FINANCIAL MANAGEMENT MODULE-VI DIVIDEND DECESIONS

PRIYANKA SAXENA

DIVIDEND DECISIONS An Introduction

Meaning of dividend- Dividend is a part of retained earning which is distributed among the shareholders on equity / Pref. shares ,they hold Meaning of dividend policy A question in front of management is either to retain the profit or to distribute it with an objective to maximize shareholders wealth. A dividend policy is such which explains how much is to be paid and how much is to be retained

OBJECTIVES OF DIVIDEND POLICY

1- Firms need for funds. 2- Shareholders need for income. 3- Firms investment opportunities and financial needs. 4- Shareholders expectations.

STABILITY OF DIVIDENDS
It is considered a desirable policy . It means regularity in paying some dividend annually .Three forms of stability may be distinguished 1. Constant dividend per share 2. Constant Dividend payout ratio 3. Constant dividend per share plus extra dividend

CONSTANT DIVIDEND PER SHARE PLUS EXTRA

DIVIDEND

This policy is desirable where earnings are fluctuating . Merits of stability of dividends 1. Resolution of investors uncertainty 2. Investors desire for current income 3. Raising additional finance

FORMS OF DIVIDENDS
Cash dividends Bonus Shares

Bonus Shares vs. Share split

Buy Back of Shares-

DIVIDEND THEORIES

1. 2.

On the relationship between dividend policy and value of firm, different theories have been advanced .these theories can be grouped into two categories Theories that consider dividend decisions to be relevant Theories that consider dividend decisions to be irrelevant

DIVIDEND RELEVANCE WALTERS MODEL

1. 2. 3.

4.
5.

Prof. James. E. Walter argues that the choice of dividend policy always affects the value of firm. It is based on following assumptionsInternal Financing Constant return and cost of capital 100% payout or retention Constant EPS and DIV Infinite time

 Walters

formula to determine the market price per share is as followsp= DIV/k + r(EPS-DIV)/k/k
P=Market price per share DIV= Dividend per share EPS=Earning per share r = Firms rate of return k- Firms cost of capital or capitalization rate

DIVIDEND POLICY : APPLICATION OF WALTERS' MODEL

There are three type of firms as per this model

Growth Firms -Internal rate more than opportunity cost of capital (r>k) Normal Firms Internal rate equals opportunity Cost of capital (r=k) Declining Firms- Internal rate less than opportunity cost of capital ( r<k)

CRITICISM OF WALTERS' MODEL

No external Financing Constant return ,r Constant opportunity cost of capital ,k

GORDONS MODEL

1. 2. 3. 4. 5.

6.
7. 8.

Myron Gordon develops one very popular model explicitly relating to the market value of the firm to dividend policy. This model is based on following assumptionsAll equity firm No external financing Constant return Constant cost of capital Perpetual earning No taxes Constant Retention Cost of capital greater than growth rate

 According

to the Gordons model , the market value of a share is equal to the present value of an infinite stream of dividend received by the shareholders . Thus the formula is Po= DIV1 / k-g or Po= EPS1(1-b)/ k-br EPS1= Earning per share k =cost of capital r= rate of return b= retention ratio g= br = growth rate

APPLICATION OF GORDONS DIVIDEND MODEL

The implication of the dividend policy as per Gordon's model are as follows for normal, growth and declining firms The market value of share ,Po increases with the retention ratio ,b, for the firms with growth opportunities i.e. r>k The market value of the share , Po , increases with the payout ratio, (1-b), for declining firms i.e. r< k The market value of the share is not affected by dividend policy when r=k

DIVIDEND IRRELEVANCE MM HYPOTHESIS

According to Modigliani and Miller, under a perfect market situation, the dividend policy of the firm is irrelevant, as it doesnt affect the value of the firm . Thus, when the investment decisions are given , dividend decisions are of no significance in determining the value of the firm . A firm may face the following 3 situations regarding the payment of dividends The firm has the sufficient cash to pay dividends The firm doesnt have sufficient cash to pay dividends , therefore it issues new shares to finance the payment s of dividend The firm doesnt pay the dividend s, but a shareholder needs cash .

In

the first situation when the firm pays the dividends, shareholders get cash in their hands, but the firms assets reduce. What shareholders gain in the form of cash dividends, they lose in the form of their claims on the assets. There is no net gain or loss. Since it is a fair transaction under perfect capital market conditions, the value of the firm will remain unaffected. In the second situation, when the firm issues new shares to finance the payment of dividends, two transactions take place. First, the existing shareholders get cash in the form of dividends

ASSUMPTIONS OF THIS THEORY

Perfect

capital market No taxes Investment policies No risk

Under the MM theory , r will be equal to k , and identical for all the shares . As a result , the prices of each share must adjust so that the rate of return and the capital gains will be equal to k on each share.

Thus the minimum rate of return may be calculated as follows -r = Dividends+ capital gains /Share price Or r= DIV+(P1-Po)/ Po

RELEVANCE OF THE DIVIDEND POLICY UNDER MARKET IMPERFECTIONSThe MM theory on simplifying assumption. But these assumption may not be found valid under in practiced . The following are the situations where MM hypothesis may go wrong Uncertainty and shareholders preference Transaction cost and case against the dividend payments Tax differentials Informational content of dividends

BY:-

PRIYANKA

SAXENA
20