FM II Chapter 1
FM II Chapter 1
FM II Chapter 1
The term dividend usually refers to payment made out of a firm’s earnings to its owners, either in the
form of cash or stock. If a payment is made from sources other than current or accumulated retained
earnings, the term distribution rather than dividend is used. However, it is acceptable to refer to a
distribution from earnings as a dividend and a distribution from capital as a liquidating dividend.
Dividend is the amount of returns payable to the shareholders for their investment. The dividend is
normally paid out of profits. Successful companies earn income. That income can then be reinvested
in operating assets, used to acquire securities, used to retire debt, or distributed to stockholders as
dividends.
Dividend may be distributed among the shareholders in various forms. The major categories
Include:
a. Cash dividend c. Bond dividend
b. Stock dividend d. Property dividend
1. Cash Dividend: If the dividend is paid in the form of cash to the shareholders, it is called cash
dividend. It is paid periodically out of the business income. Cash dividends are common and
popular type.
Cash dividends come in several different forms. The basic types are:
i Regular cash dividend-A cash payment made by a firm to its owners in the normal course of
the business, usually made four times a year.
ii Extra dividend-sometimes firms will pay a regular cash dividend and an extra cash dividend.
Extra indicates that the extra part may or may not be repeated in the future.
iii Special dividend- is unusual or onetime event, and won’t be repeated. Generally company
declares special dividend in case of abnormal profits.
Did you ever wonder why some companies pay dividends while others don't? There are several
factors that influence whether or not a company pays a dividend and how much it chooses to pay.
While there are too many possible factors to list here, these are some of the most influential.
1. Profitability Position of the Firm: dividend decision depends on the profitability position of the
business. When the firm earns more profit, they can distribute more dividends to the
shareholders. Unprofitable companies cannot for ever go on paying dividends out of retained
profits made in the past.
2. Uncertainty of Future Income: future income is a very important factor, which affects the
dividend policy. When the shareholder needs regular income, the firm should maintain regular
dividend policy. But, if future income is uncertain, the amount and timing of dividend paid may
vary.
3. Legal Constrains: companies put several restrictions regarding payments and declaration of
dividends.
4. Liquidity Position: the firm’s ability to pay cash dividend is constrained by the amount of liquid
assets (such as cash and marketable securities) available. Liquidity position of a firm leads to
easy payments of dividend. If firms have high liquidity, the firms can provide cash dividend
otherwise, they have to pay stock dividend.
5. Sources of Finance: the ease with which a company could raise extra finance from sources
other than retained earnings affects its dividend policy. Small companies which find it hard to
raise finance might have to rely more heavily on retained earnings than large companies.
6. Growth Rate of the Firm; high growth rate implies that the firm can distribute more dividends
to its shareholders. On the other hand, fast growing companies may choose to reinvest their
earnings for further growth and expansion.
7. Tax Policy: tax policy of the government also affects the dividend policy of the firm. When the
government gives tax incentives, the company pays more dividends.
8. Capital Market Conditions: due to the capital market conditions, dividend policy may be
affected. If the capital market is prefect, it leads to improve the higher dividend.
Dividends are normally paid quarterly, and, if conditions permit the dividend is increased once each
year. Take the following example to illustrate dividend payment procedures;
Dividend policy depends upon the nature of the firm, type of shareholder and profitable position of
the firm. On the basis of dividend declaration by the firm, the dividend policy may be classified
under the following types:
Regular dividend policy
Stable dividend policy
Irregular dividend policy
No dividend policy.
Regular Dividend Policy
Dividend payable at the usual rate is regarded as regular dividend policy. Though the rate is usual,
the dividends vary per income earned. This type of policy is suitable to the small investors, retired
persons and companies which get regular earning. Regular dividend policy has several advantages,
including:
1. Creating confidence among shareholders
“Does a dividend policy really have any effect on the firm's value?"
Several theories have been documented on the relevance and irrelevance of dividend policy on firm
value maximization. Here, we begin by describing the dividend irrelevance theory, developed by
Merton Miller and Franco Modigliani (MM), which is used as a backdrop for discussion of the key
arguments in support of dividend irrelevance and then those in support of dividend relevance will be
presented.
According to professors Modigliani and Miller (MM), a firm’s dividend policy has no effect on
firm value or its stock price. That is, there is no relation between the dividend rate and value of the
firm. Modigliani and Miller contributed a major approach to prove the irrelevance dividend concept.
Conversely, if a company pays a higher dividend than an investor desires, the investor can use the
unwanted dividends to buy additional shares of the company’s stock. If investors could buy and sell
shares and thus create their own dividend policy without incurring costs, then the firm’s dividend
policy would truly be irrelevant.
Assumptions
MM approach is based on the following important assumptions:
a) Perfect capital market.
b) Investors are rational.
c) There are no taxes.
d) The firm has fixed investment policy.
e) No risk or uncertainty.
Where,
Po = Prevailing market price of a share.
Ke = Cost of equity capital.
D1 = Dividend to be received at the end of period one.
P1 = Market price of the share at the end of period one
P1 can be calculated with the help of the following formula.
P1 = Po (1+Ke) – D1
Hence, by replacing P1 =Po (1+Ke) –D1 in the Po formula, we get
Po = Po, which indicates that price of stock, remains constant regardless of the amount of dividends
declared and paid by the company.
New equity capital is more expensive than capital raised through retained earnings. Hence, financing
investments internally (through dividends) may be favoured.
D. Expectation theory
As the time approaches for management to announce the amount of next dividend, investors form
expectations as to how much the dividend will be.
If the actual dividend is as expected, the market prices will remain unchanged; otherwise higher or
lower than expected amounts will force investors to reassess their perception about the firm, and the
According to this concept, dividend policy is considered to affect the value of the firm. Dividend
relevance implies that shareholders prefer current dividend and hence there is direct relationship
between dividend policy and value of the firm. Relevance of dividend concept is supported by two
eminent persons: Walter and Gordon.
A. Walter’s Model
Prof. James E. Walter argues that the dividend policy almost always affects the value of the firm.
Walter’s model is based on the relationship between the following important factors:
Internal rate of return (r)
The annual rate of growth an investment is expected to generate.
Cost of capital (k)
Required return necessary to make an investment worthwhile
Assumptions
Walter’s model is based on the following important assumptions:
(a) The firm uses only internal finance.
(b) The firm has constant return and cost of capital.
(c) The firm has 100 percent pay out/retention policy.
Walter has developed a mathematical formula for determining the value of market share.
Example2
From the following information given to you, ascertain whether the firm is following an optimal
dividend policy as per Walter’s Model?
The firm is expected to maintain its rate of return on fresh investments as well. Will your decision
change if the P/E ratio is 7.25 and return on investment is 10%?
𝑃=150 𝑅𝑠.
Walter’s model assumes that there is no extracted finance used by the firm. It is not practically
applicable.
There is no possibility of constant return. Return may increase or decrease depending upon the
business situation.
Walter’s model is based on constant cost of capital; however, cost of capital varies mainly due to
differences in risk exposures of firms.
B. Gordon’s Model
Myron Gordon suggests one of the popular models, which assumes that dividend policy of a firm
affects its value. It is based on the following basic assumptions:
a) The firm is an all equity firm (no debt).
b) Cost of capital and return are constant.
c) There are no taxes.
d) There is constant retention ratio (g=br).
e) Cost of capital is greater than growth rate (Ke>br).
Gordon’s model can be proved with the help of the following formula
Where,
P = Price of a share
E = Earnings per share
1 – b = D/P ratio (i.e., percentage of earnings distributed as dividends)
Ke = cost of capital
br = Growth rate = rate of return on investment of an all equity firm.
Note: the above model indicates that the market value of the company’s share is the sum total of the
present values of infinite future dividends to be declared.
Traditional Model
As to this model, stock market is overwhelmingly in favour of liberal dividends and against
insufficient dividends. Accordingly, in the valuation of shares, the weight attached to dividends is
higher than the weight attached to retained earnings.