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The Dividend Policy Rationale and Theories

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The Dividend Policy Rationale and
If a company thinks that by investing its retained earnings it will generate more than the
market returns, then it should retain higher profit and should not pay more dividends (or
also may not pay dividend at all). If a company is not so confident that it will not be able to
generate more than the market returns, it should pay out more dividends (or 100%

Dividend Policy
Firm’s dividend policy divides net earnings into retained earnings and dividends. Dividend
is a part of the after tax profit for a company and that part of after tax profit is divided into
the shareholders of that company. The remaining of the PAT is called as “Retained
Dividend policy of the firm is governed by:
Long term financing decision: When dividend decision is treated as a financing decision,



The Dividend Policy Rationale and Theories

net earnings are viewed as a source of long term financing. When the firm does not have
profitable investment opportunities, dividends will be paid.
Wealth maximization decision: Because of market imperfections and uncertainty,
shareholders give higher value to near dividends and capital gains. When the firm
increases retained earnings, shareholders’ dividends decrease and consequently market
price is affected. Use of retained earnings to finance profitable investments increase future
earnings per share. On the other hand, increase in dividends may cause the firm to forego
investment opportunities for lack of funds and thereby decrease the future earnings per
share. Thus, the management should develop a dividend policy which divides net earnings
into dividends and retained earnings in an optimum way so as to achieve the objective of
wealth maximization for shareholders.
The formulation of dividend policy depends upon answers to the questions:
Whether there should be a stable pattern of dividends over the years; or
Whether the company should treat each dividend decision completely independent.
The various theories on dividend policies are discussed in the report hereafter.

Theory of irrelevance of dividend policy states that a company's dividend has no effect on
its market value or cost of capital.
Modigliani and Miller proposed that dividend is a relevant factor in assessing the corporate
market. They argue that shareholder value is determined solely by real considerations
namely the earning capacity of the company and its investment policy. The dividends do
not affect the valuation of the company. The proceeds are split between dividends and
retained earnings and have no effect on shareholder wealth.
According to M & M, it does not matter how it is divided between profits. In M & M the
decision of the dividends is one in which leaders do not need to agony, trying to find the
optimal policy of dividends, as the optimal dividend policy does not exist.



For example, suppose that an investor's point of view is that a company's profits are too
high. The investor can then buy more stock with the dividends of investor confidence.
dividends from a company are too small,
Blogif, from the standpoint
Contact of the investor,
Buy Now
an investor could sell part of its portfolio to replicate the cash he or she should. Thus
investors care little sense for dividend policy of a company because they can simulate
their own.

My account

MM hypothesis is built on assumptions about an ideal economy. An ideal economy is
characterized by perfect capital markets, rational behaviour and perfect certainty.

Rational behaviour
It implies that investors prefer more wealth to less. In addition, they are indifferent to
whether a given increase in their wealth is in the form of dividends or increasing the value
of its shares. Modigliani and Miller continue the usual assumption of rational behavior,
introducing the concept of symmetric market rationality. Symmetric market rationality
hypothesis is based on the assumption that each investor is also alleged to market
opportunities. It is assumed that all other investors are rational and in turn also
responsible for the rationality of the market. This applies only to the choice behavior of
individuals but also their expectations for the selection behavior of others. symmetric
market rationality can not conclude that the rational individual behavior.
If a reasonable investor is usually a good reason to believe that other investors do not
behave rationally, then it might be sensible, that takes the strategy he would otherwise
have rejected the absurd. This hypothesis therefore excludes the possibility of "bubbles"
that would otherwise reasonable investor to buy overpriced security (too expensive in
relation to its long-term expected return on investment to justify the addition of its
portfolio), in the hope that it can sell at inflated prices even before the bubble bursts. This



The Dividend Policy Rationale and Theories

hypothesis symmetric market rationality to extend the concept of adequacy of the overall
Perfect certainty means full security of a portion of an investor with respect to the future
investment program and the future profits of all firms. The latter proved that the MM
approach applies even if this assumption is abandoned.

Perfect Capital Market
It has a large number of issuers and investors. The operations of non-participant may
have a significant impact on market prices. The information is free and is also accessible
to all.
There is no transaction in the form of commissions, transfer taxes, etc. to buy or sell
securities. No costs of flotation, such as issuance costs and prices under the issuer, the
issuing of new shares. Not among the distributed profits and retained earnings, or between
dividends and capital gains.

The presence of taxes
M&M assume that there are no personal taxes. Taxes on dividends (ordinary income) are
higher than taxes on capital gains. Thus, in the presence of personal taxes, companies
should not pay dividends because investors require higher returns for companies that pay
dividends. If the fees are payable, shareholders of the company should opt for other
alternatives, such as share repurchases. This is the truth, if taxes on dividends are higher
than taxes on capital gains.
However, different investors have different tax rates. People with high tax rates that the
company prefers to invest more, while those with low taxes may prefer the company not to
invest and pay dividends. Investors choose their own customers. However, the presence of
customers does not explain why companies decide to start paying dividends.

Information asymmetries
It argues that in perfect markets dividend policy is irrelevant. One of the assumptions of
the model is that all individuals have the same information.
Managers and insiders have access to private information. Business managers who expect
a high cash flow stream (type of business law) to communicate this information to the
market. Remember the good and bad companies are encouraged to report that they are
good companies, so we need a sign of unity that we can separate the good from the bad
And indicate that the use of debt sends a positive signal to the market. This signal is
credible because firms can issue debt bonds, but bad because companies can’t have
financial problems in the future. The contract includes the signal, (companies that issue
bonds are good companies) and reward companies that issue bonds with an increase in
Dividends can be used in a similar manner to convey a good (or bad) information. A
company that increases the signs of the dividends expected future cash flows, dividend
policy because it tends to remain stable over the years. Bad company can also increase
dividends, but they are bad and companies in the future, will reduce its dividend, and the
market penalize them.
This perspective may signal why companies pay dividends: the dissemination of private
property on the market.

Walter’s Model
To start off with the Walter’s model, let’s go through the basics. Dividend is a part of the
after tax profit for a company and that part of after tax profit is divided into the
shareholders of that company. And the remaining of the PAT is called as “Retained
Earnings”. Therefore if the dividend pay-out is high, the retained earnings will be lower.



The Dividend Policy Rationale and Theories

If a company thinks that by investing its retained earnings it will generate more than the
market returns, then it should retain higher profit and should not pay more dividends (or
also may not pay dividend at all). Other way around, if a company is not so confident that it
will not be able to generate more than the market returns, it should pay out more dividends
(or 100% dividends). There are two reasons for doing this:Shareholders usually prefer early inflow of cash
Shareholders also believe in investing this cash to generate more returns (since market
returns are expected to be higher than returns generated by the company).

How Does Walter Model Work?
He has given a formula in which he has delivered a way by which dividends can be used to
maximise the wealth proposition of the shareholders. Considering a long run situation,
according to Walter, share price gives an idea about the present value of future stream of
dividends. Retained earnings influence stock prices only through their effect on further

There are some assumptions that we need to consider before implementing the formula
proposed by Walter. These assumptions are:The company is a going concern with perpetual life span.
For this company, retained earnings are the only source of finance and it doesn’t have
any other alternative of finance.
The cost of capital and return on investment are constant throughout the life of the
If there is an additional investment taking place, then firm’s business risk doesn’t change.
(This means that ‘r’ (internal rate of return) and ‘k’ (cost of capital) are constant.)
The firm has an indefinite life.

Walter’s Model (Formula)
Ke – g
Where:P = Price of equity shares
Ke = Cost of equity capital
D = Initial dividend
g = Growth rate expected
After accounting for retained earnings, the model would be:
Ke – rb
b = Retention rate (E - D)/E
r = Expected rate of return on firm’s investments
Equation showing the value of a share (as present value of all dividends plus the present
value of all capital gains) – Walter's model:P = [D + r/Ke(E – D)] / Ke
Where: D = Dividend per share and E = Earnings per share



The Dividend Policy Rationale and Theories

Example 1
A Ltd. paid a dividend of INR 10 per share for 2009-10. The company follows a fixed
dividend pay-out ratio of 35% and earns a return of 19% on its investments. Cost of capital
is 12%. The expected price of the shares of A Ltd. using Walter Model would be calculated
as follows
EPS = Dividend / pay-out Ratio
=10 / 0.35 = Rs.28.57
According to Walter Model,
P = [D + (E - D) x ROI / Kc] / Kc
P = [10 + (28.57 – 10.00) x 0.19 / 0.14] / 0.14
P = 251.44

Example 2
These are some facts given for a company
Cost of capital (ke) = 0.12
Earnings per share (E) = $13
Rate of return on investments ( r) = 9.2%
Dividend pay-out ratio: Case A: 60% Case B: 30%
Show the effect of the dividend policy on the market price of the shares.

Case 1:D/P ratio = 60%
When EPS = $13 and D/P Ratio = 60%, D = 13 * 60%= $7.8
P = {7.8 + [0.092/13]*[13 – 6]} / 0.12 = $65.41

Case 2:D/P ratio = 30%
When EPS = $13 and D/P Ratio = 30%, D = 13 * 30%= $3.9
P = {3.9 + [0.092/13]*[13 – 3]} / 0.12 = $38.9

If r > ke, then the value of shares will be inversely related to the D/P ratio.
If r < ke, the D/P ratio and the value of shares will be positively correlated.
When r = ke, the market value of shares is constant irrespective of the D/P ratio. In this
case, there is no optimum D/P ratio.

Gordon Growth Model
The market value of the firm to dividend policy can be explicitly related by this model. In
this model, the current ex-dividend at the amount which shareholders expected rate of
return exceeds the constant growth rate of dividends.

It is based on the following assumptions:
The firm is completely financed by equity and it has no debt.



The Dividend Policy Rationale and Theories

No external financing is used and investment programs are financed by retained earnings.
The internal rate of return, r, of the firm is constant.
The discount rate, ke, for the firm remains constant.
The retention ratio (i.e. % of earnings retained), b, is constant. Thus the growth rate, g =
br, is also constant.
The discount rate, ke, is greater than the growth rate, g.
According to Myron Gordon, what is available at present is preferable to what may be
available in the future. Being rational, the investors want to avoid risk and uncertainty.
They would prefer to pay a higher price for shares on which current dividends are paid.
However, they would discount the value of shares of a firm which postpones dividends.

The relationship between dividend and share price on the basis of Gordon growth model is
as follows:
V = Market price per share (ex-dividend)
ke = cost of equity capital (Expected rate of return)
Do = Current year dividend
g = constant annual growth rate of dividends
Example 1: Starlite Ltd. is having its shares quoted in major stock exchanges. Its share
current market price after dividend distributed at the rate of 20% per annum having paidup shares capital of Rs.10 lakhs is Rs. 10 each. Annual growth rate in dividend expected is
2%. The expected rate of return on its equity capital is 15%.
Calculate the value of Starlite Ltd.’s share based on Gordon’s model.

When the growth is incorporated in earnings and dividends, the present value of market
price per share (Po) is given by:
Po = Present market price per share
E = Earnings per share
b = Retention ratio (i.e. % of earnings retained)
r = Internal rate of return (IRR)
k = cost of capital
Example 2: Calculate the market price of a share of a company by dividend growth model
(Gordon Growth model) for the given data:
Earnings per share (EPS) = Rs. 10
Cost of capital (k) = 20%
Internal rate of return (IRR) on investment = 25%
Retention ratio = 60%

Market price per share,

The primary advantage of this model is that readily available or easily estimated inputs are



The Dividend Policy Rationale and Theories

used to perform the valuation calculation.
The model is particularly useful among companies or industries having relatively stable
and strong cash flows; and having consistent leverage patterns.
It has wide applications in providing guideline fair values in mature industries – viz.
Financial services and large-scale real-estate ventures.

One of its drawbacks is that it takes no account of qualitative factors such as industry
trends or management strategy. For example, in a company generating high cash, nearfuture dividend payouts could be limited by management’s strategy of retaining cash to
fund a likely future investment. As the model is simple, it is not flexible enough to consider
projected changes in the rate of future dividend growth.
It is less suitable for use in industries that are rapidly growing like software or mobile
telecommunications. This is because the basic premise is that future dividends will grow at
a constant rate in perpetuity.

Graham and Dodd Model
Dividend policy of a company is very crucial in order to maintain good relations with the
investors (specially the shareholders) of the company. When a company makes a profit,
the management decides on what to do with those profits.
They have the option of retaining the profits and reinvesting them so as to earn more
profits and increase shareholder wealth in terms of increase in share prices or paying the
profits earned as dividend to shareholders so that the shareholders can have some cash
in hand.
However, once the company decides to pay dividends, it should establish a permanent
dividend policy, which may impact on investors and perceptions of the company in the
financial markets. Generally, companies paying dividends are respected by the
shareholders given the liquidity preference theory. If the company thinks that it has
enough investment opportunities and they would be able to substantially increase the
value of the company for the shareholders, it should retain the profits. What they decide
depends on the situation of the company now and in the future. It also depends on the
preferences of investors and potential investors.

Factors Favouring Higher Dividend Payout
AGENCY COSTS- Agency costs are differences between the interests of stockholders and
the interests of management. More external capital is required to pay higher dividends.
This leads to a greater scrutiny in the market therby reducing agency costs.
"BIRD-IN-HAND"- This argument holds that future earnings are less predictable and more
uncertain than dividends, at least because they are further in the future. The greater
uncertainty of future earnings should be reflected in a higher discount rate on capital
gains than on dividends. This in turn would cause investors to prefer a more certain $1.00
of dividends over a less certain $1.00 of future earnings.
"PROSPECT THEORY"- This argument suggests that investors have a different attitude
toward capital gains than toward dividends. Capital gains become part of the investment
base or permanent capital, which investors hesitate to reduce. Paid dividends, however,
are considered as current income and are spendable. Because "homemade" dividends
require reduction of capital, they have a different psychological impact than paid dividends
and are an imperfect substitute.

Factors Favouring a Lower Dividend Payout



The Dividend Policy Rationale and Theories

TAXES- Although both capital gains and dividends are taxed, the tax on capital gains is
lower and will not be paid until the stock is sold. Since payment of capital gains tax can be
delayed, investors will be reluctant to create dividends by selling stock. Investors
attempting to undo a dividend payment by buying stock with dividends must pay taxes on
the dividends, and cannot totally reverse the dividend. The investor will be better off if the
firm retains the earnings and reinvests them to produce capital gains, since tax payment is
TRANSACTIONS COSTS- In addition to taxes, investors reinvesting dividends will also face
various transactions costs such a brokerage fees. Conversely, a firm that pays dividends
and then must turn to external sources also faces transactions costs such as the "flotation
costs" of issuing new securities. If the firm retains the funds and reinvests directly, both
types of cost are avoided.

Other Considerations
DIVIDENDS AS A RESIDUAL- The argument for dividend irrelevancy assumes that all
investment takes place at the required rate of return for the firm. In actuality, it is likely that
the firm faces a mix of risk and return possibilities. The firm should thus accept all projects
with a positive net present value, and pay dividends only if it has more funds than are
expected to be required for attractive projects. While attractive to academics, this
approach is seldom used in practice because it results in uncertain dividends and a
greater perception of risk by investors.
CLIENTELE EFFECT- The clientele effect indicates that investors will tend to hold stocks
whose dividend policy fits their needs. That is, investors preferring more certain dividends
over uncertain future earnings, or having a preference for current income over capital
gains, will tend to hold stocks with relatively high dividend payout, and vice versa (i.e., a
stock will have a clientele attracted by its dividend policy). Under these conditions, it is not
the dividend policy itself that is relevant, but the stability of the policy.
SIGNALING- Most theoretical models assume that information is freely available to all. It
has been suggested that in reality access to information varies. Management may have
access to inside information, causing an "information asymmetry" between management
and stockholders. Signaling refers to the use of dividends and dividend changes to convey
information to investors. Similar to the clientele effect, it is not the absolute but rather the
relative level of dividends that is important. Under this argument management will avoid
increasing dividends unless it is highly likely that the higher level of dividends can be
maintained. This implies that a dividend increase is a signal that the firm has reached a
new level of profitability, and is a positive signal. A dividend decrease, on the other hand,
indicates that profitability has decreased and the former dividend level cannot be
supported, a negative signal. Note that under the residual argument, however, a dividend
increase (decrease) signals a lack (abundance) of attractive projects and decreased
(increased) future firm growth. Because of the potential for false signals, more costly
signaling is considered more reliable.

Graham and Dodd Model
Graham and Dodd Model holds that the stock market favours companies, which give more
dividends than on, retained earnings. Hence an investor should evaluate a common stock
by applying one multiplier to the portion of earnings paid out as dividends and a smaller
multiplier to undistributed profits. In other words, more weight should be put on dividends
than on retained earnings.
Their viewpoint is expressed as

P=m x (D + E/3)
P = Market price/share;
m = multiplier;



The Dividend Policy Rationale and Theories

D = DPS;

The main assumptions of this model are:
Investors are rational.
Under conditions of uncertainty they turn risk averse.

Implications and Criticism
The main implication of this model is that weight attached to dividends is equal to four
times the weight attached to retained earnings.This can be shown by re-arranging the
above formula:

P=mx (D + (D+R)/3)
The weights provided by Graham and Dodd are based on their subjective judgements. So
the conclusion of this model is that a liberal payout policy has a favourable impact on the
stock price.

Alpha Ltd. has recorded an EPS of Rs. 6 for 1998-99. The company follows a fixed
dividend payout ratio of 75%. If the multiplier for the industry is 12, compute the expected
market price for the share based on the Graham-Dodd Model.

The dividend per share is Rs. 6 * 0.75 = Rs.4.50
Based on the Graham-Dodd Model, the expected market price would be
P = m (D + E/3) = 12 (4.50 + 6/3)
= Rs. 78 per share.

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