Dividend Policy

Background
Dividend policy means
What proportion of earnings are retained by the business, and What proportion is paid out as dividend to investors

Capital budgeting and dividend policy

If capital budgeting and dividend policy are independent, then
Higher dividend pay out will mean higher dependence on external financing

If capital budgeting and dividend policy are dependent on each other, then
Higher dividend will cause shrinkage of capital budget

Various approaches to look at dividend policy

1. Traditional approach 2. Walter model 3. Gordon model 4. Miller and Modigliani position

Traditional approach
As per this approach, market gives more weight to dividend than retained earnings As per this approach P = m (D + E/3)
P market price per share, D- Dividend per share , E Earning per share, M a multiplier

P = m ( D + (D+R)/3) = m4D/3 + m R/3

Illustration of traditional approach

Walter model
It states that
Dividend policy has bearing on share valuation

Assumptions
Retained earnings are only source of financing for a firm Cost of capital and RoI of firm remain constant

Price per share = P = (D + ((E-D) r/k)) *1/k

P- price per share, D- Dividend per share, E- earnings per share, (ED) retained earnings per share, r RoI, k Cost of Capital

Illustration of Walter model

Implications of Walter model

When return is greater than cost of capital, (r>k) price of share increases , as dividend pay out decreases
Hence, optimal pay out ratio for growing firm should be nil

When r = k, price per share does not vary with change in dividend pay out ratio
Hence, Pay out ratio for a normal firm is irrelevant

When r< k , then price per share increases as dividend pay out ratio increases
Hence, Optimal Payout ratio for a declining firm is 100 %

Gordon Model
Gordons basic valuation formula
P0

Y0 (1-b)/ (k-br)

P0 -Price per share at the beginning of the year

Y0 - EPS at the end of the year B - retained earning ( 1-b) dividend k- rate of return required by shareholders r RoI br - growth rate of earnings and dividends

Gordon Model
Implications of Gordon model are similar to Walter model Do it as home work

Miller and Modigliani position

Dividend irrelevance theorem Assumptions of M & M model
Markets are perfect Investors are rational Floatation costs are nil There are no taxes

Dividend irrelevance theorem

If company retains earnings, instead of giving as dividend
Shareholder benefits by way of capital appreciation

If company gives dividend,

shareholder benefits by way of dividend in his hands

Hence, it does not matter whether earnings are retained or distributed

What matters is level of earnings

Criticism of M & M model

Dividends paid by the company tell investors Information about the prospect of the company Not all investors want current income Issue cost Transaction cost Different rates of taxes