dividend and determinants of dividend policy

7/31/2019 Dividend and Determinants of Dividend Policy

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a. constant dividend per shareb. constant dividend payout ratio orc. constant dividend per share plus extra dividend

3. Legal, contractual and internal constraints and restrictions

Legal stipulations do not require a dividend declaration but theyspecify the conditions under which dividends must be paid. Suchconditions pertain to capital impairment, net profits and insolvency.Important contractual restrictions may be accepted by the companyregarding payment of dividends when the company obtains externalfunds. These restrictions may cause the firm to restrict the payment of cash dividends until a certain level of earnings has been achieved orlimit the amount of dividends paid to a certain amount or percentageof earnings. Internal constraints are unique to a firm and include liquidassets, growth prospects, financial requirements, availability of funds,earnings stability and control.

4. Owner's considerations

The dividend policy is also likely to be affected by the owner'sconsiderations of the tax status of the shareholders, their opportunitiesof investment and the dilution of ownership.

5. Capital market considerations

The extent to which the firm has access to the capital markets, also

affects the dividend policy. In case the firm has easy access to thecapital market, it can follow a liberal dividend policy. If the firm hasonly limited access to capital markets, it is likely to adopt a lowdividend payout ratio. Such companies rely on retained earnings as amajor source of financing for future growth.

6. Inflation

With rising prices due to inflation, the funds generated fromdepreciation may not be sufficient to replace obsolete equipments andmachinery. So, they may have to rely upon retained earnings as asource of fund to replace those assets. Thus, inflation affects dividendpayout ratio in the negative side.

Bonus shares and stock splits


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Bonus share is referred to as stock dividend. They involve payment toexisting owners of dividend in the form of shares. It is an integral part of dividend policy of a firm to use bonus shares and stock splits. A stock split isa method commonly used to lower the market price of shares by increasingthe number of shares belonging to each shareholder. Bonus shares may be

issued to satisfy the existing shareholders in a situation where cash positionhas to be maintained.

Gordon's Dividend Capitalization ModelGordon's theory contends that dividends are relevant. This model is of theview that dividend policy of a firm affects its value.

Assumptions of this model:

1. The firm is an all equity firm. No external financing is used andinvestment programmes are financed exclusively by retained earnings.

2. Return on investment( r ) and Cost of equity(K e ) are constant.3. The firm has perpetual life.4. The retention ratio, once decided upon, is constant. Thus, the growth

rate, (g = br) is also constant.5. Ke > br

Arguments of this model:

1. Dividend policy of the firm is relevant and that investors put a positivepremium on current incomes/dividends.

2. This model assumes that investors are risk averse and they put apremium on a certain return and discount uncertain returns.

3. Investors are rational and want to avoid risk.4. The rational investors can reasonably be expected to prefer current

dividend. They would discount future dividends. The retained earningsare evaluated by the investors as a risky promise. In case the earningsare retained, the market price of the shares would be adverselyaffected. In case the earnings are retained, the market price of theshares would be adversely affected.

5. Investors would be inclined to pay a higher price for shares on whichcurrent dividends are paid and they would discount the value of sharesof a firm which postpones dividends.

6. The omission of dividends or payment of low dividends would lowerthe value of the shares.


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Dividend Capitalization model:

According to Gordon, the market value of a share is equal to the presentvalue of the future streams of dividends.

P = E(1 - b)

Ke - brWhere:

P = Price of a shareE = Earnings per shareb = Retention ratio1 -b = Dividend payout ratio

Ke =Cost of capital or thecapitalization rate

br- g =Growth rate (rate or returnon investment of an all-equity firm)

Example: Determination of value of shares, given the following data:

CaseA

CaseB

D/P Ratio 40 30RetentionRatio 60 70

Cost of capital 17% 18%R 12% 12%EPS $20 $20

P=$20

(1 -0.60)

=>$81.63(CaseA)


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0.17 (0.60 x0.12)

P=

$20(1 -

0.70)

0.18 (0.70 x0.12)

=>$62.50(CaseB)

Gordon's model thus asserts that the dividend decision has a bearing on the market price of the shares and that the market price of the share is favorably affected with more dividends.

Walter's Dividend ModelWalter's model supports the principle that dividends are relevant. Theinvestment policy of a firm cannot be separated from its dividend policy andboth are inter-related. The choice of an appropriate dividend policy affectsthe value of an enterprise.

Assumptions of this model:

1. Retained earnings are the only source of finance. This means that thecompany does not rely upon external funds like debt or new equitycapital.

2. The firm's business risk does not change with additional investmentsundertaken. It implies that r(internal rate of return) and k(cost of capital) are constant.

3. There is no change in the key variables, namely, beginning earnings

per share(E), and dividends per share(D). The values of D and E maybe changed in the model to determine results, but any given value of Eand D are assumed to remain constant in determining a given value.

4. The firm has an indefinite life.

Formula: Walter's model


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P = DKe g

Where: P = Price of equity

sharesD = Initial

dividendKe = Cost of

equitycapital

g = Growthrateexpected

After accounting for retained earnings, the model would be:

P = DKe rb

Where: r = Expected rate of return on firmsinvestments

b = Retention rate (E -D)/E

Equation showing the value of a share (as present value of all dividends plusthe present value of all capital gains) Walter's model:

P = D +r/k e (E- D)

k e

Where: D= Dividend per shareand

E = Earnings per share

Example:

A company has the following facts:Cost of capital (ke) = 0.10Earnings per share (E) = $10Rate of return on investments ( r) = 8%


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Dividend payout ratio: Case A: 50% Case B: 25%Show the effect of the dividend policy on the market price of the shares.

Solution:

Case A:D/P ratio = 50%When EPS = $10 and D/P ratio is 50%, D = 10 x 50% = $5

P =

5 + [0.08 /0.10] [10 -

5]

0.10

=> $90

Case B:D/P ratio = 25%When EPS = $10 and D/P ratio is 25%, D = 10 x 25% = $2.5

P =

2.5 + [0.08 / 0.10] [10

- 2.5]

0.10

=> $85

Conclusions of Walter's model:

1. When r > k e , the value of shares is inversely related to the D/P ratio.As the D/P ratio increases, the market value of shares decline. Its value is the highest when D/P ratio is 0. So, if the firm retains itsearnings entirely, it will maximize the market value of the shares. Theoptimum payout ratio is zero.

2. When r < k e , the D/P ratio and the value of shares are positivelycorrelated. As the D/P ratio increases, the market price of the sharesalso increases. The optimum payout ratio is 100%.

3. When r = k e , the market value of shares is constant irrespective of theD/P ratio. In this case, there is no optimum D/P ratio.

Limitations of this model:


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1. Walter's model assumes that the firm's investments are purelyfinanced by retained earnings. So this model would be applicable onlyto all-equity firms.

2. The assumption of r as constant is not realistic.3. The assumption of a constant ke ignores the effect of risk on the value

of the firm.

Miller and Modigliani Model (MM Model)Miller and Modigliani Model assume that the dividends are irrelevant.Dividend irrelevance implies that the value of a firm is unaffected by thedistribution of dividends and is determined solely by the earning power andrisk of its assets. Under conditions of perfect capital markets, rationalinvestors, absence of tax discrimination between dividend income and capitalappreciation, given the firms investment poli cy, its dividend policy may haveno influence on the market price of the shares, according to this model.

Assumptions of MM model

1. Existence of perfect capital markets and all investors in it are rational.Information is available to all free of cost, there are no transactionscosts, securities are infinitely divisible, no investor is large enough toinfluence the market price of securities and there are no floatationcosts.

2. There are no taxes. Alternatively, there are no differences in tax rates

applicable to capital gains and dividends.3. A firm has a given investment policy which does not change. It impliesthat the financing of new investments out of retained earnings will notchange the business risk complexion of the firm and thus there wouldbe no change in the required rate of return.

4. Investors know for certain the future investments and profits of thefirm (but this assumption has been dropped by MM later).

Argument of this Model

1. By the argument of arbitrage, MM Model asserts the irrelevance of dividends. Arbitrage implies the distribution of earnings toshareholders and raising an equal amount externally. The effect of dividend payment would be offset by the effect of raising additionalfunds.

2. MM model argues that when dividends are paid to the shareholders,the market price of the shares will decrease and thus whatever is


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gained by the investors as a result of increased dividends will beneutralized completely by the reduction in the market value of theshares.

3. The cost of capital is independent of leverage and the real cost of debtis the same as the real cost of equity, according to this model.

4. Those investors are indifferent between dividend and retained earningsimply that the dividend decision is irrelevant. With dividends beingirrelevant, a firms cost of capital would be independent of its dividend -payout ratio.

5. Arbitrage process will ensure that under conditions of uncertainty alsothe dividend policy would be irrelevant.

MM Model:Market price of the share in the beginning of the period = Present value of dividends paid at the end of the period + Market price of share at the end of the period.

P0 = 1/(1 + k e ) x (D 1 + P 1 )

Where: P0 =Prevailingmarket priceof a share

k e =cost of equitycapital

D1 =

Dividend to

be received atthe end of period 1 and

P1 =

Market priceof a share atthe end of period 1.

Value of the

firm,nP 0

=

(n + n) P 1 I + E

(1 + k e )

Where: n = number of shares outstandingat the beginning of the periodn =

change in the number of sharesoutstanding during the period/


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additional shares issued.

I = Total amount required forinvestment

E = Earnings of the firm during theperiod.

Example: A company whose capitalization rate is 10% has outstanding shares of 25,000 selling at $100 each. The firm is expecting to pay a dividend of $5per share at the end of the current financial year. The company's expectednet earnings are $250,000 and the new proposed investment requires$500,000. Prove that using MM model, the payment of dividend does notaffect the value of the firm.

Solution:

1. Value of the firm when dividends are paid:

i. Price per share at the end of year 1:

P0 = 1/(1 + k e ) x (D 1 + P 1 )$100 = 1/(1 + 0.10) x ($5 + P 1 )P1 = $105

ii. Amount required to be raised from the issue of new shares:

n P 1 = I (E nD 1 )

=> $500,000 ($250,000 - $125,000)=> $375,000iii. Number of additional shares to be issued:

n = $375,000 / 105 => 3571.42857 shares (unrounded) iv. Value of the firm:

=> (25,000 + 3571.42857) (105) -$500,000 + $250,000

(1 + 0.10)=> $2,500,000

2. Value of the firm when dividends are not paid:

i. Price per share at the end of year 1:

P0 = 1/(1 + k e ) x (D 1 + P 1 )$100 = 1/(1 + 0.10) x ($0 + P 1 )P1 = $110


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ii. Amount required to be raised from the issue of new shares:

=> $500,000 ($250,000 -0) = $250,000iii. Number of additional shares to be issued:

=> $250,000/$110 = 2272.7273 shares (unrounded)iv. Value of the firm:

=> (25,000 + 2272.7273) (110) -$500,000 + $250,000

(1 + 0.10)=> $2,500,000

Thus, according to MM model, the value of the firm remains the samewhether dividends are paid or not. This example proves that theshareholders are indifferent between the retention of profits and thepayment of dividend.

Limitations of MM model:

1. The assumption of perfect capital market is unrealistic. Practically,there are taxes, floatation costs and transaction costs.

2. Investors cannot be indifferent between dividend and retainedearnings under conditions of uncertainty. This can be proved at leastwith the aspects of i) near Vs distant dividends, ii) informationalcontent of dividends, iii) preference for current income and iv) sale of

stock at uncertain price.

dividend and determinants of dividend policy

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