Dividend Decisions

Unit 5
DIVIDEND

• The term dividend refers to that portion of profit which is distributed

among the owners/shareholders of the firm.

Types of dividend:
a. Cash
b. Stock
c. Asset
d. Special
e. Common
DIVIDEND POLICY

The dividend policy of the firm determines what

portion of earnings is paid to share holders by way
of dividend and what portion is ploughed back in
the firm for reinvestment purposes. In other
words, the term dividend policy refers to policy
concerning quantum of profits to be distributed as
dividend .
FACTORS AFFECTING DIVIDEND POLICY

The factors affecting a company’s dividend policy can be classified

as: -

1. Internal Factors
2. External Factors
INTERNAL FACTORS

 Stability of earnings
Age of corporation
Liquidity of funds
Financial needs of the company
Desire of control
Past dividend rate
Desire of shareholders
EXTERNAL FACTORS

Legal requirements
General state of the economy
Taxation policy
Government policies
CONSTRAINTS ON PAYING DIVIDEND

1. Bond Indenture: A bond indenture is a legal document

or contract between the bond issuer and the
bondholder that records the obligations of
the bond issuer and benefits owed to the Bondholder.
2. Preferred Stock Restriction: Preferred stockholders
have a higher claim to dividends or asset distribution
than common stockholders.
CONTD.

3. Impairment of Capital Rule: The capital impairment rule is a state-

level legal restriction on corporate dividend policy. It basically limits the
amount of dividends a company can pay out to shareholders. The limit is
described as either a limit per capital stock or per the par value of the firm.
4. Cash Availability: A company may not have enough cash to pay the
dividend and may be using debt to pay investors.
5. Tax Penalty: If there is a determination that a corporation has
accumulated income beyond the reasonable needs of the business, the 10-
percent improperly accumulated earnings tax shall be imposed
STABILITY OF DIVIDEND POLICY

The term Stability of Dividends means consistency or lack of

variability in the stream of dividend payment. To be more precise,
it means regular payment of a certain minimum amount as dividend.
Shareholders generally favour this policy and value stable dividends
higher than the fluctuating ones. All other things being the same,
stable dividends have a positive impact on the market price of the
share.
Stability of dividend can be of three forms:-
1. CONSTANT DIVIDEND PER SHARE

• The company pays a certain fixed amount per share as dividend.

Several companies follow this policy. However, this policy does not
imply that the dividend per share will never be increased. When the
company reaches new levels of earnings and expects to maintain it,
the annual dividend per share may be increased.
• This policy is generally preferred by those persons that depend upon
the dividend income to meet their living, increases and decreases in
market values may even be of little concern to these investors, and
this condition tends to produce a steady long-run demand that
automatically stabilizes the market value of the share.
2. CONSTANT PERCENTAGE

• A certain percentage of net earnings is paid by way of dividend to

share holders year after year. In case of such a policy, the amount
of dividend fluctuates in direct proportion to the earnings of the
company.
• For example: if a company adopts 30% dividend payout ratio, it
means out of every one rupee earned by it, it will distribute 30
paisa among its shareholders. In case a company earns rupees 2
per share, the company will pay 60 paisa as dividend to the
shareholders.
3. STABLE RUPEE DIVIDEND PLUS EXTRA
DIVIDEND

• The firm usually pays fixed dividend per share to

the shareholders. However, in periods of market
prosperity, additional or extra dividend is paid
over and above the regular dividend. This extra
dividend is cut by the firm as soon as the normal
conditions return.
TYPES OF DIVIDEND

Types of Mode of Time of

shares payment Payment
Cash
Regular
●

Equity Dividend
●
●
●
Stock
●
Preference ●
Bond ●
Interim
Property
Dividend
●

●
Composite
●
Special
CASH DIVIDEND

• Cash dividend is that portion of profit which is

declared by the board of directors to be paid as
dividends to the shareholders of the company
in return to their investments done in the
company and then discharging such dividend
payment liability by paying cash or through
bank transfer.
BOND DIVIDEND

• Sometimes companies pay dividend in the form of debentures or

bonds or notes for a long term, yielding interest at fixed rate. The
bond dividends and dividend in scrips are similar, but the
difference is that Bond dividend carry longer maturity period and
bears interest. The main purpose of issuing bond dividend is to
postpone the payment of dividend. But it is not desirable as it
creates a liability to the company for a long period.
STOCK DIVIDEND

• Sometimes, company issues shares to its existing shareholders free

of cost rather than paying cash dividend. These free shares are
called bonus shares. They are termed as stock dividend in U.S.A.
Bonus shares are issued to existing shareholders in a fixed
proportion over their existing shareholdings. For example, if a
company declares 10% stock dividend, a shareholder having 100
shares will get 10 bonus shares as dividend and total number of
shares with him will become 110. Stock dividend decreases the
reserves of the company but increases the share capital of the
company.
BONUS ISSUE IN INDIA

• Companies in India can make a bonus issue subject to the following

provisions:-
1. Statutory restriction:
A company may issue fully paid-up bonus shares to its members, in any manner
whatsoever out of:
a) Its free reserves;
b) The security premium account; or
c) The capital redemption reserve account
Provided that no issue of bonus shares shall be made by capitalizing reserves
created by revaluation of assets.
CONTD.
2. No company shall capitalize its profit or reserves for the purpose of
issuing fully paid-up bonus shares under sub- sec (1),unless:
a) It is authorised by its articles;
b) It has, on the recommendation of the Board, been authorised in the
Generalised meeting of the company;
c) It has not defaulted in payment of interest or principal in respect of
fixed deposits or debt securities issued by it;
d) It has not defaulted in respect of the payment of statutory dues of the
employees, such as, contribution of provident fund, gratuity and bonus;
e) The party paid-up shares, if any outstanding on the date of allotment,
are made fully paid-up;
f) It complies with such conditions as may be prescribed.
COMPOSITE AND PROPERTY DIVIDEND

• Composite Dividend: When dividend is paid partly in the form of

cash and partly in other form, it is called as composite dividend.

• Property Dividend: A property dividend is a nonreciprocal transfer

of non monetary assets between an enterprise and its owner. It is
payable in form of assets other than cash. They may be in the
form of merchandise, real estate, or investments.
INTERIM, REGULAR AND SPECIAL DIVIDEND
Interim Dividend: Generally dividend is declared at the end of financial year,
but sometime company pays dividend before it declares divide in its annual
general meeting. In other words, we can say that it is dividend paid between
two annual general meetings.
Regular Dividend: Dividend declared in annual general meeting is called as
regular dividend. Every year company declares dividend in its annual general
meeting.
Special Dividend: A special dividend is a non-recurring distribution of company
assets, usually in the form of cash, to shareholders. A special dividend is
usually larger compared to normal dividends paid out by the company and
often tied to a specific event like an asset sale or other windfall event. Special
dividends are also referred to as extra dividends.
STOCK SPLIT

• A stock split is a corporate action in which a company divides its

existing shares into multiple shares to boost the liquidity of the
shares. Although the number of shares outstanding increases by a
specific multiple, the total value of the shares remains the same
compared to pre-split amounts, because the split does not add any
real value. The most common split ratios are 2-for-1 or 3-for-1,
which means that the stockholder will have two or three shares,
respectively, for every share held earlier.
KEY DIVIDEND DATES

1. Declaration Date: The declaration date is the date on which the

board of directors announces and approves the payment of a
dividend. The declaration includes the size of the dividend being
issued and outlines the record date and payment date.
2. Ex-Dividend Date: The ex-dividend date is the first day that a
stock trades without a dividend. The company does not set the ex-
dividend date – the ex-dividend date is set by the stock exchange
where the company’s stock is traded. The ex-dividend date typically
occurs up to three days before the record date. Purchasers of shares
on or after the ex-dividend date are not entitled to a dividend.
CONTD.

3. Record Date: The record date, also known as the date of record, is the
date on which the investor must be on the company’s books in order to
receive a dividend. It is the day on which eligible stockholders are
recognized.
4. Cum Dividend Date: Time period when dividend has been declared by
the firm but not paid. Stocks trade cum-dividend till the ex-dividend
date.
5. Payment Date: The date on which the dividend is paid to
shareholders. Dividend payments may be either mailed or
electronically transferred to the accounts of shareholders.
BUYBACK OF SHARES

• A buyback, also known as a share repurchase, is when a company

buys its own outstanding shares to reduce the number of shares
available on the open market. Companies buy back shares for a
number of reasons, such as to increase the value of remaining shares
available by reducing the supply or to prevent other shareholder. A
buyback allows companies to invest in themselves. Another reason
for a buyback is for Compensation purposes. Companies often award
their employees and management with stock rewards and stock
options. To offer rewards and options, companies buy back shares
and issue them to employees and management. This helps avoid
the dilution of existing shareholders from taking a  controlling stake.
METHODS OF SHARE BUYBACK

• BUYING FROM OPEN MARKET: In this method of share buyback, the company
buys its own stocks from the market. This transaction happens through
company’s brokers. The company has the option to cancel it.
• FIXED PRICE TENDER OFFER: In this method, the company makes an offer to
buy a fixed no. of share at a fixed price to its shareholders. The price
offered by the company is above the current market price.
• DUTCH AUCTION TENDER OFFER: This is very similar to fixed price tender
offer. Instead of specifying a fixed price, the company offers a range of
prices to the shareholders. The minimum price is above the current market
price.
• REPURCHASE BY DIRECT NEGOTIATION: In this method, the company
approaches only those shareholders who have a large
• block of shares. They are paid a premium above the current market price.
DIVIDEND DECISION MODEL’S

• A firm must decide whether to distribute all profits, retain them,

or distribute a portion and retain the balance. The dividend
decision models help a firm to make a profitable choice.
• Dividend decision consists of 2 important theories based on the
relationship between dividend decision and value of the firm:-

1. Relevance theory – Walter’s Model and Gordon’s Model

2. Irrelevance Theory – Modigliani and Miller’s Approach.
WALTER’S MODEL

• The Walter’s Model Theory of Dividend explains that the value of

an enterprise gets affected by the choices of the various dividend
policies. Walters’s model explains the relationship between ‘k’ the
cost of capital and ‘r’ the rate of return in finding out the
dividend policy and this maximizes the shareholder’s wealth.
• James.E.Walter believed that the dividend decision of the firm
always affects the market value of the firm.
Contd.
• Walter identified three kinds of firm:-
• 1. Growth Firms: (R>K): The firms having R>K may be referred to as growth firm. These
firms have investment opportunities and they can earn a return which is more than what
shareholders could earn on their own. So optimum payout ratio for growth firm is 0% .
• 2. Normal Firms (R = K): If R is equal to K the firm is known as a normal firm. These firms
do not have unlimited profitable investment opportunities and they can earn a rate of
return which is equal to that of shareholders. In this case dividend policy will not have
any influence on the price per share. So there is nothing like optimum payout ratio for a
normal firm. All the payout ratios are optimum.
• 3. Declining Firms (R<K): If the company has no profitable investment opportunities and
the company earns a return which is less than, what the shareholders can earn on their
investments, it is known as a declining firm. Here it should not make any sense to retain
the earnings. So entire earnings optimum payout ratio for declining firms is 100%. So
according to Walter, the optimum payout ratio is either 0% (when R>K) or 100% (when
R<K)
ASSUMPTIONS OF WALTER MODEL

A company finances all its investments only through its earning or better to say
retained earning. It indicates that there is no chance for new equity or debt.
The internal rate return of a firm or r and its capital’s cost k are constant.
All earnings are either reinvested internally or distributed as dividend
There is no change in key factors like EPS and DPS
The company has a very long and perpetual life.
 The market value of a share is affected by the present value of future
dividends.
Retained earnings in the business affect the expected future dividend and this,
in turn, affect the market value of a share.
FORMULA

P = D/k + {r*(E-D)/k}/k, 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
LIMITATIONS

• Walter’s model assumes that the firm’s investments are purely

financed by retained earnings. So this model would be applicable
only to all-equity firms.
• The assumption of r as constant is not realistic.
• The assumption of a constant ke ignores the effect of risk on the
value of the firm.
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.
• Gordon’s Model assumes that the investors are risk averse i.e. not
willing to take risks and prefers certain returns to uncertain
returns.
• It is also called as Bird-In-Hand theory, which states that a person
will prefer one bird which is already in his hand to 2 birds in the
bushes. The investors prefer current dividends to avoid risk; here
the risk is the possibility of not getting the returns from the
investments.
ASSUMPTIONS

The firm is an all equity firm.

The internal rate of return (r) of the firm is constant.
Corporate taxes does not exist
The cost of capital (K) of the firm remains constant.
Growth rate is constant .
Cost of capital is greater than growth rate.
FORMULA

Where,
P – Price of share
E – Earnings per share
b – Retention ratio
1-b – proportion of earnings distributed as dividend
K – capitalization rate or cost of capital
br – Growth rate.
CRITISISMS

1. 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.
2. 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.
3. 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.
MODIGLIANI AND MILLER’S MODEL

• Modigliani and Miller suggested that in a perfect world with no

taxes or bankruptcy cost, the dividend policy is irrelevant. They
proposed that the dividend policy of a company has no effect on
the stock price of a company or the company’s capital structure.
• Modigliani – Miller theory is a major proponent of ‘Dividend
Irrelevance notion. According to dividend irrelevance concept,
the dividend decision does not effect the value of the firm. It
states that the value of the firm depends on the earnings of the
firm, and not on how the earnings are distributed.
CONTD.

• MM theory argue that if a firm that has an investment opportunity

decides to distribute dividend and retained earnings are
insufficient to finance the investment, the firm will have to
borrow from outside sources; which in turn will lead to decrease in
the value of shares. Instead if the amount is retained by the firm,
the shareholders will have the benefit of capital appreciation.
ASSUMPTIONS

Taxes does not exist

It assumes that all the investors are rational and they have access
to free information.
There is no floating or transaction costs.
The company does not change its existing investment policy.
There is no risk of uncertainty.
FORMULA

P0 = (D + P1) / (1 + K)
Where
P0 – prevailing market price of the share
D – Dividend to be received
K – Cost of Equity share
P1 - market price at the end of the period.
Example

AB ltd. has 1000 share of Rs.100/- each. The company has a required
rate of return of 10%. The company declares Rs.20 dividend per share.
Here:
P0 – 100
D – 20
K- 10%
So P1 = 100 (1+.10) -20
= 90
 k Y o u
Th a n