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DIVIDEND AND RETENTION
POLICY
By :
Shafqat AliMBA iv:
University of Azad Jammu and
Kashmir Muzaffarabad.
Dated: 25-02-2013
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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
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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
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Forms/Types of
Dividend On the basis of Types of Share
Equity Dividend
Preference Dividend
On the basis of Mode of Payment
Cash Dividend
Stock Dividend
Bond Dividend
Property Dividend
Composite Dividend
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On the basis of Time of
Payment
Interim Dividend
Regular Dividend
Special Dividend
Cont
d.
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What is Dividend
Policy :
“ Dividend policy determines the division of
earnings between payments to shareholders
and retained earnings”.
- Weston and Bringham
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Dividend Policies involve the decisions, whether-
To retain earnings for capital investment and
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.
Cont
d.
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Factors Affecting Dividend
Policy Legal Restrictions
Magnitude and trend of earnings
Desire and type of Shareholders
Nature of Industry
Age of the company
Future Financial Requirements
Taxation Policy
Stage of Business cycle
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Regularity
Requirements of Institutional Investors
Cont
d.
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Dimensions of Dividend
Policy
Pay-out Ratio
Funds requirement
Liquidity
Access to external sources of financing
Shareholder preference
Difference in the cost of External Equity and
Retained Earnings
Control
Taxes
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Stability
Stable dividend payout Ratio
Stable Dividends or Steadily changing
Dividends
Cont
d.
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Types of Dividend
Policy
Regular Dividend Policy
Stable Dividend Policy
Constant dividend per share
Constant pay out ratio
Stable rupee dividend + extra
dividend
Irregular Dividend Policy
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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
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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
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Assumptions of Walter’s
Model:
Internal Financing
constant Return in Cost of
Capital
100% payout or Retention
Constant EPS and DPS
Infinite time
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Formula of Walter’s Model
Where,
P = Current Market Price of equity share
E = Earning per share
D = 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
P
D + r (E-D)
k
k=
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Growth Firm (r > k):
r = 20% k = 15% E = Rs. 4
If D = Rs. 4
P = 4+(0) 0.20 /0 .15 = Rs. 26.67
0.15
If D = Rs. 2
P = 2+(2) 0.20 / 0.15 = Rs. 31.11
0.15
Illustration
:
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Normal Firm (r = k):
r = 15% k = 15% E = Rs. 4
If D = Rs. 4
P = 4+(0) 0.15 / 0.15 = Rs. 26.67
0.15
If D = Rs. 2
P = 2+(2) 0.15 / 0.15 = Rs. 26.67
0.15
Illustration
:
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Declining Firm (r < k):
r = 10% k = 15% E = Rs. 4
If D = Rs. 4
P = 4+(0) 0.10 / 0.15 = Rs. 26.67
0.15
If D = Rs. 2
P = 2+(2) 0.10 / 0.15 = Rs. 22.22
0.15
Illustration
:
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Effect of Dividend Policy on Value of
Share
Case If Dividend Payout
ratio Increases
If Dividend Payout
Ration 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
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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.
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Gordon’s
Model According to Prof. Gordon, Dividend Policy
almost always affects the value of the firm. HeShowed how dividend policy can be used tomaximize the wealth of the shareholders.
The main proposition of the model is that thevalue of a share reflects the value of the futuredividends accruing to that share. Hence, thedividend payment and its growth are relevant invaluation of shares.
The model holds that the share’s market price isequal to the sum of share’s discounted futuredividend payment.
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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)
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Formula of Gordon’s
Model
Where,
P = Price
E = Earning per Share
b = Retention Ratio
k = Cost of Capital
br = g = Growth Rate
P =E (1 – b)
K - br
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Growth Firm (r > k):
r = 20% k = 15% E = Rs. 4
If b = 0.25
P0 = (0.75) 4 = Rs. 30
0.15- (0.25)(0.20)
If b = 0.50
P0 = (0.50) 4 = Rs. 40
0.15- (0.5)(0.20)
Illustration
:
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Normal Firm (r = k):
r = 15% k = 15% E = Rs. 4
If b = 0.25
P0 = (0.75) 4 = Rs. 26.67
0.15- (0.25)(0.15)
If b = 0.50
P0 = (0.50) 4 = Rs. 26.67
0.15- (0.5)(0.15)
Illustration
:
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Declining Firm (r < k):
r = 10% k = 15% E = Rs. 4
If 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
:
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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.
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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
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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
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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.
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Hence,
the division of earnings between dividends and
retained earnings is IRRELEVANT from the point
of view of shareholders.
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Formula of M-M’s
Approach
P
o
=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
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The expression of the outstanding equity
shares of the firm at time 0 is obtained as:
nPo =1 {nD1+(n + m)P1- mP1}
(1 + p)
nPo =1 (nD1+nP1)
(1 + p)
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nPo =1 [nD1+ (n + m)P1– {I – (X –
nD1)}]
(1 + p)
mP1 = I – (X – nD1)
Where,
X = Total net profit of the firm for year 1
nPo =1 nD1+ (n + m)P1– I +X – nD1
(1 + p)
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nPo =1 (n + m)P1– I +X
(1 + p)
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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
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Traditional Approach
This theory regards dividend decision merely
as a part of financing decision because
The earnings available may be retained in the
business for re-investment
Or if the funds are not required in the business
they may be distributed as dividends.
Thus the decision to pay the dividends or
retain the earnings may be taken as a residual
decision
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This theory assumes that the investors do
not differentiate between dividends and
retentions by the firm
Thus, a firm should retain the earnings if it
has profitable investment opportunities
otherwise it should pay than as dividends.
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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 Traditional Approach and MM’s
Approach says that Value of the Firm is
irrelevant to Dividend we pay.
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Bibliograph
y
Financial management by prasanna
chandra.
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