Bernard Mnzava (PhD)

Senior Lecturer
Office Location: Block D,
Room No. 008A
DIVIDEND AND DIVIDEND POLICY
Outline
:
 What is Dividend?
 What is dividend policy?

 Theories of Dividend Policy

 Relevant Theory
 Walter’s Model
 Gordon’s Model

 Irrelevant Theory
 M-M’s Approach
 Traditional
Approach
 What is Dividend?
• A dividend is a distribution of a portion of
company’s earnings, decided by board of
directors, paid to a class of its shareholders.
• Dividends can be issued as cash payments, as
shares of stock, or other property.
 Cont
d.

 On the basis of Time of

Payment
 InterimDividend
 Regular Dividend

 Special Dividend
Forms/Types of
Dividend
 On the basis of Types of Share
 Equity Dividend
 Preference Dividend

 On the basis of Mode of Payment

 Cash Dividend
 Stock Dividend
 Property Dividend
What is Dividend
Policy :

 “ Dividend policy determines the division of

earnings between payments to shareholders
and retained earnings”.
 Cont
d.

Dividend Policies involve the decisions, whether-

 To retain earnings for capital investment and

other purposes; or
 To distribute earnings in the form of dividend
among shareholders; or
 To retain some earning and to distribute
remaining earnings to shareholders.
Factors Affecting Dividend
Policy
 Legal Restrictions
 Magnitude and trend of earnings

 Desire and type of Shareholders

 Nature of Industry

 Age of the company

 Future Financial Requirements

 Taxation Policy

 Stage of Business cycle

 Cont
d.

 Regularity
 Requirements of Institutional Investors
Dimensions of Dividend
Policy
 Pay-out Ratio
 Funds requirement
 Liquidity
 Access to external sources of financing
 Shareholder preference
 Difference in the cost of External Equity
and
Retained Earnings
 Control

 Taxes
 Cont
d.

 Stability
 Stable dividend payout Ratio
 Stable Dividends or Steadily changing
Dividends
Types of Dividend
Policy
 Regular Dividend Policy
 Stable Dividend Policy

 Constant dividend per share

 Constant pay out ratio

 Stable cash (TZS)

dividend + extra
dividend
 Irregular Dividend Policy
 Dividend Theories

Irrelevance Theories
Relevance Theories
(i.e. which consider dividend
(i.e. which consider
decision to be irrelevant as it
dividend
does not affects the value of the
affects
decision the
tovalue of the firm)
be relevant as it firm)

Walter’s Gordon’s
Model Model

Modigliani and Traditional

Miller’s Model Approach
Walter’s Model
 Prof. James E Walter argued that in the long-
run the share prices reflect only the present
value of expected dividends. Retentions
influence stock price only through their effect
on future dividends. Walter has formulated
this and used the dividend to optimize the
wealth
of the equity shareholders.
 Assumptions of Walter’s
Model:
 Internal
Financing
 constant Return in Cost of
Capital
 100% payout or Retention
 Constant EPS and DPS

 Infinite time
Formula of Walter’s Model
D + r (E-D)
P = k
k
Where,
P = Current Market Price of equity share
E = Earning per share
D = Dividend per share
(E-D) = Retained earning per share
r = Rate of Return on firm’s investment or Internal Rate of
Return
k = Cost of Equity Capital
Illustration
:
 Growth Firm (r > k):
r = 20% k = 15% E = TZS. 4
If D = TZS. 4
P = 4+(0) 0.20 /0 .15 = TZS. 26.67
0.15
If D = TZS. 2
P = 2+(2) 0.20 / = TZS. 31.11
0.15 0.15
Illustration
:
 Normal Firm (r = k):
r = 15% k = 15% E = TZS. 4
If D = TZS. 4
P = 4+(0) 0.15 / 0.15 = TZS. 26.67
0.15
If D = TZS. 2
P = 2+(2) 0.15 / = TZS. 26.67
0.15 0.15
Illustration
:
 Declining Firm (r < k):
r = 10% k = 15% E = TZS. 4
If D = TZS. 4
P = 4+(0) 0.10 / = TZS. 26.67
0.15 0.15
If D = TZS. 2
P = 2+(2) 0.10 / = TZS. 22.22
0.15 0.15
Effect of Dividend Policy on Value of
Share
Case If Dividend Payout If Dividend Payout
ratio Increases Ration decreases

1. In case of Growing Market Value of Share Market Value of a

share firm i.e. where r > k decreases increases

2. In case of Declining Market Value of Share Market Value of share

firm i.e. where r < k increases decreases

3. In case of normal firm No change in value of No change in value of

i.e. where r = k Share Share
Criticisms of Walter’s
Model
 No External Financing
 Firm’s internal rate of return not always
does
remain constant. In fact, r decreases as more
and more investment in made.
 Firm’s cost of capital does not always remain
constant. In fact, k changes directly with the
firm’s risk.
 Gordon’s
Model
 According to Prof. Gordon, Dividend Policy
almost always affects the value of the firm. He
Showed how dividend policy can be used to
maximize the wealth of the shareholders.
 The main proposition of the model is that the
value of a share reflects the value of the future
dividends accruing to that share. Hence, the
dividend payment and its growth are relevant in
valuation of shares.
 The model holds that the share’s market price is
equal to the sum of share’s discounted future
dividend payment.
 Assumptions:
 All
equity firm
 No external Financing
 Constant Returns
 Constant Cost of Capital
 Perpetual Earnings

 No taxes

 Constant Retention
 Costof Capital is greater then growth rate
(k>br=g)
Formula of Gordon’s
Model
E (1 – b)
P =
K - br

 Where,
P = Price
E = Earning per
Share
b = Retention Ratio
k = Cost of Capital
br = g = Growth Rate
Illustration
:
 Growth Firm (r > k):
r = 20% k = 15% E = TZS. 4
If b = 0.25
P0 = (0.75) 4 = TZS. 30
0.15- (0.25)(0.20)
If b = 0.50
P0 = (0.50) 4 = TZS. 40
0.15- (0.5)(0.20)
Illustration
:
 Normal Firm (r = k):
r = 15% k = 15% E = TZS. 4
If b = 0.25
P0 = (0.75) 4 = TZS. 26.67
0.15- (0.25)(0.15)
If b = 0.50
P0 = (0.50) 4 = TZS. 26.67
0.15- (0.5)(0.15)
Illustration
:
 Declining Firm (r < k):
r = 10% k = 15% E = TZS. 4
If b = 0.25
P0 = (0.75) 4 = TZS. 24
0.15- (0.25)(0.10)
If b = 0.50
P0 = (0.50) 4 = TZS. 20
0.15- (0.5)(0.10)
Criticisms of Gordon’s
model
 As the assumptions of Walter’s Model
and Gordon’s Model are same so the
Gordon’s model suffers from the
same limitations as the Walter’s
Model.
Modigliani & Miller’s Irrelevance
Model

Value of Firm (i.e. Wealth of Shareholders)

Depends on

Firm’s Earnings

Depends on

Firm’s Investment Policy and not on dividend policy

Modigliani and Miller’s
Approach
 Assumption
 Capital are Perfect and people are
Markets
Rational
 No taxes
 Floating Costs are nil
 Investment opportunities and future profits of
firms are known with certainty (This assumption
was dropped later)
 Investment and Dividend Decisions are
independent
M-M’s Argument
 If a company retains earnings instead of giving
it out as dividends, the shareholder enjoy
capital appreciation equal to the amount of
earnings retained.
 If it distributes earnings by the way of
dividends instead of retaining it, shareholder
enjoys dividends equal in value to the amount
by which his capital would have appreciated
had the company chosen to retain its earning.
 Hence,
the division of earnings between dividends and
retained earnings is IRRELEVANT from the
point of view of shareholders.
Criticism of M-M
Model
 No perfect Capital Market
 Existence of Transaction
Cost
 Existence of Floatation Cost

 Lack of Relevant Information

 Differential rates of Taxes



No fixed investment
Investor’s desire Policy
to obtain current
income
Traditional Approach
 This theory regards dividend decision merely
as a part of financing decision because
 The earnings available may be retained in the
business for re-investment
 Or if the funds are not required in the business
they may be distributed as dividends.
 Thus the decision to pay the dividends or
retain the earnings may be taken as a residual
decision
 This theory assumes that the investors do
not differentiate between dividends and
retentions by the firm
 Thus, a firm should retain the earnings if it
has profitable investment opportunities
otherwise it should pay than as
dividends.
Synopsis
 Dividend is the part of profit paid to
Shareholders.
 Firm decide, depending on the profit, the

percentage of paying dividend.

 Walter and Gordon says that a Dividend
Decision affects the valuation of the firm.
 While the Traditional Approach and
MM’s Approach says that Value of the
Firm is irrelevant to Dividend we pay.
 The End

• Thank You