affected by the dividend policy. The company with low pay-out with heavy re-investment attracts more shareholders involved in capital gains instead of current income. The investors who prefer current income invest in the company with high dividend pay-out. The working of shareholder groups acts as the major issue for the manager for framing dividend policy. ” 6) Usage of Corporate Earnings: The funds which are hot used ate distributed inthe forn of dividend distribution. The dividend policy influences the sharcholder's wealth by changing the dividend pay font ratio, The financial manager takes the decision ty rive the corporate earnings or not for declaring the dividend policy The given issues are the part of dividend policy formulation, ‘These affect the financial structure, the flow of funds liquidity, stock prices and the shareholders’ satisfaction. Hence, the management requires implementing the high degree discriminative decisions in the formulation of sound dividend pattern Factors which are Relevant for Determining the Dividend Payout Ratio Following are the factors which are relevant for determining the dividend payout ratio: 1) Return on Assets: Profitability effect on the payment of dividends for the dividend is a portion of the net profit obtained by the company. Therefore, the dividend will be distributed if the company's gain. Profitability ratios are taken as research material in the form of Retum on Assets. Profitability is a major determinant of the level of dividend payments and the possibility of the company’s to pay dividends. 2) Debt to Equity Ratio: Debt to Equity Ratio is a ratio that reflects the company's ability to meet all its obligations, which is shown by some sections of their own capital which used to pay debt. Companies that have greater leverage ratio should pay smaller dividend, because the profit earned is used to pay off liabilities. 3) Asset Growth: Assets are used for operational activities of the company. The greater assets expected operating results generated by the company. However, companies with growth rates and high investment opportunities will require a large intemal fund to finance these investments, so companies tend to pay a dividend that is low or even no paid. Dividend Payout Ratio a Year Before: Dividend ii the value of the company's net income after tax less retained earnings as a reserve for the company. Generally, the magnitude of the current dividend is based on the amount of dividends years ago. 4) eee aL) THEORY MODEL Maximisation of a company's value is closely linked (in direct proportion) to maximisation of its shareholder's wealth. The opinions regarding effect of dividend decision of a company on its valuation differ, and at times contradictory, from one expert to another. Supporters of one school of thought’ are of the view that a company’s dividend decision is relevant and influences to a greatYou (Mowtute ttt Sufents tho shareholder's wealth and there Valuation af the con Many (relevance theary af dividend However, the supporters at “another pants ‘hough Nok the opinion that company’ divider decision is twrelevant, “when a company's shateholdes's wealth TRAtuns Mnaltectedt by ite dividend decision (lnelevmmne theory of dividends). ‘The theory of ¢ ‘ance is supported on and the theory or Nant and Milter by Prof, Walter and Prof, \rrelevanee is propounded by Modigl 2 8.2.1. Dividend Relevance Decisions There are two Models or theories of the dividend relevance decisions: -——— Dividend Relevance Decision: 8.2.2. Walter's Model Professor Walter (1963) proposed a model which Maintains that the “Dividen id Policy’ of a company is applicable in ascertaining its net-worth. According to this model, the dividends received by the shareholders of a company are reinvested by them onwards to have higher rate of retums. From the company's perspective, the cost of dividends paid to the sharcholders is considered as “Opportunity Cost’ or the ‘Cost of Capital’ (K.) of the company. Had the dividends been not paid to the shareholders, it (dividend amount) could have been used 4s capital by the company. In another scenario, a Company decides not to pay dividends to its Shareholders, and instead invests the amount of dividends in some remunerative avenues to earn better rate of retums (r). The value of ‘r’ has to be necessarily more than or atleast equal to ‘K,’, only then the retums earned by the company by investing elsewhere would be considered profitable as compared with the situation where the dividends were paid. The relationship between ‘r' and ‘K, ‘is very significant as it forms the basis on which the dividend Policy of a company needs to be formulated, According to the Walter's model, if r < K,, then the company may decide in favour of distributing the profits in the form of dividends to the shareholders. On the other hand if r > K., then the investment opportunities would yield better earnings for the company and thus, the company may decide investing the retained carnings, instead of paying dividends to its shareholders. 8.2.2.1. Assumptions of Walter’s Model Certain presumptions which form the basis of Walter's model, are mentioned as below 1) Internal Financing: Investment is made by the company out of the retained earnings exclusively; issue of fresh equity or debt instruments are not involved, 2) Constant Return and Cost of Capital: The rate of return on the investment is made by the company (r) and the cost of capital (K.) remains unchanged. Sati MIKA Siccond Semester (Financial Ma ee es em, pividend | uy Cant Par | for distribution of gj 2Mi numongat th cholders or remvested interngy eM *OPI amongst the 1 ra ‘on prompt manner Mo 4) Constant EPS and DPS: Under the Walter Moa the value of Earning Per Share (EPS) and fy, Per Share (DPS) may be changed in order to esas" results, but there is a presumption that the yay, Ue of EPS or DPS would remain unchanged. However 0 the a) Ds initial earnings and dividends do not undergo, Se change 7 5) Infinite Time: The life of the company is very long, infinite. ' 8.2.2.2, Walter’s Formula for Determining the Value of a Share For arriving at the market price of @ share. Prof. Walter had evolved the following formula: Inb D+r(E-D)/K, give Market price per share (P) = = or 7 - DK, 2) p_D ,"E-DyK, 2 kK, ; Es Where, P = Market price per share: fe D = Dividend per share: B r= Internal rate of return P E = Earnings per share; and K, = Cost of equity capital s Based on the relationship between Internal Rate (r) and Cost of Capital (K.), the companies may be of following three types: 1) Growth-Oriented Companies (having ‘r' > °K.) 2) Normal Companies (having ‘r= *K..”), and 3) Decline-Oriented Companies (having *r <°K.’) The three types of companies given above are described as follows: 1) Growth-Oriented Companies: Such companies have “Internal Rate’ more than the “Opportunity Cost of Capital’ (r > K,), These companies tend to grow fast, as they are able to grab better investment opportunities, which provide them more yields than the ‘Opportunity Cost or Cost of capital’, Their net- worth in terms of *Market Value per Share” may be ‘maximised if they have a policy of diverting the entire ‘retained earnings’ to internal investment. without bothering for dividend Payout to its shareholders. This Means, for a ‘Growth Oriented Company’ the Optimum payout ratio would be zero. In the above formula, an increase in *P’ (Market price per share) would be followed by a decrease in pay-out ratio, 2) Normal Companies: Such companies have “Intemal Rate’ equal to the ‘Opportunity Cost of Capital’ (‘r= °K,”). Their growth is neither too fast nor too slow, as they have limited ability to explore better investment Spportunities (having yielded more than theSaloial Dos istonty (Chapter 8) Opportunity Cost of Cost of Capital). ty Walter's Mosel, for such normal companies with "a "K,', the suywtend pottey hay no impact on the ‘Market Value yet Share’. Therefore, the concept of “Optimum Payout Ratio” iv also lacking under this eatepory of coopatnies. The dividend policy of a normal company iste no Way different from the other: 3) Decline-Oriented Companies: Such companies have tngernal Rate" less than the ‘Opportunity Cost or Cost of Capital” (r K,, and 2) Entire earnings to be distributed as dividend amongst the shareholders, when t < K.. Example 1: The following information relate to ABC, Lid. eaming per share %9; internal rate of return 18%, cost of capital 12%, payout ratio 33.33%. Calculate the market price under the Walter's model. Solution: According to Walter's Model, Market price per share (P) = D#%™E-D)/K, Where, Internal rate of return (r) = 18% Eamings per share (E) = %9 Cost of equity capital (K,) = 12% Dividend Payout Ratio (D/P Ratio)= 33.33% Dividend per share (D) So, D = Ex D/P Ratio 3 9) x 33.33% = 83 3+.18(9-3)/.12 _ 0.12 - Thus, Market price per share under Walter's Model is 7100. Market price per share (P) = 2100 Example 2: Given the following information about ZED Ltd., show the effect of the dividend policy on the market price of its shares, using the Walter's model: Equity capitalisation rate (K.) 2% Earnings per share (E) 8 Assumed return on investments (r) are as follows: 1) r=15% 2) r=10% Solution: To show the effect of the different dividend policies on the share value of the firm for the three levels of r let us consider the Dividend Payout (D/P) ratios of Zer0, 25%, 50%, 75% and 100%. Market price per share (P) = aaennne lot VW) P> Ke (r= 15%, Ke = 12%) i) [Dividend payout ratio (D/P Ratio) = 0 Dividend per share (D) = Earnings per share (1) x DIPR akx0=0 Market price per share (P) 2 — OF 0.15(8 = OV 012 ‘Thus, Market price per share (P) is 83, when D/P ratio is 0%. @83 ii) If Dividend payout ratio (D/P Ratio) = 25% Dividend per share (D) = Earnings per share (E) x DIP Ratio =8x 25 =% Market price per share (P) 2+0.15(8 - 2)/0.12 0.12 =e Thus, Market price per share (P) is 279, when DIP ratio is 25%. iii) If Dividend payout ratio (D/P Ratio) = 50% Dividend per share (D) = Earnings per share (E) x D/P Ratio =8x.50=%4 Market price per share (P) 4 +0.15(8 - 4)/0.12 = tS 0.12 Thus, Market price per share (P) is 275, when D/P ratio is 50%. iv) If Dividend payout ratio (D/P ratio) = 75% Dividend per share (D) = Earnings per share (B) x DiP Ratio =8x.15=%6 Market price per share (P) 6+ 0:15(8 - 6)/0.12 _ 24 0.12 Thus, Market price per share (P) is 271, when D/P ratio is 75%. v) If Dividend payout ratio (D/P ratio) = 100% Dividend per share (D) = Earnings per share (B) x DIP Ratio. =8x 1.00=%8 Market price per share (P) +.0.15(8 — 8)/ 0.12 =%67 ‘Thus, Market price per share (P) is 767, when D/P ratio is 100%. Interpretation: From the above calculations it can be observed that when the return on investment is greater than the cost of capital, there is an inverse relation between the value of the share and the payout ratio. Thus, the value of ZED Ltd. is the highest when the D/P ratio is zero (P = 283) and this goes on declining1o2(Moxtute tty SEVP ratio inereayes, Hence, the optimum it policy fora growth fem ix a zero dividend PAVOUE Latio. FOROS 10%, Ke tee) HIE Dividend payout ratio (D/P ratio) = 0% Barnings per share (2) Dividend per share (D) X D/P Rane 8x00 Matket price per share (P) 0 + O10(8 — 0)/0,12 = OF O10 ~ 090.12 _ ggg O12 Thus. Market price per share (P) is £56, when DP ratio is 0% 11 Dividend payout ratio (D/P ratio) = 25% Dividend per share (D) = Earnings per share (E) x DP Ratio =8x 25282 Market price per share (P) _ 2 +0.10(8 - 2)/0.12 0.12 Thus. Market price per share (P) is %58, when DP ratio is 25%. ii) =%58 iui) If Dividend payout ratio (D/P ratio) = 50% Dividend per share (D) = Earnings per share (E) x DP Ratio =8x 50=%4 Market price per share (P) _4+0.10(8 - 4)/0.12 0.12 Thus, Market price per share (P) is 261, when DP? ratio is 50%. iv) If Dividend payout ratio (D/P ratio) = 75% Dividend per share (D) = Earnings per share (E) x D/P Ratio =%61 =8x.75=%6 Market price per share (P) = 6+ 0.108 - 6)/0.12 _ 9, 0.12 Thus, Market price per share (P) is %64, when DIP ratio is 75%. ¥) If Dividend payout ratio (D/P ratio) = 100% Dividend per share (D) = Earnings per share (E) x D/P Ratio =8 x 1.00=%8 Market price per share (P) 8 + 0.10(8 - 8)/0.12 - 0.12 Thus, Market price per share (P) is %67, when D/P ratio is 100%. = %67 Interpretation: When the return on investment is less than the cost of equity capital, calculations reveal that the firm’s value will enhance as the D/P ratio MIA Second Semester (inancial Manga, € correlat 1. Due to this positive Correlation wi hare price and the dividend payout rato, a h oO extent less thay their returns on invest me eal Cupital should prefer Bizher diyiggA Sm von order to maximize the share valye. py increase: Je 3: The EPS of a company is TH andy, exampli yi ang eeaiation applicable is 10%. The company rw option of adopting: 1) 50 2) 75, and 3) 100 per cent dividend payout ratio. Compute the market price of the company’s share. Walter's Model if it can earn a return o 1) 15% 2) 10% and 3) 5% on its retained earnings. Solution: Given, Equity capitalisation rate (K,) = 10% Eaming per share (E) = 8 Return on Investment (r) are: 1) r= 15% 2) r=10% 3) r=5% As Per Walter Model, D+r(E-D)/K, Market Price per Share (P) = —————""= K, 1) When, r>K, (r= 15%, K, = 10%) i) If Dividend Payout ratio (D/P ratio) = 50% Dividend per Share (D) = Earnings per Share (E) x DPP Ratio = 8 x 0.50 = %4 4+0.15(8— 4)/0.10 Marke i shi P)= arket price per share(P) aaa _ 44+0.15(4)/0.10 0.10 Thus, market price per share P is 7100, when D/P dividend payout ratio is 50% If Dividend Payout ratio (D/P ratio) = 75% Dividend per Share (P) = Earnings per Share (E) x D?P Ratio =8x0.75=6 Market Price per Share (P) = £+0.15(8-6)/0.10 = S4015(8-6)/0.10 0.10 Thus, market price per share P is %90, when D/P ratio is 75% If Dividend Payout Ratio (D/P ratio) = 100% Dividend per Share (D) = Earning per Share (E) x D/P Ratio= 8 x 1.00 =8 225 9,08 0.10 0.10 Market Price per Share (P) _8+0.15(8-8)/0.10 _ 9.5 Thus, market price per share P is 295, when D/P ratio is 100% 100 =90ied Desisons (Chater When r< Ky (r= US, Ky = 10%) WE Divider Payout Ratio (DM gato) = $064 "piston! Bor Share (PY = Barings per Share (LYN DIP Ratio = 8X 0.50 54 Market Price Per Share (P) 40.108) 4/010 O10 Thus, market price per share (P) is BRO, when UVP ratio ts SO% Ue Dividend Payout Ratio (D/P ratio) = 7 Dividend Per Share (P) = Eamings per Share (EN DIP Ratio = 8X 0.75 = 6 Market Price Per Share (P) Thus. market price per share P is %80, when D/P Rano is 75% If Dividend Payout Ratio (D/P Ratio) = 100% Dividend Per Share (P) = Earnings per Share (E) x DP Ratio = 8 x 1.00=8 Market Price Per Share (P) _8+0.10(8-8)/0. 0.10 °° Thus, market price per share P is 790, when D/P Ratio is 100% 3) When, r br ). If this presumption is not met, it is: difficult to amve att significant value for the sha s 8.2.3.2. Gordon’s Formula for Determining the Value of a Share As per the Gordon's ‘Stock Valuation Model’, the market value of a company’s share is equal to the present value of future stream of dividends to be received by a shareholder of the company, Following formula would make it more explicit: Price of share (P) = or

K.. Thus, firms with rate of retum greater than the cost of capital should have & higher retention ratio and those firms which have a rate of retum less than the cost of capital should have a lower retention ratio. The dividend policy of firms which have a rate of retum equal to the cost of capital will, however, not have any impact on its share value. Example 7: Assume that a firm has current earings of 312 per share. It can use these eamings in projects that provide a retum of 15%. The expected retum to shareholders is 20%. What is the value of the firm under Walter's Model and Gordon’s Model, if it retains 50%, 60% and 80% of the earnings? Solution: 1) Calculate of Market Price of Share under Walter’s Model Market Price Per Share (p) = D*E=DY/K, K, Here, Earnings per Share (E) = 712 Equity Capitalisation Rate (K,) = 20% or 0.20 Return on Investment (r) = 15% or 0.15 i) If Dividend Payment Ratio (D/P Ratio) = 50% Dividend per Share (D) = Earnings per Share (E) x D/P Ratio = 12 x 50% = %6 Market Price Per Share (p) = 9+ 0.15(12=6)/0.20 0.20 0. .. = 54091020 _ 6445 105 a6) sus 0.20 0.20 0.20 price of share (P) is %52.5, when D/P ratio is 50%. ii) If Dividend Payout (D/P) Ratio = 60% Dividend per Share (D) = Earnings per Share (E) x D/P Ratio = 12x 60% = 27.2 Market Price Per Share (P) - 7.2+0.15(12-7.2)/0.20 0.20 MWA Secon Semester (Mnunelal Management yy ) 207.2436 _ 108 _ ~~ 920 0.20 t Y ‘thus, price of share (P) is 854, when DIP ratio jy 00%. r iii) If Dividend Payout (D/P) Ratio = 80% Dividend per Share (D) ; rings per Share () x D/P Ratio = 12 x 80% = 29.6 9.6+0.15(12-9.6 Market Price Per Share (P) = ———~ 0.20 9.6+0.36/0.20 _ 96418 _ 14 ey 0.20 0.20 0.20 ‘Thus, price of share (P) is €57, when D/P ratio is 80%. Calculation of Market Price of Share under Gordon’s Model iceof Share (p) =E0-») Marke Priceof Share (P) = Here, Earnings per Share (E) = 12 Equity Capitalisation Rate (K,) = 20% or 0.20 Return on Investments (r) = 15% or 0.15 If Dividend Payment (D/P) Ratio = 50% Retention Ratio (b) = 100% - 50% = 50% or 0.50 Growth Rate (br) = Retention Ratio x Ratio of Return on Investments = 0.50 x 0.15 = 0.075 12(1-0.50) _12x0.5__ 6 0.20-0.075 0.125 0.125 =%48 Thus, price of share (P) is 248, when D/P ratio is %. Price of Share (P) = If Dividend Payout (D/P) Ratio = 60% Retention Ratio (b) = 100% - 60% = 40% or 0.40 Growth Rate (br) = Retention Ratio x Rate of Retum on Investments = 0.40 x 0.15 = 0.06 Price of Share (P) = 12(.-0.40) 12x06 _ 7.2 0.20-0.06 0.14 0.14 = 51.43 Thus, price of share (P) is 251.43, when D/P ratio is 60%, iii) If Dividend Payout (D/P) Ratio = 80% Growth Rate (br) = Retention Ratio x Rate of Return on Investments ii Retention Ratio (b) Price of Share (P) = = 0.20-0.03 0.17 0.17 = %56.47 ‘Thus, price of share (P) is 756.47, when D/P ratio is 80%,dant Dovistony (Chapter 8) anaple 8. The wet protit fOr the Tieth cor orporation for the y NWO 1s F20.00,000. The number of ontstanding cael ¢ SAN\000, The rate of retum on the investment ie IR! pe rate OF KOU Tequited by the: i Shareholders is 18% siculale the price per share as per Walter a ae jonint Model if the dividend payout ratio fg 400% and 60h shution: According to Walter's Model D +18 Dyk tushet ice PerShane(P) = DEES Dyk, here ate of Retum on Investment = 18%. XK, = Rate of Retum by Shareholders = 154% 7 Net Income ~ Number of Outstanding Share: ro Ky (r= 18%, K, = 18%) 1) Dividend Payout Ratio (D/P Ratio) = 40% Dividend Per Share (D) = Earnings Per Share (E) x D/P Ratio =4x0.40 =U6 MarketPrice Per Share(P) = L8*0-18(4=1.6)00.15, SONS a _1.6+(0.72-0.288)/0.15 015 1642.88 0.15 = 29.866 or 830 Thus, Market Price Per Share (P) is ®30, when D/P ratio is 40%. 2). IfDividend Payout Ratio (D/P Ratio) = 60% Dividend Per Share (D) = Earnings Per Share (E) x DIP Ratio 40.60 24 Master Poe Per Stare = 24 nae 20)5 _2.4+(0.72-0.432)/0.15 0.15 2441.92 01s =28.8 of 229 ‘Thus, Market Price Per Share (P) is 829, when D/P ratio is 60%, According to Gordon’s Model Market Price Per Share (P) = © Where, 1 = Rate of Return on Investment = 18% kK = Rate of Return by Shareholders = 15% Eaming Per Share (E) = %4 K,-b, 407 1) I Dividend Payout Ratio (D/P Ratic Retention Ratio (b) = 100% ~ 409 Growth Rate (b,) = 40% a Retention Ratio x Rate of Return con Investment = 0.00 20.18 = 0.108 41-0,00) 1.6 0.15-0,10K 0,042 Thus, Price of Share (P) is 238, when D/P Ratio is 40%, Price of Share (P) = 2) Dividend Payout Ratio (D/P Ratio) = Retention Ratio (b) = 100 — 60% = 40% Growth Rate (b,) = Retention Ratio x Rate of Return on Investment = 0.40 x 0.18 0.072 Priceof Share(P) = A= 940). __2-4 ———— = —— = 50.16 0r 31 0.15-0.072 0.078 60% ‘Thus, Market Price Per Share (P) is 731, when D/P Ratio is 60%. 8.2.3.3. Criticism of Gordon’s Model The assumption of Gordon Model has resemblance to Walter model. The concluding essence of the Gordon's Model and Walter's Model about dividend policy are more or less the same. This may be due to the similar presumptions underlying both the models. That is why the limitations prevailing under the ‘Walter Model’ also exist in the ‘Gordon Model’. 8.2.4. Dividend Irrelevance Decisions Proponents of Irrelevance theory of dividends hold the view that a company’s valuation remains unaffected by its, dividend decision. There are two models in this regard. Following are the two models of irrelevance: Dividend Irrelevance Decisions Traditional/Residual Approach 8.2.5. MM _ Theory/Modigliani and Miller Hypothesis The genesis of Dividend Irrelevance Theory of Modigliani and Miller may be traced back to the ‘Capital Imelevance Model’ advocated by them in a paper published in 1958. Under the above model, a view was held that the capital framework of a company has no relevance as far as its future outlook is conceed. The above puper was followed by another paper published in 1961, wherein they came up with an entirely innovative idea, according to which the investors need not bother about the paymenvnon-payment of dividends from a company, in which they have an investment (of course subject to certain presumptions). Under the MM Model, a view was held that for the investors the ‘dividends’ and ‘capital gains” are nothing but the ‘returns’ on their investment. Modigliani and Miller Hypothesis/Modelvostole Hb tne value of a eomypeany, dheeetenes ates ee ity ung, shiv as the outcome OF ts 1) Investment policy Alec istonts, ann Sy Overall performance ef the andustiy, 1m which the Gampany is engaged Devistead pobey oF a company has gor netting do with tee vafuanon The information, an investor is required 10 Mee thet a company, for takingt am divestment decision ree ne the -vompany”ssavestment polity and perfowmance of that particular industry investor needs 10 The theory further elaborates as to why be unnhifferent with on and to the Aevoniing (0 this model, the ‘cash-inflow information syste! A them, as per their cash requirements ire fast whether the stocks held by them bring dividend oF not Tocase an investor has dividend paying share in its portfolio “ind he does not have the use of money’ at that time, the Joviend proceeds would be reinvested in some shares (of Same company or some other company). Similarly, if an ‘mrestor of a non-dlividend paying company needs cash, he can sella part of his stock holdings. 8.2.5.1. Assumptions of Modigliani and Miller Model There are certain assumptions (mentioned below), on which MM model of irrelevance is based: 1) Perfect Capital Markets: A company manages its business in a perfect capital market*. * perfect capital market involves: i) Behaviour of investors needs to be reasonable and logical ii) It should have transparency, i.e., any information searched for should be easily available. iii) There should not be a transaction/floatation cost. iv) No single investor should be big enough to influence the price of a share. No Taxes: Taxes are either non-existent or the tax rates applicable to ‘Capital Gains’ and ‘Dividends’ are the same. For an investor, value of a rupee received as dividend payout should not be different from the value of a rupee received as capital gain. very company has a fixed dividend payouts ve their own yestors may in respect to the stocks held spective of the 3) Fixed Investment Policy: Jong-term ‘Investment Policy’ 4) No Risk: There are no elements of underlying risks regarding uncertainty. 8.2.5.2. Modigliani and Miller Formula for Determining the Value of a Share The following formula is used to determine the market price of a share: _D +P P= 1+K, Where, Pp = Market price per share at the beginning of ing market price of a share at the end of the period the period, or prev D, = Dividend to be received sper se Market price P Pe Maca coll ao ns spe erived PY the ¢ val oll ean be nevi Ke) PI re | fexplainint spate ee nl re! quirements pany ae) payouls ate financed OUt OF the dividend sity share ve applied co eateulate the number u may Pe ed by the company obtained with the y's value may be Further, the comp help of the following formula: | (nem -(I-8) wp, =k oe be issued 77 Investment required FE. =Total earnings of the firm during the riod p, =Market price per share at the end of the period val K, = Cost of equity capital Ke = Namber of shares outstanding at the beginning of the period D, =Dividend to be paid at the end of the period nP) = Value of the firm Example 9: ABC Lid, has a capital of 710 lacs in equity shares of 2100 each. The shares are currently quoted at par. The company proposes declaration of a dividend of 210 per share at the end of the current financial year. The capitalisation rate for the risk class to which the company belongs is 12%. What will be the market price of the share at the end of the year, if: 1) A dividend is declared? 2) A dividend is not declared? Assuming that the company pays the dividend and has net profits of €5,00,000 and makes new investment of 10 lacs during the period, how many new shares must be issued. Use the MM Model. Solution: 1) Number of shares to be issued when a dividend is declared (%10 per share) i) Price of the share at the end of the current financial year P, = Pol +K.)-D, Where, Market price per share at the ae eee at the beginning of the Dividend to be received f eee at the end of the period Cost of equity capital (K.) = 12% or 12 Ww)res asians (CTMPIE SY jad OE snaet pre SE MMATE AL the end oF the period an ooh + 0.12 10 = 1000.12) 10 102 ay Naan of shares 0 be issued 1-(B=nb,) me Where, tavestment required (1) = 10,00,000 oval earnings of the firm during the E = §,00,000 cmon Number of shares outstanding at the beginni the period (n) = 10,00,000 + 100 ginning of = 10,000 outstanding shares Dividend to be received at the end of the period (D)=210 ‘re Market price per share at the end of the period (Pi) = 102 Number of shares to be issued (m) ~10,00,000(5,00,000-10,000%10) 7 102 __10,00,000~(4,00,000) i: 102 £:00.000 _ 5982 shares. 102 +) Number of shares to be issued when a dividend is not declared 3) Price of the share at the end of the current financial year: P, =Po(l +K)-Di Where. Market price per share at the beginning of the period (Pp) = 100 Pividend to be received atthe end of the period @,)=0 Cost of equity capital (Ke) = 12% or 12 Market price per share at the end of the period (Py) = 100(1 + 0.12) - 0 = 100(1.12) = #112 ii) Number of shares to be issued: 1-(E-nD,) ne P Where, Investment required (1) = 10,00,000 Total earnings of the firm during the period (E) = 5,00,000 Number of shares outstanding at the beginning of the period (n) = 10,00,000 + 100 10,000 outstanding shares Dividend to be received at the end of the period (D))=0 Market price per share at the end of the period @y=U2 Ww Number of shares ta be issued (1) _1,00,0000 (5,00,000--0)_ 5,00,000 _ jpa64 shares m2 112 25% rewurns (0 its of its share is %80 firm is expected 10 Example 10; Excel Lid. is providing shareholders, The current market price with 1.25 crore shares outstanding. The e earn @4 crore in the year, while its investment requirement is % crore. The company is distributing dividend at 75% in budget, company is wo of the carnings. To meet the expansio! thinking of skipping the dividend. You are supp? 0 calculate the value of the firm under two situations: 1) When company continues with its policy of declaring dividend, and 2) When the company skips the dividend. Solution: ny 1) Value of the Firm when Company Continues its Policy of Declaring Dividend . i) Price of Share at the end of the current financial year. P, = Po (1 +Ke)~Di Where, Market price per s! period (Po) = %80 Bindend to be received at the end of the period (D) =%2.4 Cost of equity capital (K,) = 25% oF 0.25 Market price per share at the end of the period 0 (1 + 0.25) - 2.4 80 x 1.25) - 24 = 100-24 =%97.6 Note: Calculation of Dividend (D,) . Dividends Dividend perShare= 5 Share < 75% of %4 _ TsMof B4crore _ yy 4 1.25crore hare at the beginning of the ii) Numberof ste where, Investment required (1) = €6,00,00,000 Total earnings of the firm during the period (E) = %4,00,00,000 Number of Shares outstanding at the beginning of the period (n) = 1,25,00,000 Dividend to be received at the end of the period (D,) =%24 Market Price per share at the end of the Period (P) = 897.6 Number of Share to be issued - 6,00,00,000 —[4,00,00,000 — (1,25,00,000%: 2.4)] 97.6 = £6,00,00,000 — (4,00,00,000 - 3,00,00,000) 97.6 (m)170 (Moxtute thy = 800,00,000—1,00,00,000 M76 12,295 shares UW) Value of the Firm Valueof the firmnp,) = (¢ P= UB) 14K, Number of Shares outstandin, i Shares outstanding at the beginning of the period (1 00,000 Number of shares to be isstied (m) = §,12,295 Market Price per share at the end of period (P,) 6 Investment required (1) = %6,00,00,000 Total earnings of the firm during the period (E) = %4.00,00,000 Cost of Capital (K.) = 25% or 0.25 (1,25,00,000 + 5,12,295)x97.6 Value of Firm (nP, ) = —{6:00,00,000 — 4,00,00,000) 1+0.25 = 1,30,12,295x97.6) — 2,00,00,000 1+0.25 — 1:26,99,99,992 —2,00,00,000 1.25 pe 99,99,992 _ = 5 = £99,99,99,994 2) Calculation of Value of Firm when Dividends are Skipped i) Price per share at the end of the current financial year. P; =Po(1+K.)-D, where, Market price per share at the beginning of the period (Po) = 780 Dividend to be received at the end of the period (D;) =0 Cost of equity capital (K.) = 25% or 0.25 Market price per share at the end of the period (P,) = 80 (1+ 0.25) -0 = 80x 1.25=%100 ii) Number of Shares to be Issued _ (E-nD,) mu? where, Investment required (I) = %6,00,00,000 Total earnings of the firm during the period (E) = %4,00,00,000 , Number of shares outstanding at the beginning of the period (n) = 1,25, 00,000 shares Dividend to be received at the end of the period @y)=0 : Marker price per share at the end of the period (P,) = 7100 ie | MIA Second Semester (Financial Management) Gy) Number of shares to be issued (m) 10,000 — (4,00,00,000 ~ 0) 100 _ 2,00,00,000 _5.99,000shares | 100 | iii) Value of the Firm iii) Val name 1+K, Number of shares outstanding at the beginning of the period (n) =1,25,00,000 Number of shares to be issued (m) = 2,00,009 | shares ] Market price per share at the end of the period | (P,) = 2100 } Investment required (1) = 6,00,00,000 Total earnings of the firm during the period (E) = %4,00,00,000 Cost of capital (K.) = 25% or 0.25 | Value of the Firm (nPo) (1,25,00,000 + 2,00,000) x100 6,00,00,000 - 4,00,00,000) is __(1,27,00,000100) — 2,00,00,000 " 1.25 | _1.27,00,00,000 — 2,00,00,000 ee _1,25,00,00,000 1.25 = 71, 00,00,00,000 Value of the Firm (nPo) = Example 11: ABC Ltd. belongs to a risk class for which the appropriate capitalisation rate is 10%. It currently has outstanding 5,000 shares selling at 7100 each. The firm is contemplating the declaration of dividend of %6 per share at the end of the current financial year. The company expects to have a net income of %50,000 and has a proposal for making new investments of %1,00,000. Show that under the MM hypothesis, the payment of dividend does not affect the value of the firm. Solution: 1) Value of the firm when dividends are paid: i) Price of the share at the end of the current financial year. P, = Po(1+K,) — D, Where, Market price per share at the beginning of the period (Py) = 2100 Dividend to be received at the end of the period (D,) = %6 per share Cost of equity capital (K.) = 10% or 10 Market price per share at the end of the period (P,) = 100(1+.10) — 6 = 100 x 110-6 = 110-6 =@1042 pesos Cryer 8) Oper of shares to be issued, nal i 1 m= (Baud) Wher’ jnvestment required (1) = %1,00,000 otal earnings of the firm during the period (Ii) = 50,000 Number of shares outstanding at the beginning of the period (n) = 5,000 outstanding shares Dividend to be received at the end of the period (Dy =% Market price per share at the end of the period (Py) = R104 Number of shares to be issued (m) 000 - (50,000 - 5,000x6) 104 80,000 104 = 769.23 shares iii) Value of the firm Value ofthe firm(nPy) = @+MR=O-B 1+K, Number of shares outstanding at the beginning of the period (n) = 5,000 Number of shares to be issued (m) = 769.23 Market price per share at the end of the period (P)) = 2110 Investment required (1) = %1,00,000 Total earings of the firm during the period (E) = 250,000 Cost of equity capital (K,) = 10% or .10 (6,000 + 769.23) x104 = 1,00,000 = 50.000) - 14.10 _ (6,769.23) 104 — (50,000) ~ 1.10 __6,00,000 - 50,000 ~ 1.10 Value of the firm when dividends are not paid: i) Price per share at the end of the current financial 50,000 1.10 = %5,00,000 year. Py = Po (I+K.)-Di Where, Market price per share at the beginning of the period (Po) = 7100 Dividend to be received at the end of the period (D)=0 Cost of equity capital (Ke) = 10% or .10 Market price per share at the end of the period (P,) = 100(1+.10) - 0 = 100 x 1.10 = @110 ii) Number of shares to be issued. D,) 8.2.5.3. iii) m1 Where, Investment req ed) = 21,00,00) Total earnings of the firm during the p 250,000 Number of shares outstanding at the beginning of the period (n) = 5,000 outstanding shares at the end of the period Dividend to be received (D)) =0 Market price per share at the end of the period (P)) = 210 Number of shares to be issued (m) _ 1,00,000 - __ 50,000, 7 110 = 454,54 shares Value of the firm (n+ myP, -(1-E) 1+K Number of shares outstanding at the beginning of the period (n) = 5,000 Number of shares to be issued (m) = 454.54 Market price per share atthe end of the period (P= e110 Investment required (1) = %1,00,000 ‘Total earnings of the firm during the period (E) = 850,000 Cost of equity capital (K,) = 10% or 10 (6.000 + 454.54) x110~(1,00,000— 50.000) . 1+10 = (5454.54) 110 = (50,000) - 1.10 £6,00,000—50,000 _ 5,50,000 1.10 1.10 Hence, whether dividends are paid or not, the value of the firm remains the same %5,00,000. Value of the firm (nPo) = = 5,00,000 ‘The MM model has been under criticism on account of the following grounds Tax Differentials: The presumption under MM 1) approach regarding absence of taxes is not a realistic one. The fact is the dividends received at the investor's end are not taxable, whereas capital gains are taxable. Under the circumstances a shareholder, as a tax saving measure, would prefer to continue having dividends (and avoiding tax payment) rather than booking capital gains (and paying tax thereon). Floatation Cost: Under MM Model, payment of dividends and raising exieral funds has been considered on equal basis. This consideration cannot be correct because of the floatation costs involved in raising of external funds. Thus, one rupee of dividend is not replaceable with one rupee raised through external funds. Retention of the earning is, therefore beneficial for a company :2 Mestute Ub 8 Voatoaetian Caste: 1 the transaction eosty are tut wvuved the Cat af one upee ef capital value ts vonvertible (to ane rupee at current income anil vee Yerwa Temeans that ia situation whete dividends are Her being pad, a shareholder fookinge for eurtent AHCAINE MK ELT setLt part of hivher stock holdings Without paying any (hansnction cost However im practice, due to the transaetion casts are involvedl, nvestor's preference iy for current dividend toathor than avtamed eamings 4) Diversifioati carting HW company decides to retain its Ainstewl of dividend) payouts), the Shareholders would not be ina position to expand oF Alversity their portfolios, The investors. oF shareholder pay higher value to a company which distnbute Larger amount as current dividend S\_ Uncertainty: Acconting to MM Model, share prices of the (wo companies identical in all the respect (other than the dividend policy), would necessarily be the same, However, due to the logic behind ‘Bird in Hand’ theory this cannot be true. 8.2.6. Traditional/Residual Model This approach is founded by Graham and Dodd. This theory is irrelevant to determine the market value of share. According to the ‘Traditional Approach’, out of the net Profit, enough cash is set aside as ‘Retained Earnings’, Which is used for investment in profitable and viable Projects. The residual of ‘net profit’ of the company is available for distribution amongst the shareholders as “dividend payouts’. Supporters of this model holds the view that level of dividend payment (higher or lower) is not ‘material in deciding the company’s future market value. Thus. the dividend payouts to the shareholders should never be at the cost of investment in desirable and profitable projects. There is a class of investors, who firmly believe in this approach and they do not bother whether dividend payouts are distributed by a company or not in the present. They are concemed with long-term and brighter future prospects of the company, which ultimately may result in capital appreciation in their holdings and also higher dividend distribution in the years to come. Criticisms of Residual Model Although there is no practical evidence in support of this approach, it is quite logical and obvious to be convincing. Most of the companies prefer to fulfil their investment and growth strategies before taking a decision to pay dividends to its shareholders. 8.3.1. Multiple Choice Questions 1) Which of the following methods does a firm resort to avoid dividend payments? a) Share splitting b) Declaring bonus shares ©) Rights issued) Allof the above i PvE ee AR second Semele! cei MIA Seco Jin puro ‘anninyss bbe Prati above hy Meta Dividen 1) Reese ay Divi ce) None ob the! o the uted js any jolders oF company of a company poividend is di ay Debentu by Bankers of cy Shareholders oF dy Allof the above yy large extent affect I Policy of a company 1 larg ect Dividend Pol “orpora ity ie r by Cosporate Liquidity Hinancial Structure ae A Gout of the company d) Allo! oy Ge cd common form of dividend is b) Cash Dividend 5) ‘The most important an 4d) Serips Dividend a) Stock Dividend c) Bond Dividend ‘the dividend which is paid without preparing final 6) The accounts of the comp: a) Interim Dividend ©) Scrips Dividend any is called as aan Bond Dividend d) None of the above 9 Which one of the following are the relevance theory 7) 7 b) Walter rd o) esl @) Both and 8) Imelevance Theory is dividend decision is proposed by. Jiani and Miler Or b) Walter 3 Gaon None ofthe above 9) Which of the following assumption made by MM in case of capital structure theory? a) No Corporate Tax ©) Investors Act Rationally d) b) Perfect Market Condition All of the Above Under traditional approach Cost of Equity is a) More than cost of debt b) Equal to overall cost c) Less than cost of debt d) Less than overall cost 10) 11) Which of the following factor determine the dividend policy? a) Size of the company b) ©) Inflationary condition d) Nature of the business All of the above f 12) As per Walter model if the required retum is mort cost of capital then the company should. a) Pay more dividend) Less dividend ©) No dividend at all d) None of the abov Ans Dob aa XX ¢ yd 3) 6) a nd oa 9d Ul Wd Ie 8.3.2. Theoretical Questions 1) What is dividend? What are the forms of dividend 2) What is dividend policy? Explain the if objectives of dividend policy. 3) Discuss the factor affecting of dividend policy company. 4) Explain the importance and issues in dividend policy "| ]S wl h. Sunshine Group of Institutions ANSWER SHEET J y ntemal Examination for M.B.AJM.C.A/ Semester. ame c Of Student : rs Roll No __ Sudject ;_________ | ——— Sign. of Student ite: ~ [Signature of Ss ONo Upervisor : Time : ! a | 6 | 7] 8] 9 | 10} Tota Main Answer Sheet} 1 i. oe Supplementry Sign of invgilator | Total | | Corporat Brana - wos aeMejor Deesion To be Taker Cagital Sedgetfag Dividend. Copied Structwe OT Dividend fv a le 5 portion ‘of Pat whth GHe, pad _— the holders : Tnbsdam beyedend DSivedend Yetid.. Gaw t i PAT _ 4 *} 4 PayoukDivi 5 pour ch prottt AVste? bteol | 40 share — holatens = : Nek Gaxniag oS Cos a ed TGenoallye __ Rolafned 2n ioustness pe an +0 _Etnance long an fas Nit Palen Taal dr Wiyided iy issues OF Dividend Deetfon_2 = __ah Grow th, Sy cy Cosk & net Best Attownalive _ ay Managerial. Cao abol —Reteined Bividencl—_—t Objectives of Stvidend Pedsion %- A Wealth Mas tnkad ion be Fulwe Prospeclo c) Stable Rgte ot brviderd. dy Degree of Control. # i - - Tegal Aspects — Ftnancta)_ ome zs ~ Berorminanl of DStvtdend. Paltey. £- _ ~~ Dividend — RaMfo, a. Health oe by For eg band a Sail Dividen BY leqat Roqulremeni zm ae — ay Cagital etka Conti es eeI ypes Or BMyvfdend Pore Qe OO Regute ree > on ra 7 Constant OPS lo) Staloke "Tp Constant" Posyous - be Stalolo Ruspoe. > Lrreg alos — pividend — PolPap dy No Bivtdend Forms OF Svdend.$ Mytdend 7 heory- x lla ltes deat > M Approach) ° TAS | a> Gordon Model / i ey Second “Growl. 2 \ a alter fodel $= — — = RELEVANT ‘Decrston a a > Thue typet of frm ©. cure P : Oo edly O Stalole : 0 Grow'ng Concong i 7 _ “Avad