DIVIDEND POLICY

Content
◦ What is Dividend ?
◦ What is Dividend Policy ?
◦ Theories of Dividend Policy
Irrelevance Theories of Dividend
Residual Theory of Dividend

Modigliani and Miller

Approach

Relevance Theories of Dividend

Walter’s Model
Gordon’s
Model
 Dividend
◦Dividend refers to that portion of profit which is distributed
among the owners or shareholders of the firm. The finance
manager has to take few decisions which are inter – related like
investment, financing and dividend decisions. Dividend
decision is related to the shareholder’s share in the profits of
the company.
 Dividend Policy
◦A dividend policy can be defined as the dividend distribution
guidelines provided by the board of directors of a company. It sets
the parameter for delivering returns to the equity shareholders, on
the capital invested by them in the business.
◦While taking such decisions, the company has to maintain a
proper balance between its debt and equity composition.
Theories of Dividend
Policy
Irrelevanc Relevanc
e e
Theories
Modiglian
Theories
Residua Walter’ Gordon’
i and
l s s
Miller
Theory Model Model
Approach
 Theories of Dividend
policy
1. Irrelevance Theory : According to irrelevance theory dividend policy do not
affect value of firm, thus it is called irrelevance theory.
• Residual Theory
• Modigliani & Miller Approach ( MM Approach)

2. Relevance Theory : According to relevance theory dividend policy affects

value of firm, thus it is called relevance theory.
• Walter’s model
• Gordon’s
Model
Irrelevance
Theories
 Residual Theory
◦According to this theory, dividend policy has no effect on the
wealth of the shareholders or prices of the shares and hence it
is irrelevant so far as the valuation of the firm is concerned.
◦This theory regards dividend policy merely as a part of
financial decision because the earnings available may be
retained in the business for reinvestment. But if the funds are
not required in the business they may be distributed as
dividend.
◦Thus, the decision to pay dividends or retain the earnings may
be taken as residual decision.
 Assumption
◦The assumption of this theory is that raising financing from external
sources involves higher cost. This can be explained with the help of
example.
◦Suppose, A Ltd wants to raise Rs 10,00,000 additional funds to finance an
investment project and its floatation cost is Rs 1,00,000. A Ltd has to raise Rs
11,00,000 from issue of shares so that the net proceed with the company
remains Rs 10,00,000 after paying floatation cost of Rs 1,00,000. It means
that the issue of new capital is more expensive than financing the project
through retained earnings. The dividend will be paid only after using
available profits for investment needs. This referred as Residual Theory
of dividend.
 Modigliani and Miller
Approach
◦Modigliani-Miller have argued that firm’s dividend policy is irrelevant
to the value of the firm.
◦According to this approach, the market price of a share is dependent on
the earnings of the firm on its investment and not on the dividend paid
by it. Earnings of the firm which affect its value, further depends upon
the investment opportunities available to it.
 Assumptio
◦ Perfect Capital Markets - This theory believes in the existence of ‘perfect capital markets’. It assumes that
n to free information, there are no flotation or transaction costs
all the investors are rational, they have access
and no large investor to influence the market price of the share.
◦ No Taxes - There is no existence of taxes. Alternatively, both dividends and capital gains are taxed at the
same rate.
◦ Fixed Investment Policy - The company does not change its existing investment policy. It means
whatever may be the dividend payment, the company will make investment as it has already decided upon.
If the company is going to pay more amount of dividend, then it will more equity shares and vice versa.
◦ No Risk of Uncertainty - All the investors are certain about the future market prices and the dividends.
This means that the same discount rate is applicable for all types of stocks in all time periods.
◦ Investor is indifferent between dividend income and capital gain income - It is assumed that investor is
indifferent between dividend income and capital gain income. It means if he requires total return of Rs.
500, he may get Rs. 200 dividend income and Rs. 300 as capital gain income or reverse, in either of the
case he gets equal satisfaction.
Formula of Modigliani and Miller
Approach
1 (D1+P1)
0 = 1 1 (i
(1+ke) 1+ke
)

0
= Current market price of the share.

e
= Cost of equity capital.

1
= Expected dividend at the end of the year.

1
= Expected price of the share at the end of year one.
 If the company has ‘r’ number of shares outstanding then the market value of the firm will be:
1
× 𝑟 𝐷 1+ 𝑟
(1+ke)
( ii
𝑟 𝑃 0= 𝑃 1 )
If the firm decided to issue ‘s’ number of additional equity shares at expected price 𝑃1 then the total
additional amount raised through issue of equity shares would be s𝑃1 and equal to:
sP1 = Total investment required – Retained earnings used for investment.
𝑠𝑃1 = I – (E - 𝑟𝐷1) = I – E + 𝑟𝐷1
Where I = Total investment required.
E = Earning of a firm.
Equation (ii) can also be written as follows:
1
(1+k )
× 𝑟 𝐷1 + 𝑟 𝑃1 + 𝑠 𝑃1 − ( iii
𝑟 𝑃 0
= 1 𝑠 𝑃1 )
𝑟𝑃 0= × [𝑟𝐷1+(r + s)𝑃1 − s𝑃1] ( iv
(1+ke)
)
Now, putting the value of 𝑠𝑃1 in the equation ( iv ) we have:
𝑟 𝑃 1 = 𝑟𝐷 +(r + s)𝑃 - I + E - 𝑟𝐷 ]
0 × (v
1+ke 1 1 1
1
)
And finally 𝑟 0 × [(r + s)𝑃1- I +E] ( vi
(1+ ke
𝑃 = )
Illustratio
Ghajini Ltd. Currently has 10,00,000 equity shares outstanding. Current market price per share is Rs 100.the
n
net income for the current year is Rs 3,00,00,000 and investment budget is Rs 4,00,00,000. Cost of equity is 10%.
The company is contemplating declaration of dividends @ Rs 5 per share. Assuming MM approach.
i) Calculate market price per share if dividend is declared and if it is not declared.
ii) How many equity share are to be issued under both the options.
Solution: i) Calculation of market price of share as per MM approach
𝑃0 = (D1+P1) = 𝑃 1 = 𝑃 (1 + 𝑘 ) - 𝐷
(1+ke) 0 e 1

𝑃0 = Current market price of the share = Rs 100

𝐷1 = Expected dividend at the end of year one = Rs 5
𝑘e = Cost of equity = 10%
𝑃1 = Expected price of the share at the end of year one = ?
a) When dividend is Declared:
= 110 – 5 =Rs
𝑃1 = 100 × (1 + 0.10) – 5
105
b) When dividend is not declared:
=110 -0 =Rs 110
𝑃1 = 100 × (1 + 0.10) – 0
ii) Calculation of No. of additional equity shares to be issued:
Amount to be raised
s= I –(E –rD1)
Expected price of equity share = P1
Where, s = No. of additional equity shares to be issued.
I = Total investment required =
4,00,00,000 E = Earnings of a company. =
3,00,00,000

r = No. of existing shares outstanding. = 10,00,000

𝑃1= Expected price.
a) When dividend is declared:
𝐷 = Expected dividend.
1
4,00,00,000 –(3,00,00,000–1,00,000 ×5) =1,42,857
s= 105
shares
b) When dividend is not declared:

s=
4,00,00,000 –(3,00,00,000 –1,00,000 ×0) = 90,909 shares
110
Relevance
Theories
 Walter’s
Model
◦ According to Walter’s Model, value of the firm depends upon firm’s earning
level, dividend payout, constant reinvestment rate and the shareholder’s
expected rate of return.
◦ The model suggests that dividend policy of the company depends upon the fact that
whether firm has got good investment opportunities or not. If the firm does not have
enough investment opportunities then it will pay the dividend otherwise it will retain
the money.
◦ If the firm pays dividend then shareholder’s invest the dividend income to get further
return. The expected return on reinvestment of dividend income by shareholders is
called the opportunity cost to the firm or the cost of capital ( e
) of the firm. On the
other hand, if dividend is not paid then the firm will reinvest the retained earning for
its future growth. The expected rate of return on reinvestment of retained earning is
called rate of return (r).
 Assumption
◦ Internal Financing: All the investments are financed by the firm through retained
earnings. In other words, retained earnings are the only source of finance. This means that
the company does not rely upon external funds like debt or new equity capital.
◦ Constant IRR and Cost of Capital: The internal rate of return (r) and the cost of
capital (k) of the firm are constant. The business risks remain same for all the investment
decisions.
◦ Constant EPS and DPS: Beginning earnings and dividends of the firm never change.
Though different values of EPS and DPS may be used in the model, but they are
assumed to remain constant while determining a value.
◦ 100% Retention or Pay-out: All the earnings of the company are either reinvested
internally or distributed as dividends.
◦ Infinite Life: The company has an infinite or a very long life.
 Formula of Walter’s
Model r
D (E –D) D+( r )( E –D)
P= + k or k
e e
ke ke ke

P = Market price of equity share.

D = Dividend per share.
E = Earning per share.
r = Rate of return on investment of the firm.
k = Cost of equity share capital.
e
Hence, Value of firm = N × P
Where, N = No. of outstanding equity shares.
Illustratio
n
◦ Following are the details of three companies X Ltd., Y Ltd. and Z
Ltd.
X Ltd. Y Ltd. Z Ltd.
r = 20% r = 15% r = 10%
𝑘e = 15% 𝑘e = 15% 𝑘e = 15%
E = Rs 8 E = Rs 8 E = Rs 8

◦ Calculate the value of an equity share of each of these companies applying Walter’s Model when D/P ratio
is
(a) 40% (b) 70% (c) 90%.
◦ Solution: Value of an Equity Share as perrWalter’s Model
D (E –D) D+( )( E –D)
◦ P= + kre or k
e
ke ke ke
 Value of Equity Share as per Walter’s Model
X Ltd. Y Ltd. Z Ltd.
r = 20% r = 15% r = 10%
𝑘e = 15% 𝑘e = 15% 𝑘e = 15%
E = Rs 8 E = Rs 8 E = Rs 8
D/P Ratio Market Price of the Share (P)
3.20+(0.20(8 – 3.20) 3.20 (0.15(8 – 3.20) 3.20+(0.10(8 – 3.20)
40%, 0.15 0.15 0.15
D = Rs 3.20 0.15 P= 0.15 P= 0.15 P=
P =64.00 P = 53.33 P = 42.67
0.20 0.15
70%, 5.60+( (8 –5.60) 5.60+( (8 –5.60) 5.60+(0.10(8 –5.60)
0.15 0.15 0.15
D = Rs 5.60 0.15 P= 0.15 P= 0.15 P=
P = 58.67 P = 53.33 P = 48.00
0.20 0.15
90%, 7.20+( (8 –7.20) 7.20 ( (8 –7.20) 7.20+(0.10(8 –7.20)
0.15 0.15 0.15
D = Rs 7.20 0.15 P= 0.15 P= 0.15 P=
P = 55.11 P = 53.33 P = 51.55
X Ltd. is a “growth firm” , Where r > 𝑘e. Therefore, to maximize the market price, the company needs to retain all
its earnings, otherwise its price will decline.
Y Ltd. is a “normal firm”, where r = 𝑘e. In this case D/P ratio does not have any impact on the value of the firm and
it’s share price.
Z Ltd. is a “declining firm”. The rate of return is less than the cost of capital i.e., r < 𝑘e. Therefore, to maximize the
market price of the share, the company should distribute all its earnings as dividend. The value of the share is increasing
when we increase the payout ratio from 40% to 90%.
 Gordon’s
◦According to
Model
Gordon’s Model, Dividend policy of a firm is
relevant and can affect the value of a firm. Like Walter’s Model
value of the firm under this method also depends upon
reinvestment rate (r) and shareholder’s expectations ( ).
◦This is based on the premise that the investors are generally risk-
aversers and prefer to have current income i.e. dividend. Hence
there is a direct relationship between dividend policy and the
value of a firm.
 Assumptio
n
◦ No Debt: The model assumes that the company is an all equity company, with no proportion of debt
in the capital structure.
◦ No External Financing: The model assumes that all investment of the company is financed by
retained earnings and no external financing is required.
◦ Constant IRR: The model assumes a constant Internal Rate of Return (r), ignoring the diminishing
marginal efficiency of the investment.
◦ Constant Cost of Capital: The model is based on the assumption of a constant cost of capital (k),
implying the business risk of all the investments to be the same.
◦ Perpetual Earnings: Gordon’s model believes in the theory of perpetual earnings for the company.
◦ Corporate taxes: Corporate taxes are not accounted for in this model.
◦ Constant Retention Ratio: The model assumes a constant retention ratio (b) once it is decided by
the company. Since the growth rate (g) = b*r, the growth rate is also constant by this logic.
◦ K>g: Gordon’s model assumes that the cost of capital (k) > growth rate (g). This is important for
obtaining the meaningful value of the company’s share.
 Formula of Gordon’s
Model
E (1 –b)
P=
ke –br
P = Market price of equity share.
E = Earnings per share.
b = Retention ratio.( 1 – payout ratio)
r = Rate Cost
of return on investment.
of equity capital.
e
br = Growth rate of the firm.
Hence, value of firm = N × P
Where, N = No. of outstanding equity shares.
Illustration
Assuming that cost of equity is 11%; rate of return on investment is 12%; and earning per share is Rs
15.Calculate price per share by ‘Gordon Model’ if dividend payout ratio is 10% and 30%.

Solution: According to Gordon’s Model : P = E (1 –b)

ke –br
P = Market price of equity share. E = Earnings per share.
b = Retention ratio.( 1 – payout ratio) r = Rate of return on investment.

e Cost of equity capital. br = Growth rate of the firm.

1.5
15 (1–0.90) = Rs 750
When D/P Ratio is 10% P = =
0.11 –(0.90 ×0.12) 0.002
15(1 –0.70) 4.5
When D/P Ratio is 30% P = 0.11 – (0.70 ×0.12)
=
0.026
= Rs
173.08
 References
◦ Financial Management by Surender Singh
◦ https://theinvestorsbook.com/dividend-policy.html
◦ Https://efinancemanagement.com/dividend-decisions/modigliani-miller-theory-on-dividend-policy
◦ https://efinancemanagement.com/dividend-decisions/gordons-theory-on-dividend-policy