DIVIDEND DECISION

DIVIDENDS

DIVIDEND refers to that portion of a firms net earnings which are paid out to the share holders.

Dividend payout ratio

Retention ratio

Larger retentions, lesser dividends; smaller retention, larger dividends.

The management has to choose between distributing the profit to the share holders and ploughing back them into the business.

Dividend decision
Amount distributed among shareholders Amount of earnings to be retained

Maximization of present value (value of the firm)

There are conflicting opinions regarding the impact of dividends on the valuation of a firm.
According to one school of thought , dividends are irrelevant .so that the amount of dividends paid has no effect on the valuation of a firm.

On the other hand certain theory consider the dividend decision as relevant to the value of the firm measured in terms of the market price of the shares.

Relevance of dividend

Irrelevance of dividends

Relevance of dividend

There are some theories which consider dividend decisions to be an active variable in determining the value o a firm. The divined decision is therefore relevant.

Walters model Gordons model

Walters model supports the doctrine that dividends are relevant. The investment policy of the firm cannot be separated from its dividend policy and both are according to Walter, interlinked. The choice of an appropriate dividend policy affect the value of the firm .

The key argument in support of the relevance proposition of Walter's model is the relationship between the return on firms investment or its internal rate of return(r) and its cost of capital or required rate of return.

A firm will have an optimum dividend policy which will be determined by the relationship of r and k.

In other words, if the return on investment exceeds the cost of capital, the firm should retain the earnings, whereas it should distribute the earnings to the shareholders in case the required Rate of return exceeds the expected return on the firms investments.

The rationale is that if r>k the firm is able to earn more than what shareholders could by reinvesting, If the earnings are paid to them. The implication of r<k that shareholders can earn a higher return by investing elsewhere.

Walters model, thus relates the distribution of dividends to available investment opportunities .

If the firm has adequate profitable investment opportunities it will be able to earn more than what the investors expect. Such firms are known and growth firms. For the growth firms, the optimum dividend policy would be given by a D/P ratio of zero.

That is to say, they should plough back the earnings within the firm. the market value of the shares will be maximized as a result. In contrast, if a firm does not have profitable investment opportunities (when r<k), the shareholders will be better off if earnings are paid out to them so as to enable them to earn a higher return by using the funds elsewhere.

In such a case the market price of shares will be maximized by the distribution of the entire earnings as dividends. The D/P ratio of 100 would give an optimum dividends policy.

Finally when r=k (normal firm)it is a matter o indifference where earnings are retained or distributed. This is so because for all D/P ratio the market price of shares will remain constant. For such firms thee is no optimum dividend policy.

Assumptions

All financing is done through retained earnings; external sources of funds like debt or new equity capital are not used.

With additional investments undertaken, the firms business risk does not change. It implies that r and k are constant.

There is no change in the key variables, namely, beginning EPS(E) and dividend per share(D). E and D will be changed in the model to determine results.

The firm has perpetual life

equation
P= D+r/ke(E-D) ke

P=prevailing market price of a share D=Dividend per share E=Earnings per share

Irrelevance of dividends

The crux of the argument supporting the irrelevance of dividend to the valuation is that dividend policy of a firm is a part of financing decision. As a part of the financing decision, the dividend policy of the firm is a residual decision and dividends are passive residual.

Modigliani and Miller (MM) Hypothesis

The most comprehensive argument in support of the irrelevance of dividends is provided by the MM hypothesis. Modigliani and Miller maintain that dividend policy has no effect on the share price of the firm and is, therefore, of no consequence. Dividend Irrelevance Dividend irrelevance implies that the value of a firm is unaffected by the distribution of dividends and is determined solely by the earning power and risk of its assets.

Assumptions The MM hypothesis of irrelevance of dividends is based on the following critical assumptions: Perfect capital markets in which all investors are rational. There are no taxes. Alternatively, there are no differences in tax rates applicable to capital gains and dividends. A firm has a given investment policy which does not change. There is a perfect certainty by every investor as to future investments and profits of the firm.

Crux of the Argument The crux of the MM position on the irrelevance of dividend is the arbitrage argument. The arbitrage process involves a switching and balancing operation. In other words, arbitrage refers to entering simultaneously into two transactions which exactly balance or completely offset each other. The two transactions here are the acts of paying out dividends and raising external fundseither through the sale of new shares or raising additional loansto finance investment programmes.

Proof: MM provide the proof in support of their argument in the following manner. Step 1: The market price of a share in the beginning of the period is equal to the present value of dividends paid at the end of the period plus the market price of share at the end of the period. Symbolically, P0=(1/1+ke)(D1+P1) P0=prevailing market price of a share Ke=cost of equity capital D1=dividend to be received at the end of period 1 P1=market price of a share at the end o period of 1

Step 2: Assuming no external financing, the total capitalized value of the firm would be simply the number of shares (n) times the price of each share (P0). Thus, nP0=(1/1+ke)(nD1+nP1) n=number of shares

Step 3: If the firms internal sources of financing its investment opportunities fall short of the funds required, and n is the number of new shares issued at the end of year 1 at price of P1, Eq. 2 can be written as: nP0=(1/1+ke)[(nD1+(n+ n)P- nP1)]

where

n = Number of shares outstanding at the beginning of the period n = Change in the number period/Additional shares issued of shares outstanding during the

Equation 3 implies that the total value of the firm is the capitalised value of the dividends to be received during the period plus the value of the number of shares outstanding at the end of the period, considering new shares, less the value of the new shares. Thus, in effect, Eq. 3 is equivalent to Eq. 2.

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Step 4: If the firm were to finance all investment proposals, the total amount raised through new shares issued would be given in Eq. 4. or
nP1 nP1 = I (E nD1) = I E + nD1

(4)

where nP1 = Amount obtained from the sale of new shares of finance capital budget. I E nD1 = Total amount/requirement of capital budget = Earnings of the firm during the period = Total dividends paid

(E nD1) = Retained earnings According to Equation 4, whatever investment needs (I) are not financed by retained earnings, must be financed through the sale of additional equity shares.

Step 5: If we substitute Eq. 4 into Eq. 3 we derive Eq. 5.

nP0=(n+ n)P1-I+E)/(1+ke)

Step 6: Conclusion Since dividends (D) are not found in Eq. 6, Modigliani and Miller conclude that dividends do not count and that dividend policy has no effect on the share price.
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Dividend policy

Refers to the policy chalked out by companies regarding the amount it would pay to their shareholders as dividend.

Legal aspects of dividend policy

It is necessary for a company to declare and pay dividend only out of profits for that year arrived at after providing for depreciation in accordance with the provisions of section 205(2) of the act.

A dividend could be declared out of profits of the company for any previous financial year or years arrived after providing for depreciation in accordance with those provisions and remaining undistributed.

The dividend can also be declared out of moneys provided by the central govt. or a state govt. for the payment of dividend in pursuance of guarantee given by that govt. The company is required to transfer to the reserves such percentage of its profits for that year not exceeding 10% in addition to providing for depreciation as required under section 205(2A) of the Act.

Unpaid dividend to be transferred to special dividend account:

Dividends are to be paid within 30 days from the date of the declaration If they are not paid the company is required to transfer the unpaid dividend to unpaid account within 7 days of the expiry of the period of 30 days.

The company is required to open this account in any scheduled bank as required under section 205-A of the Companies Act, 1956

Dividend is to be paid only to registered shareholders or to their order or their bankers