4. WHAT IS DIVIDEND ?
Payments made to stockholders from the firm’s earnings,
whether those earnings were generated in the current
period or in previous periods.
Portion of profit (after tax) distributed among owners/
shareholders of the firm.
May be distributed in form of cash, scrip, property
dividend or bonus shares.
5. DIVIDEND DECISION
One of the three basic decisions of a financial manager,
the other two being investment decision and financing
decision.
Decision as to whether the firm’s profits should be paid
as dividend or retained and in what amount.
Objective : Maximize wealth of shareholders,
Increase the goodwill of the firm,
Satisfy the obligations to shareholders.
7. TYPES OF THEORIES
DIVIDEND THEORIES
RELEVANCE THEORY IRRELEVANCE THEORY
MODIGILANI
WALTER’S GORDON’S RESIDUAL
AND MILLER
MODEL MODEL MODEL
MODEL
8. RELEVANCE THEORY
Dividend policy is very essential for any business firm
as it affects the overall value of the firm.
Dividend policy is relevant & dividend decision form a
very integral part of the investment and financing
decision of the firm.
Shareholders prefer current dividends & hence there
is a direct relationships between the dividend policy
& the market value of the firm
9. WALTER MODEL
Dividend policy affects the value of the firm.
Together, the cost of capital (k) and rate of return (r)
determine the dividend policy that will maximize the
shareholders wealth.
COST
OF
CAPITAL
(k)
VALUE OF DIVIDEND
THE FIRM POLICY
RATE OF
RETURN
(r)
10. WALTER MODEL -- assumption
The firm finances all investment through retained
earnings while debt and new equity is not used.
Business risk remains constant i.e., r & k are also
constant.
The firm has infinite life.
The firm either goes for a 100 % pay-out or a 100 %
retention.
11. WALTER MODEL -- decisions
CONDITION
r>k r<k r =k
EVALUATION
TYPE OF FIRM Growth firm Declining firm Normal firm
PAY-OUT RATIO Zero 100 % Indifferent
INVESTMENT
OPPORTUNITIES Abundant None / very few Optimal
Company Company should Dividend does
DECISION should retain all distribute all not affect
earnings for earnings in the market price
investment form dividends of share
12. WALTER MODEL -- criticisms
It ignores the benefit of optimal capital structure.
Assumption that ‘K’ remains constant does not hold
good in practice.
It ignores that market price is affected by many factors.
13. GORDON’S MODEL
Also known as the ‘bird in hand argument.
Dividend policy is relevant as the investors prefer
current dividends as against the future uncertain
capital gains.
Investors discount the firm’s earnings at lower rate
when they are certain about returns, placing a higher
value for the share and that of the firm.
14. GORDON’S MODEL - assumptions
No external financing is available.
Corporate tax does not exist.
The firm has infinite life.
Investors are basically risk-averse.
The growth rate of firm ‘g’ is the product of its retention
ratio ‘b’ and its rate of return ‘r’ i.e., g = br.
The cost of capital is constant and also more than
growth rate, i.e., k > g.
15. GORDON’S MODEL -- decisions
If r > k > g :- Company should distribute less dividend
and retain high profit.
If r < k :- Company should distribute more profits as
dividend.
If r = k :- Pay-out ratio is not effected by retention ratio.
16. IRRELEVANCE THEORY
Dividend policy is irrelevant to maximizing the
shareholders wealth.
Value of the firm is affected by the earning capacity
of the firm i.e., investment policy and not the dividend
policy.
Whether the firm retains its earnings or pays dividend,
the market price of the share is indifferent towards it.
17. MODIGILANI & MILLER
MODEL -- concept
Crux of MM position is arbitrage argument. Arbitrage is
entering simultaneously in two transactions which
balance each other.
Between dividend and retention of earnings the investors
would be indifferent due to balancing nature of internal
financing and external financing.
So, the firm is indifferent towards the dividend decision.
18. MODIGILANI & MILLER
MODEL
Modigilani and Miller were two staunch supporters
of the irrelevance concept.
The value of the firm is not affected by the decision
of pay-out or plough-back.
Firm’s dividend policy have no influence on the market
prices of the shares.
19. M-M MODEL -- assumptions
Perfect capital market.
Investors behave rationally.
There are no taxes.
No floating cost on issue of shares.
20. M-M MODEL -- criticisms
It is wrong to assume that there are no taxes, floating
costs do not exist and there is absence of transaction
costs.
The perfect capital market condition is not always true.
