dividend policy.pptx

7/29/2019 dividend policy.pptx

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DIVIDEND POLICY

BY ---------

SWETA

AGARWAL

1stYEAR PGDBM ;SEC - B


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INTRODUCTION

The term dividend refers to that portion of

companys net earning that is to be paid out to

the equity shareholders

Dividend policy of a firm decides the same andthe portion that is ploughed back in the firm for

investment purpose


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THEORY

The value of the firm can be maximised if theshareholders wealth is maximised.

According to one school of thought, dividend

decision does not affect the shareholders wealthand valuation of the firm.

on the other hand, If the choice of the dividend

policy affects the value of the firm, it is considered

as relevant theory


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WALTERS MODEL(RELEVANT)

Prof. Walter's model is based on the relationship

between the firms:

Return on investment, i.e. r

The cost of capital or the required rate of return, i.e. k.

Based on the following assumption:

The firm finances its entire retained earning only.

R and K of the firm remains constant. The firm earning are either distributed as dividend

or reinvested internally.


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BEGINNING EARNING AND DIVIDEND OF THE

FIRM WILL NEVER CHANGE WHILE DETERMING

THE VALUE.

The firm has a very long or infinite life.

P = D + r(E- D)/Ke

Ke Ke

P = Market price per share

D = Dividend per share

E = Earning per share

R = internal rate of return

Ke = Cost of capital


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CRITICISM OF WALTER'S MODEL

Investments are financed through retainedearnings only is seldom true in real world. Firmsdo raise funds from external financing.

The internal rate of return does not remainconstant with the increased investment the rate ofreturn also changes.

The assumption that cost of capital remains

constant does not hold good. As the firms riskpattern does not remain constant it is not properto assume K remains constant.


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WALTERS VIEW ON OPTIMUM DIVIDENED PAYOUT

Growth firms ( R>K ): Firms can naturally earn a returnwhich is more than what shareholders could earn on their

own. So OPR for growth is 0%.

NORMAL FIRMS (R=K): Firms earn a rate of return whichis equal to that of shareholders in that case dividendpolicy will not have any influence on the price per share.So all OPR are optimum.

DECLINING FIRMS(R


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PRACTICAL PROBLEMS

Question1 : EPS = RS 8

Assumed rate of return

Cost of capital (K) = 12%

a) 15%b) 10 %

c) 12 %

Solution: To show the effect of dividend policy,let us consider 0%, 50%, 100%,


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I WHEN R>K (15>12)

At 0% payout ratio (dividend = 0)

P = D + R(E D)/ Ke

Ke

= 0 + 0.15/0.12(8-0) = Rs 83.33

O.12

At 50% payout ratio

= 4 + 0.15/0.12(8-4) = Rs 75

0.12

At 100% payout ratio

= 8 + 0.15/0.12(8-8) = Rs 66.67

0.12

Price per share decreases as and when payout ratio isincreased


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II. WHEN R


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III. WHEN R=K (12% = 12%)At 0% payout ratioP = 0 + 0.12/0.12(8-0) = Rs 66.66

0.12

At 50% payout ratio

P = 4 + 0.12/0.12(8-4) = Rs 66.660.12

At 100% payout ratio

P = 8 + 0.12/0.12(8-8) = Rs 66.66

0.12Price per share remains the same at all payout ratios.

So there is no one payout ratio, which is optimum.


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2.GORDONS MODEL(RELEVANT)ASSUMPTIONS: The firm is an all equity firm ( no debt)

No outside financing and all investments are financedby retained earning

(R) remains constant. K also remains constant

Firm derives its earning in perpetuity.

The retention ratio (b) once decided upon is constant

thus, the growth rate (g ) is also constant (g=b) K>g

A corporate tax does not exit.


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FORMULAP = E (1 b)

Ke brP = Price per share

K = cost of capital

E = earning per share

b = retention ratio(1 b) = payout ratio

G = b growth rate. ( r = internal rate of return).

According to Gordon, when R>K, The price per share

increases as the dividend payout ratio decreases.When R


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PROBLEMS:

If K= 11% and earning per share = Rs 15.calculate price per share. For r = 12%,

11%, 10% for the following levels of D/ P

Ratios.D/P RATIO RETENTION

RATIO

1. 10% 90%

2. 50% 50%


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SOLUTION:

If R>K(12>11)

P = E( 1-b)

Ke -br

a). D/P ratio of 10%. Retention = 90%

P = 15 ( 1- 0.9 ) = Rs 750

0.11-0.9*0.12

b). D/P RATIO OF 50%. b = 50%

P = 15 (1 0.5 ) = Rs 1500.11- 0.5 *0.12

Price per share increases and the payout ratio

decreases


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R=K (11%=11%)

a) D/P RATIO OF 10% . R = 90%

P = 15(1 0.9) = Rs 136.6

0.110.9*0.11

b) D/P RATIO OF 50%. R = 50%

P = 15(1-0.5) = Rs 136.6

0.11- 0.5 *0.11

Price per share remains same at all payout ratio


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If R< K (10%


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THE THEORY OF IRRELEVANCEThe theory of irrelevance says that the value of

firm is independent of its dividend policy.

A. Residual approach

B. Modigliani and miller approach(MM model)


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THE IRRELEVANCE CONCEPT OF DIVIDEND

RESIDUAL APPROACH According to this theory,dividend decision has no affect on the wealth ofthe shareholders or the prices of the shares andhence it is irrelevant as far as the valuation of the

firm is concerned. Dividend decision merelydecision because the

earnings available may be retained in thebusiness for re-investment as a part of financingdecision . Thus , decision to pay the dividend orretain the earnings may be taken as a residualdecision.

It assumes that investors do not differentiatebetween dividend and retentions by the firm. Their

basic desire to earn a higher rate of return


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But, if the funds are not required in the

business they may be distributed as

dividends.

Thus, the decision to pay dividends or retain

the earnings may be taken as residual

decision.

This theory assumes that investors do notdifferentiate between dividends and retention

by the firm


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MODIGLIANI MILLER MODEL(IRRELEVANCE THEORY)According to MM, the dividend policy of

the firm is irrelevant, as it has no effect on

the market price of the shares and the

value of the firm is determined by theearning capacity of the firm or its

investment policy.

Splitting of earning between retention anddividends may be in any manner the firm

likes does not affect the value of the firm.


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ASSUMPTIONS

There are perfect capital markets.

Investors behave rationally

Information about the company is available to allwithout any costs.

There are no floatation(costs of printings, paying theunderwriters, government fees) and transactioncosts.

No investor is large enough to affect the market priceof shares.

There are either no taxes or there are no differencesin the tax rates applicable to dividends and capitalgains.


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The firm has a rigid investment policy.

There is no risk or uncertainty in regard to

future of the firm.


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THE ARGUMENT OF MM

The argument given by MM in support of theirhypothesis is that whatever increase in thevalue of the firm results from the payment of thedividend, will be exactly off set by the decline in

the market price of shares because of externalfinancing and there will no change in the totalwealth of the shareholders.

For e.g, if a co. having investment

opportunities, distributes all its earnings amongthe shareholders,it will have to raise additionalfunds from external sources.


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This will result in the increase in no. of

shares or payment of interest charges,

resulting in fall in the earnings per share in

the future.

Thus whatever a shareholder gains on

account of dividend payment is neutralised

completely by the fall in the market price ofshares due to decline in expected future

earnings per share.


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This can be put in the form of the following:

Po = D1 + P1

1 + Ke

Where,

Po = Market price per share at the beginning of

the period, or prevailing market price of ashare

D1 = Dividend to be received at the end of the

period


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P1 = Market price per share at the end of the

period.

Ke = cost of equity capital .

The value of P1 can be derived by the above

equation as under:

P1 = Po (1 + Ke ) D1


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The MM hypothesis can be explained in another

form also presuming that investment required by

the firm on account ofpayment of dividends is

financed out of the new issue of equity shares.In such case no of shares to be issued can be

computed as:

M = I ( E Nd1)

P1


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Further , the value of the firm can be ascertained with thehelp of the following formula:

nPo = (n + m)P1 ( I E)

1 + Ke m = no of shares to be issued.

I = investment required .

E = total earning of the firm during the period.

Ke = cost of equity capital. n = no of shares outstanding at the beginning of the

period.

D1 = dividend to be paid at the end of the period.

npo = value of the firm


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Q.ABC ltd belongs to a risk class for which theappropriate capitalisation rate is 10%. It currently

has outstanding 5000 shares selling at Rs 100

each. The firm is contemplating the declaration ofdividend of Rs 6 per share at the end of the current

financial year. The company expects to have a net

income of Rs50,000 and has a proposal for making

new investments of Rs 1,00,000. show that underthe MM hypothesis the payment of dividend does

not affect the value of the firm


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(A)Value of the firm when dividend are paid:

(1) Price of the share at the end of the current

financial yearP1 = Po (1 + Ke) D1

= 100 (1+.10) 6

= 100 * 1.10 6= 110 -6

= RS 104


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(2) No of the shares to be issuedm = I (E- nD1)

P1

= 1,00,000 (50,000 5000 * 6)104

= 80,000 = 769

104

3) Value of the firmnPo = (n+ m )P1 (I-E)

I + Ke


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3) Value of the firm

nPo = (n+ m )P1 (I-E)

I + Ke

= (5000+ 80,000/104 ) *104 (1,00,00050000)

1 + .10

= 5,00,000


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( b) Value of the firm when dividend are not paid:

1) Price per share at the end of the financial year

P1 = Po (1 + Ke) D1

= 100(1+.10)- 0

= 100 * 1.10 = RS 110

2) No of the shares to be issued

m = I ( E- nD1) = 1,00,000-(50000-0) = 455

P1 110


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3) Value of the firm

npo = (n+m)P1(I-E)

1 + Ke

= (5000+50000/110)110 (1,00,000-50,000)

1 + .10

= 5,00,000

Hence, whether dividends are paid or not the

value of the firm remains the same Rs 5,00,000


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CRITICISM OF MM APPROACH Perfect capital market does not exist in reality. Information about the co. is not available to all

the persons.

The firms have to incur floatation costs whileissuing securities.

Taxes do exist and there is normally different taxtreatment for dividends and capital gains.

The firms do not follow a rigid investment policy. Shareholders may prefer current income as

compared to further gains.

dividend policy.pptx

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