13. Dividend and determinants of Dividend Policy

Dividend and determinants of Dividend Policy

Dividend

Dividend refers to the corporate net profits distributed among shareholders. Dividends can be both preference dividends and equity dividends. Preference dividends are fixed dividends paid as a percentage every year to the preference shareholders if net earnings are positive. After the payment of preference dividends, the remaining net profits are paid or retained or both depending upon the decision taken by the management.

Determinants of Dividend Policy

The main determinants of dividend policy of a firm can be classified into:

• Dividend payout ratio
• Stability of dividends
• Legal, contractual and internal constraints and restrictions
• Owner's considerations
• Capital market considerations and
• Inflation.

• Dividend payout ratio
  
  
  Dividend payout ratio refers to the percentage share of the net earnings distributed to the shareholders as dividends. Dividend policy involves the decision to pay out earnings or to retain them for reinvestment in the firm. The retained earnings constitute a source of finance. The optimum dividend policy should strike a balance between current dividends and future growth which maximizes the price of the firm's shares. The dividend payout ratio of a firm should be determined with reference to two basic objectives – maximizing the wealth of the firm’s owners and providing sufficient funds to finance growth. These objectives are interrelated.
• Stability of dividends
  
  
  Dividend stability refers to the payment of a certain minimum amount of dividend regularly. The stability of dividends can take any of the following three forms:

  • constant dividend per share
  • constant dividend payout ratio or
  • constant dividend per share plus extra dividend
• Legal, contractual and internal constraints and restrictions
  
  
  Legal stipulations do not require a dividend declaration but they specify the conditions under which dividends must be paid. Such conditions pertain to capital impairment, net profits and insolvency. Important contractual restrictions may be accepted by the company regarding payment of dividends when the company obtains external funds. These restrictions may cause the firm to restrict the payment of cash dividends until a certain level of earnings has been achieved or limit the amount of dividends paid to a certain amount or percentage of earnings. Internal constraints are unique to a firm and include liquid assets, growth prospects, financial requirements, availability of funds, earnings stability and control.
• Owner's considerations
  
  
  The dividend policy is also likely to be affected by the owner's considerations of the tax status of the shareholders, their opportunities of investment and the dilution of ownership.
• Capital market considerations
  
  
  The extent to which the firm has access to the capital markets, also affects the dividend policy. In case the firm has easy access to the capital market, it can follow a liberal dividend policy. If the firm has only limited access to capital markets, it is likely to adopt a low dividend payout ratio. Such companies rely on retained earnings as a major source of financing for future growth.
• Inflation
  
  
  With rising prices due to inflation, the funds generated from depreciation may not be sufficient to replace obsolete equipments and machinery. So, they may have to rely upon retained earnings as a source of fund to replace those assets. Thus, inflation affects dividend payout ratio in the negative side.

Bonus shares and stock splits

Bonus share is referred to as stock dividend. They involve payment to existing owners of dividend in the form of shares. It is an integral part of dividend policy of a firm to use bonus shares and stock splits. A stock split is a method commonly used to lower the market price of shares by increasing the number of shares belonging to each shareholder. Bonus shares may be issued to satisfy the existing shareholders in a situation where cash position has to be maintained.

11. Miller and Modigliani Model (MM Model)

Miller and Modigliani Model (MM Model)

Miller and Modigliani Model assume that the dividends are irrelevant. Dividend irrelevance implies that the value of a firm is unaffected by the distribution of dividends and is determined solely by the earning power and risk of its assets. Under conditions of perfect capital markets, rational investors, absence of tax discrimination between dividend income and capital appreciation, given the firm’s investment policy, its dividend policy may have no influence on the market price of the shares, according to this model.

Assumptions of MM model

• Existence of perfect capital markets and all investors in it are rational. Information is available to all free of cost, there are no transactions costs, securities are infinitely divisible, no investor is large enough to influence the market price of securities and there are no floatation costs.
• There are no taxes. Alternatively, there are no differences in tax rates applicable to capital gains and dividends.
• A firm has a given investment policy which does not change. It implies that the financing of new investments out of retained earnings will not change the business risk complexion of the firm and thus there would be no change in the required rate of return.
• Investors know for certain the future investments and profits of the firm (but this assumption has been dropped by MM later).

Argument of this Model

• By the argument of arbitrage, MM Model asserts the irrelevance of dividends. Arbitrage implies the distribution of earnings to shareholders and raising an equal amount externally. The effect of dividend payment would be offset by the effect of raising additional funds.
• MM model argues that when dividends are paid to the shareholders, the market price of the shares will decrease and thus whatever is gained by the investors as a result of increased dividends will be neutralized completely by the reduction in the market value of the shares.
• The cost of capital is independent of leverage and the real cost of debt is the same as the real cost of equity, according to this model.
• That investors are indifferent between dividend and retained earnings implies that the dividend decision is irrelevant. With dividends being irrelevant, a firm’s cost of capital would be independent of its dividend-payout ratio.
• Arbitrage process will ensure that under conditions of uncertainty also the dividend policy would be irrelevant.

MM Model:

Market price of the share in the beginning of the period = Present value of dividends paid at the end of the period + Market price of share at the end of the period.

P0 = 1/(1 + ke) x (D1 + P1)

Where:	P0	=	Prevailing market price of a share
	ke	=	cost of equity capital
	D1	=	Dividend to be received at the end of period 1 and
	P1	=	Market price of a share at the end of period 1.

Value of the firm, nP0

=

(n + ∆ n) P1 – I + E (1 + ke)

Where:	n	=	number of shares outstanding at the beginning of the period
	∆ n	=	change in the number of shares outstanding during the period/ additional shares issued.
	I	=	Total amount required for investment
	E	=	Earnings of the firm during the period.

Example:

A company whose capitalization rate is 10% has outstanding shares of 25,000 selling at $100 each. The firm is expecting to pay a dividend of $5 per share at the end of the current financial year. The company's expected net earnings are $250,000 and the new proposed investment requires $500,000. Prove that using MM model, the payment of dividend does not affect the value of the firm.

Solution:

• Value of the firm when dividends are paid:
  
  
  • Price per share at the end of year 1:
    
    P0 = 1/(1 + ke) x (D1 + P1)
    $100 = 1/(1 + 0.10) x ($5 + P1)
    P1 = $105
  • Amount required to be raised from the issue of new shares:
    
    ∆ n P1 = I – (E – nD1)
    => $500,000 – ($250,000 - $125,000)
    => $375,000
  • Number of additional shares to be issued:
    
    ∆n = $375,000 / 105 => 3571.42857 shares (unrounded)
  • Value of the firm:
    
    

    => (25,000 + 3571.42857) (105) - $500,000 + $250,000 (1 + 0.10)

    => $2,500,000

• Value of the firm when dividends are not paid:
  
  
  • Price per share at the end of year 1:
    
    P0 = 1/(1 + ke) x (D1 + P1)
    $100 = 1/(1 + 0.10) x ($0 + P1)
    P1 = $110
  • Amount required to be raised from the issue of new shares:
    
    => $500,000 – ($250,000 -0) = $250,000
  • Number of additional shares to be issued:
    
    => $250,000/$110 = 2272.7273 shares (unrounded)
  • Value of the firm:
    
    

    => (25,000 + 2272.7273) (110) - $500,000 + $250,000 (1 + 0.10)

    => $2,500,000

Thus, according to MM model, the value of the firm remains the same whether dividends are paid or not. This example proves that the shareholders are indifferent between the retention of profits and the payment of dividend.

Limitations of MM model:

• The assumption of perfect capital market is unrealistic. Practically, there are taxes, floatation costs and transaction costs.
• Investors cannot be indifferent between dividend and retained earnings under conditions of uncertainty. This can be proved at least with the aspects of i) near Vs distant dividends, ii) informational content of dividends, iii) preference for current income and iv) sale of stock at uncertain price.

12. Gordon's Dividend Capitalization Model

Gordon's Dividend Capitalization Model

Gordon's theory contends that dividends are relevant. This model is of the view that dividend policy of a firm affects its value.

Assumptions of this model:

• The firm is an all equity firm. No external financing is used and investment programmes are financed exclusively by retained earnings.
• Return on investment( r ) and Cost of equity(Ke) are constant.
• The firm has perpetual life.
• The retention ratio, once decided upon, is constant. Thus, the growth rate, (g = br) is also constant.
• Ke > br

Arguments of this model:

• Dividend policy of the firm is relevant and that investors put a positive premium on current incomes/dividends.
• This model assumes that investors are risk averse and they put a premium on a certain return and discount uncertain returns.
• Investors are rational and want to avoid risk.
• The rational investors can reasonably be expected to prefer current dividend. They would discount future dividends. The retained earnings are evaluated by the investors as a risky promise. In case the earnings are retained, the market price of the shares would be adversely affected. In case the earnings are retained, the market price of the shares would be adversely affected.
• Investors would be inclined to pay a higher price for shares on which current dividends are paid and they would discount the value of shares of a firm which postpones dividends.
• The omission of dividends or payment of low dividends would lower the value of the shares.

Dividend Capitalization model:

According to Gordon, the market value of a share is equal to the present value of the future streams of dividends.

P

=

E(1 - b) Ke - br

Where:

	P	=	Price of a share
	E	=	Earnings per share
	b	=	Retention ratio
	1 - b	=	Dividend payout ratio
	Ke	=	Cost of capital or the capitalization rate
	br - g	=	Growth rate (rate or return on investment of an all-equity firm)

Example:  Determination of value of shares, given the following data:

	Case A	Case B
D/P Ratio	40	30
Retention Ratio	60	70
Cost of capital	17%	18%
r	12%	12%
EPS	$20	$20

P	=	$20 (1 - 0.60)      0.17 – (0.60 x 0.12)	=>	$81.63 (Case A)
P	=	$20 (1 - 0.70)       0.18 – (0.70 x 0.12)	=>	$62.50 (Case B)

Gordon's model thus asserts that the dividend decision has a bearing on the market price of the shares and that the market price of the share is favorably affected with more dividends.

10. Walter's Dividend Model

Walter's Dividend Model

Walter's model supports the principle that dividends are relevant. The investment policy of a firm cannot be separated from its dividend policy and both are inter-related. The choice of an appropriate dividend policy affects the value of an enterprise.

Assumptions of this model:

• Retained earnings are the only source of finance. This means that the company does not rely upon external funds like debt or new equity capital.
• The firm's business risk does not change with additional investments undertaken. It implies that r(internal rate of return) and k(cost of capital) are constant.
• There is no change in the key variables, namely, beginning earnings per share(E), and dividends per share(D). The values of D and E may be changed in the model to determine results, but any given value of E and D are assumed to remain constant in determining a given value.
• The firm has an indefinite life.

Formula: Walter's model

P

=

D    Ke – g

Where:	P	=	Price of equity shares
	D	=	Initial dividend
	Ke	=	Cost of equity capital
	g	=	Growth rate expected

After accounting for retained earnings, the model would be:

P

=

D    Ke – rb

Where:	r	=	Expected rate of return on firm’s investments
	b	=	Retention rate (E - D)/E

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

Example:

A company has the following facts:
Cost of capital (ke) = 0.10
Earnings per share (E) = $10
Rate of return on investments ( r) = 8%
Dividend payout ratio: Case A: 50% Case B: 25%
Show the effect of the dividend policy on the market price of the shares.

Solution:

Case A:

D/P ratio = 50%
When EPS = $10 and D/P ratio is 50%, D = 10 x 50% = $5

P

=

5 + [0.08 / 0.10] [10 - 5] 0.10

=> $90

Case B:

D/P ratio = 25%
When EPS = $10 and D/P ratio is 25%, D = 10 x 25% = $2.5

P

=

2.5 + [0.08 / 0.10] [10 - 2.5] 0.10

=> $85

Conclusions of Walter's model:

• When r > ke, the value of shares is inversely related to the D/P ratio. As the D/P ratio increases, the market value of shares decline. It’s value is the highest when D/P ratio is 0. So, if the firm retains its earnings entirely, it will maximize the market value of the shares. The optimum payout ratio is zero.
• When r < ke, the D/P ratio and the value of shares are positively correlated. As the D/P ratio increases, the market price of the shares also increases. The optimum payout ratio is 100%.
• 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.

Limitations of this model:

• Walter's model assumes that the firm's investments are purely financed by retained earnings. So this model would be applicable only to all-equity firms.
• The assumption of r as constant is not realistic.
• The assumption of a constant ke ignores the effect of risk on the value of the firm.