IV Sem Business Finance

Module 5

Management of Profits

Meaning &importance of Profit, forms of Dividend, dividend policy & factors

influencing dividend policy, MM Theory & Walter Theory.

Introduction: Dividend policy of the firm is one of the crucial areas of financial management.
The prime objective of a firm is to maximize the wealth of its owners i.e., shareholders. Cash
inflows are generated from the successful business operations, which is used for payment of
dividends to its shareholders. Dividend paid represents a cash outflow which depletes the cash
resources. Therefore, dividend decision is regarded as a financing decision since any cash
dividend paid reduces the amount of cash available for investment by the firm. Dividends are
periodic cash payment by the company to its shareholders. The dividend payable to the
preference shareholders is usually fixed by the terms of the issue of preference shares. But the
dividend on equity shares is payable at the discretion of the Board of Directors of the company.

Meaning: The term ‘dividend’ refers to that part of divisible profits distributed among its
shareholders. Dividend is that portion of company’s profit which is distributed among its
shareholders as a percentage of par values of share or at a fixed rate per share according to the
decision of its board of directors. In other words, the profits of a company when made available
for the distribution among its shareholders are called dividend. The decision for distributing or
paying a dividend is taken in the meeting of Board of Directors and is confirmed generally by
the annual general meeting of the shareholders. The dividend can be declared only out of
divisible profits, remained after setting of all the expenses, transferring the reasonable amount
of profit to reserve fund, and providing for depreciation and taxation for the year. It means if
in any year, there are not profits; no dividend shall be distributed that year. The shareholders
cannot insist upon the company to declare the dividend. It is solely the discretion of the
directors. Distribution of dividend involves reduction of current assets (cash) but not always.
Stock dividend or bonus shares are an exception to it.

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Types of dividends:

Dividend may be of different types. It can be classified according to the mode of its distribution
as follows:

a) Cash dividend: Dividends are usually paid in the form of cash. When dividend is paid
in cash, it is known as cash dividend. But payment of dividend in cash results in outflow
of funds. Thus, the firm must have adequate liquid resources in its disposal or provide
for such resources so that its liquidity position is not adversely affected on account of
cash dividends.

b) Scrip Dividend. Scrip dividends are used when earnings justify a dividend, but the
cash position of the company is temporarily weak. These are promises to make the
payment of dividends at a future date: Instead of paying the dividend now, the firm
elects to pay it at some later date. The ‘scrip’ issued to stockholders is merely a special
form of promissory note or notes payable. Such dividend was allowed before passing
of the Companies (Amendment) Act 1960, but thereafter this dividend practice was
stopped.

c) Bond Dividends. In rare instances, dividends are paid in the form of debentures or
bonds or notes for a long-term period. The effect of such dividend is the same as that
of paying dividend in scrip. The shareholders become the secured creditors as the
bonds have a lien on assets. In India, bond dividend is not popular. The reason behind
such an issue is the postponement of payment of immediate dividend in cash.

d) Property Dividend. Sometimes, dividend is paid in the form of asset instead of

payment of dividend in cash. The distribution of dividend is made whenever the asset
is no longer required in the business such as investment or stock of finished goods.
Property dividend is also not popular in India.

e) Stock-Dividend (Bonus shares): Companies, not having good cash position, generally
pay dividend in the form of shares by capitalizing the profits of current year and of past
years. Such shares are issued instead of paying dividend in cash and called 'Bonus
Shares'. Basically, there is no change in the equity of shareholders. Certain guidelines
have been used by the company Law Board in respect of Bonus Shares. But it is,
however, important to note that in India, distribution of dividend is permissible in the
form of cash or bonus shares only. Distribution of dividend in any other form is not

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allowed. Thus 'Bonus share' represents a distribution of share in lieu of or in addition

to the cash dividend to the existing shareholders, if the Articles so permit. The Shares
are issued to the existing ordinary shareholders in proportion to their present holdings.
Thus, it makes no difference in their proportionate ownership. The main advantage of
bonus shares to the shareholders is that they get more cash dividend in future years if
the company maintains the pre-bonus rate dividend on equity shares.

Advantages of Bonus Shares: The following are advantages of the bonus shares to
shareholders:
a) Tax benefit: One of the advantages to shareholders in the receipt of bonus shares is the
beneficial treatment of such dividends regarding income taxes.
b) Indication of higher future profits: The issue of bonus shares is normally interpreted
by shareholders as an indication of higher profitability.
c) Future dividends may increase: if a Company has been following a policy of paying
a fixed amount of dividend per share and continues it after the declaration of the bonus
issue, the total cash dividend of the shareholders will increase in the future.
d) Psychological Value: The declaration of the bonus issue may have a favorable
psychological effect on shareholders. The receipt of bonus shares gives them a chance
sell the shares to make capital gains without impairing their principal investment. They
also associate it with the prosperity of the company.

Types of Dividend Policy: Dividend policy is a very significant financial decision. It

determines the divisions of earnings between payments to shareholders and retained earnings.
If the value of firm is a function of its dividend-pay-out ratio, the dividend policy will affect
directly the firms cost of capital. As the equity shareholders prefer stable dividend to fluctuating
once, the dividend policy of the firm should have a degree of stability, i.e., earnings/profits may
fluctuate from year to year but not the dividend. Stable dividend relates to the consistency or
lack of variability in the stream of dividends payments. In short, it means a regular payment of
a certain minimum amount as dividend.

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Irregular No Dvidend
Dividend Policy Policy

Stable Dividend Conservative

Policy Dividend Policy

Regular Types of Liberal

Dividend Policy Dividend Policy Dividend Policy

a) Regular Dividend Policy: In this type of dividend policy, profit distribution to the
shareholders is made at the usual rate. Regular dividend policy is usually preferred
by investors who seek a steady stream of income, such as retired persons, middle
class families, etc. The objective of this policy is to provide regular and substantial
dividend flow, while it also allows the company to maintain enough liquidity so that
it can take advantage of any attractive future investment opportunity. This type of
dividend policy can only be followed by companies with long-standing and stable
earnings.
b) Stable Dividend Policy: In this type of dividend policy, the investors receive
dividends consistently, although the amount of dividend may vary from year to year.
Basically, the companies decide to distribute a certain portion of the profit to the
shareholders every year in the form of dividends. These companies are mostly mature
and don’t intend to pursue any strong growth strategy. Further, the policy is best
suited for investors for whom a steady source of income today is more important
than capital appreciation. The stable dividend policy can be further sub-classified
into – constant dividend per share, constant payout ratio, and constant dividend per
share plus extra dividend.

a. Constant dividend payout Policy: This method is also known as ‘constant

payout ratio method’. This concept dividend policy means ‘always paying a

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fixed percentage of the net earnings as dividend every year’. Under this
method, if earnings vary, the amount of dividend also varies from year to year.
It means the amount of dividend fluctuates in direct proportion to the earnings
of the company. The dividend policy is entirely based on company’s ability to
pay under this policy.

b. Constant dividend rate policy: It is the most popular kind of policy which
advocates the payment of dividend at a constant rate, even when earnings vary
from year to year. Under this policy, the firm pays a certain fixed amount per
share by way of dividends. This policy is possible only through the
maintenance of ‘dividend equalization reserve’ which enables them to pay the
fixed dividend even in the year when the earnings are not sufficient or when
there are losses.

c. Constant dividend per share plus extra dividend: Under this policy, a
fixed dividend per share is paid to the shareholders. But during market
prosperity, additional or extra dividend is paid over and above the regular
dividend. Such a policy is most suitable to the companies having fluctuating
earnings from year to year.

c) Irregular Dividend Policy: In this type of dividend policy, companies don’t pay
dividends regularly due to various reasons, such as lack of liquidity, volatility in
future earnings, etc. In fact, the companies following this dividend strategy are
exactly opposite in nature to the companies with regular dividend policy – they don’t
have a history of stable earnings. In other words, investors in these companies are
never sure whether there will be any dividend during a year, and if yes, what amount
will be paid as a dividend.

d) No Dividend Policy: This type of dividend distribution policy is followed by

companies that require capital for funding attractive future growth opportunities or to
support liquidity stretch due to unfavorable working capital position. There are also
instances where a company decides against paying any dividend so that it can retain
the entire profit for reinvesting in the future growth of the business. However, in such
a scenario the company should be able to convince its shareholders about the no
dividend policy. Some of the current investors might become disgruntled as such a
policy doesn’t benefit them in the near term, although it may result in capital

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appreciation in the longer term. So, shareholders who stay for longer with the
company may reap the benefits of capital appreciation by way of more profits in the
future.

e) Conservative Dividend Policy: Conservative dividend policy is one where the

management distributes only a part of profit as dividend in spite of excessive profit
earned. Under this policy major part of the whole profit is reinvested in the business
and shareholders are paid minimum possible dividend. Thus, the main consideration
in adopting this dividend policy is the financial soundness of the business and
shareholders’ current expectations are reared in the background.

f) Liberal Dividend Policy: It is a policy of distributing a major part of its earnings to its
shareholders as dividends and retains a minimum amount as retained earnings. Thus,
the ratio of dividend distribution is very large as compared to retained earnings.

Factors influencing dividend policy:

Dividend policy determines the division of earnings between payments to shareholders and
reinvestment in the firm. Several considerations affect the dividend policy of the company.
The major factors are:

a) Liquidity resources: To pay dividend, a company requires cash and, therefore the
availability of cash resources within the company will be an important factor in
dividend decisions. A dividend represents a cash outflow, the greater the funds and the
liquidity of the firm the better the ability to pay dividend. The liquidity of a firm
depends very much on the investment and financial decisions of the firm which in turn
determines the rate of expansion and the manner of financing. If cash position is weak,
stock dividend will be distributed and if cash position is good, company can distribute
the cash dividend.

b) Stability of Earnings. The nature of business has an important bearing on the dividend
policy. If earnings are relatively stable, a firm is better able to predict what its future
earnings will be. Industrial units having stability of earnings may formulate a more
consistent dividend policy than those having an uneven flow of incomes because they
can easily predict their savings and earnings.

c) Age of corporation. Age of the corporation counts much in deciding the dividend

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policy. A newly established company may require much of its earnings for expansion
and plant improvement and may adopt a rigid dividend policy while, on the other hand,
an older company can formulate a clear cut and more consistent policy regarding
dividend.

d) Taxation Policy. Taxation policy of Government also affects the dividend policy. High
taxation reduces the earnings of the companies and consequently the rate of dividend
is lowered down. A company should keep in mind the tax position of the shareholders
before declaring any dividend. If the shareholders are in high tax bracket lower dividend
should be declared or issue bonus shares and vice versa.

e) Past dividend Rates. While formulating the dividend policy, the directors must keep
in mind the dividend paid in past years. The current rate should be around the average
past rat. If it has been abnormally increased the shares will be subjected to speculation.
In a new concern, the company should consider the dividend policy of the rival
organisation.

f) Stability in Dividend Payment. The stability of dividend ensures the consistency of

future stream of income to the shareholders. Dividends should be paid regularly
because each investor is interested in the regular payment of dividend. The
management should, despite regular payment of dividends, consider that the rate of
dividend should be all the most constant. For this purpose, sometimes companies
maintain dividend equalization Fund.

g) Needs for additional capital. Companies retain a part of their profits for strengthening
their financial position. The income may be conserved for meeting the increased
requirements of working capital or of future expansion. Small companies usually find
difficulties in raising finance for their needs of increased working capital for expansion
programmes. They have no other alternative but to use their ploughed back profits.
Thus, such companies distribute dividend at low rates and retain a big part of profits.

h) Legal provisions. The company must comply with the provisions of the companies
Act, 1956 for payment of dividends. To protect the interests of creditors, the companies
Act 1956 prescribes certain guidelines in respect of the distribution and payment of
dividend. Moreover, a company is required to provide for depreciation on its fixed and
tangible assets before declaring dividend on shares. It proposes that dividend should

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not be distributed out of capital, in any case. Likewise, contractual obligation should
also be fulfilled, for example, payment of dividend on preference shares in priority over
ordinary dividend.

i) Trade Cycles. Business cycles also exercise influence upon dividend policy. Dividend
policy is adjusted according to the business fluctuations. Inflation acts as a constraint
in the payment of dividends. Higher rates of dividend can be used as a tool for
marketing the securities in an otherwise depressed market. The financial solvency can
be proved and maintained by the companies in dull years if the adequate reserves have
been built up.

j) Government Policies. The earnings capacity of the enterprise is widely affected by the
change in fiscal, industrial, labour, control, and other government policies. Sometimes
government restricts the distribution of dividend beyond a certain percentage in a
particular industry or in all spheres of business activity as was done in emergency. The
dividend policy must be modified or formulated accordingly in those enterprises.

Difference between Dividend Payout and Retained Earnings

Factor Dividend Payout Retained Earnings
Portion of profit distributed to Profit retained within the
Definition
shareholders as dividends company for reinvestment
Financing business growth
Purpose Rewarding investors with returns
and expansion
Impact on Supports long-term business
Limits reinvestment funds
Growth development
Investor Preferred by income-seeking Preferred by growth-focused
Preference investors investors
Provides a steady income for Helps in financial stability
Stability
investors and future investments

Capitalization Rate: In dividend theory, the capitalization rate refers to the required rate of
return or the discount rate used to determine the present value of a firm's expected future
earnings or dividends. It represents the rate at which investors capitalize or discount future
dividends to estimate the firm's market value.

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Approaches
to Dividend
Policy

Irrelevance Relevance

Gordon's
Dividend as a Modified MM Walter's Model (Bird's
MM Model
Residual Model Model in Hand
Theory)

Feature Relevance Dividend Theory Irrelevance Dividend Theory

Suggests that dividend policy Suggests that dividend policy does

Concept affects a firm’s value and stock not impact a firm's value or stock
price. price.

John Lintner, Gordon (Walter Franco Modigliani & Merton

Key Proponents
& Gordon Model). Miller (M&M Theory).

Investors are indifferent to

Shareholders prefer regular and
Impact on dividends and capital gains; firm
high dividends as they reduce
Shareholders value depends on earnings and
uncertainty.
investment policies.

Investors see dividends as a Investors focus on total returns

Market
positive signal of profitability (dividends + capital gains), not
Perception
and stability. just dividends.

Retaining earnings for

High dividends increase reinvestment does not harm
Company Growth
shareholder satisfaction, but investors, as they can create
Consideration
may limit growth opportunities. "homemade dividends" by selling
shares.

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Irrelevance Theory of Dividend:

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 and Example: 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 (M&M) Model: 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.
M&M’s Assumptions:
 Perfect Capital Markets – No taxes, transaction costs, or flotation costs.
 Rational Investors – Investors can create their own dividends by selling shares if they
need cash.
 No Information Asymmetry – All investors have access to the same information.
 Investment Policy is Fixed – A firm’s value depends on its investment decisions, not
dividends.
(𝑫𝟏 + 𝑷𝟏 )
𝑭𝒐𝒓𝒎𝒖𝒍𝒂 𝒐𝒇 𝑴𝑴 𝑨𝒑𝒑𝒓𝒐𝒂𝒄𝒉: 𝑷𝟎 =
𝟏 + 𝑲𝒆

Where 𝑃0 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑆ℎ𝑎𝑟𝑒

𝐾𝑒 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
𝐷1 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑎𝑡 𝑡ℎ𝑒 𝑒𝑛𝑑 𝑜𝑓 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟.

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𝑃1 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑆ℎ𝑎𝑟𝑒 𝑎𝑡 𝑡ℎ𝑒 𝑒𝑛𝑑 𝑜𝑓 𝑦𝑒𝑎𝑟.

The MM Hypothesis can also be explained in another form also presuming that investment
required by the firm on account of payment of dividends is financed out of the new equity
shares. In such a case, the number of shares to be issued can be computed:

𝑰 (𝑬 − 𝒏𝑫𝟏 )
𝒎=
𝑷𝟏
Further the value of the firm can be ascertained with the help of the following formula:
(𝒏 + 𝒎)𝑷𝟏 − (𝑰 − 𝑬)
𝒏𝑷𝟎 =
𝟏 + 𝒌𝒆
Where 𝑚 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑡𝑜 𝑏𝑒 𝑖𝑠𝑠𝑢𝑒𝑑.
𝐼 = 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑
𝐸 = 𝑇𝑜𝑡𝑎𝑙 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑.
𝑃1 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑃𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 𝑎𝑡 𝑡ℎ𝑒 𝑒𝑛𝑑 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑.
𝐾𝑒 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
𝐷1 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑡𝑜 𝑏𝑒 𝑝𝑎𝑖𝑑 𝑎𝑡 𝑡ℎ𝑒 𝑒𝑛𝑑 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑.
𝑛 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑎𝑡 𝑡ℎ𝑒 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑.
𝑛𝑃0 = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚

Relevance Theory of Dividends:

Walter’s Model of Dividend Policy: Proposed by James E. Walter, this model suggests that
a firm’s dividend policy directly influences its stock price, depending on the relationship
between the firm's return on investment (r) and cost of capital (k).
Assumptions: This model is based on the following assumptions:

a) The firm finances new investments through retained earnings only.

b) The firm’s internal rate of return, and cost of capital are constant.
c) Earnings and dividends do not change while determining the value.
d) The firm has a very long life.

(𝑬 − 𝑫 ) ∗ 𝒓
𝑫+ 𝒌𝒆
𝑾𝒂𝒍𝒕𝒆𝒓′ 𝒔𝑭𝒐𝒓𝒎𝒖𝒍𝒂 =
𝒌𝒆

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𝑊ℎ𝑒𝑟𝑒: 𝑃 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒,

𝐷 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒
𝐸 = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒
𝑟 = 𝐼𝑛𝑡𝑒𝑟𝑛𝑎𝑙 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛
𝑘𝑒 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

Key Implications of Walter’s Model:

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

Gordon’s Model (Bird-in-Hand Theory): Proposed by Myron Gordon, this model argues
that investors prefer dividends over future capital gains due to the uncertainty of stock price
appreciation. He believes that a firm’s value increases with higher dividend payments. This
theory is based on the saying “A bird in the hand is worth two in the bush,” meaning that
investors prefer a certain and immediate dividend over uncertain future capital gains.

Myron Gordon proposed a model of stock valuation, which is supporting the dividend
relevance decision in case of a growth firm [when r > k], and in case of a declining firm [when
r < k] and dividend irrelevance decision in case of a normal firm [when r = k]. This theory
relating dividend policy and the firm’s value, based on the following assumptions:

a) The firm has only equity capital, and no debt.

b) Only retained earnings will be used for financing expansion.
c) Firm’s rate of return on the firm’s investment r, is constant.

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d) The firm and its stream of earnings are perpetual.

e) The corporate taxes are nil.
f) The retention ratio (b) , once decided, remains constant. Thus, the growth rate of the
firm g = br is also constant.
g) The Cost of Capital for the firm remains constant and it is greater than the growth rate
i.e k > br.
𝑬 ( 𝟏 − 𝒃) 𝑫𝟏 𝑫𝟎 ( 𝟏 + 𝒈)
𝑷= 𝒐𝒓 𝑷𝟎 = 𝒐𝒓
𝒌𝒆 − 𝒃𝒓 𝑲𝒆 − 𝒈 𝑲𝒆 − 𝒈

𝑊ℎ𝑒𝑟𝑒: 𝑃 = 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒𝑠

𝐸 = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒
𝑏 = 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑖𝑜
𝑘𝑒 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
𝑏𝑟 = 𝑔 = 𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒 𝑖𝑛 𝑟, 𝑖. 𝑒 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑜𝑓 𝑎𝑙𝑙 − 𝑒𝑞𝑢𝑖𝑡𝑦 𝑓𝑖𝑟𝑚
𝐷0 = 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒
𝐷1 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑎𝑡 𝑡ℎ𝑒 𝑒𝑛𝑑 𝑜𝑓 𝑌𝑒𝑎𝑟 1.

Key Implications of Gordon’s Model:

 When the rate of return is greater than required rate of return i.e when (r > k), the price
per share increases as the dividend pay-out ratio decreases. Thus growth firm should
distribute smaller dividends and should retain maximum earnings.
 When the rate of return is equal to the required rate of return i.e when (r=k), the price
per share remains unchanged and is not affected by dividend policy. Thus for a normal
firm there is no optimum dividend payout.
 When the rate of return is less than the required rate of return (r<k), the price per share
increases as the dividend payout ratio increases. Thus the shareholders of the deciling
firm stand to gain if the firm distributes its earnings. Therefore, 100% dividend payout
ratio is optimum.

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IV Sem Business Finance

Practical Questions:

Q1) ABC Ltd belongs to a risk class for which the appropriate capitalization rate is 10%. It
Currently has outstanding 5,000 shares selling at Rs 100 each. The firm is contemplating the
declaration of dividend of Rs 6 Per share at the end of the current financial year. The company
expects to have a net income of Rs 50,000 and has a proposal for making new investments of
Rs 1,00,000. Show that under the MM Hypothesis, the payment of dividends doesn’t effect the
value of the firm.

Q2) Expandent Ltd had 50,000 equity shares of Rs 10 each outstanding on 1 st Jan. the shares
are currently being quoted at par in the market. In the wake of the removal of dividend restraint,
the company now intends to pay a dividend of Rs 2 Per share for the current calendar year. It
belongs to a risk-class whose appropriate capitalization rate is 15%. Using MM Model and
assuming no taxes, ascertain the price of the company’s share as it is likely to prevail at the end
of the year (i) when dividend is declared, (ii) when dividend is not declared. Also find out the
number of new equity shares that the company must issue to meet its investment needs of Rs 2
Lakhs, assuming a net income of Rs 1.1 Lakhs and also assuming that the dividend is paid.

Q3) The Agro-chemicals Company belongs to a risk class for which the appropriate
capitalization rate is 10%. It currently has 1,00,000 shares selling at Rs 100 each. The firm is
contemplating the declaration of Rs 5 as dividend at the end of the current financial year, which
has just begun. What will be the price of the share at the end of the year, if a dividend is not
declared? What will be the price if it is declared? Calculate the above using MM Approach and
assuming no taxes.

Q4) The Earnings per share of company are Rs 8 and the rate of Capitalization applicable to
the company is 10%. The company has before it an option of adopting a payout ratio of 25%
or 50% or 75%. Using walter’s Model of dividend payout, compute the market value of the
company’s share if the productivity of retained earnings is (i) 15%, (ii) 10% and (iii) 5%.

Q5) The Earnings per share of company are Rs 10 and the rate of Capitalization applicable to
the company is 10%. The company has before it an option of adopting a payout ratio of 20%
or 40% or 80%. Using walter’s Model of dividend payout, compute the market value of the
company’s share if the productivity of retained earnings is (i) 20%, (ii) 10% and (iii) 8%.

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IV Sem Business Finance

Q6) The following information relates to XYZ Ltd:

Paid-up Equity Capital (Rs) 20,00,000

Earnings of the Company (Rs) 2,00,000
Dividend Paid (Rs) 1,60,000
Price - Earnings Ratio 12.5
Number of Outstanding Shares 20,000

Using walter’s Model calculate if the Company’s Dividend Payout ratio is optimal.

Q7) The following information is available in respect of the rate of return on investment (r)
the Cost of Capital (k) and earnings per share (E) of ABC Ltd:
Rate of Return on Investment (r) = (i) 15%, (ii) 12% and (iii) 10%.
Cost of Capital (k) = 12%
Earnings Per Share (E) = Rs 10
Determine the value of its shares using Gordon’s Model assuming the following:
D/P Ratio (1-b) Retention Ratio (b)
(a) 100 0
(b) 80 20
(c) 40 60

Q8) The following information is available in respect of return on investment (r), the cost of
capital (ke) and Earnings Per share (E) of XYZ Ltd: r = 10%, E = Rs 40
Determine the value of its shares using Gordon’s Model, assuming the following:
D/P Ratio (1-b) Cost of Equity (Ke)
(a) 20 20
(b) 40 18
(c) 60 16
(d) 80 14

Q9) A Company is expected to pay a dividend of Rs 6 Per share next year. The dividend are
expected to grow perpetually at a rate of 9%. Calculate the value of its share if the required rate
of return is 15%.

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IV Sem Business Finance

Q10) The Current price of a company’s share is Rs 75 and dividend per share is Rs 5. Calculate
the dividend growth rate if its capitalization rate is 12%.

Q11) The book value per share of a company is Rs 145.50 and its rate of return on equity is
10%. The company follows a dividend policy of 60% Payout. Calculate the price of its share
if the capitalization rate is 12%.

Q12) A Company has a total Investment of Rs 5,00,000 in assets and 50,000 Outstanding
ordinary shares at Rs 10 Per Share (Par Value). It earns a rate of 15% on its investment, and
has a policy of retained 50% of the earnings. If the appropriate discount rate of the firm is 10%,
determine the price of its shares using Gordon’s Model. What shall happen to the price of the
share, if the company has a payout of 80%.

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