Module IV : Dividend Decision

Weightage 15 Percent

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 Topics
• Introduction, Factors determining dividend policy,
• Types of dividends.
• Theories of Dividend Decisions-
❑MM Hypothesis,
❑Walter Model,
❑Gordon Model.
▪ Forms of Dividends- cash dividend, Bonus shares, stock split.
▪ Dividend policies in practice.

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 Dividend
Meaning Definition

It is that part of profits which is According to Companies Act 2013,

distributed to the shareholder Dividend is defined as, “the profit of the
company which is not retained in the
business and is distributed among the
shareholders in proportions to the
amount paid up on the shares held by
them”
 Cash A Cash dividend is the most common form of
Dividend the dividend. The shareholders are paid in cash
per share.

Scrip Scrip dividend is a promissory note to pay the

shareholders later.
Dividend
Bonus share is also called as the stock dividend.
Bonus Bonus shares are issued by the company when
Dividend they have low operating cash. In simple a stock
Dividend dividend is a payment to shareholders that is
made in shares rather than in cash

The company makes the payment in the form of

Property assets in the property dividend.

When the company returns the original capital

Liquidating contributed by the equity shareholders as a
dividend, it is termed as liquidating dividend.
Under this type of Under this type of dividend Under this type of Under this type of policy, the
dividend policy, the policy, the company dividend policy company company follows the
company follows the follows the procedure to states that it has no procedure of paying no
procedure to pay out a pay out a defined fixed obligation in respect of dividend to the shareholders
dividend to its percentage of profits as paying a dividend to the irrespective of its profit or
shareholders every year dividends every year shareholders. loss.
The Value of the firm is maximized by maximizing the wealth of the share holders. There are
conflicting views regarding the impact of dividend declaration on the Valuation of the Firm. There
are two school of thoughts regarding Dividend declaration and its impact on the Value of the firm

Theories of
Dividend

Irrelevance Relevance
Approach Approach

Residual MM Walter’s Gordon’s

Theory Theory Model Model
 IRRELEVANCE THEORY

Residual Theory MM Theory

According to this theory, Dividend According to this theory the dividend policy has no effect on the
decision has no impact on the Wealth of Market price of the share and the value of the firm is determine
the shareholder or the market price of the by the earning Capacity of the firm or its investment policy. The
share and hence it Is irrelevant so far, the division of the earning between retention and dividend may be
valuation of the firm is concerned. in any manner, it will have no impact on the value of the firm
This theory regards dividend decision ASSUMPTIONS
merely a part of the financing decision a.There is perfect capital market
because the earnings available may be b.Investors behave rationally
retained in the business for the c.Information about the company is available to all without any
reinvestment. But if the funds are not cost
required in the business, it may be d.There is no flotation and transaction cost
distributed as dividend. Thus, the decision e.There are either no taxes or no difference in tax rates
to pay dividend or retained the earnings applicable to dividend &capital gain
may be taken as a residual decision. f. The firm has a rigid investment policy
 P1 = P0 (1+ke) – D1 Argument
The argument given by MM is that what ever increase in
P1 is price at the end of the period the value of the firm result from the payment of the
P0 is price at the beginning of the period dividend, will be exactly off set by the decline in the
D1 is Dividend Market price of the shares because of the external
financing and there will be no Change in the total wealth
[ I – (E –nD1)] of the shareholder. e.g.
m=
P1

m is the number of shares to be issued Question 1

I is the investment The cost of capital of R ltd is 10%. It currently has
E is the earning outstanding 5000 shares Selling price is Rs.100. each. The
D1 is the dividend firm is contemplating the declaration of dividend of Rs.6
n is the no of outstanding shares at the per share at the end of the current financial year. The
beginning of the period company expects Rs 50000 earnings and has a proposal
for making new investment of Rs.100000 Prove under
(n+m)P1 – (I− E) MM Hypothesis that payment of dividend does not have
np=
1+Ke
impact on the Value of the Firm
np is the value of the firm
 Walter ‘s approach
According to Prof. Walter dividend decision is
relevant and do have impact on the Value of the
Firm.
The relationship between internal rate of return (r)
and cost of capital (k) is very Significant in
determining the dividend policy to achieve the P is the market price of the share
ultimate goal of Maximizing the wealth of the Ke is the cost of Capital or Equity Capitalization rate
shareholder D is the Dividend
If r > k 100% retention E is the Earnings
If r< k 100% payout. r is the internal rate of return
Assumptions Example: Cost of capital is 10%
a. The investments of the firm are financed through Earning per share is Rs.50
the retained earnings and the firm does not use Assume Rate of return
external sources of funds i. 12% , ii. 8%, iii. 10%
b. The internal rate of return and the cost of capital Show the effect of dividend policy on the market price of
of the firm are constant the share using Walter
Model when dividend payout are as follows
c. The life of the firm is infinite
i. 20%, ii. 50%, iii. 70%, iv 100%
 Gordon Model

Gordon has also developed a model on the lines of

P = E(1-b)/ Ke – br
Prof. Walter suggesting that Dividends are relevant, E is the earnings
and it do affect the value of the firm. b is the Retention
The theory is based on the following assumptions r is the rate of return
a. The firm is all equity firm Ke is the cost of capital
b. No external financing is available or used. RE is e.g.
the only source of financing new investments Rate of return on investment (r)
c. The rate of return on the firm's investment is i. 15% ii. 12% iii. 10%
constant Cost of Capital (k) 12%
Earning per share Rs.10
d. The retention ratio once decided upon will remain
Determine the Market value of the firm using
constant
Gordon Model
e. The firm has perpetual life If Dividend payout ratio is
f. Corporate taxes do not exist. i. 30%
ii. 50%
iii. 80%
Gordon’s model believes that the dividend policy impacts the company in various scenarios as follows:
Growth Firm: A growth firm’s internal rate of return (r) > cost of capital (k). It benefits the shareholders more
if the company reinvests the dividends rather than distributing it. So, the optimum payout ratio for growth
firms is zero.
Normal Firm: A normal firm’s internal rate of return (r) = cost of the capital (k). So, it does not make any
difference if the company reinvested the dividends or distributed to its shareholders. So, there is no optimum
dividend payout ratio for normal firms.
However, Gordon revised this theory later and stated that the dividend policy of the firm impacts the market
value even when r=k. Investors will always prefer a share where more current dividends are paid.
Declining Firm: The internal rate of return (r) < cost of the capital (k) in the declining firms. The shareholders
are benefitted more if the dividends are distributed rather than reinvested. So, the optimum dividend payout
ratio for declining firms is 100%.
Question 2
Rara Ltd has a cost of equity capital of 10% and the current value of the firm is ₹2000000 (@₹20 per
share)
Assume that the new Investment requirement is ₹680000, and the Earning of the firm is assumed to ₹
150000.
The company is required to pay Dividend of ₹1 per share.
Show under MM hypothesis that the payment of dividend and non-payment of dividend does not
affects the value of the firm.

Question 3
(i)The Apex company has earned ₹5 per share and the has a capitalization rate of 10% with Rate of
return of 12%. Using Walter Model determine the optimum pay-out and price of the shares at this
pay-out.
(ii)Assume that the shares of these companies are trading at ₹100, and the firm is contemplating the
declaration of ₹5 as dividend at the end of the year. What will be the price of share at the end of the year if (i)
dividend is declared (ii) dividend is not declared. (Using MM approach answer the question).
Question 4. Omega earns ₹5 per share and the Capitalization rate is 10% and Rate of Return
on Investment is 18%. According to Walter model what will be the price at 25% pay-out? Do
you think the pay-out is optimum?

Question 5. From the Following information determine the Market Value of the Share of the
company using Walter Model. Further is the payout optimal? If not, then what is optimal
payout, calculate market price at optimal payout.
The Earnings of the Company ₹500000.
Dividend Paid ₹300000
Number of shares outstanding 100000
P/E Ratio is 8
Rate of Return on Investment 15%
Question 6.Using the following information
(i) ascertain whether the Firms Payout is optimal or not according to Walter Model.
(ii) Calculate the Market Price of Share at optimal Payout.
(iii)What should be the P/E Ratio at which Dividend payout has no impact on the value of the share.
(iv)Will your decision change regarding the optimum payout if P/E Ratio changes to 8 instead of 12.5
The firm started a year ago with an equity capital of ₹20 lakhs.
Earnings of the Firms ₹2,00,000
Number of share outstanding is 20,000 @100 each
Dividend paid is ₹1,50,000
P/E Ratio is 12.5

Question7. According to Gordon Model what rate of return should be earned on the
investment to ensure that the market price of share is Rs 50 when dividend payout ratio is 40
percent. Earnings per Share Rs 5, The rate of Return required by shareholders is 16 percent.
(ii) If the dividend payout is 50 percent, then what rate of return is required by shareholders.
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Question 8
For each of the companies describe below, would you expect it to have a medium/high or a
low dividend payout ratio? Explain why?
• A company with a large proportion of inside ownership, all of whom are high income
individual
• A growth company with an abundance of good investment opportunities
• A company experiencing ordinary growth that has liquidity and much unused borrowing
capacity
• A dividend paying company that experiences an unexpected drop in earnings from a trend
• A company with volatile earnings and high business risk
Question 9. XYZ company expects with some degree of certainty to generate the following
profits and to have the following capital investment during the next five years.

Year 1 2 3 4 5
Net Income 50,00,000 40,00,000 25,00,000 20,00,000 15,00,000
Investment 20,00,000 2,500,000 32,00,000 40,00,000 50,00,000

The company currently has 10,00,000 shares of equity and pays dividends of Rs 5 per share.
(i) Determine dividends per share if dividend policy is treated as a residual decision
(ii) Determine dividends per share and the amounts of the external financing that will be necessary if a
dividend payout ratio of 50% is maintained.

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