INTRODUCTION: Dividend is that portion of profits of a company which is distributable among its shareholders according to the decision taken and resolution passed in the meeting of Board of Directors.. This may be paid as a fixed percentage on the share capital contributed by them or at a fixed amount per share. It means only profits after meeting all the expenses and providing for taxation and depreciation and transferring a reasonable amount to reserve funds should be distributed to shareholders as dividend. There is always a problem before top management or Board of Directors to decide how much profit should be transferred to Reserve funds to meet any unforeseen contingencies and how much should be distributed to shareholders as dividend. Payment of dividend is desirable because it affects the goodwill of the concern in the market on th e one hand, and on the other, shareholders get a reasonable, return on their investment. Retained earnings are the source of internal finance for the financing of corporate future projects but payment of dividend constitutes an outflow of cash to shareholders. A l t h o u g h b o t h — h — expansion expansion and payment of dividend — dividend — are a re desirable, these two are in conflicts. It is, therefore, one of the im portant functions of the financial management to constitute a dividend policy which can balance these two contradictory viewpoints and allocate the reasonable amount of profits after tax between retained earnings and dividend.
Such payment of dividend in between the two Annual General meetings before finalizing the accounts is called Interim Dividend. No Interim Dividend can be declared or paid unless depreciation for the full year (not proportionately) has been provided for. It is, thus, an extra dividend paid during the year requiring no need of approval of th e An nu al Ge ne ra l Me et in g. Stock Dividend: Dividend: Companies, not having good cash position, generally pay dividend in the form of shares by capitalising the profits of current year and of past years. Such shares are issued instead of paying dividend in cash and called 'Bonus Shares'. Basically there is no change in the equity of shareholders. Scrip Dividend: Dividend: Scrip dividends are used when earnings justify a dividend, but the cash position of the company is temporarily weak. So, shareholders are issued shares or debentures if other companies held by the company as
investment. Such payment of dividend is called Scrip Dividend. Shareholders generally do not like such dividend because the shares or debentures so paid are worthless for the shareholders as directors would use only such investments which they found were not good. Such dividend was allowed before passing of the Companies (Amendment) Act 1960, but thereafter this unhealthy practice was stopped. stopped. - - Bond Dividends: In Dividends: In rare instance, dividends are paid in the form of debentures or bonds or notes for a long-term period bearing interest at fixed rate. The effect of such dividend is the same as that of paying dividend in scrip. The shareh sha rehold olders ers become bec ome the secured secured creditors creditors if if the bonds bonds have a lien on assets. assets. Property Dividend: Dividend: Sometimes, dividend is paid in the form of asset instead of payment of, dividend in cash. The distribution of dividend is made whenever the benefits no longer required in the business such as investment or stock of finished goods. But, it is, however, important to note that in India, distribution of dividend is permissible in the form of cash or bonus shares only. Distribution of dividend in any other form is not allowed. Dividend Policy: The economic soundness soundness of a company company is generally judged by the amount of dividend declared and paid by it to the shareholders. It affects its goodwill among the shareholders and the prospective shareholders. Dividend is a part of profits distributed among the shareholders. The basic question before the Board of Directors is how much profits should be divided among shareholders as dividend and how much should be retained as reserves to meet the future contingencies and for expansion of business. It requires a sound dividend policy to be followed by the corporation. According to Weston and Brigham Brigham "Dividend policy determine, the division of earnings between payments to shareholders and retained earnings” In this connection, the dividend declared during previous years may be taken as a base and the same rate is followed in the coming years. Generally, Board of Directors aims at maintaining the dividend rate which we may call a 'Stable Dividend Policy'. For this purpose a 'dividend equalization fund' is created out of profits to equalize the profits of the coming years. Basic Issues Involved in Dividend Policy. There , are certain basic questions 'which are involved in determining the sound dividend policy. Such questions are:-1. Cost of Capital: Cost Capital: Cost of capital is one of the considerat ions for taking a decision whether to distribute dividend or not. As a decision making tool, the Board calculates the ratio of rupee profits the
business expects to earn (Ra) to the rupee profits that the shareholders can expect to earn outside (Rc) Ra/Rc. If the ratio is less than one, it is a signal to distribute dividend and if it is more than one, the distribution of dividend will be discontinued. 2. Realisation of Objectives: The main objectives of the firm, i e., maximisation of wealth for shareholders including the current rate of dividend should also be aimed at in formulating the dividend policy. 3. Shareholders' Group: Dividend policy affects the shareholders' group. It means a company with low pay-out and heavy reinvestment attracts shareholders interested in capital gains rather than in current income whereas a company with high dividend payout attracts those who are interested in current income. 4. Release of Corporate Earnings: Dividend distribution is taken as a means of distributing unused funds. Dividend policy affects the shareholders wealth by varying its dividend pay-out ratio. In dividend policy, the financial managers decide whether to release corporate earnings or not. These are certain basic issues involved in formulating a dividend policy. Dividend policy to a large extent affects the financial structure, the flow of funds, liquidity,, stock prices a-,d in the last shareholders' satisfaction. That is why management exercises a high degree of judgment in establishing a sound dividend pattern. Factors affecting Dividend Policy: A number of considerations affect the dividend policy of a company. The major factors are 1. Stability of Earnings: The nature of business has an important bearing on the dividend policy. Industrial units having stability of earnings may formulate a more consistent dividend policy than those having an even flow of incomes because they can predict easily their savings and earnings. Usually, enterprises dealing in necessities suffer less from oscillating earnings than those dealing in luxuries or fancy goods. 2. Age of a Corporation: Age of the corporation counts much in deciding the dividend policy. A newly established company may require much of its earnings for expansion and plant improvement and may adopt a rigid dividend policy while, on the other hand, an older company can formulate a clear cut and more consistent policy regarding dividend. 3. Liquidity of funds: Availability of cash and sound, financial position is also an important factor in dividend decisions. A dividend represents a cash outflow, the greater the funds and the liquidity of the firm, the better the ability to pay dividend. The liquidity of a firm depends very much on the investment and financial decisions of the firm which in turn determines the rate of expansion and the manner of
financing. If cash position is weak, stock dividend will be preferred and if cash_ positions good, company can distribute cash dividend. 4. Extent of Share Distribution: Nature of ownership also affects the dividend decisions. A closely held company is likely to get the assent of the shareholders for the suspension of dividend or for following a conservative dividend policy. On the other hand, a company having a good number of shareholders widely distributed and forming low or medium income group would face a great difficulty in securing such assent because they will emphasis to distribute higher dividends in Cash immediately. 5. Needs for Additional Capital: Companies retain a part or their profits for strengthening their financial position. The income may be conserved for meeting the increased requirements of working capital or of future expansion. Small companies usually find difficulties in raising finance for their needs of increased working capital for expansion programmes. They, having no other alternative use their ploughed back profits. Thus, such companies distribute' dividend at low rates and retain a big part of profits. 6. Trade Cycles: Business cycles also exercise influence upon dividend policy. Dividend policy is adjusted according to the business oscillations. During the boom, prudent management creates good reserves for contingencies. Higher rates of dividend can be used as a tool for marketing the securities in an otherwise depressed market. The financial solvency can be proved and maintained by the companies in dull years if the adequate reserves have been built up. 7. Government Policies: The earning capacity of the enterprises is widely affected by the change in fiscal, industrial, labour, control and other Government policies. Sometimes Government restricts the distribution of dividend beyond a certain percentage in a particular industry or in all spheres of business activity, as was done by the Government of India in emergency. The dividend policy has to be modified or formulated accordingly. DIVIDEND DECISION AND VALUE OF FIRM: The value of the firm can be maximized if the shareholders wealth is maximized. There are contradictory views about the impact of dividend decision on the value of the firm. According to one school of thought dividend decision does not affect the shareholders’ wealth and hence the value of the firm. On the other hand, according to the other school of thought, dividend decision significantly affects the shareholders’ wealth and also the value of the firm. There are the views of the two schools of thought under two groups: a. The Relevance Concept of Dividend or the Theory of Relevance
b. The Irrelevance Concept of Dividend or the Theory of Irrelevance The Relevance Concept of Dividends: According to this school of thought, dividends are relevant and the amount of dividend paid affects the value of the firm. Walter, Gordon and others advocated that dividend decisions are important in determining the value of the firm. Walter argues that the choices of dividend policies almost and always affect the value of the enterprise. The Irrelevance Concept of Dividend: The other school of thought propounded by Modigliani and Miller in 1961. According to MM approach, the dividend policy of a firm is irrelevant and it does not affect the wealth of the shareholders. They advocate that the value of the firm depends on the market price of the share; the dividend decision is of no use in determining the value of the firm. WALTER’S MODEL : Walter’s model, clearly indicates that the choice of appropriate dividend policy always affects the value of the enterprise. Professor James E. Walter has very scholarly studied the importance of the relationship between the firm’s internal rate of return, r, (or actual capitalization rate) and it’s Cost of Capital, Ke (normal capitalization rate) in determining such dividend policy as will maximize the wealth of the stockholders. Walter’s model is based on the following premises: 1) The firm finance its entire investments by means of retained earnings. New equity stock or debenture is not issued to raise funds. 2) Internal rate of return (r) and cost of capital (Ke) of the firm remain constant. 3) The firm’s earnings are either distributed as dividends or reinvested internally. 4) Earnings and dividends of the firm never change. 5) The firm has long or infinite life. The formula used by Walter to determine the market price per share is:
Where, P = Market price per share D = Dividend per share E = Earnings per share r = Internal rate of return (Actual capitalization rate) K = Cost capital (External capitalization rate) It may be noted that Walter’s formula has the same effect as the continuing dividend growth formula. It seeks to measure the effect of dividends on common stock value by comparing actual and normal capitalization rates.
Another characteristic of Walter’s formula is that it provides an added or reduced Weight to the retained earnings portion of the capitalization earnings formula. The factors ‘r’ and ‘k’ are placed in front of retained earnings to change its weighted value under different situations as discussed below: 1. Growth Firms: In growth firms internal rate of return is greater than the normal rate(r > k). Therefore, r/k factor will greater than 1. Such firms must reinvest retained earnings since existing alternative investments offer a lower return than the firm is able to secure. Each rupee of retained earnings will have a higher weighting in Walter’s formula than a comparable rupee of dividends. Thus, large the firm retains, higher the value of the firm. Optimum dividend payout ratio for such a firm will be zero. 2. Normal Firm Normal firms comprise those firms whose internal rate of return is equal to normal capitalization (r=k). These firms earn on their investments rate of return equal to market rate of return. For such firms dividend policy will have no effect on the market value per share in the Walter’s model. Accordingly, retained earnings will have the same weighted value as dividends. In this case the market value per share is affected by the payout ratio. 3. Declining Firms Firms which earn on their investments less than the minimum rate required are designated as declining firms. The management of such firms would like to distribute its earnings to the stockholders so that they may either spend it or invest elsewhere to earn higher return than earned by the declining firms. Under such a situation each rupee of retained earnings will receive lower weight than dividends and market value of the firm will tend to be maximum when it does not retain earnings at all. 4. Evaluation of the Walter’s Model Professor Walter has endeavoured to show in an erudite manner the effects of dividend policy on value of equity shares under different situations of a firm. However, the basic premises on which edifice of the theory are laid down are unrealistic and therefore, conclusions drawn from the Walter’s model are hardly true for real life situations. Thus, for instance assume that a firm finances its investment opportunities only by means of internal sources and no external financing is resorted to for this purpose. Under such a situation, either the value of the firm’s investment or dividend or both will be sub-optimum. In its attempt to maximize the value of the firm, the management should go on making investments so long as return of investment is equal to the cost
of capital. This is the optimum level of investment; the remaining amount should be raised from external sources. On the contrary, Walter argues that value of the firm is maximized by retaining all the profits because magnitude of investments financed by retained earnings may be less than the optimum level of investment. Further, Professor Walter has assumed that ‘r’ remains constant under all the situations. As a matter of fact, ‘r’ tends to decrease in correspondence with increase in level of investments. This is why it is suggested that the management should make investments upto optimal level where r = k. Finally, assumption of constant cost of capital k is incorrect. On the contrary, it varies in tune with change in risk of the firm. Illustration 1 : The earnings per share of a company is Rs. 8 and the rate of capitalisation applicable is 10%. The company has before it an option of adopting (i) 50%, (ii) 75% and (iii)100% dividend payout ratio. Compute the market price of the company’s quoted shares as per Walter’s model if it can earn a return of (i) 15%, (ii) 10% and (iii) 5% on its retained earnings. Computation of market price of Company’s share by applying Walter’s formula
Now, we can calculate the market price per share based on different IRRs and dividend payout rations. (i) Market price per share when Ra = 15% (a) When dividend payout ratio is 50% Dividend paid = 8 × 50/100 = Rs. 4
(b) When dividend payout ratio is 75% Dividend paid = Rs. 8×75/100 = Rs. 6
(c) When dividend payout ratio is 100% i.e., dividend paid = Rs. 8
GORDON’S MODEL: Myron Gordon has also developed a model on the lines of Prof. Walter suggesting that dividends are relevant and the dividend decision of the firm affects its value. His basic valuation model is based on the following assumptions: 1. The firm is an all equity firm. 2. No external financing is available or used. Retained earnings represent the only source of financing investment programmes. 3. The rate of return on the firm’s investment r, is constant. 4. The retention ratio, b, once decided upon is constant. Thus, the growth rate of the firm (g = br), is also constant. 5. The cost of capital for the firm remains constant and it is greater than the growth rate, i.e. k > br.
6. The firm has perpetual life. 7. Corporate taxes do not exist. According to Gordon, the market value of a share is equal to the present value of future stream of dividends. Thus, Gordon’s basic valuation formula is as under:
OR
Where, P = Price of shares E = Earnings per share b = Retention Ratio ke = Cost of equity capital br = g = growth rate in r, i.e., rate of return on investment of an all-equity firm D = Dividend per share The implications of Gordon’s basic valuation model may be summarized as below : 1. When the rate of return of firm’s investment is greater than the required rate of return, i.e. when r > k, the price per share increases as the dividend payout ratio decreases. Thus, growth firm should distribute smaller dividends and should retain maximum earnings. 2. When the rate of return is equal to the required rate of return, i.e, when r = k, the price per share remains unchanged and is not affected by dividend policy. Thus, for a normal firm there is no optimum dividend payout. 3. When the rate of return is less than the required rate of return, i.e., when r
(1) There exists perfect capital market where all investors are rational. Information is available to all at no cost; there are no transaction costs and floatation costs. There is no such investor as could alone influence market value of shares. (2) There does not exist taxes. Alternatively, there is no tax differential between income on dividend and capital gains. (3) Firm has uncertainty as to future investments and profits of the firm. Thus, investors are able to predict future prices and dividend with certainty. This assumption is dropped by M-M later. M-M’s irrelevance approach is based on arbitrage argument. Arbitrage is the process of entering into such transactions simultaneously as exactly balance or completely offset each other. The two transactions in the present case are payment of dividends and garnering funds to exploit investment opportunities. Suppose, for example, a firm decides to invest in a project it has alternatives: (1) Pay out dividends and raise an equal amount of funds from the market; (2) Retain its entire earnings to finance the investment programme. The arbitrage process is involved where a firm decides to pay dividends and raise funds from outside. When a firm pays its earnings as dividends, it will have to approach market for procuring funds to meet a given investment programme. Acquisition of additional capital will dilute the firms share capital which will result in drop in share values. Thus, what the stockholders gain in cash dividends they lose in decreased share values. The market price before and after payment of dividend would be identical and hence the stockholders would be indifferent between dividend and retention of earnings. This suggests that dividend decision is irrelevant. M-M’s argument of irrelevance of dividend remains unchanged whether external funds are obtained by means of share capital or borrowings. This is for the fact that investors are indifferent between debt and equity with respect to leverage and cost of debt is the same as the real cost of equity. Finally, even under conditions of uncertainty, divided decision will be of no relevance because of operation of arbitrage. Market value of share of the two firms would be the same if they identical with respect to business risk, prospective future earnings and investment policies. This is because of rational behavior of investor who would prefer more wealth to less wealth. Difference in respect of current and future dividend policies cannot influence share values of the two firms. M-M approach contains the following mathematical formulations to prove irrelevance of dividend decision.
The market value of a share in the beginning of the year is equal to the present value of dividends paid at the year end plus the market price of the share at the end of the year, this can be expressed as below :
Where, P0 = Existing price of a share K = Cost of capital D1 = Dividend to be received at the year end P1 = Market value of a share at the year end If there is no additional financing from external sources, value of the firm (V) will be number of share (n) multiplied by the price of each share (Po). Symbolically:
If the firm issues m number of share to raise funds at the end of year 1 so as to finance investment and at price P1, value of the firm at time o will be :
Thus, the total value of the firm as per equation (3) is equal to the capitalized value of the dividends to be received during the period, plus the value of the number of share outstanding at the end of the period, less the value of the newly issued shares. A firm can finance its investment programme either by ploughing back of its earnings or by issue of new share or by both. Thus, total amount of new share that the firm will issue to finance its investment will be : mP1 = I1 – (X1 - nD1) Where, mP1 = Total amount of funds raised by issue of new share to finance investment projects. I1 = Total amount of investment during first period X1 = Total amount of net profit during first period Criticism of MM Approach MM hypothesis has been criticised on account of various unrealistic assumptions as given below. 1. Perfect capital market does not exist in reality. 2. Information about the company is not available to all the persons. 3. The firms have to incur flotation costs while issuing securities. 4. Taxes do exit and there is normally different tax treatment for dividends and capital gain. 5. The firms do not follow a rigid investment policy.
6. The investors have to pay brokerage, fees etc., while doing any transaction. 7. Shareholders may prefer current income as compared to further gains. Illustration: Agile Ltd. belongs to a risk class of which the appropriate capitalisation rate is 10%. It currently has 1,00,000 shares selling at Rs. 100 each. The firm is contemplating declaration of a dividend of Rs.6 per share at the end of the current fiscal year which has just begun. Answer the following questions based on Modigliani and Miller Model and assumption of no taxes: (i) What will be the price of the shares at the end of the year if a diviend is not declared? (ii) What will be the price if dividend is declared? (iii) Assuming that the firm pays dividend, has net income of Rs. 10 lakh and new investments of Rs. 20 lakhs during the period, how many new shares must be issued? Solution: Modigliani and Miller - Dividend Irrelevancy Model
100× 1.10 = P1 + 6
110 = P1 + 6 P1 = 110 - 6 P1 = Rs. 104 (ii) Calculation of No. of Shares to be issued Particulars
Net Income Less: Dividend Paid Retained Earning New investment Amount to be raised by new issue (A) Market Price per share (B) New shares to be issued (A / B)
Dividend Declared 10,00,000 6,00,000 4,00,000
Dividend not declared 10,00,000 10,00,000
16,00,000 104 15,385
10,00,000 110 9,091
Alternatively, the number of new shares to be issued is calculated as follows :
Where, n = Number of Shares outstanding at the beginning of the period i.e., 1,00,000 shares ΔN = Change in the number of Shares outstanding during the period (to be ascertained) I = Total investment required for capital budget i.e., Rs. 20,00,000 E = Earning of the firm during the period after payment of dividend. If dividend declared =10,00,000 - 6,00,000 = Rs. 4,00,000 If no dividend declared = 10,00,000 Now we can calculate the number of new shares to be issued : (I) If dividend declared:
(II) If no dividend declared :
MM Dividend irrelevance theory Particulars Existing shares New shares issued Total No. of shares at the end
Dividend Declared 1,00,000 15,385 1,15,385
Dividend declared 1,00,000 9,091 1,09,091
not
Market price per share 104 110 Total market value of shares at the year 1,20,00,000 1,20,00,000 end Therefore, whether dividends are paid or not, value of the firm remains the same as per M.M. approach. TYPES OF DIVIDEND POLICY: The various types of dividend policies are discussed as follows: 1. Regular Dividend Policy Payment of dividend at the usual rate is termed as regular dividend. The investors such as retired persons, widows and other economically weaker persons prefer to get regular dividends. A regular dividend policy offers the following advantages. a. It establishes a profitable record of the company. b. It creates confidence amongst the shareholders. c. It aids in long-term financing and renders financing easier. d. It stabilizes the market value of shares. e. The ordinary shareholders view dividends as a source of funds to meet their day-today living expenses. f. If profits are not distributed regularly and are retained, the shareholders may have to pay a higher rate of tax in the year when accumulated profits are distributed. However, it must be remembered that regular dividends can be maintained only by companies of long standing and stable earnings. A company should establish the regular dividend at a lower rate as compared to the average earnings of the company. 2. Stable Dividend Policy Under this policy, stable or almost stable rate of dividend is maintained. Company maintains reserves in the years of prosperity and uses them in paying dividend in lean years. If company follows stable dividend policy, the market price of its shares shall be higher. 'There are several reasons why investors prefer stable dividend policy. Main reasons are (a) Confidence among Shareholders: A regular and stable dividend payment may serve to resolve uncertainty in the minds of shareholders. • The are 'many resorts not to cut the dividend rate even if its profits are declining, i t maintains the -rate of dividend by appropriating its reserves. Stable dividend presents a good image of the company and thus gains the confidence of the shareholders and the goodwill of the company increases in the eyes of the investors re
(b) Income Conscious Investors: The second factor favoring stable dividend policy is that some investors are income conscious and f avor
a stable rate of dividend. They, too, never favor an unstable rate of dividend. A stable dividend policy may also satisfy such investors. (c) Stability in Market Price of Shares: Other things being equal, the market price vary with the rate of dividend the company declares on its equity shares. The value of shares of a company 'laving a stable dividend policy fluctuates not widely even if the earnings of the company is lower than the previous year. Thus, this policy buffers the market price of the stock. (d) Encouragement to Institutional Investors: A stable dividend policy attracts investments from institutional investors. Such institutional investor generally prepare a list of securities, mainly incorporating the securities of the companies having stable dividend policy in which they invest their surpluses or their long-term funds such as pensions or provident funds etc. In this way, stability and regularity of dividends not only affects the market price of shares but also increases the general credit of the company that benefits the company in the long run. The company with stable dividend policy can formulate its financial planning very easily because the financial manager can correctly estimate the future demand and supply of capital in the firth. Timing of dividend payment can also be forecasted easily by preparing cash flow statement. Stability of dividends can taken three distinct forms: (a) Constant dividend per share: Under this policy, the management follows the policy of paying a fixed amount of dividend per share every year irrespective of the fluctuations in the earnings. It does not imply that the rate of dividend will never be increased. When the earnings of the company increase at a new level and the management is of the view that it can easily .maintain that level of earnings, it increases the rate of dividend per share. The policy is easy to follow when company earning s are stable. lf earnings fluctuate widely, the company can policy by maintaining a dividend fluctuation fund in surplus years.
(b) Constant payout ratio: Some companies follow the policy of paying a fixed per cent or net profits as dividend every year, i e., policy of constant' payout ratio. Suppose, a company adopts a 40 per cent payout ratio, it means, 40 per cent net earnings of the company will be paid-out to shareholders every year as dividend. In the year of loss, no dividend is paid. Internal financing under this policy is automatic. For example, in the above case, 60% of the profits are transferred to reserves. Thus the policy leaves nothing to the management discretion.
(c) Stable rupee dividend plus extra dividend: Some companies follow a policy of paying constant low dividend per share plus an extra dividend in the years of high profits. Such a policy is most suitable to the firm having fluctuating earnings from year to year. Dangers of Stable Dividend Policy In spite of many advantages, the stable dividend policy suffers from certain limitations. Once a stable dividend policy is followed by a company, it is not easier to change it. If the stable dividends are not paid to the shareholders on any account including insufficient profits, the financial standing of the company in the minds of the investors is damaged and they may like to dispose off their holdings. It adversely affects the market price of shares of the company. And if the company pays stable dividends in spite of its incapacity, it will be suicidal in the long-run. 3. Irregular Dividend Policy Some companies follow irregular dividend payments on account of the following: a. Uncertainty of earnings. b. Unsuccessful business operations.
c. Lack of liquid resources. d. Fear of adverse effects of regular dividends on the financial standing of the company. 4. No Dividend Policy A company may follow a policy of paying no dividends presently because of its unfavourable working capital position or on account of requirements of funds for future expansion and growth. 5. Residual Dividend Policy When new equity is raised floatation costs are involved. This makes new equity costlier than retained earnings. Under the Residual approach, dividends are paid out of profits after making provision for money required to meet upcoming capital expenditure commitments. STABILITY OF DIVIDEND: Another important dimension of a dividend policy is the stability of dividends i.e. how stable, regular or steady should the dividend stream be, over time? It is generally said that the shareholders favour stable dividends and those dividends, which have prospects of steady upward growth. If a firm develops such a pattern of paying stable and steady dividends, then the investors/shareholders may be willing to pay a higher price for the shares. So while designing a dividend policy for the firm, it is also to be considered as to whether the firm will have a consistency in dividend payments or the dividends will fluctuate from one year to another. In the long run, every firm will like to have a consistent dividend policy, yet fluctuations from one year to another may be unfavourable. Rationale for stability of dividend Most of the firms follow stable dividends or gradually increasing dividends due to following reasons — a. Many investors consider dividends as a part of regular income to meet their expenses. Hence, they prefer a predictable pattern of dividends rather than fluctuating pattern. A fall in the dividend income may lead to sale of some shares. On the other hand when the dividend income increases, an investor may invest some of the proceeds as reinvestment in shares. Both the cases involve transaction cost and inconvenience for investor. Hence, they prefer regular dividends. b. The dividend policy of firms conveys a lot to the investors. Increasing dividends means better prospects of the company. On the contrary, decreasing dividends suggest bad earnings expectations. In addition, stable dividends are sings of stable earnings of the company. On the other hand, varying dividends lead to uncertainty in the mind of shareholders.
c. Certain investors mainly institutional, consider the stability of dividends as an important criterion before they decide on the investment in that particular firm. Illustration 1 A company has following capital : 7% Preference Shares of Rs. 100 each Ordinary Shares of Rs. 10 each
6,00,000 16,00,000 22,00,000 The following information are available relating to its financial year ending 31-122008: i) Profit, after taxation @ 40%, Rs. 5,42,000 ii) Ordinary dividend paid 20%. iii) Depreciation Rs. 1,20,000 iv) Market price of Ordinary Shares Rs. 40 v) Capital Commitment Rs. 2,40,000. You are required to calculate the following: a) The dividend yield on the Ordinary Shares. b) The cover for the preference and Ordinary dividends. c) The earnings yield, d) The price - earnings ratio, e) The Net Cash Flow, f) The reason for the comparison of net cash flow with capital commitment. Solution: a) Dividend yield on ordinary shares (or) dividend yield ratio = (DPS / market price) × 100 = (10 ×20% /40) × 100 = 5% [Market price = Capitalized value of dividend] b) Dividend coverage ratio: Preference = (PAT / Preference dividend) = 542000 / 42000 = 12.9 times Equity = (PAT – Preference dividend) / equity dividend = 500000 / 320000 = 1.5625 times c) Earnings yield ratio = (EPS / market price ) x 100 = (3.125 / 40) x 100 = 7.8125 % [EPS = 500000 / 160000 = Rs 3.125] d) Price Earning Ratio = [(40 / 3.125)] = 12.8 times (Market price / EPS) e) Net cash flow Rs PAT 542000 (+) depreciation 120000 662000 (-) preference dividend 42000 (-) equity dividend 320000 Net cash flow 300000 f) Since the cash flow position shows the firm’s ability to meet the capital expenditure / Capital commitment.
Illustration 2: ABC Ltd. has a capital of Rs.10 lakhs in equity shares of Rs.100 each. The shares currently quoted at par. The company proposes declaration of a dividend of Rs.10 per share at the end of the current financial year. The capitalisation rate for the risk class to which the company belongs is 12%. What will be the market price of the share at the end of the year, if i) A dividend is not declared? ii) A dividend is declared? iii) Assuming that the company pays the dividend and has net profits of Rs.5,00,000 and makes new investments of Rs.10 lakhs during the period, how many new shares must be issued? Use the M.M. model. Solution: Modigliani – Miller Approach n = no of shares = 10000 P0 = market price = Rs100 D1 = Expected dividend = Rs10 Ke = cost of capital = 12% i. Market price of share ( P1) if dividend not declared Given D1 = 0 We know, P0 = (D1+P1)/ (1+Ke) P1 = 112 ii. P1 if dividend declared D1 = Rs10 P0 = (D1+P1) / (1+ Ke ) P1 = Rs.102 iii. No of shares to be issued : Δn = (I – E + n D 1 )/ P1 = (1000000 – 500000 + 100000) / 102 = 5882 shares Illustration 3 A textile company belongs to a risk-class for which the appropriate PE ratio is 10. It currently has 50,000 outstanding shares selling at Rs.100 each. The firm is contemplating the declaration of Rs.8 dividend at the end of the current fiscal year which has just started. Given the assumption of MM, answer the following questions: i) What will be the price of the share at the end of the year: (a) if a dividend is not declared, (b) if it is declared? ii) Assuming that the firm pays the dividend and has a net income of Rs.5,00,000 and makes new investments of Rs.10,00,000 during the period, how many new shares must be issued? iii) What would be the current value of the firm: (a) if a dividend is declared, (b) if a dividend is not declared? Solution: Given, P/E ratio = 10 n = 50,000shares P0 = Rs. 100 D1 = Rs. 8 E = Rs. 5,00,000 I = Rs. 10,00,000 Ke = 1 / (P/E ratio)
1. Calculation of P1 1. If dividend not declared: P0 = (D1+ P1) / (1+Ke) P1 = Rs110 2. if dividend declared: P0 = (D1+ P1) / (1+Ke) P1 = Rs.102 3. If the company pay dividend: P1 = Rs102 Δn = (I – E +nD1) / P1 No of new shares, Δn = 900000 / 102 = 8823.5294 shares 4. Value of the firm: a) If the company pay dividend: V = (n + Δn) P1 = (58823.5294) 102 = Rs6000000 b) If the company does not pay dividend: V = (n+Δn) P1 = 54545.4545 x 110 = Rs6000000 Working notes: Δn = (1000000 - 500000) / 110 = 4545.4545 Illustration 4 (i) From the following information supplied to you, ascertain whether the firm’s D/P ratio is optimal according to Walter. The firm was started a year ago with an equity capital of Rs. 20 lakh. Earnings of the firm Rs 2,00,000.00 Dividend paid 1,50,000.00 P/E ratio 12.50 Number of shares outstanding, 20,000 @ Rs.100 each. The firm is expected to maintain its current rate of earnings on investment. ii) What should be the P/E ratio at which the dividend payout ratio will have no effect on the value of the share? iii) Will your decision change if the P/E ratio is 8, instead of 12.5? Solution: i. Ke = (EPS / market price) = 1 /(12.5) = 8 % r = (200000 / 2000000) x 100 = 10 % Payout ratio = (150000/200000) x 100 = 75% It is the growth firm (r > Ke), as per WALTER’s model the optimum payout ratio is Zero. So in the given case pay out ratio is not optimum. Proof: a). Market price at 75% payout ratio EPS = Rs10 DPS =Rs7.5 r = 10 % & Ke = 8%
b). Market price at zero payout: EPS = Rs10 DPS = Rs0 r = 10 % & Ke = 8 %
Therefore Zero Payout is optimum. i. The payment of dividend in case of normal firms(r = Ke) has no effect on the market value of the share. Ke = r = 10% P/E ratio = 10times i.e [ 1 / Ke] ii. If P/E ratio = 8 , Ke= 12.5 % r = 10% When r < Ke the firm is Decline firm as per WALTER and its Optimum payout ratio is 100%. So in the given case it is 75% payout only, it is not optimum payout. Proof: Market price at 75% payout:
100% payout
Illustration 5 Excellence Ltd registered earnings of Rs. 800,000 for the year ended 31 st March. They finance all investments out of retained earnings. The opportunities for investments are many. If such opportunities are not availed their earnings will stay perpetually at Rs. 800,000. Following figures are relevant.
The returns to shareholders are expected to rise if the earnings are retained because of the risk attached to new investments. As for the current year, dividend payments will be made with or without retained earnings. What according to you, should be retained? Solution:
Evaluation of different dividend policies:
From the above policies, policy B gives more value to the share holders. Hence it is advisable to adopt the policy B.
Illustration 6 X Ltd. has 1000 shares of Rs 10 each raised at a premium of Rs. 15 per share. The company’s retained earnings are Rs. 552500. The Company’s stock sells for Rs. 20 per share. a. If a 10% stock dividend is declared how many new shares would be issued? b. What would be the market price after the stock dividend? c. How would the equity account change? d. If a 25% stock dividend is declared what changes will take place? e. If the company instead declares a 5:1 stock split, how many shares will be outstanding? What would be the new par value? What would be the new market price? f. If the company declares a 1:4 reverse split, how many shares will be outstanding? What would be the new par value? What would be the new market price? g. If the company declares a dividend of Rs. 2 per share and the stock goes ex dividend tomorrow, what will be the price at which it will sell? Solution: a) If 10% stock dividend declared: No of new shares issued as bonus = 100 b) Market price after bonus issue = [(1000 x 20) + (100 x 0 )] / 1100 = Rs.18.18 c) Change in equity account Equity share capital increased by Rs1000 Reserves decreased by Rs1000. Hence, there is no change in the Net Equity d) If 25% stock dividend declared 1) No. of new shares issued = 1000 @ 25 % = 250 shares 2) Market price after stock dividend = [(1000 x 20) + (250 x 0)] / 1250 = Rs.16 3) Change in EQUITY account: Capital increased by Rs. 2500 Reserve decreased Rs.2500 There is no change in Net Equity. e) If the company declares 5 : 1 stock split i.e. 5 shares issued in exchange of 1 share each.
No of shares outstanding = 5000 New face value of share = 10/ 5 = Rs.2 New market price = 20 / 5 = Rs.4 f) If the company declares 1: 4 reverse split i.e 1 share issued in exchange of every 4 shares. No of shares outstanding = 250 New face value = 4 x 10 = Rs.40 Market price = 20 x 4 = Rs.80 g) Cum dividend market price = Rs. 20 (-) dividend = 2 Ex-dividend market price Rs. 18 Illustration 7 Following is the capital structure of Progressive Co. Ltd. as on 31 st March, 2009. Rs. Equity Share Capital (1,00,000 shares of Rs. 10 each) 10,00,000 Share premium 15,00,000 Reserves & Surpluses 5,00,000 Net worth 30,00,000 On 1st April, 2007, the company made a bonus issue of two shares for every five held. The market price at the time of bonus issue was Rs. 40 per share. X holds 100 shares of the Progressive Co. Ltd. purchased on 1st April, 2003 a market price of Rs. 30. He sold these shares on 31st March, 2009 at Rs. 50 per share. The income – tax rate for X is 20% and capital gain tax is 15% for him. If the company pays a regular dividend of 10% on par before transferring earnings to reserves and surpluses, state whether X was able to earn his required rate of return of 10% on his investment? (The PV at 10% 1st year 0.91; 2nd year 0.83; 3rd year 0.75; 4th year 0.68; 5th year 0.62 and 6th year 0.56) Solution: Appraisal of Investment decision: [NPV method ] 1) Initial Investment (out flow): 100 shares @ 30 e ach = 3000 2) Present value recurring cash inflows
3) Present value of terminal cash inflow: Sale proceeds 140shares @ 50 each = 7000 (-) capital gain tax 4000@ 15% = 600 6400 Its present value = 6400 x 0.56 = 3584 4) NET PRESENT VALUE: Present value of cash inflow (407.52+3584) = 3,991.52 (-) outflow 3,000 Net present value 991.52 The investment yields more than 10 % return to the investor.
Exercise: 1) The earnings per share of a Company are Rs. 8 and the rate of cap it al iz at io n applicable to the company is 10%. The company has before it an option of adopting a payment ratio of 25% or 50% or 75%. Using Walter's formula of dividend payout compute the market value of the company's share if the productivity of retained earnings is (i) 15%, (ii) 10%, and (i ii) 5%. 2) The e ar ni ng s per share of a company are Rs. 10. It has rate of return of 15% and the capitalization rate of risk class is 12.5%. If Walter's model is used (i) what should be the optimum payout ratio of the firm? (ii) What would be the price of the share at this payout? (iii) How shall the price of the share be affected if a different payout was employed? 3) The earnings per share of a share of the face value of Rs. 100 of PQR Ltd. is Rs. 20. It has rate of return of 25%. Capitalization rate of its risk class is 12.5%. If Walter's model is used: a) What should be the optimum payout ratio? b) What should be the market price per share if the payout rat io is zero? c) Suppose, the company has a payout of 25% of EPS, what would be the price per share? 4) The earning per share of ABC Ltd. is Rs. 10 and rate of capitalization applicable to it is 10%. The company has before it the options of adopting a pay-out of 20% or 40% or 80%. Using Walter’s formula, compute the market value of the company's share if the productivity of retained earnings is (i) 20% (ii) 10%, or (iii) 8%. 5) Determine market value of equity shares of the company from the following information as per Walter's Model : Earnings of the company
Rs.5,00,000
Dividend paid
Rs. 3,00,000
Number of shares outstanding
1,00,000
Price-earning ratio
8
Rate of return on investment
15%
Are you satisfied with the current dividend policy of the firm? If not what sh ou l d be the optimal dividend payout ratio? 6) ABC and Co. has been following a dividend policy which can maximize the market value of the firm as per Waller's model. Accordingly, each year, at dividend time the capital budget is reviewed in conjunction with the earnings for the periods and alternative investment opportunities for the shareholders. In the current year, the firm expects earnings of Rs. 5,00,000. It is estimated that the firm can earn Rs. 1,00,000 if the profits are retained. The investors have alternative investment opportunity that will yield them 10% return. The firm has 50,000 shares outstanding. What sh ou l d he the d i v i d e n d payout ratio in order to maximize the wealth of the shareholders? Also find out the current market price of the share. 7) The earnings per share of a company are Rs. 16. The market rate of discount applicable to the company is 12.5%. Retained earnings can be employed to
yi el d a return of 10%. The company is considering a pay-out of 25%, 50% and 75%. Which of these would maximize the wealth of shareholder? 8) Cal cu la te the mar ke t price of a share of ABC Ltd. under (i) Wa lt er 's formula; and (ii) di vi de nd growth the model from the following data : Earnings per share Rs.5 Dividend per share
Rs.3
Cost of capital
16%
IRR on investment
20%
Retention ratio
40%
9) A Company has a total investment of Rs. 5,00,000 in assets, and 50,000 outstanding common share at Rs. 10 per shares (par value). It earns a rate of 15% on its in ve st me nt , and has a po lic y of retaini ng 50% of the earnings, if the appropriate discount rate of the firm is 10 percent, determine the price of its share using Gordon's model. What will happen to the price of the share if the company has payout of 80% or 20%? 10) The following information is available in respect of ABC Ltd. EPS Rate of return Required rate of return of equ ity investment, ke
Rs. 10 20% 16%
Find out the market price of the share under Gordon model if the firm follows a payout of 50% or 25%.
