DIVIDEND AND RETENTION POLICY

Bidyadhar Nayak (04) Navjot Panesar (07) Prachi Jadhav (06) Rashmi Vaishya (14) Sunil Shinde (15)

Introduction : 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 to shareholders out of profit or reserve available for this purpose.”

- Institute of Chartered Accountants of India

Forms/Types of Dividend

EQUITYPREFERENCE

CASHSTOCKBONDPROPERTYCOMPOSITE

INTERIMREGULARSPECIAL

Type Of Share

Modes Of Payment

Time Of Payment

On The Basis Of

What is Dividend Policy???

“ Dividend policy determines the division of earnings between payments to shareholders and retained earnings.”

- Weston and Bringham

Dividend Policies involve the decisions, whether

To retain earnings for capital investment & 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.

Contd…

INTERNAL EXTERNALStability of Earnings Legal RequirementsAge of corporation Government Policies

Liquidity of Funds Taxation Policy

Extent of share Distribution

Needs for Additional CapitalTrade CyclesPast dividend Rates

Ability to Borrow

Policy of Control

Repayments of Loan

Time for Payment of Dividend

Regularity and stability in Dividend Payment

Factors Affecting Dividend Policy

Bonus Shares

Stock Dividend

Capitalizing the Reserves

Given as a ratio 1:2

Conserves Cash

For the Shareholder, tax liability is less as stock dividend is not treated as income

Benefits of Bonus Shares to the Company

No cash Outflow Higher Liquidity Good Image Higher Market Capitalisation Reduction in Rate of Dividend No Dividend Tax Undercapitalisation

Benefits of Bonus Shares to the Shareholders

Higher Holding

Partial Liquidation

Taxability

Higher Liquidity

Higher Future Dividend

Dividend Theories

Relevance Theories(i.e. which consider

dividend decision to be relevant as it affects the

value of the firm)

Walter’s Model

Gordon’s Model

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

the firm)

Modigliani and Miller’s Model

Traditional Approach

Relevance Theory

According to relevant theory payment of dividend affect the firm's stock and its cost of capital.

This theory is based on rate of interest and cost of capital.

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.

Walter’s Model

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

P D + r (E-D)

k k

=

Where, P = Current Market Price of equity share

E = Earning per shareD = 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

Growth Firm (r > k):r = 20% k = 15% E = Rs. 4If D = Rs. 4

P = 4+(0) 0.20 /0 .15 = Rs. 26.67 0.15

If D = Rs. 2P = 2+(2) 0.20 / 0.15 = Rs. 31.11

0.15

Illustration :

Normal Firm (r = k):r = 15% k = 15% E = Rs. 4If D = Rs. 4

P = 4+(0) 0.15 / 0.15 = Rs. 26.67 0.15

If D = Rs. 2P = 2+(2) 0.15 / 0.15 = Rs. 26.67

0.15

Illustration :

Declining Firm (r < k):r = 10% k = 15% E = Rs. 4If D = Rs. 4

P = 4+(0) 0.10 / 0.15 = Rs. 26.67 0.15

If D = Rs. 2P = 2+(2) 0.10 / 0.15 = Rs. 22.22

0.15

Illustration :

Example :

The following information is available for Avanti Corporation:

Earning per share(EPS) Rs. 40 Rate of return on investment

or internal earning 18% Rate of return required by shareholder 15%

What will be the price per share as per the Walter model if the pay out ratio is

40%?? 50%?? 60%??

Given: E=4 rs, r=18%=0.18, k=15%=0.15To Find: Price per equity share=P @ 40%,50%

& 60%Solution: According to Walter Model,

P D + r (E-D)

k k=

Payout ratio Price per share (P) P

40% 1.60+0.18(2.40)/0.15 0.15

Rs. 29.87

50% 2+0.18(2)/0.15 0.15

Rs. 29.33

60% 2.40+0.18(1.60)/0.15 0.15

Rs. 28.80

Effect of Dividend Policy on Value of Share

CaseIf Dividend Payout

Ratio IncreasesIf Dividend Payout Ratio Decreases

1. In case of Growing firm i.e. where r > k

Market Value of Share decreases

Market Value of a share increases

2. In case of Declining firm i.e. where r < k

Market Value of Share increases

Market Value of share decreases

3. In case of normal firm i.e. where r = k

No change in value of Share

No change in value of Share

Criticisms of Walter’s Model

No External Financing

Firm’s internal rate of return does not always 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 Cost of Capital is greater then growth rate

(k>br=g)

Formula of Gordon’s Model

Where,P = PriceE = Earning per Shareb = Retention Ratiok = Cost of Capitalbr = g = Growth Rate

P = E (1 – b) K - br

Growth Firm (r > k):r = 20% k = 15% E = Rs. 4If b = 0.25

P0 = (0.75) 4 = Rs. 30 0.15- (0.25)(0.20)

If b = 0.50P0 = (0.50) 4 = Rs. 40 0.15- (0.5)(0.20)

Illustration :

Normal Firm (r = k):r = 15% k = 15% E = Rs. 4If b = 0.25

P0 = (0.75) 4 = Rs. 26.67 0.15- (0.25)(0.15)

If b = 0.50P0 = (0.50) 4 = Rs. 26.67 0.15- (0.5)(0.15)

Illustration :

Declining Firm (r < k):r = 10% k = 15% E = Rs. 4If b = 0.25

P0 = (0.75) 4 = Rs. 24 0.15- (0.25)(0.10)

If b = 0.50 P0 = (0.50) 4 = Rs. 20 0.15- (0.5)(0.10)

Illustration :

Example :

The following information is available for Kavita Musicals:

Earning per share(EPS) Rs. 5 Rate of return required by shareholder 16%

Assuming that the Gordon valuation model holds, what rate of return should be earned on investment to ensure that the market price is Rs.50 when the dividend payout is 40%?

Given:

Solution: According to Gordon Model;

Dividend payout = 40% = 0.4 So, b= 100-40=60%=0.6

b = Retention Ratio = 0.6

P = Price = Rs 50 E = Earning per Share = 5

k = Cost of Capital=16% = 0.16

br = g = Growth Rate

P = E (1-b)

k-br

50 = 5 (1 - 0.6)

0.16-0.6r

50(0.16-0.6r) = 5(1-0.6)

50(0.16-0.6r) = 2

8-30r = 2

30r = 8-2 = 6

r = 0.20 = 20%

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.

Irrelevance Theory

Dividend irrelevance theory is one of the major theories concerning dividend policy in an enterprise. It was first developed by Franco Modigliani and Merton Miller in a famous seminal paper in1961.

The authors claimed that neither the price of firm's stock nor its cost of capital are affected by its dividend policy.

Modigliani & Miller’s Irrelevance Model

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

Firm’s Earnings

Firm’s Investment Policy and not on dividend policy

Depends on

Depends on

Modigliani and Miller’s Approach

Assumption Capital Markets are Perfect and people are

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.

Formula of M-M’s Approach

Po

= 1 ( D1+P1 ) (1 + p)

Where,

Po = Market price per share at time 0,

D1 = Dividend per share at time 1,

P1 = Market price of share at time 1

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 Policy Investor’s desire to obtain current

income

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 MM’s Approach says that Value of the Firm is irrelevant to Dividend we pay.

Bibliography

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Financial management by PRASANNA CHANDRA.

THANK YOU…