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Dividend Theory

Dividend Theory
DIVIDEND THEORIES FINANCIAL MANAGEMENTINTRODUCTION OF DIVIDEND A dividend is a distribution of a portion of acompany’s earning to a class of its shareholders . Dividends can be in the form of cash , stock ,and less commonly, property. Most stable companies offer dividends to shareholders Often the stock price s of these financially secure companies do not move much ,anddividend’s are offered as a a way to entice , reward and retain investors.DEFINITION OF DIVIDEND According to S. M. Saha “Dividend are profits of trading company divided amongst members in proportion to their shares.” According to the Supreme Court of India “Dividend is the proportion of profits of the company which is allocated to the holders of shares in the company.”DECLARATION OF DIVIDEND Need of the Company The financial requirements of the company should be estimated and if there need are more urgent than company can void dividend declaration and keep all profits as retained earnings and plough back in business. Reasonable returns to shareholders Dividends are earnings for shareholders and they expect reasonable earnings from their investments. Therefore company should declare reasonable dividends regularly and if this does not happen then shareholders are disheartened and market prices of shares.DIVIDEND AND ITS VARIOUS FORMS Dividend is distribution of profits earned by a company among its various shareholders. It is also called payout ratio. In most cases, dividends are paid in cash; but there may be other forms dividends also. Let us describe each one of them separately.Forms/Types of Dividend • On the basis of Types of Share – Equity Dividend – Preference Dividend – Scrip Dividends – Bonus Share • On the basis of Mode of Payment – Cash Dividend – Stock Dividend – Bond Dividend – Property Dividend – Composite DividendOn the basis of Time of Payment Interim Dividend Regular Dividend Special Dividend Optional DividendDimensions of Dividend Decision • Payout Ratio – Funds requirement – Liquidity – Access to external sources of financing – Shareholder preference – Difference in the cost of External Equity and Retained Earnings – Control – Taxes• Stability – Stable dividend payout Ratio – Stable Dividends or Steadily changing DividendsFactors Affecting Dividend Decision • Legal Provisions• Control Factor • Magnitude of earnings• Liquidity Position • Desire of Share holders• Future requirements • Nature of Industry• Agency Costs • Age of the Company• Stage of Business cycle • Taxation Policy• Business RisksDIVIDEND THEORIESDIVIDEND THEORIES Relationship between Dividend and Value of the Company. A company's dividend policy has the effect of dividing the company's disposable profit into two categories:  Funds to finance longterm growth and  Funds to be distributed to the shareholders.The company may adopt two possible viewpoints on the decision to pay dividends. As a Longterm Financing Decision : With this approach all the disposable profits can be viewed as source of longterm financing. The declaration of cash dividends reduces the amount of funds available to finance the growth and either restricts growth or forces the company to find other sources of financing. Thus, company might accept a guideline to retain earnings as long as either of the following two conditions exists: 1. Sufficient profitable projects are available 2. Capital structure needs equity fundsAs a Maximization of Wealth Decisions: • With this approach, the company recognizes that the payment of dividends has a strong influence on the market price of the equity shares. High dividends increase the value of shares to many investors. • Similarly, low dividends decrease the perceived value of the equity shares. Company must declare sufficient dividends to meet the expectations of investors and shareholders.Dividend Theories Relevance Theories Irrelevance Theories (i.e. which consider dividend decision to be (i.e. which consider dividend decision to be relevant as it affects the value of the firm) irrelevant as it does not affects the value of the firm) Modigliani and Miller’s Gordon’s Model Walter’s Model Traditional Approach ModelDividend Decision and Valuation of firms: The value of the firm can be maximized if the shareholders’ wealth is maximized. • One school of thought, dividend decision does not affect the shareholders’ wealth and hence the valuation of the firm. • Other school of thought, dividend decision materially affects the shareholders’ wealth and also the valuation of the firm.Below mentioned are the views of the two schools of thought under two groups: • The Irrelevance concept of Dividend or the Theory of Irrelevance, and • The Relevance concept of Dividend or the Theory of Relevance.Relevance TheoriesRELEVANCE AND IRRELEVANCE DIVIDEND VIEW POINT • Dividend and market price of shares are interrelated. However ,there are two schools of thought : while one school of thought opinions is that the dividend has an impact on the value of the firm, another school argues that the amount of dividend paid has no effect on the valuation of firm. • The first school of thought refers to the relevance of dividend while the other one relates to the irrelevance of dividend. RELEVANCE OF DIVIDEND Walter and Gordon suggested that shareholders prefer current dividends and hence a positive relationship exists between dividend and market value . The logic put behinds this argument is that investors are generally risk averse and that they prefer current dividend, attaching lesser importance to future dividends or capital gains.The Relevance Concept or Theory of Relevance: We have two theories: 1. Walter’s Approach 2. Gordon’s ApproachWalter's Model • Professor James E. Walter argues that the choice of dividend policies almost always affect the value of the firm . • His model, one of the earlier theoretical works, shows the importance of the relationship between the firm’s rate of return, r, and its cost of capital, K, in determining the dividend policy that will maximize the wealth of shareholders .WALTER’S MODEL ASSUMPTION Walter’s model is based on the some assumption some of them are as follow: • Internal Financing • Constant return and Cost of Capital • 100 payout or Retention • Constants EPS and DIV • Infinite TimeFORMULA OF WALTER’S MODEL P= Market price per share DIV=Dividend per share EPS=Earnings per share r =Firm’s rate of return (average) k= Firm’s cost of capital or capitalization ratewhen r k (a case of growth firms) This generally refers to the situation of growth companies which have abundant profitable investments opportunities, so that return from investments exceeds cost of capital. These companies should retain all earnings for investments if value per share is to be maximized. In other words, when r k the dividend payout ratio should be zero, i.e., P will be maximum when payout ratio is 0 or P increases as payout ratio declines.When r k (a case of declining firms) • Declining firms are those business entities who do not have profitable investment opportunities to reinvest their earnings. Here the rate of return (r) from new investments is less than the cost of capital (k), so that retention is not profitable. In this situation a company should distribute its entire earnings in the form of dividends instead of retaining them in the business for reinvestment. • This will enable the shareholders to get a higher return from investments elsewhere. Thus, when r k, P increases as payout ratio increases i.e., P will be maximum when payout ratio is 100 (EPS = DPS).When r = k (a case of normal firms) • Normal firms are those business entities who do not have unlimited profitable investment opportunities. Thus, once the profitable investment opportunities are exhausted, the return from investments (r) equals to the cost of capital (k). As soon as r = k, the dividend policy does not affect the market price of the shares. • That is, market price of shares becomes insensitive to payout ratio. And in this case dividend becomes irrelevant factor in determining the market value per share.Example • Earning per share of a company is Rs. 10 and market capitalization rate is 10. The company has before it an option of adopting a payment ratio of 50. 75 and 100. • Using Walter's formula of dividend payout, compute the market value of the Companies Share, if the rate of return on internal investment is (a) 15, (b) 10 and (c) 8.Criticism of Walter's Model a) It ignores the benefits of optimal capital structure. b) Actual share price in practice are likely to be different from those determined by the Walter's formula. c) No external financing. d) It assumes that 'r' is constant. But 'r' is generally declined when more and more investments are taken up. e) Assumption that cost of capital (k) remains constant may not hold true/good in practice. f) It ignores the fact that market prices are affected by many factors and present value of future expected dividend is one of them.Gordon's Model M. J. Gordon also holds the view that dividend is relevant to the value of the firm and dividend policy certainly affects the value of the firm i.e. market price of the shares of a company.GORDON’S MODEL ASSUMPTIONS • All equity firm • No external financing • Constants returns • Constants cost of capital • Perpetual earnings • No taxes • Constants retention • Cost of capital growth rateFORMULA where, •P = Market price of the share •E = Earnings per share •b = Retention ratio (1 payout ratio) •r = Rate of return on the firm's investments •k = Cost of equity e •br = Growth rate of the firm (g)When rk (Case of growth firms) • T' increases with the increase in retention ratio (). Thus, when r k, the company should distribute lesser dividend and retain higher amount of profitWhen rk (Case of declining firms) • P decreases with increase in retention ratio (). Thus, when r k, retention becomes undesirable and more and more profits should be distributed as dividends.When r = k (Normal forms) • P is not effected by the retention ratio(b). Thus, dividend becomes irrelevant in such cases.EXAMPLE Given: • Cost of Capital (k) = 10. • Earnings per Share (E) = Rs. 10. • Internal rate of return (r) = (i) 15, (ii) 10 and (iii) 8. • Determine the value per share assuming the following retention • (a) RetentionRatio (b) Payout Ratiob=R/E D/E 0 100 10 90 30 70 50 50 60 40DIVIDENDS AND UNCERTAINTY: BIRD IN THE HAND ARGUMENT  According to Gordon’s model, dividend policy is irrelevant where r=k , when all other assumptions are held valid. But when the simplifying assumptions are modified to confirm more closely to reality, Gordon concludes that a dividend policy does affect the value of share even when r=k.  This view is based on the assumption that under the conditions of uncertainty, investors tend to discount distant dividend (capital gains) at a higher rate than they discount near dividends.  Investors, behaving rationally, are risk averse and therefore, have a preference for near dividends to future dividends .the logic underlying the dividend effect on share value can be described us Bird –In – Hand the argument. Krishman, first of all, put forward the Bird –InThe –Hand argument KRISHMAN BIRD IN HAND ARGUMENT VIEW  Of two stocks with identical earnings record, and prospects but the one paying larger dividends than the other, the former will undoubtedly command higher price nearly because stockholders prefer present to future values.  Myopic vision plays a part in the price – making process .stockholders often act upon the principle that a bird in the hand is worth two in the bush and for the reason are willing to pay a premium for the stock with the higher dividend rate, just as they discount the one with the lower rate.Graham and Dodd also hold a similar view when they state:  The typical investor would most certainly prefer to have his dividend today and let tomorrow take care of itself. No instances are on record in which the withholding of dividends for the sake of future profits has been hailed with such enthusiasm as to advance the price of the stock. The direct opposite has invariably been true. Given two companies in the same general positions and with the same earnings power, the one paying the larger dividend will always sell at a higher price. GORDON’S stated that the increase in earnings retention will result in a lower value of share. To emphasise, he reached this conclusion through two assumptions regarding investor’s behaviour: Continue...  Investors are risk averters  They considers distant dividends as less certain than near dividends Thus , incorporating uncertainty into his model, Gordon concluded that the dividend policy affects the value of share .his reformulation of this model justifies the behaviour of investor who value a rupee of dividend income more than a rupee of capital gains income . These investors prefer dividend above capital gains because dividends are easier to predict, are less uncertain and less risky and are therefore, discounted with a lower discount rate. However, all do not agree with this view.Irrelevance Concept of Dividend Decision • Some experts hold the view that dividend is not relevant determining the value of the company. Dividend policy and value of the company both are independent variables. In other words, there is no role of dividend policy in maximizing the value of the company.CONCLUSION Dividends are that portion of a firm’s net earnings paid to the shareholders. Equity holders’ dividends fluctuate year after year. It depends on what portion of earnings is to be retained by the firm and what portion is to be paid off.