DIVIDEND DECESION

A STRATEGIC PERSPECTIVE
MEANING OF DIVIDENED

The term “Dividend” refers to that part of after

tax profit which is distributed to owners
(shareholders) of the company. The
undistributed part of profit is known as
Retained Earnings.
MEANING OF DIVIDEND POLICY

The dividend policy of a company refers to the

views and policies of the management with
respect to distribution of dividends. The
dividend policy of a company should aim at
shareholder – wealth maximization.
Factors influencing dividend policy

 Age of company
 Past dividend rates
 Liquidity of company
 Stability of earning
 Expectation of share holder
 Legal restrictions
ESSENCE OF DIVIDEND POLICY

If the company is confident of creating more than

market returns then only it should retain higher
profits and pay less as dividends, as shareholders
can expect higher share prices based on higher RoI
of the company.

However if the company is not confident of generating

more than market returns, it should payout more
dividends .
REASONS FOR PAYOUT

Payout is done because of two reasons:

 The shareholder prefer early receipt of cash

(liquidity preference theory).

 The shareholders can invest this cash to

generate more returns (since market rate of

interest is higher than returns generated by
company).
GRAHAM MODEL

Based on his observations of stock over the years,

Benjamin Graham developed a stock valuation
model that allows for future growth. Graham
observed that the average no-growth stock sold at
8.5 times earnings, and that price-earnings

P/E = 8.5 + 2G
where G is the rate of earnings growth, stated as a
percentage.
SHORTCOMINGS OF MODEL

The original formulation was made at a time when

there was very little inflation, and growth could be
assumed to be real growth; the AAA corporate bond
interest rate prevailing at the time was 4.4%. In later
years, the formula was adjusted for higher current
interest rates that contained an inflationary
component:
P/E = [8.5 + 2G] × 4.4/Y
where Y is the current yield on AAA corporate bonds.
EXAMPLE

As an example, at a 6% bond yield and an

assumed annual earnings growth rate of
10%, the P/E multiplier would be:
P/E = [8.5 + 2(10)] × 4.4/6
       = 28.5 × 0.73
       = 20.9
INTERPRETATION OF MODEL

The Graham and Dodd P/E Matrix uses this

valuation formula to show the price-earnings
ratio that results from a given bond yield at a
given rate of earnings growth. You will be
able see from the table that changes in
interest rates will have a dramatic effect on
price-earnings ratios for any given earnings
growth rate.
 Graham & Dodd P/E Matrix
Bond Expected 5-Year Annual Growth Rate:
Yield 0% 5% 10% 15% 20% 25% 30% 35% 40%
1% 37.4 81.4 125.4 169.4 213.4 257.4 301.4 345.1 389.4
2% 18.7 40.7 62.7 84.7 106.7 128.7 150.7 172.7 194.7
3% 12.5 27.1 41.8 56.5 71.1 85.8 100.5 115.1 129.8
4% 9.4 20.4 31.4 42.4 53.4 64.4 75.4 86.4 97.4
5% 7.5 16.3 25.1 33.9 42.7 51.5 60.3 69.1 77.9
6% 6.2 13.6 20.9 28.2 35.6 42.9 50.2 57.6 64.9
7% 5.3 11.6 17.9 24.2 30.5 36.8 43.1 49.3 55.6
8% 4.7 10.2 15.7 21.2 26.7 32.2 37.7 43.2 48.7
9% 4.2 9.0 13.9 18.8 23.7 28.6 33.5 38.4 43.3
10% 3.7 8.1 12.5 16.9 21.3 25.7 30.1 34.5 38.9
11% 3.4 7.4 11.4 15.4 19.4 23.4 27.4 31.4 35.4
12% 3.1 6.8 10.5 14.1 17.8 21.5 25.1 28.8 32.5
13% 2.9 6.3 9.6 13.0 16.4 19.8 23.2 26.6 30.0
14% 2.7 5.8 9.0 12.1 15.2 18.4 21.5 24.7 27.8
15% 2.5 5.4 8.4 11.3 14.2 17.2 20.1 23.0 26.0
16% 2.3 5.1 7.8 10.6 13.3 16.1 18.8 21.6 24.3
LINTER’S MODEL

In the 1950’s, Lintner conducted a classic

series of interviews with corporate managers
about their dividend policy. He then
proceeded to formulate a seemingly logical
model of how companies decide on dividend
payments. The findings of Lintner’s survey
can be summarised in four “stylised facts”, as
interpreted by Marsh and Merton
 Firms have long-term target dividend payout ratios.
 Managers focus more on dividend changes than on
absolute levels.
 Dividend changes follow shifts in long-term,
sustainable earnings. This trend implies that
managers tend to “smooth” dividends so that
changes in transitory earnings are unlikely to affect
dividend payments over the short term.
 Managers are reluctant to make changes to
dividends that might have to be reversed. They are
particularly concerned about having to rescind a
dividend increase.
ESSENCE OF MODEL

The essence of Lintner’s dividend model is that,

if a firm persisted with its target payout ratio,
then the dividend payment in the ensuing
year (Div1) would equal a constant proportion
of earnings per share (EPS1), or

Div1 = target ratio * EPS1

If a firm adhered to its target payout ratio, it would change its dividend
whenever its earnings changed. However, the managers in Lintner’s
(1956) survey were reluctant to do this. They believe that shareholders
prefer a steady progression in dividends. If, for instance, circumstances
appeared to warrant a large increase in their company’s dividend, they
would move only partially towards their target dividend. Their dividend
changes appear to conform to the following model:
Div1 – Div0 = adjustment rate * target change = adjustment rate * [(target
ratio * EPS1) - Div0]
This equation can be rewritten in a summarised form as:
D1 – D0 = a*(TE1 – D0) = aTE1 – aD0 (2)
 where a = adjustment rate;
 T = target rate;
 D1 = current dividend;
 E1 = current earnings; and
 D0 = previous dividend.
WALTER MODEL

Prof. James E. Walter devised an easy and

simple formula to show how dividend can be
used to maximize the wealth position of
shareholders.

He considered dividend as one of the important

factor determining the market valuation.
According to Walter, in the long run share
prices reflect present value of future stream
of dividends. Retained earnings influence
stock prices only through their effects on
further dividends.
ASSUMPTIONS OF THE MODEL

 Internal financing
 100% payout or retention
 Constant RoI and cost of capital
 Infinite time
According to Walter model

P= [D+(E-D)*RoI/Kc]/Kc
P = Market price per share
E = Earning per share
D = Dividend per share
Kc = Cost of capital
RoI = Return on investment
EXAMPLE
r = 0.15, 0.10, 0.08
K = 0.10
Eps = Rs.10
Dps = 40%

P = (4 / 0.1) + (0.15 / 0.1) (10 – 4) = Rs.130

0.1
P = (4 / 0.1) + (0.1 / 0.1) (10 – 4) = Rs.100
0.1
P = (4 / 0.1) + (0.08 / 0.1) (10 – 4) = Rs.88
0.1
SHORT COMINGS OF THE MODEL

The model considers internal rate of return (IRR),

market capitalization rate Kc and dividend payout
ratio in determination of share price. However it
ignores the various other factors determining share
price .it fails to accurately calculate prices of
companies that resort to external sources of finance.

Further the assumption of constant return and

constant cost of capital are unrealastic.
INTERPRETATION OF WALTER
MODEL
If the internal rate of return of retained earning
is higher than the market capitalization rate,
value of ordinary share would be high even if
dividends are low. However, if the RoI within
the business is lower than what market
expects, the value of shares would be low. In
such case shareholders would expect higher
dividends.

If RoI > Kc Price would be high even if dividend is low.

GORDON’S MODEL

According to Gordon’s Model the market value

of a share is equal to an infinite stream of
dividends received by shareholders.

The formula is:

Po = DIV1/K-G
OR
Po= EPS1 (1-b)/K-br
Here
EPS = Earning per share
r = Rate of return
b = Retention Ratio
g = Growth rate
k = Cost of capital
EXAMPLE

r = 0.15, 0.10, 0.08

K = 0.10
Eps = Rs.10

b = 60%

P = 10(1-0.6) / 0.10 (0.15 * 0.60) = Rs. 400

P = 10(1-0.6) / 0.10 (0.10 * 0.60) = Rs. 100
P = 10(1-0.6) / 0.10 (0.08 * 0.60) = Rs. 77
Assumptions of Gordon’s Model

 All equity funds

 No external financing
 Constant return
 Perpetual earning
 No taxes
 Constant Retention
 Cost of capital greater than growth rate
Interpretation of Gordon’s Model

According to Gordon’ s model dividend policy is

irrelevant where r=k, when all assumptions
are held valid. as per this theory dividend
policy does affect value of share even when
r=k. This view is based on the assumption
that under conditions of uncertainty investor
tends to discount distant dividend at higher
rate than they discount near dividends.
The implication of dividend policy as per
Gordon’s model for growth firms, normal
firms and declining firms are as follow:
 The market value of share increases with
retention ratio for firms with growth
opportunities i.e. r>k.

 The value of share increases with payout

ratio (1-b) for declining firms i.e. r<k.

 The market value of share is not affected by

dividend policy when r=k.
MM HYPOTHESIS

According to Modigilani and Miller under a

perfect market situation, the dividend policy
of a firm is irrelevant, as it does not affect
value of the firm.
ASSUMPTIONS OF MM
HYPOTHESIS
 Perfect capital market
 No taxes
 No risk
Interpretation of MM Hypothesis

Under the MM theory r will be equal to k and identical

for all shares. As a result the price of each share will
adjust so that rate of return and capital gains will be
equal to k on each share.
Thus minimum rate of return may be calculated as
follows:

r = Dividends + Capital Gains

Share price
Shortcoming of MM Hypothesis

The assumptions of theory are not valid under

practice. The following are the situations
where MM Hypothesis may go wrong:
 Uncertainty and shareholder preference

 Transaction cost

 Tax differentials
BONUS ISSUE

Bonus share: In place of or in addition to cash

dividend a company may offer additional
shares.
Example: The company may decide to give 1
additional share to holder of every 2 share.
 You own 100 shares@100 each (Rs 1200)

 After bonus issue you have 150 shares @Rs.

8 each (Rs. 1200)
SHARE SPLIT

 Change in number of share outstanding

 3 for 2 split
 You owned 100 shares @ 12 each (Rs1200)
 After split you have 150 share @ 8 each (Rs
1200)
 Same impact as bonus issue