Financial Management - Dividend Policy

 

FINANCIAL MANAGEMENT

Dividend Policy

 

Part A: Discussion of basic theories including various formulas

Part B: 7 Illustrations with solutions

Part A

Introduction and definition

Dividend is paid out of net divisible profits to the shareholders (equity and preference). Since preference shareholders are paid dividends at a stipulated rate as per the terms and conditions of issuing preference shares, dividend policies involve payment of dividend to equity shareholders only. Dividend policies are again relevant to widely-held public limited companies only, because dividend issue does not pose a major problem for closely-held private limited companies.

 

Dividend policy refers to the policy regarding distribution of a portion of profits among the shareholders i.e. whether to pay dividend to the equity shareholders or retain the earnings instead of paying dividend. Therefore, there is a type of reciprocal relationship between retained earnings and dividend payment as follows:

(a)  Larger retentions accompany lesser dividends;

(b)  Smaller retentions accompany larger dividends.

 

Cost of equity capital, internal rate of return and dividend pay-out ratio

Let cost of equity capital (i.e. required rate of return) is ‘k_e’ and internal rate of return (i.e. expected rate of return) be ‘r’. If r > k_e earnings are retained and on the other hand, if r < k_e earnings are paid as dividends. In other words, dividend pay-out ratio (i.e. the ratio of DPS to EPS expressed in %) varies from 0% to 100%. The ratio is 0% when no dividend is paid at all; rather all the earnings are retained and invested into abundantly available profitable projects. But the ratio is 100% when there are no profitable opportunities and the entire earnings is paid out as dividends.

 

Dividend policy and maximisation of shareholders’ wealth

Given the objective of financial management of maximising shareholders’ wealth the firm would take decision for payment of dividends instead of retaining the earnings if it (the decision) increases the market price of the equity shares as well as the total value of the firm. On the other hand, the firm may also take decision not to pay dividends retaining the earnings for investments into future projects if it (the decision) leads to increase in the market price of the equity shares as well as the total value of the firm.

 

Different opinions/theories regarding dividend policies

There are conflicting opinions regarding the impact of dividends on the valuation of the firm. According to one such opinion payments of dividends is irrelevant implying that the amount of dividends paid has no effect on the valuation of the firm. On the other hand, there are certain other opinions according to which payments of dividends are relevant implying that the value of the firm measured in terms of the market price of the equity shares is impacted by the dividend decision.

 

Irrelevance of dividends – MM Hypothesis

The most comprehensive argument in support of the irrelevance of payments of dividends is provided by the MM (Modigliani – Miller) Hypothesis. Under this hypothesis dividend policy has no effect on the share prices of the firm and is, therefore, of no consequence. What matters according to this hypothesis is the investment policy through which the firm can increase its earnings and thereby the total market value.

 

Assumptions of MM Hypothesis

1. Capital markets are perfect implying that –

    (a)      Securities are infinitely divisible,

   (b)    Investors are free to buy and sell securities and no investor is large enough to influence the market price of the shares,

    (c)       There are no transaction costs and floatation costs,

    (d)       All investors are rational and behave accordingly,

    (e)       Each investor has the same information which is readily available free of cost.

 

2.  There are no taxes implying that there are no differences in tax rates applicable to capital gains and dividends.

3.  The firm has a given investment policy that does not change.

4.  There is a perfect certainty by every investor as to future investments and profits of the firm. In other words, investors are able to forecast future prices of shares and dividends with certainty.

 

Relevance of dividends – Walter’s Model

Walter’s model supports the doctrine that dividends are relevant. The choice of an appropriate dividend policy affects the value of an enterprise. The firm would have an optimum dividend policy which will be determined by the relationship of ‘r’ and ‘k_e’.

 

If a firm has adequate profitable investment opportunities, i.e. where r > k_e, it will be able to earn more than what the investors expect. Such firms may be called growth firms. For growth firms the optimum dividend policy is: 0% dividend pay-out ratio. As per Walter’s model for such growth firms the market value of the shares will be the maximum if the dividend pay-out ratio is 0%, i.e. if the firm retains the entire earnings for investing in future profitable projects.

 

If the firm does not have profitable investment opportunities i.e. where r < k_e, the shareholders will be better off if earnings are paid out to them so as to enable them to earn a higher return by investing the funds elsewhere. In such a case the market price of shares will be the maximum if the entire earnings are distributed as dividends to the shareholders. For this type of firms the optimum dividend policy is: 100% dividend pay-out ratio.

 

For a firm where r = k_e it is a matter of indifference whether earnings are retained or distributed. In case of such firms, for all dividend pay-out ratios (ranging from 0% to 100%) the market price of the shares will remain constant. For such firms there is no optimum dividend policy.

 

Assumptions of Walter’s Model

1.  All financing is done through retained earnings. External sources of funds like debt or new equity capital are not used.

2.  With additional investments undertaken the firm’s business risk does not change. It implies that ‘r’ and ‘k_e’ are constant.

3.  There is no change in the key variables namely, Earnings per Share (EPS) and Dividend per Share (DPS) for a given value of the firm.

4.  The firm has perpetual life.

 

Relevance of dividends – Gordon’s Model

Gordon’s model also supports the doctrine that dividends are relevant. The choice of an appropriate dividend policy affects the value of an enterprise. As per the Gordon’s model market price of equity shares and the value of the firm –

i.     Increases as the dividend pay-out ratio increases, when r < k_e

ii.    Decreases as the dividend pay-out ratio increases, when r > k_e

iii.  Remains constant even if the dividend pay-out ratio increases or decreases, when r = k_e

 

Assumptions of Gordon’s Model

1. The firm is an all-equity firm. New investment projects are financed exclusively by retained earnings i.e., no external financing is used for future investment purpose.

2. ‘r’ and ‘k_e’ are constant.

3. The retention ratio (b) is constant. Therefore, the growth rate (g = br) is also constant.

4. k_e > br i.e., b < k_e/r (i.e., retention ratio must be less than the ratio of k_e/r).

5. The firm has perpetual life.

 

  Important formulas

	MM Hypothesis
1	P0	(D1 + P1) ÷ (1 + ke)
2	P1	P0 (1 + ke) – D1
3	Δn	[I – (E – nD1)] ÷ P1
4	V	[(n + Δn) P1 – I + E] ÷ (1 + ke)
5	V	[n (P1 + D1)] ÷ (1 + ke)
	Walter’s Model
6	P0	[D1 + r/ke (EPS1 – D1)] ÷ ke
	Gordon’s Model
7	P0	[EPS1 (1 – b)] ÷ (Ke – br)

 

  Meanings of abbreviations

1	P0 =	Prevailing market price of equity share
2	P1 =	Market price of equity share at the end of the current year
3	D1 =	Dividend per equity share at the end of the current year
4	Ke =	Cost of equity share capital (Also known as capitalisation rate and required rate of return on investment)
5	n =	Number of equity shares outstanding at the beginning of the year
6	Δn =	Number of additional equity shares to be issued
7	I =	New investment
8	E =	Total earnings made during the current year
9	EPS1 =	Earnings per equity share at the end of the current year
10	r =	Expected rate of return on investment (Also known as internal rate of return)
11	b =	Retention ratio
12	V =	Market value of the firm

 

 Part B

Illustration: 1

Sahu & Co. earns Rs 6 per share having capitalisation rate of 10 per cent and an expected rate of return on investment of 20 per cent. According to Walter’s Model, what should be the price per share at 30 per cent dividend payout ratio? Is this the optimum dividend payout ratio as per Walter’s Model?

Solution: 1

Illustration: 2

X Ltd., has 8 lakhs equity shares outstanding at the beginning of the year 2005. The current market price per share is Rs 120. The Board of Directors of the company is contemplating Rs 6.40 per share as dividend. The rate of capitalisation, appropriate to the risk-class to which the company belongs, is 9.6%.

 

Based on M-M Approach, calculate

i.  The market price of the share of the company, when the dividend is - (a)   declared; and (b) not declared.

ii.  How many new shares are to be issued by the company, if the company   desires to fund an investment budget of Rs 3.20 crores by the end of the year   assuming that net income for the year will be Rs 1.60 crores?

Solution: 2

Illustration: 3

A Company pays a dividend of Rs 2.00 per share with a growth rate of 7%. The risk free rate of return is 9% and the market rate of return is 13%. The Company has a beta factor of 1.50. However, due to a decision of the Finance Manager, beta is likely to increase to 1.75. Find out the present value of the share before the decision as well as the likely value of the share after the decision.

 

 Solution: 3

 

Illustration: 4

The following figures are collected from the annual report of XYZ Ltd.:

Particulars	Rs
Net Profit	30 lakhs
Outstanding 12% preference shares	100 lakhs
No. of equity shares	3 lakhs
Return on Investment	20%

 

What should be the approximate dividend pay-out ratio so as to keep the share price at Rs 42 by using Walter’s Model? Capitalisation rate, appropriate to the risk-class to which the company belongs, is 16%.

 

Solution: 4

Illustration: 5

The following information pertains to M/s XY Ltd.:

Earnings of the Company	Rs 5,00,000
Dividend Payout ratio	60%
Number of equity shares outstanding	1,00,000
Equity capitalization rate	12%
Rate of return on investment	15%

 

i.    What should be the prevailing market value per share as per Walter’s Model?

ii.  What is the optimum dividend payout ratio as per Walter’s Model and what   should be the market value of Company’s share at that payout ratio?

 

Solution: 5

Illustration: 6

ABC Limited has 50,000 outstanding shares. The current market price of its share is Rs 100 each. It hopes to make a net income of Rs 5, 00,000 at the end of current year. The Company’s Board is considering a dividend of Rs 5 per share at the end of current financial year. The company needs to raise Rs 10, 00,000 for approved investment expenditure. The company belongs to a risk class for which the capitalization rate is 10%. Show, how the M-M approach affects the value of firm if the dividends are paid or not paid.

 

Solution: 6

Illustration: 7

The following information of Avatar Limited is supplied to you:

Particulars	Rs
Total Earnings	2,00,000
Number of equity shares (of Rs 100 each)	20,000
Dividend paid	1,50,000
Price/Earnings (P/E) Ratio	12.5

 

i.   Ascertain whether the company is following an optimal dividend policy.

ii.  Find out what should be the P/E ratio at which the dividend policy will have no   effect on the value of the share.

Solution: 7