Dividend and retention policy By Dr Manish Dadhich

Dividend and retention policy By : Dr. Manish Dadhich

Introduction : • What is Dividend? • What is dividend policy? • Theories of Dividend Policy – Relevant Theory • Walter’s Model • Gordon’s Model – Irrelevant Theory • M-M’s Approach • Traditional Approach

What is Dividend? “A dividend is a distribution to shareholders out of profit or reserve available for this purpose”. - Institute of Chartered Accountants of India

Forms/Types of Dividend • On the basis of Types of Share – Equity Dividend – Preference Dividend • On the basis of Mode of Payment – Cash Dividend – Stock Dividend – Bond Dividend – Property Dividend – Composite Dividend

Contd. • On the basis of Time of Payment – Interim Dividend – Regular Dividend – Special Dividend

What is Dividend Policy : • “ Dividend policy determines the division of earnings between payments to shareholders and retained earnings”. - Weston and Bringham

Contd. Dividend Policies involve the decisions, whether- – To retain earnings for capital investment and other purposes; or – To distribute earnings in the form of dividend among shareholders; or – To retain some earning and to distribute remaining earnings to shareholders.

Factors Affecting Dividend Policy • • Legal Restrictions Magnitude and trend of earnings Desire and type of Shareholders Nature of Industry Age of the company Future Financial Requirements Taxation Policy Stage of Business cycle

Contd. • Regularity • Requirements of Institutional Investors

Dimensions of Dividend Policy • Pay-out Ratio – Funds requirement – Liquidity – Access to external sources of financing – Shareholder preference – Difference in the cost of External Equity and Retained Earnings – Control – Taxes

Contd. • Stability – Stable dividend payout Ratio – Stable Dividends or Steadily changing Dividends

Types of Dividend Policy • Regular Dividend Policy • Stable Dividend Policy – Constant dividend per share – Constant pay out ratio – Stable rupee dividend + extra dividend • Irregular Dividend Policy

DIVIDEND THEORIES

Dividend Theories Relevance Theories Irrelevance Theories (i. e. which consider dividend decision to be relevant as it affects the value of the firm) (i. e. which consider dividend decision to be irrelevant as it does not affects the value of the firm) Walter’s Model Gordon’s Model Modigliani and Miller’s Model Traditional Approach

Relevance Theories

Walter’s Model • Prof. James E Walter argued that in the longrun the share prices reflect only the present value of expected dividends. Retentions influence stock price only through their effect on future dividends. Walter has formulated this and used the dividend to optimize the wealth of the equity shareholders.

• Assumptions of Walter’s Model: – Internal Financing – constant Return in Cost of Capital – 100% payout or Retention – Constant EPS and DPS – Infinite time

Formula of Walter’s Model P Where, P E D (E-D) r k = D + r (E-D) k k = Current Market Price of equity share = Earning per share = Dividend per share = Retained earning per share = Rate of Return on firm’s investment or Internal Rate of Return = Cost of Equity Capital

Illustration : • Growth Firm (r > k): r = 20% k = 15% E = Rs. 4 If D = Rs. 4 P = 4+(0) 0. 20 /0. 15 = Rs. 26. 67 0. 15 If D = Rs. 2 P = 2+(2) 0. 20 / 0. 15 = Rs. 31. 11 0. 15

Illustration : • Normal Firm (r = k): r = 15% k = 15% E = Rs. 4 If D = Rs. 4 P = 4+(0) 0. 15 / 0. 15 = Rs. 26. 67 0. 15 If D = Rs. 2 P = 2+(2) 0. 15 / 0. 15 = Rs. 26. 67 0. 15

Illustration : • Declining Firm (r < k): r = 10% k = 15% E = Rs. 4 If D = Rs. 4 P = 4+(0) 0. 10 / 0. 15 = Rs. 26. 67 0. 15 If D = Rs. 2 P = 2+(2) 0. 10 / 0. 15 = Rs. 22 0. 15

Effect of Dividend Policy on Value of Share Case If Dividend Payout ratio Increases If Dividend Payout Ratio decreases 1. In case of Growing firm i. e. where r > k 2. In case of Declining firm i. e. where r < k Market Value of Share decreases Market Value of a share increases Market Value of Share increases Market Value of share decreases 3. In case of normal No change in value firm i. e. where r = k of Share No change in value of Share

Criticisms of Walter’s Model • No External Financing • Firm’s internal rate of return does not always remain constant. In fact, r decreases as more and more investment in made. • Firm’s cost of capital does not always remain constant. In fact, k changes directly with the firm’s risk.

Gordon’s Model According to Prof. Gordon, Dividend Policy almost always affects the value of the firm. He Showed how dividend policy can be used to maximize the wealth of the shareholders. q The main proposition of the model is that the value of a share reflects the value of the future dividends accruing to that share. Hence, the dividend payment and its growth are relevant in valuation of shares. q The model holds that the share’s market price is equal to the sum of share’s discounted future dividend payment. q

• Assumptions: – All equity firm – No external Financing – Constant Returns – Constant Cost of Capital – Perpetual Earnings – No taxes – Constant Retention – Cost of Capital is greater then growth rate (k>br=g)

Formula of Gordon’s Model P = E (1 – b) K - br • Where, P = Price E = Earning per Share b = Retention Ratio k = Cost of Capital br = g = Growth Rate

Illustration : • Growth Firm (r > k): r = 20% k = 15% E = Rs. 4 If b = 0. 25 P 0 = (0. 75) 4 0. 15 - (0. 25)(0. 20) If b = 0. 50 P 0 = (0. 50) 4 0. 15 - (0. 5)(0. 20) = Rs. 30 = Rs. 40

Illustration : • Normal Firm (r = k): r = 15% k = 15% E = Rs. 4 If b = 0. 25 P 0 = (0. 75) 4 0. 15 - (0. 25)(0. 15) If b = 0. 50 P 0 = (0. 50) 4 0. 15 - (0. 5)(0. 15) = Rs. 26. 67

Illustration : • Declining Firm (r < k): r = 10% k = 15% E = Rs. 4 If b = 0. 25 P 0 = (0. 75) 4 0. 15 - (0. 25)(0. 10) If b = 0. 50 P 0 = (0. 50) 4 0. 15 - (0. 5)(0. 10) = Rs. 24 = Rs. 20

Criticisms of Gordon’s model • As the assumptions of Walter’s Model and Gordon’s Model are same so the Gordon’s model suffers from the same limitations as the Walter’s Model.

• Irrelevance Theories

Modigliani & Miller’s Irrelevance Model Value of Firm (i. e. Wealth of Shareholders) Depends on Firm’s Earnings Depends on Firm’s Investment Policy and not on dividend policy

Modigliani and Miller’s Approach • Assumption – Capital Markets are Perfect and people are Rational – No taxes – Floating Costs are nil – Investment opportunities and future profits of firms are known with certainty (This assumption was dropped later) – Investment and Dividend Decisions are independent

M-M’s Argument • If a company retains earnings instead of giving it out as dividends, the shareholder enjoy capital appreciation equal to the amount of earnings retained. • If it distributes earnings by the way of dividends instead of retaining it, shareholder enjoys dividends equal in value to the amount by which his capital would have appreciated had the company chosen to retain its earning.

• Hence, the division of earnings between dividends and retained earnings is IRRELEVANT from the point of view of shareholders.

Formula of M-M’s Approach Po = 1 ( D 1+P 1 ) (1 + p) Where, Po = Market price per share at time 0, D 1 = Dividend per share at time 1, P 1 = Market price of share at time 1

n. P o = 1 (n. D 1+n. P 1) (1 + p) • The expression of the outstanding equity shares of the firm at time 0 is obtained as: n. P o = 1 {n. D 1+(n + m)P 1 - m. P 1} (1 + p)

m. P 1 = I – (X – n. D 1) Where, X = Total net profit of the firm for year 1 n. P o = 1 [n. D 1+ (n + m)P 1– {I – (X – n. D 1)}] (1 + p) = 1 n. D 1+ (n + m)P 1– I +X – n. D 1 (1 + p)

n. P o = 1 (1 + p) (n + m)P 1– I +X

Criticism of M-M Model No perfect Capital Market Existence of Transaction Cost Existence of Floatation Cost Lack of Relevant Information Differential rates of Taxes No fixed investment Policy Investor’s desire to obtain current income

Traditional Approach • This theory regards dividend decision merely as a part of financing decision because – The earnings available may be retained in the business for re-investment – Or if the funds are not required in the business they may be distributed as dividends. • Thus the decision to pay the dividends or retain the earnings may be taken as a residual decision

• This theory assumes that the investors do not differentiate between dividends and retentions by the firm • Thus, a firm should retain the earnings if it has profitable investment opportunities otherwise it should pay as dividends.

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