FINANCIAL MANAGEMENT (PART-19) DIVIDEND POLICY I. Dear students, Welcome to the lecture series on Financial Management.

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1 FINANCIAL MANAGEMENT (PART-19) DIVIDEND POLICY I 1. INTRODUCTION Dear students, Welcome to the lecture series on Financial Management. Learning Objectives Introduction Types of Dividend Policy Major issues in Dividend Policy Factors affecting Dividend Policy Theories of Dividend Payment Walter Model Practical aspect of Walter s model Summary and Conclusions The major decision areas of financial management are: FINANCIAL MANAGEMENT FINANCING INVESTING DIVIDEND DECISION

2 Hence, the third major decision area in financial management relates to dividend policy. The dividend policy decision involves the choice between distributing the profits belonging to the shareholders and their retention by the firm. The selection would be influenced by the effect on the objective of financial management of minimizing shareholders wealth. Given the net value maximization objective, there is need to ascertain whether the dividend policy has a bearing on the value of the firm or not. The focus of the chapter is primarily on the different theories/ approaches to analyses the relationship between dividend policy and value of the firm. 2. MEANING AND TYPES OF DIVIDEND & DIVIDEND POLICY Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. Our focus is on dividends paid to the ordinary shareholders because holders of preference shares are entitled to a stipulated rate of dividend. Moreover, the discussion is relevant to widely held public company as the dividend issue does not pose a major problem in closely held companies. What is closely held company A firm whose shares of common stock are owned by relatively few individuals and are generally unavailable to outsiders.

3 What is widely held company Enterprise whose ownership is held by the general public, including individuals, officers, employees, and institutional investors. A publicly held company has stock listed on an exchange and must file financial statements and reports with the SEC. Since dividends are paid out of the retained earnings the alternative to the payment of dividend is the retention of the profit. The retained earnings constitute an easily accessible important source of financing the investment requirements of firms. There is, thus, a type of inverse relationship between retained earnings and cash dividends; larger retentions, lesser dividends; smaller retentions, larger dividends. Thus the alternative uses of the net earnings dividends and retained earnings are competitive and conflicting. A major decision of financial management is the dividend decision in the sense that e firm has to choose between distributing the profits to the shareholders and plough them back into the business. The choice would obviously hinge on the effect of the decision on the maximization of the shareholders wealth. That is, the firm would be well advised to use the net profits for paying dividends to the shareholders if the payment will lead to the maximization of wealth of owners. If not, the firm should rather retain them to finance investment programs. The relationship between dividends and value of the firm should, therefore, be the decision criteria.

4 Types of Dividend : 1. Cash dividends- This is the most popular and prevalent form of dividend. Generally shareholders prefer cash dividends because it is very convenient for them. Usually companies with sound liquidity position distribute dividends in cash. 2. Stock dividend- Stock dividend is popularly known as dividend in the form of bonus shares. When a company has surplus reserve but does not have adequate liquidity then the company capitalizes its reserve and distributes these reserves as bonus shares. 3. Bond dividend- When a company is not in a position to distribute dividend in cash due to liquidity problem then the company can distribute dividend in the forms of bonds or debentures payable after 5 to 7 years. Some times company also pays interest on debentures. Promissory notes can also be issued in lieu of dividend. 4. Property dividend-dividends can be distributed in the form of property. Some times company does not possess adequate liquidity but possess property then the company can distribute dividend in the form of securities of other companies or government. Likewise the company can distribute any other divisible asset as dividend. This form of dividend is not popular in India but in western countries some of the beverage companies distribute dividend in the form of wine bottles. 5. Composite dividend-when a company pays some part of dividend in cash and remaining in the form of property, it is called composite dividend. 6. Optional dividend- When a company gives an option to its shareholders to receive dividend either in cash or kind, then it is called optional dividend. 7. Interim dividend- Usually a company pays dividend at the end of a financial year. Sometimes a company earns sufficient profit before the close of the financial year and its management declares dividend. This dividend is called interim dividend.

5 8. Extra or special dividend- There should not be frequent changes in dividend rates if a company wants to follow a sound and stable dividend policy. A company should keep extra ordinary profits then company may pay special dividend besides regular dividend. 9. Regular Dividend- it is the final dividend which company usually pays after the end of the financial year. 3. FACTORS AFFECTING DIVIDEND POLICY Basic issues involved in Dividend policy- 1. cost of capital- Cost of capital is one of the consideration 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) t other rupee profits that the shareholders can expect to earn outside (Rc) Let us understand certain factors which are going to affect the dividend policy, so our next topic of discussion is factors affecting dividend policy, the first one is known as cost of capital, cost of capital is the expectation of the shareholders from the company and it is represented by the symbol called Ke, it is the cost which a company needs to incur to use the funds in the form of equity share, cost of capital is the minimum required rate of return which a company should fetch from the investment which a investor has put into the organization, So we can say that it s the minimum required rate of return and it should be higher than internal rate of return that means productivity index of rate of return that means R should be always greater than Ke, so it s an index to find out how the company is being working that it s able to work up to the cost of capital and the profitability of the company can be worked out by working on the return on investment ratio and we can compute the Ke, Ke plays a very important role in the factors which are going to affect the dividend policy because there are certain models like Wolter s model,

6 Gordon s model in which the Ke is going to play important role to find out the theoretical cost or the theoretical value of the price of the share of company, next one is retain earnings, retain earnings are of vital importance when we find out the dividend policy because the decision of paying the dividend is primary based on the retained earnings, if there are adequate retain earnings, what a company should do whether it retain 100 % income of the business and go back into another production or it can payback this dividend or the retain earnings to the shareholders in the form of dividend, so we have to analysis the position of the retain earnings in order to take up a decision in relation to the payment of dividend to the equity shareholders, next one is age of corporation, by age of corporation we mean that how old the corporation is or enterprise, if a newly open enterprise is there, they should pay the dividends but not at a very higher end, the rate of dividends can be low but they should maintain the consistency paying a dividend, so age of the corporation is also going to affect the dividend policy so frame by the management while the old corporation can be go for a higher rate of dividend provided they are stable in the payment of dividend, if a one end they are paying higher dividend and in the coming year, they are not able to pay the dividends such policies are the defective policies of paying a dividend so the company should make out certain criteria s by which they can pay the dividends in a regular basis and in a stable basis adequately to the shareholders so that the wealth of the shareholders can be maximized. 2. Retained Earnings are of C 3. Age of Corporation 4. Release of corporate earnings.

7 4. THEORIES RELATED TO DIVIDEND POLICY Now we are going to learn certain models affecting Dividend Theories. Dividend Theories Relevance Theories (i.e. which consider dividend decision to be relevant as it affects the value of the firm) Irrelevance Theories (i.e. which consider dividend decision to be irrelevant as it does not affects the value of the firm) Walter s Model Gordon s Model Modigliani and Miller s Model Walter Model Prof James E. Walter devised an easy and simple formula to show how dividend can be used to maximize the wealth

8 e e Position of shareholders. He considers dividend as one of the important factors determining the market valuation. According to Walter, in the long run, share prices reflect the present value of future stream of dividends. Retained earnings influence stock prices only through their effect on further dividends. Assumptions: The company is a going concern with perpetual life span. The only source of finance is retained earnings. i.e. no other alternative means of financing. The cost of capital and return on investment are constant throughout the life of the company.

9 According to Walter Model, Effect on Market price of share under Walter model Case 1. In case of Growing firm i.e. where r > k 2. In case of Declining firm i.e. where r < k 3. In case of normal firm i.e. where r = k If Dividend Payout ratio Increases Market Value of Share decreases Market Value of Share increases No change in value of Share If Dividend Payout Ration decreases Market Value of a share increases Market Value of share decreases No change in value of Share 5. WALTERS MODEL WHERE r > ke Example- EPS = Rs. 8 Ke= 10% (i) r= 15% ( ii) r= 10% (iii) r= 5% The company has the option to adopt the pay out of either (i) 25% (ii) 50% and (iii) 75% Case 1 Where r=15% P0= 2+.15/(8-2) =Rs. 110 ( at 25% pay out) P0= 4+.15/(8-4) =Rs. 100 (at 50% pay out)

10 P0= 6+.15/(8-6) =Rs. 90 ( at 75% pay out) 6. WALTERS MODEL WHERE r = ke Case 2- r=10% P0= 2+ /(8-2) =Rs. 8 0 ( at 25% pay out) P0= 4+ /(8-4) =Rs. 8o ( at 50% pay out) P0= 6+ /(8-6) =Rs. 80 ( at 75% pay out) 7. WALTERS MODEL WHERE r < ke Case 3 r= 5% P0= 2+.05/(8-2) =Rs. 50 ( at 25% pay out) P0= 4+.05/(8-4) =Rs. 60( at 50% pay out) P0= 6+.05/(8-6) =Rs. 70 ( at 75% pay out) Conclusion When r is 15% it is greater than ke 10%. It means that the company has better investment policy than shareholders. In such a case lower the payout ratio, higher will be the value of share.

11 And the price will be maximum when Pay out ratio is 100% P= 0+.15/( 8-0) = Rs. 120/- The model considers internal rate of return (IRR) Market Capitalization rate (Kc) and dividend payout ratio in determination of share prices. However, it ignores various other factors determining the share prices. It fails to appropriately calculate prices of companies that resort to external sources of finance. Further, the assumption of constant cost of capital and constant return are unrealistic. 8. SUMMARY With this we are ending up our lecture of today where we have discussed in detail about the dividend policies, types of dividends and the models which is based on relevant theory of dividend where valuation of the firm is affected by the dividend payment and it has been suggested by James Walter, we have learn in detail analysis and with this we are ending up of our lecture, thank you.