Presentation on

DIVIDEND DECISION
For the students of
Semester – VI
B.Com.(Hons. & General)
 By
Prof.Sumanta Lodh
Introduction
The term dividend refers to those profits of a
company which is distributed by company among its
shareholders. It is the reward of the shareholders for
investments made by them in the shares of the
company. It may also be termed as the part of the
profit of a business concern, which is distributed
among its shareholders.
According to the Institute of Chartered Accountant
of India, dividend is defined as “a distribution to
shareholders out of profits or reserves available for
this purpose”.
TYPES OF DIVIDEND/FORM OF DIVIDEND
Dividend can be divided into the following types:
Based on Forms of Payment (a) Cash dividend.
(b) Bonus (or, non-cash) dividend
Based on Timing of Payment (c)
Interim Dividend (d) Final Dividend
Based on Variability
(e) Fixed Dividend (f)
Fluctuating dividend.
Dividend Decision – An Important
Financial Management Decision
Dividend decision determines the division of earnings
between payments to shareholders and retained
earnings.
In dividend decision, a financial manager is concerned to
decide one or more of the following:
- Should the profits be ploughed back to finance the
investment decisions?
- Whether any dividend be paid? If yes, how much
dividend be paid?
- When these dividend be paid? Interim or final. - In
what form the dividend be paid? Cash dividend or Bonus
shares.
TYPES OF DIVIDEND POLICY
A few basic dividend policies which firms generally
pursue are mentioned below:
Regular Dividend Policy: Dividend payable at the usual
rate is called as regular dividend policy. This type of
policy is suitable to the small investors, retired persons
and others.
Irregular Dividend Policy When the companies are
facing constraints of earnings and unsuccessful business
operation, they may follow irregular dividend policy. It is
one of the temporary arrangements to meet the
financial problems.
No Dividend Policy Sometimes the company may follow
no dividend policy because of its unfavorable working
capital position of the amount required for future
growth of the concerns.
TYPES OF DIVIDEND POLICY
Stable dividend policy: Stable Dividend Policy means payment of certain
minimum amount of dividend regularly. This dividend policy consists of the
following three important forms:
Constant Rate of Dividend: As per this policy, the firm pays a dividend at a
fixed rate on the paid up share capital.
•The shareholders are more or less sure on the earnings on their investment.
•not create any problem in those years in which the company is making steady
profit.
•may face the trouble in the year when the company fails to earn the steady
profit. The rate of dividend should be maintained at a lower level if thus policy
is followed.
Constant Percentage of Earnings: A firm may pay dividend at a constant
rate on earnings.
Fluctuations in profits lead to fluctuations in dividends, the principle adversely
affects the price of the shares. As a result, the firm will find it difficult to raise
capital from the external source.
Stable Rupee Dividend plus Extra Dividend: Under this policy, a firm pays
fixed dividend to the shareholders. In the year the firm is earning higher profits
it pays extra dividend over and above the regular dividend. When the normal
condition returns, the firm begins to pay normal dividend by cutting down the
extra dividend.
 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
Future income is a very important factor, which affects the
dividend policy. When the shareholder needs regular
income, the firm should maintain regular dividend policy.
3. Contractual constraints constrained by restrictive
provisions in a loan agreement. constraints prohibit the
payment of cash dividends until a certain level of
earnings have been achieved, or they may limit
dividends to a certain amount or a percentage of
earnings.
 FACTORS DETERMINING DIVIDEND POLICY
4. Internal constraints
Suppose that the firm has total liquid assets of Rs.50, 000 (Rs.20, 000 cash
+marketable securities worth Rs.30, 000) and Rs.35, 000 of this is needed for
operations, the maximum cash dividend the firm can pay is 15,000 (Rs.50,
000 – Rs.35, 000)
5. Growth prospects
If the firm is in a growth stage, it may need all its funds to finance capital
expenditures. A growth firm is likely to have to depend heavily on internal
financing through retained earnings instead of distributing current income as
dividends.
6. Market Considerations
The risk-return concept also applies to the firm’s dividend policy. A firm where
the dividends fluctuate from period to period will be viewed as risky, and
investors will require a high rate of return, which will increase the firm’s cost of
capital. So, the firm’s dividend policy also depends on the market’s probable
response to certain types of policies. Shareholders are believed to value a
 FACTORS DETERMINING DIVIDEND POLICY
fixed or increasing level of dividends as opposed to a fluctuating pattern of
dividends.
7. Owner considerations
The firm’s primary concern normally would be to maximize shareholder’s
wealth.
Tax status of a firm’s owners. Suppose that if a firm has a large percentage of
wealthy shareholders who are in a high tax bracket, it may decide to pay out
a lower percentage of its earnings to allow the owners to delay the payments
of taxes until they sell the stock. Of course, when the equity share is sold, the
proceeds are in excess of the original purchase price, the capital gain will be
taxed, possible at a more favorable rate than the one applied to ordinary
income. Lower-income shareholders, however who need dividend income will
prefer a higher payout of earnings. As of now, the dividend income is not taxed
in the hands of the share holders in India. Instead, for paying out such
dividends to its share holders, the company bears the dividend distribution tax.
 FACTORS DETERMINING DIVIDEND POLICY
8. Legal Constrains
The Companies Act 1956 has put several restrictions regarding payments and
declaration of dividends. Similarly, Income Tax Act, 1961 also lays down
certain restrictions on payment of dividends.
9. Liquidity Position
Liquidity position of the firms leads to easy payments of dividend. If the firms
have high liquidity, the firms can provide cash dividend otherwise, they have
to pay stock dividend.
10. Sources of Finance
If the firm has finance sources, it will be easy to mobilize large finance. The
firm shall not go for retained earnings.
11. Growth Rate of the Firm
High growth rate implies that the firm can distribute more dividends to its
shareholders.
12. 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 dividends.
 FACTORS DETERMINING DIVIDEND POLICY
13. 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.
 Dividend Ratios: Payout and Retention
Dividend payout ratio is the percentage of a
company’s earnings that it pays out to investors in the
form of dividends. It is calculated by dividing dividends
paid during a period by net earnings for that period.
Dividend payout ratio is an important indicator of a
company’s performance from an investor’s point of
view.
Formula
Dividends Paid Dividend per Share(DPS)

Dividend Payout Ratio = =

 Net Income Earnings per Share(EPS)
Interpretation of Dividend Payout Ratio
The dividend payout ratio helps investors determine which
companies align best with their investment goals. When
shareholders invest in a company, return on their investment comes
from two sources: dividends and capital gains. The two sources of
return are related as follows:
A high DPR means that the company is reinvesting less money back
into the company, while paying out relatively more of its earnings in
the form of dividends. Such companies tend to attract income
investors who prefer the assurance of a steady stream of income to
high potential for growth in share price.
A low DPR means that the company is reinvesting more money back
into expanding its business. By virtue of investing in business
growth, the company will likely be able to generate higher levels of
capital gains for investors in the future. Therefore, these types of
companies tend to attract growth investors who are more interested
in potential profits from a significant rise in share price, and less
interested in dividend income.
Keep in mind that average DPRs may vary greatly from
one industry to another. Investors may be willing to
forego dividends if a firm has great growth prospects,
which is typically the case with companies in sectors
such as technology and biotechnology. The retention
rate for technology companies in a relatively early stage
of development is generally 100%, as they seldom pay
dividends. But in mature sectors such as utilities and
telecommunications, where investors expect a
reasonable dividend, the retention ratio is typically quite
low because of the high dividend payout ratio. Real
estate investment trusts (REITs) are required by law to
pay out a very high percentage of their earnings as
dividends to investors.
Example
Based on the information given below, calculate and analyze
dividend payout ratio for AAPL Co. and XOM. Corp. All amounts
are Rs.(in million).
2016 2017 2018 2019

AAPL

Dividends - 2,488 10,564 11,126

Net income 25,922 41,733 37,037 39,510

 Cash and investments 25,952 29,129 40,590 25,158

XOM. Corp.

Dividends 9,020 10,092 10,875 11,568

Net income 41,060 44,880 32,580 32,520

Cash and investments 12,664 9,582 4,644 4,616

Solution

2,488
Dividend Payout Ratio for AAPL for 2017 = = 5.96%
41,733
The table below shows dividend payout ratios for AAPL and XOM from 2016
till 2019.
Industry 2016 2017 2018 2019
 AAPL Technology 0 5.96% 28.52% 28.16%
XOM Oil and Gas 21.97% 22.49% 33.38% 35.57%
AAPL Co. did not pay any dividends in 2016 because the management believed that
higher return for investors can be achieved if the earnings generated are reinvested in
projects that will generate future growth. This is supported by the company’s
exceptional revenue growth in 2017. However, during the period from 2017 till 2019
the company’s cash pile was way above the level needed to avail the feasible new
projects, so the management paid generous dividends in these years. However, in
case of a technology company, high dividend payouts are an exception and not a rule.
XOM Corp. on the other hand is in a mature industry which it is expected to maintain
a steady dividend payout and even increase it over periods. XOM payout ratio has
hovered in the range of 23-36% in the four years which is pretty stable.
Retention Ratio
The retention ratio also referred as the plough-back ratio, is an
important financial parameter that measures the number of profits or
earnings that are added to retained earnings (reserves) at the end of
the financial year. In simple words, the retention rate is the percentage
of net profits that are retained by the company and not distributed as
dividends to investors at the end of the financial year. It is the opposite
of the payout ratio.
The retention rate is calculated by subtracting the dividends distributed
(including dividend distribution tax) by a company during the period
from the net profit/income and dividing the difference by the net
profit/income for the period.
The formula for the retention ratio is:
Retention Ratio = (Net Income - Dividends) / Net Income On
a per-share basis, the retention ratio can be expressed as 1
– (Dividends per share / EPS).
Another formula is:
Retention Ratio = 1 - Payout Ratio
The retention ratio is typically higher for growth companies that
are experiencing rapid increases in revenues and profits. A
growth company would prefer to plough earnings back
into its business if it believes that it can reward its shareholders
by increasing revenues and profits at a faster pace than
shareholders could achieve by investing their dividend receipts.
The retention ratio may change from one year to the next,
depending on the company’s earnings volatility and dividend
payment policy. Many blue-chip companies have a policy of
paying steadily increasing or, at least, stable dividends.
Companies in defensive sectors such as pharmaceuticals and
consumer staples are likely to have more stable payout and
retention ratios than energy and commodity companies, whose
earnings are more cyclical.
Examples of Retention Ratio Formula
ABC Company earned `200,000 of net profit during the financial year and
decided to give dividends of `40,000 to its shareholders.
Following calculations show how to calculate retention ratio or plowback ratio.
•Retention Ratio = (Net Income – Dividend distributed) / (Net Income)
•Retention Ratio = ( `200,000 – `40,000) / `200,000
•Retention Ratio = 80 %
Or,
•Dividend Pay-out Ratio = 40,000 / 200,000
•Dividend Pay-out Ratio = 20 %
•Retention Ratio = 1 – Dividend Pay-out Ratio
•Retention Ratio = 1 – 20 %
•Retention Ratio = 80 %
As you can see, ABC company’s retention rate is 80 percent. In other words,
ABC keeps 80 percent of its profits in the company and only 20 % of its net
profits are distributed to shareholders as dividends. 80 % of the net profit is
retained into the business shows business is in a growth phase and more
capital is required for future growth. Though one ratio is not sufficient to jump
to conclusion, analyst or investor need to look into other parameters to access
the growth.
Explanation of Retention Ratio Formula
As companies need to keep part or full portion of their net profits in
order to continue its operation and grow, investors take this ratio to help
to forecast where companies will be in the near future. Mature
companies will start giving a dividend, growing companies will try to
keep as much profit they can to fuel the future growth of the company.
Most of the tech companies rarely gave dividends because these
companies wanted to reinvest in their business and continue to grow at
a good rate. The exact opposite is true for established companies like
General Electric. General Electric gives dividends every year to its
shareholders.
Higher retention ratios are not always considered good from an
investors point of view because this means the company doesn’t give
many dividends. It might also mean that the stock price is continually
appreciating because of company growth prospects. This ratio helps to
understand the difference between an earnings stock and a growth
stock.
20
 Presentation on
DIVIDEND DECISION
PART-II
For the students of
Semester – VI
B.Com.(Hons. & General)

By
Prof.Sumanta Lodh
 THEORIES OF DIVIDEND
Walter’s Model: Prof. James E Walter formed a model for share
valuation that states that the dividend policy of a company has an effect
on its valuation. He categorized two factors that influence the price of
the share viz. dividend payout ratio of the company and the
relationship between the internal rate of return (r) of the company and
the cost of capital (k).

According to Prof. Walter, If r>k i.e. if the firm earns a higher rate of
return on its investment than the required rate of return, the firm should
retain the earnings. Such firms are termed as growth firms and the
optimum pay-out would be zero which would maximize value of
shares.
In case of declining firms which do not have profitable investments i.e.
where r<k, the shareholder would stand to gain if the firm distributes it
earnings. For such firms, the optimum payout would be 100% and the
firms should distribute the entire earnings as dividend.
In case of normal firms where r=k the dividend policy will not affect the
market value of shares as the shareholders will get the same return
from the firm as expected by them. For such firms, there is no optimum
dividend payout and value of firm would not change with the change in
dividend rate.

Assumptions of Walter’s model

(i) The firm has a very long life.
(ii)Earnings and dividends do not change
while determining the value.
 (iii)The Internal rate of return ( r ) and the
cost of capital (k) of the firm are constant.
(iv)The investments of the firm are financed
through retained earnings only and the firm
does not use external sources of funds.
Walter’s formula to calculate the market price per share (P) is:
 where
P = market price per share D =
dividend per share E = earnings
per share r = internal rate of return
of the firm k = cost of capital of the
firm
Example: A company has an EPS of Rs. 15.
The market rate of discount applicable to the
company is 12.5%. Retained earnings can be
reinvested at IRR of 10%. The company is
paying out Rs.5 as a dividend.
Calculate the market price of the share using
Walter’s model.
Solution:
Here,
D = 5, E = 15, k = 12.5%, r = 10%
Market price of the share (P)
= 5/.125 + {.10 * (15-5)/.125} /.125
= Rs.104
 Criticism of Walter’s Model
Walter’s model has been criticized on account of various
assumptions made by Prof Walter in formulating his
hypothesis.
(i) The basic assumption that investments are financed
through retained earnings only is seldom true in real world.
Firms do raise fund by external financing.
(ii) The internal rate of return i.e. r also does not remain
constant. As a matter of fact, with increased investment the
rate of return also changes.
(iii) The assumption that cost of capital (k) will remain
constant also does not hold good. As a firm’s risk pattern does
not remain constant, it is not proper to assume that (k) will
always remain constant.
 Note: Here, the cost of capital (K) = Cost of equity (Ke),
because no external source of financing is used.
Illustration 2:
The following information relates to XYZ Ltd.:

You are required to find out whether the company’s dividend

payout ratio is optimal, using Walter’s Model.
Solution:
Thus, the firm can increase the market price of the share up to
Rs. 156.25 by increasing the retention ratio to 100%, the optimal
payout ratio for the firm is zero.
Illustration 3:
Cost of Capital (k) = 10%
Earnings per share (E) = Rs. 10.
Assume Internal Rate of Return (r):
(i) 15%; (ii) 10%; and (iii) 8% respectively
Assuming that the D/P ratios are: 0; 40%; 75% and 100% i.e., dividend share
is (a) Rs. 0, (b) Rs. 4, (c) Rs. 7.5 and (d) Rs. 10, the effect of different dividend
policies for three alternatives of r may be shown as under:
Thus, according to the Walter’s model, the optimum dividend policy depends on the
relationship between the internal rate of return r and the cost of capital, k. The conclusion,
which can be drawn up is that the firm should retain all earnings if r > k and it should
distribute entire earnings if r < k and it will remain indifferent when r = k.
Gordon’s Model
The Gordon’s Model, given by Myron Gordon, also supports the
doctrine that dividends are relevant to the share prices of a firm.
Here the Dividend Capitalization Model is used to study the
effects of dividend policy on a stock price of the firm.
Gordon’s Model assumes that the investors are risk averse i.e.
not willing to take risks and prefers certain returns to uncertain
returns. Therefore, they put a premium on a certain return and a
discount on the uncertain returns. The investors prefer current
dividends to avoid risk; here the risk is the possibility of not getting
the returns from the investments.
But in case, the company retains the earnings; then the investors
can expect a dividend in future. But the future dividends are
uncertain with respect to the amount as well as the time, i.e. how
much and when the dividends will be received.
Thus, an investor would discount the future dividends, i.e. puts
less importance on it as compared to the current dividends.
According to the Gordon’s Model, the market value of
the share is equal to the present value of future
dividends. It is represented as: P = [E (1-b)] /
Kebr
Where, P = price of a share E
= Earnings per share b =
retention ratio
1-b = proportion of earnings distributed as dividends
Ke = capitalization rate br
= growth rate
Assumptions of Gordon’s Model
The firm is an all-equity firm; only the retained
earnings are used to finance the investments, no
external source of financing is used.
The rate of return (r) and cost of capital (K) are
constant.
The life of a firm is indefinite.
Retention ratio once decided remains constant.
Growth rate is constant (g = br)
Cost of Capital is greater than br
Criticism of Gordon’s Model
It is assumed that firm’s investment opportunities are
financed only through the retained earnings and no
external financing viz. Debt or equity is raised. Thus, the
investment policy or the dividend policy or both can be
sub-optimal. The Gordon’s Model is only applicable to all
equity firms. It is assumed that the rate of returns is
constant, but, however, it decreases with more and more
investments.
It is assumed that the cost of capital (K) remains constant
but, however, it is not realistic in the real life situations,
 as it ignores the business risk, which has a direct impact
on the firm’s value.
Thus, Gordon model posits that the dividend plays an
important role in determining the share price of the firm.
Illustration:
Solution:
40