Dividend Policy

Dividend Policy

Deals with amount of dividends paid out by the company

to its shareholders & the frequency with which the
dividends are paid out; and how much is to be retained
• Determinants of the dividend policy of a firm are:
• dividend pay-out (D/P) ratio
• stability of dividends
• legal, contractual and internal constraints & restrictions
• owners’ considerations
• capital market considerations & inflation
 Types of Dividend
1) Cash Dividend: the most common form of dividend payment,
where shareholders receive a certain amount of money per share
2) Stock Dividend: shareholders receive new shares instead of
cash - increases the number of shares in circulation
3) Interim Dividend: payment within the financial year, before
the main dividend payment - is often paid after interim financial
statements & signals management's confidence in the financial
health of the company
4) Final Dividend: paid after the end of the financial year and
approved by the shareholders at the AGM
5) Buyback Dividend: an indirect form where the company buys
back its own shares - reduces the number of outstanding shares
and can increase the value of the remaining shares
6) Property Dividend: rarer form of dividend where shareholders
receive physical goods or services – not popular in India
 Regular vs. Stable Dividend Policy
• Regular dividend policy • Stable dividend policy
(i)constant dividend per share,
Companies with a steady cash
(ii)constant D/P ratio, &
flow and stable earnings
(iii)constant dividend per share
Dividends paid to its plus extra dividend -
shareholders every year • the first one is the most
In case of abnormal profits, the appropriate
excess profits are withheld by • % of profits paid out as
the company as RE dividends is fixed, regardless
In case of a loss, the of the amount of profits
shareholders will still be paid a earned for the financial year
dividend under the policy Shareholders face uncertainty as
they are not sure of the exact
Indian Oil, CIL, Hindustan Zinc, ITC,
IIFL Wealth Management, Power Grid dividend they will receive
Corp, Oil India etc. Vedanta, Hindustan Zinc, IOCL,
BPCL & CIL
 Dividend Models
• Two schools of thought regarding dividend policy:

Relevance of Dividend
• Dividend policy affects the value of the firm

Walter’s Model & Gordon’s Model:

• These models of valuation of the firm link the dividend
policy to the
– investment opportunities available
– rate of return on investment opportunities as compared
with expectations of the shareholders
 Walter’s Model
• Prof. J.E.Walter opined that Dividend policy always affects
the value of the firm – it is treated as a financing decision &
the cash dividend is a passive residual
• Walter’s model considers the value of the firm as sum of two
components;
1. an infinite stream of dividend, D; &
2. an infinite stream of retained earning, (E – D) reinvested at
constant rate of k, which are generated each year for infinite
length of time.
• So, the market price of share = (Present value of infinite
stream of dividend + Present value of infinite stream of
capital gain)
𝑟
𝐷+ (𝐸 −𝐷)
𝑘
• P= where r = IRR; k = cost of capital; E =
𝑘
EPS & D= DPS
 Walter’s Model
• Rationale: investment & dividend are interrelated - many firms
use the model for maintaining the share prices in the market
• Three situations:
1. Rate of return is greater than the cost of capital (r > k): the firm
must hold the earnings to increase investment opportunities -
firm will earn more compared to the reinvestment made by
shareholders - payout is zero

2. Rate of return is equal to the cost of capital (r = k): the firm’s

dividend will not impact its value – firm has to decide how
much to be retained & how much to be distributed - payout
ratio changes with different circumstances - would either be
zero or 100%

3. Rate of return is less than the cost of return (r < k): the firm
should distribute all its earnings as dividends - will give rise to
more investment opportunities for the future - payout remains
100%
 Illustration – Walter’s Model
For Growing firm: The EPS of a firm is ₹10. The equity
capitalization rate is 10% and the IRR on RE is 20%. Using
Walter’s formula calculate the following:
1) What should be the optimum payout ratio for the firm?
2) What should be the price of share at Optimum payout ratio?
3) How shall this price be affected if different payout (say 80%)
were employed?
Solution:
• For (1) Sign of r ˃ ke represents a growing firm & thus the
optimum pay out ratio should be 0%.
• For (2) & (3) Market price per share needs to be computed at the
payout ratio of 0% & 80%: ₹200 & ₹120 respectively.
• Thus, for a growing firm price decreases as the pay out increases.
 Illustration…….
• With the same condition, if :
1. The equity capitalization rate is 10% and the IRR on RE is
10% (Normal firm), what shall be the price at optimum pay
out and 80% payout ratios?
2. The equity capitalization rate is 20% and the IRR on RE is
10% (Declining firm) what shall be the price at optimum
pay out and 80% payout ratios?

Response:
1) For normal firm, any payout ratio shall be optimal &
market price shall remain same with 0% & 80% pay out
ratio i.e. ₹100/-
2) For declining firm, optimal payout ratio shall be 100% &
market price shall be ₹50 & ₹45 respectively with 100% &
80% pay out ratio
 Assumptions & Limitations
• Funding of new projects is done through REs alone
(Internal financing)

• The growth opportunities do not alter the risk profile of the

firm as a whole, and so the market capitalisation rate
remains constant (Constant cost of capital)…….an implied
assumption that the reinvestment rate ‘k’ remains constant

• The firm is a going concern and the pricing model assumes

perpetual earnings (Constant return) -Infinite life of firm &
Constant EPS and DIV

• Walter’s model assumes inter-dependence of the

investment and dividend decisions. 100 per cent payout or
retention
 A Hypothetical Situation
1. From the following information, ascertain whether the
firm’s D/P ratio is optimal according to Walter. The firm
started its operation a year ago with an equity capital of
₹50 lakh of ₹100 each:
• Earnings of the firm - ₹5,00,000
• Dividend paid - ₹3,75,000
• P/E Ratio - 8
• The firm is expected to maintain its current rate of earnings
on investment.
2. What should be the P/E Ratio at which dividend payout
ratio shall have no effect on the value of share?
3. Will your decision change if the P/E Ratio is 12.5 instead
of 8?
1. Here r = IRR on RE = (Rs.5 lakhs/ Rs.50 lakhs) = 10%
1 1
& k = (𝑃 = )= 12.5%
𝑅𝑎𝑡𝑖𝑜 8
𝐸

2. It is a declining firm (i.e. r˂ ke) & hence its payout

should be 100% not 75%. (Thus the market price per
share @ 75% payout ratio = ₹76/- & @ 100% payout
ratio should be ₹80/-).

3. At P/E Ratio 10, the D/P Ratio will have no effect (as r =
ke) - it is an indication of a normal firm, where every
payout ratio shall be optimal.

4. The decision shall change if P/E Ratio changes from 8 to

12.5 (representing growing firm where r ˃ ke ), where
the payout ratio shall be 0%.
 Gordon’s Model
• Myron Gordon propounded a growth model (GGM) - for
estimating the value of a company's stock & advocates that
the dividend policy is relevant
• GGM is a sequence of dividends that increase at a
predictable rate in the future & is frequently used to calculate
a stock’s intrinsic value - a basic dividend discount concept
(DDM)
• Model assumes that firm’s dividends will grow at a constant
rate - rate of return & cost of capital remain constant - capital
is financed entirely by equity - firm has an infinite life
• The model uses the expected dividend per share, the required
rate of return, and the expected dividend growth rate to
calculate the stock's intrinsic value
• The model can be used to value a wide range of companies,
as long as they have a clear pattern of dividend payments
 Gordon’s Model ………….
• According to Gordon, market price of a share is equal to the
present value of infinite stream of dividends.
𝐷1 𝐷2 𝐷3 𝐷∞
• So, P0= + + …………… +
(1+𝑘)1 (1+𝑘)2 (1+𝑘)3 (1+𝑘)∞
• Since retained earnings are assumed to be reinvested at ‘r’ rate
of return, the earnings & dividend grow at the rate of ‘g = br’
[‘br’ refers to rate of return on invested RE] per period
• ‘b’ is the fraction of earnings, the firm retains
𝐷1 𝐷1 (1+𝑔)1 𝐷1 (1+𝑔)2 𝐷1 (1+𝑔)∞
• Now P0= + + …………… +
(1+𝑘)1 (1+𝑘)2 (1+𝑘)3 (1+𝑘)∞
𝐷
• After simplifying the above & assuming g ˂k, P0= 1
(𝑘−𝑔)
• Substituting EPS1 (1 –b) for D1 and ‘br’ for ‘g’
𝐸𝑃𝑆1(1 −𝑏) 𝐸 (1 −𝑏)
• P0= (𝑘 −𝑏𝑟)
or P0= (𝑘 −𝑏𝑟)
 Effect of Dividend Policy on Value of Share
Case If Dividend Payout If Dividend Payout
Ratio increases Ratio decreases
i. In case of Market value of a Market value of a
Growing firm i.e. share decreases share increases
where r ˃ k
ii. In case of Market value of a Market value of a
Declining firm i.e. share increases share decreases
where r ˂ k
iii. In case of Market value of a Market value of a
Normal firm i.e. share remains share remains
where r = k unchanged unchanged
 Bird-In-the-Hand Approach
• After incorporating uncertainty into his model, Gordon
concludes that dividend policy affects the value of a share
even of a normal firm (r =k)
• Under the condition of uncertainty, investors have a
preference for near dividend to distant dividend &
discount distant dividend (i.e. capital gain) at a higher
rate than they discount near dividend
• He argued that REs rather than current dividends made
the cash flow stream for the shareholder riskier & this
would increase the cost of capital
• The future dividend stream would presumably be higher
due to the investment of REs (+NPV)
• Now called the “bird in the hand fallacy”
 Illustration – Gordon’s Model
• The EPS of a company is ₹10. The Equity Capitalization
rate is 10%. The IRR on Retained Earnings is 20%. Using
Gordon’s formula, calculate:
a) What should be the optimum payout ratio of the company?
b) What should be the price of share at optimum payout ratio?
c) Shall the price be affected if different payout ratios(say
55% or 80%) were employed?
Soln: Since r >ke, it is a growing firm – so, optimum payout
ratio is 0% - need to compute P at payout ratios of 0%, 55%, &
𝐸 (1 −𝑏) Price would decrease if
80%) - P0= (𝑘 −𝑏𝑟)
a payout ratio different
• At 0% payout ratio, P0 = ₹0 from optimum payout
• At 55% payout ratio, P0 = ₹550 ratio is employed
• At 80% payout ratio, P0 = ₹133.33
 Illustration – Gordon’s Model…….

• Keeping all other conditions same, what will happen to the

price at the above mentioned payout ratios if r = 10%,
instead of 20% as given above?
• Since it’s a normal firm, market price at any payout will be
₹100. – price will remain same at any payout ratio
• Keeping all other conditions same, what will happen to the
price at the payout ratios of 100% and 80% if ke = 20%,
instead of 10% as given above?
• Since it’s a declining firm, market price at 100% payout
will be ₹50 & price at 80% payout will be ₹44.44 – the
price decreases as and when the payout decreases
 Conflicting Theories
Irrelevance of Dividend
• According to Modigliani & Miller, under a perfect
market situation, the dividend policy of a firm is
irrelevant as it does not affect the value of the firm

• The value of the firm depends on firm earnings

which results from its investment policy

• Whatever increase in shareholders wealth results

from dividend payments will be exactly offset by
the effect of raising additional capital
 M&M Hypothesis
Value of Firm
[i.e. wealth of shareholders]
depends on
Firm’s Earnings
depends on

Firm’s Investment Policy & not Dividend Policy

Assumptions:-
• Perfect capital markets
• No taxes (either there are no taxes or there is no difference in
the tax rate applicable to dividend income & capital gain)
• Fixed Investment policy
• No risk ( investors are capable of forecasting future prices,
profits & dividend with certainty)
 A Hypothetical Situation
• A company belongs to a risk-class for which the appropriate
capitalization rate is 10%.
• It currently has outstanding 1,00,000 shares selling @ ₹110.
• The firm is contemplating to declare a dividend of ₹6 per share
at the end of the current financial year.
• The company expects to have a net income of ₹10 lakh and has
a proposal for making new investments of ₹20 lakh.
• Required:
• What will be the price of share at the end of the year if a
dividend is not declared?
• What will be the price of share at the end of the year if a
dividend is declared?
• Show under the MM assumptions, the payment of dividend
does not affect the value of the firm.
 Solution
• When dividend declared @₹6 per share, the price per share
= 100*(1+0.1) - 6 = ₹104
• When dividends are not declared = 100*(1+0.1) - 0 = ₹110
• No. of new shares to be issued:
• Particulars Dividend No Dividend
• Net Income 10,00,000 10,00,000
• Less, Dividend (6,00,000) -
• Retained Earnings 4,00,000 10,00,000
• New Investment 20,00,000 20,00,000
• Inv by new issue 16,00,000 10,00,000
• New shares @ 104- 15,385 @110- 9091
 Solution……..
• Proof of Irrelevance
• Particulars Dividend No Dividend
• Existing shares 1,00,000 1,00,000
• New shares issued 15,385 9,091
• Total shares at the end 1,15,385 1,09,091
• Market price per share ₹104 ₹110
• Total MV at the end ₹120 Lakh ₹120 Lakh

Observation: MM Theory of Irrelevance is outdated to the

present conditions – dividends are relevant as these have
information value
 Dividends: Payment Chronology
Declaration Date: date on which AGM takes
place & the board approves the dividend issue

Record Date: date the company decides to review the register to

list all eligible shareholders for the dividend - usual gap between
the dividend declaration date & record date is 30 days
Ex-Dividend date: With the T+1 settlement cycle, the date
normally is on the same day as the record date - shareholders who
own the shares before this date are entitled to receive dividend

The holder-of-record date is the date of ownership for determining

who is entitled to the dividend – identified by firm

Payment Date : established by firm as date the dividend is actually

paid
 Basics of Cash Dividend
When a dividend is paid in cash, there would be changes to the
price of the security & various items tied to it
On the ex-dividend date, the stock price is adjusted downward
by the amount of the dividend by the exchange on which the
stock trades
Typically drops by an amount
approximately equal to the
dividend payment, as no new
buyers are entitled to that
dividend

The reason for the adjustment is that the amount paid out in
dividends no longer belongs to the company & this is reflected
by a reduction in the company’s market capitalization
 Bonus Issue
It is a stock dividend instead of cash - is issued out of the reserves
of the company - shareholders receive these free shares against
shares they currently hold - allotments typically come in a fixed
ratio of 1:1, 2:1, 3:1, etc.
In a bonus issue, the stock price declines to the extent of the
bonus ratio, but this decline should not be mistaken for a
correction in stock price or a fall
Ratio Pre-Bonus Issue Post-Bonus Issue
Shares @price Investment Shares @price Investment
1:1 100 ₹75 ₹7,500 200 ₹37.5 ₹7,500
3:1 30 ₹550 ₹16,500 120 ₹137.5 ₹16,500
5:1 2,000 ₹15 ₹30,000 12,000 ₹2.5 ₹30,000
• Liquidity in the stock increases
• Effective EPS, BV & other per share values stand reduced
• Accumulated profits get reduced
• Is a sign of the good health of the company
 Stock Split
Similar to a bonus issue, when the company declares a stock
split, the number of shares held increases, but the investment
value remains the same - happens regularly in the markets
A stock split is a giant stock dividend where, the number of
shares with a stock split increase through a proportional reduction
in the par value of the shares
The difference between a bonus & a split is that in the bonus
issue, the face value of the company remains unchanged, but in
a stock split, the face value changes - If the stock’s FV is ₹20,
& there is a 1:2 stock split, then the FV will change to ₹10
The dates and timeline (announcement date, ex-date, record date,
etc.) are similar to dividend and bonus issues
Bonus shares and stock splits increase the number of shares yet
keep the same shareholding pattern - keep the total wealth of
the shareholders same