Assignment

On
Dividend Policy
Course Name: Principal of Finance
Course Code: MGT-214

Submitted To
M A Kaium Hossain
Lecturer,
Department of Management Studies
University of Barisal

Submitted By
Md. Nayem Hossen
Roll No: M-284
BBA 1st Batch
Department of Management Studies
University of Barisal

Date of Submission: November 17, 2013

Dividend Policy
Introduction
Concept of Dividend Policy
Significance of Dividend Policy
Types of Dividend Policy
Stability of Dividend
Significance of Stability of Dividend
Forms of Dividend
Stock Dividend & stock split
Reasons for stock split
Factors determining Dividend Policy of a firm
Dividend Vs capital gain
Theories of Dividend Policy
Dividend Policy issues
Problem: page 508, demonstration prob-16.1, Charles p Jones

Introduction
Dividend policy is the policy used by a company to decide how much it will pay out to

shareholders in dividends. In your financial accounting course, you learn that after deducting
expense from the revenue, a company generates profit. Part of the profit is kept in the
company as retained earnings and the other part is distributed as dividends to shareholders.
From the share valuation model, the value of a share depends very much on the amount of
dividend distributed to shareholders. Dividends are usually distributed in the form of cash
(cash dividends) or share (share dividends which are beyond the remit of this article). When a
company distributes a cash dividend, it must have sufficient cash to do so. This creates a cash
flow issue. Profit generated may not be in the form of cash. You may verify this by looking at
the cash flow statement of a Company. A company may have profit of $400 million but the
cash only increase by $190 million in a financial year. This is a concern to the management as
insufficient cash may mean the company is unable to distribute a dividend. Investors earn
returns from their shares in the form of capital gains and dividend yield. Dividend yield is an
important ratio in evaluating investment.

The Concept of Dividend policy:

The objectives of the firm are to minimize the wealth of shareholders stockholder. Sound and
successful investment decision generate positive net cash flow, which is used either for
payment of interest or dividend or retention within the firm to finance new investment. The
important aspect of a dividend decision is to determine the amount of earning to be
distributed to share holders, in one hand and the amount to be retain in the firm, on the other
the dividend decision is regarded as the financing decision since the payment of cash
dividend reduces amount of cash available for investment and the firm may have to make a
new issue of share or debt.
Dividend decision is the core of the financial decision management. Since it affects capital
structure decision and in turn investment decision of that firm. The most significant aspect of
dividend policy is to determine the amount of earnings to be distributed to the shareholders
and the amount to be retain in t he firm.

Types of Dividend Policy:

The various types of dividend policy are given in below:
1. Residual Dividend Policy: Retain and reinvest earnings as long as returns on the
investments exceed the returns stockholders could obtain on other investments of
comparable risk.
2. Stable Dividend Policy: Such dividend policy refers to payment of a specific amount
of dividend each year or periodically increasing the dividend at constant rate. In such
a policy the annual dollar/taka dividend is really predictable by investors. Most
corporations attempt to maintain a stable growth in dividend policy.
3.
4. Constant Payout Ratio Policy: Such a dividend policy refers to payment of a
constant percentage of earnings as dividends financial year. But in practice, because
firms earnings surely will fluctuate, this policy would mean that the amount of
dividend would also vary.
5. Payment of Regular D dividend Plus Ratio: A policy of paying a low regular
dividend plus a year- end extra in good years is a compromise between a stable
dividend and a constant payment rate. Such a policy gives the firm flexibility.

Significance of Dividend Policy:

There has been considerable recent debate about the importance of dividend policy.
In order to maintain the asset level, as well as to finance investment opportunities, the
firm must obtain fund from the issue of additional equity or debt. In this case dividend
policy is important.
In other word, the dividend policy of the firm affects both shareholder wealth and the
long- term growth of a firm. So dividend policy is important to be considered.
The optimum dividend policy should strike the balance between current dividend and
future growth which maximizes the price of a firms share.

Stability of Dividends:
Stability of regularity of dividends is considered as a desirable policy by the management of
most companies in practice. Shareholders also seem generally to favor this policy and value
stable dividends higher than the fluctuate ones. All other things being the same, stable
dividend may have a positive impact on the market price of the share.
Stability of dividends sometimes means regularity in paying some dividend annually, even
though the amount of dividend may not be related with earnings. There are a number of
companies which have records of paying some dividend for a long unbroken period. More
precisely, stability of dividends refers to the amounts paid out regularly. Three distinct forms
of such stability may be distinguished:
a) Constant dividend per share or dividend rate.
b) Constant payout.
c) Constant dividend per share plus extra dividend.

a) Constant dividend per share or dividend:

A number of companies follow the policy of paying a fixed amount per share or fixed rate on
paid-up capital as dividend every year irrespective of the fluctuations in the earnings. This
policy dose not implies that the dividend per share or dividend rate will never be increased.
When the company reaches new levels of earnings and expects to maintain it, the annual
dividend per share may be increased. IT is easy to follow this policy when earnings are
stable. However, if the earnings pattern of a company showed wide fluctuations, it is
difficult to maintain such a policy. With earnings fluctuating from year to year it is essential
for a company which wants to follow this policy to build up surpluses in years of high than
average earnings to maintain dividends in years to below average earnings. In practice, when
a company retains earnings in good years for this purpose, it earmarks this surplus as reserve
for dividend equalization. These funds are invested in current assets like tradable securities,
so that they may easily be converted into cash at the time of paying dividends in bad years.
5

b) Constant payout:
The ratio of dividend to earnings is known as payout ratio. Some companies may follow a
policy of constant payout ratio that paying a fixed percentage of net earnings every year. With
this policy the amount of dividend will fluctuate in direct proportion to earnings. If a
company adopts a 10% payout ratio then 40% of every taka of net earnings will be paid out.
For example, if the company earns tk.2 per share the dividend per share will be tk.80 and if it
earns tk. 1.50 per share the dividend per share will be tk.60. This policy is related to a
companys ability to pay dividends. If the company incurs losses, no dividends shall be paid
regardless of the desires of shareholders internal financing with retained earnings is automatic
when this policy is followed. At any given payout ratio the amount of dividends and the
additions to retained earnings increase with decreasing earnings. This policy does not put any
pressure on a companys liquidity since dividends are distributed only when the company has
profit.

c) Constant dividend per share or extra dividend:

Under the constant dividend per share policy, the amount of dividend is a high level, and this
policy is usually adopted by the companies with stable earnings. For companies with
fluctuating earnings, the policy to pay a minimum dividend per share with a step- up feature
is desirable. The small amount of dividend is fixed to reduce the possibility of ever missing a
dividend payment. By paying extra dividend (a number of companies in Bangladesh pay an
interim dividend followed by regular, final dividend). In period of prosperity an attempts to
be made to prevent investors from expecting that the dividend represents an increase in the
established dividend amount. This type of policy enables a company to pay constant amount
of dividend regularly without a default and allows a great deal of flexibility for
supplementing the income of shareholder only when the companys earnings are higher than
usual, without committing itself to make larger payments as a part of future fixed dividend.

Significance of stability of dividends:

6

The advantages of stability are discussed below:

a) Resolution of Investors Uncertainty: - When a company follows a policy of
stable dividends it will not changes the amount of dividend if there are temporary
changes in its earning. Thus when the earnings of a company fall and it continues
to pay same amount of dividend as in the past. Similarly the amount of dividends
increased earning level only when it is possible to maintain it in future.
b) Investors Desire For Current Income: - There are many investors such as old,
retired, and women who desire to receive periodic income. These types of investors
will prefer a company with stable dividends to the one with fluctuating dividends.
c) Institutional Investors Requirements: - Share of the company is not only
purchased by individuals but also by financial, educational, and social institutions
and trusts. Every company is interested to have these financial institutions in the
last of their investors. These institutions generally invest in the share of those
companies which have a record of regular dividends. Thus to cater the requirement
of institutional investors a company prefers to follow a stable dividend policy.
d) Raising Additional Finance: - A stable dividend policy is also advantageous in its
effort tip raise external finance. Stable and regular dividend policy tends to make
the share of a company as quality investment rather than the speculation investors
purchase these shear intend to hold them for long periods of time. The loyalty
goodwill of shareholders towards a company increase with stable policy.

Forms of dividend policy

7

The usual practice is to pay dividends in cash. Other option is to payment of the bonus shares
or stock dividend.
a) Cash Dividend: - Most companies pay dividends in cash. Sometimes cash dividend
may be supplemented by a bonus issue. A company should have enough cash in its
bank account when cash dividends are declared. If it does not have enough bank
balance arrangement should be made to borrow funds. When the company follows a
stable dividend policy, it should prepare a cash budget for the coming period to
indicate the necessary funds which would be needed to meet the regular dividend
payments of the company.
Example: $.5 for every share you hold.
b) Stock Dividend: - An issue of bonus share represents a distribution of share in
addition to the cash dividend to existing shareholders. This has the effect of
increasing the number of outstanding shears of the company. The shares are
distributed proportionately. Thus, a shareholder retains his proportionately
ownership of the company. The declaration of the bonus shares will increase the
paid-up share capital and reduce the reserves and surplus of the company. The total
net worth is not affected by the bonus issue in fact a bonus issue represents are
capitalization of the owners equity portion, that the reserves and surplus merely an
accounting transfer from reserves and surplus to paid- up capital.
Example: 1 new stock for each 10 you hold.

Stock Dividend & Stock Split:

8

Stock dividend is a dividend payment in the form of shares of stock to current owners that
is the dividend which is paid in the form of additional shares of stock rather than cash.

Stock split is an action taken by a firm to increase the number of shares outstanding. It is
nothing but splitting of existing shares into more shares. Stock split can be of any size for
example the stock could be split 2 for 1.3 for 1, 4 for 1or any other way. Stock dividend &
splits are treated differently for accounting purpose but motives for using them can be
different. But there is no real financial difference between the two.

Example: On December 17, 1986, the board of directors authorized a three for two stock
split of Ameritechs common stock, affected in the form of a stock dividend. The additional
shares were distributed in January 1987 to share owners of record on December 31, 1986. As
a result of the split, 48809000 additional shares were issued and $48.8(million) was
transferred from proceeds in excess of par to common stock.

Reason behind Split:

1. To Make Trading in Share Attractive : The main purpose of stock split is to
reduce the market price of the stock in order to make it attractive to the investors. With
reduction in the market price of the stock the stock of the company are placed in a more
popular trading range.
2. To Signal the Possibility of Higher Profit In The Future : The stock split is
used by the company management to inform to the investors that the company is
expected to earn higher profits in future. The market price of the high growth firms
stocks increases very fast.
3. To Give Higher Dividend to the Shareholders: When the stock is split seldom
does a company reduce or increase the cash dividend per share proportionately.
However, the total dividends of a stockholder increase after a stock split.

Factors Determining Dividend Policy of a Firm:

4. Stable Dividend Policy: Stability or regularity of dividends considered as a desirable

policy by the management of most companies in practice. Shareholders also seem general
to favor this policy and value stable dividends higher than the fluctuating ones. All other
things being the same, stable dividend may have a positive impact on the market price of
the share. Thats why management always tries to stable the dividend policy of firm and
they take such decisions which stable the dividend policy. Thus stable dividend policy
works as a factor determining dividend policy
5. Internal Constraint: Dividend policy may be influenced by stockholder or
managerial control motives. If a controlling (majority ownership) interest does not wish
new shares to be sold, the firms only source of new equity will be retentions. This may
impale the firm to maintain a low payout ratio to ensure an adequate supply of new equity
money.
6. Owners Consideration: The dividend policy of a firm is likely to be affected by the
owners considerations of (i) in the tax status of the shareholders (ii) then opportunities of
investments and (iii) dilution of ownership.
7. Capital Market Consideration: If a firm has only limited access to capital
markets, it is likely to follow low dividend payout ratio. They are likely to rely more
heavily on returned earnings as a source of financing their investments. Firms which loan
heavily or financial institution for raising funds declares a minimum dividend so that they
can remain on the eligible

Dividend Vs capital gain:

10

With the latest market declines reminding us anew of the inherent risks of stocks, it's a good
time to re-examine how the stock market creates wealth. There are all sorts of wrinkles but it
all really comes down to two big things: Stocks either rise in price (capital appreciation) or
companies pay out a portion of profits (dividends). Collecting dividends can be a boring way
to accumulate wealth, but it's pretty effective. The folks at Morningstar/Ibbotson have stock
market data going back to 1926. Over that time (1926 through 2009) stocks have provided an
annual average return of 9.81%. Of that return, the Ibbotson data show, capital appreciation
accounts for 5.47 percentage points, a bit more than half. Dividends, however, are not far
behind, delivering 4.13 percentage points.
Some of you will quickly notice that the two components do not precisely add up to 9.81%,
which owes to statistical noise and rounding over many decades of data. But the big point
remains: Dividends are the unsung hero of the stock market and in many ways the more
reliable provider of wealth. Of course all that could change if the tax treatment of dividends
changes dramatically in the years ahead, but that's a calculation everyone has to do for
themselves.
So is investing for dividends a better way to increase your nest egg? That depends on the
economic environment. Given the current global uncertainties stocks could remain listless,
giving dividends a leg up.

Theories of Dividend Policy

11

Dividend refers to that portion of a firms net earnings which are paid out to the shareholders.
So we can say that dividend policy means the policies taken by the administration of an
organization.
There are exactly two main theories of dividend policies. Those are:
1. Irrelevance Theory
2. Relevance Theory

1. Irrelevance Theory:
It 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. The most comprehensive
argument in support of the irrelevance of dividend is provided by the Modigliani-Miller
(MM) hypothesis. Modigliani and Miller maintain that dividend policy has no effect on the
share price of the firm and is, therefore, of no consequence.

Assumptions:
The MM hypothesis of irrelevance of dividends is based on the following critical
assumptions:

Perfect capital markets in which all investors 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, there are no
flotation 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. The operational
implication of this assumption is that financing of new investments out of retained
earnings will not change the business risk complexion of the firm and, therefore, there
would be no change I the required rate of return.
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 and dividends with
certainty. This assumption is dropped by MM later.

Mathematical Expression:

12

Let us take a one year time horizon to understand the indifference argument of M&M. We use
the following new notations:
Po: Price of the equity share at point 0
P1: Price of the equity share at point 1, that is, end of period 1
D1: Dividend per share being paid in period 1
n: existing number of issued shares
m: new shares to be issued
I: Investment needs of the company in year 1
X: Profits of the firm year in 1
The relation between the price at the beginning of the year (Po), and that at the end of the
year
(P1) is the simple question of discounted value at the shareholders expected rate of return
(KE).
Hence,
Po = (P1 +D1) / (1+ (KE) .. (1)
Equation (7) is quite easy to understand. Shareholders have got a cash return equal to D1 at
the
end of Year 1, and the share is still worth P1. Hence, discounted at the cost of equity, the
discounted value is the price at the beginning of the period. Alternatively, it may also be
stated that the
P1 = (P0)* (1+ (KE) - D1 (2)
That is to say, if the company declares dividends, the price the end of year 1 comes down to
the effect of the distribution.
Equation (7) can be manipulated. By multiplying both sides by n, and adding a selfcancelling number m, we may write (7) as follows:
nPo = [(n+m)P1 -mP1 +nD1)]/(1+(KE) (3)
Note that we have multiplied both sides by n, and the added number m along with m is
cancelled
by deducting the same outside the brackets. mP1 represents the new share capital raised by
the company to finance its investment needs. How much share capital would the company
need to raise? Given the investment needs I and the profits X, the new capital issued will be
given by the following:
mP1 = I (X - nD1) . (4)
Again, this is not difficult to understand, as the total amount of profit of the company is X,
and

13

the total amount distributed as dividends is nD1. Hence, the company is left with a funding
gap as shown by equation (4).
If the value of mP1 is substituted in Equation (3), we have the following:
nPo = [(n+m)P1 {I (X - nD1)}+nD1)]/(1+(KE) ....(5)
As nD1 would cancel out, we will be left with the following:
nPo = [(n+m)P1 I + X] /(1+(KE) (6)
Since nPo is total value of the stock at point 0, it is seen from Equation (6) that dividend is
not a factor in that valuation at all.

2. Relevance Theory:
It implies that shareholders prefer current dividends and there is no direct relationship
between dividend policy and market value of a firm. We found two theories representing the
relevance theory. Those are:
a. Walters Model
b. Gordons Model
a)

Walters Model:

The Walter formula belongs to James E Walter, and is based on a simple argument that where
the reinvestment rate, that is, rate of return that the company may earn on retained earnings,
is higher than cost of equity (which, as we have discussed before, the expected returns of the
shareholders, or rate of return of the shareholders), then, it would be in the interest of the firm
to retain the earnings. If the companys reinvestment rate on retained earnings is the less than
shareholders rate of return, the company should not retain earnings. If the two rates are the
same, then the company should be indifferent between retaining and distributing.se.
Assumptions:
The critical assumptions of Walters Model are as follow:

All financing is done through retained earnings: external sources of funds like debt
or new equity capital are not used.
With additional investments undertaken, the firms business risk does not change. It
implies that the rate of return on firms investment and cost of capital are constant.
There is no change in key variable as EPS and DPS.
The firm has perpetual (or very long) life.

Mathematical Expression:

14

The Walter formula is based on a simple analysis that the market value of equity is the capitalization
of the current earnings and growth in price.
Hence, the basis of Walter formula is:
VE =E K D + g
(1)
Here, the growth factor occurs because the rate of return on retention done by the company is higher
than the cost of equity. That is to say, the company continues to earn at r rate of return on the retained
earnings, and this is what causes growth g. Hence,
g= r (E-D)/ E K
(2)
Inserting equations (2) into (1), we have

r (E - D)/ KE--+

VE =

KE

KE
Where
r = rate of return on retained earnings of the

company
E = earnings rate
D = dividend rate

b) Gordons Model:
Another theory which contends that dividends are relevant is Gordons model. This model
opines that dividend policy of a firm affects its value,

Assumptions:
It is based on following assumptions:

The firm is an all-equity firm. No external financing is used and investment programs
are financed exclusively by retained earnings.
Rate of return and cost of equity is constant.
The firm has perpetual life.
The retention ratio, once decided upon, is constant. Thus, the growth rate is also
constant.
Cost of equity is greater than borrowing.

Mathematically:
15

Gordons growth model is simply .

D(1+ g)
VE = K Eg
This is, as we have seen above, derived from perpetual sum of a geometric progression, under
the assumption that the growth rate is less than the cost of equity.

Dividend policy issues:

Dividend policy includes signaling, perceived risk, tax-related issues, and continuity with
past dividends. All four explanations for paying dividends (signaling, bird-in-the-hand, tax
preference, and agency costs) receive some support, but the signaling explanation received
more support than the other explanations. The most important determinants of a company's
dividend policy were the level of current and expected future earnings and the pattern or
continuity of past dividends.

a)
b)
c)
d)

Clientele Effects
Information Effects (Signaling)
Agency Costs
Expectations Theory

a) Clientele Effect:
Investors needing current income will be drawn to firms with high payout ratios. Investors
preferring to avoid taxes will be drawn to firms with lower payout ratios. (i.e., firms draw a
given clientele, given their stated dividend policy). Therefore, firms should avoid making
drastic changes in their dividend policy.

If investors do in fact have a preference between dividends and capital gains, we

could expect them to seek out firms that have a dividend policy consistent with these
preferences.

Thus there would be a clientele effect, where firms draw a given clientele based on
dividend policy.

However, unless there is a greater aggregate demand for a particular policy than is
being satisfied in the market, dividend policy is still unimportant

The clientele effect only tells us to avoid making capricious changes in a company's
dividend policy.

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b) Information Content:
Changes in dividend policy may be signals concerning the firms financial condition. A
dividend increase may signal good future earnings. A dividend decrease may signal poor
future earnings.

Evidences indicate that a large, unexpected change in dividends can have

significant impact on the stock price.

Some argue that management frequently has inside information about the firm that it
cannot make available to the investors.

This information asymmetry between management and investors may result in a

lower stock price than it would be if there were no asymmetric information. In such
cases, dividend policy may be an important communication tool.

It may be that investors use a change in dividend policy as a signal about the firm's
"true" financial condition, especially its earning power.

Therefore, under asymmetric information, changes in dividend policy can affect the
market value of a firm.

c) Agency Cost

A firm's dividend policy may be perceived by owners as a tool to minimize agency

costs.

Higher dividend payments decrease agency costs by reducing the free cash flow
available to the managers of the firm.

Higher dividends reduce retained earnings and force management to go to the capital
markets to finance new investments.

Since the firm is required to provide information on its investment activities in order
to raise money in the capital market, the payment of dividends indirectly results in a
closer monitoring of management's investment activities.

Thus dividend policy may affect a firms market value by affecting the agency cost
incurred by the firm.

17

d) Expectation theory:

As the time approaches for management to announce the amount of the next dividend,
investors form expectations as to how much the dividend will be. The investor then
compares the actual dividend announced with the expected dividend.

If the amount of the dividend is as expected, even if it represents an increase from

prior years, the market price of the stock will remain unchanged. However, if the
dividend is higher or lower than expected, the investors will reassess their perceptions
about the firm and the value of the stock.

Demonstration Problem:
Alpha and beta two companies in the space technology industry are close competitors, and
their asset composition, capital structure, and profitability records have been very similar for
several years. The primary difference between the companies from a financial management
perspective is their dividend policy. Beta tries to maintain a non decreasing dividend-pershare series, while Alpha maintains a constant dividend payout ratio equal to 1/6. Their recent
EPS, DPS and stock price history are as follows:
Beta

Alpha

Year

19+7
19+6
19+5
19+4
19+3
19+2
19+1

EPS

DPS

$ 3.79
3.20
4.00
2.55
2.01
1.48
1.86

$0.50
0.50
0.50
0.45
0.40
0.40
0.40

Stock Price
Range
$31-43
30-40
27-42
21-27
14-22
11-16
15-18

EPS

DPS

$4.00
3.40
4.05
2.45
2.05
1.40
1.90

$0.67
0.57
0.68
0.41
0.34
0.23
0.32

Stock Price
Range
$26-39
28-36
22-45
16-24
7-16
5-13
12-16

In all calculations bellow that require a stock price, use the average of the two prices given in
the stock price range.
a. Determine the dividend payout ratio and price-earnings ratio for both companies for
all years.
b. Determine the average payout ratio and price-earnings ratio for both companies over
the period 19+1 through 19+7.
c. The management of alpha is puzzled about why its stock has not performed as well
historically as Betas, even though the Alpha profitability record is slightly better. The
past three years are particularly puzzling. How would you explain this?

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Solution:
a.
Particular
s
Payout
ratio
Beta
Alpha
Stock
Price
Beta
Alpha
P/E
Beta
Alpha

b.

Year
Total
+1

+2

+3

+4

+5

+6

+7

.215
.167

.270
.167

.199
.167

.176
.167

.125
.167

.156
.167

.132
.167

$16.50
$14.00

13.50
9.00

18.00
11.50

24.00
20.00

34.50
33.50

35.00
32.00

37.00
32.50

8.9
7.4

9.1
6.4

9.0
5.6

9.4
8.2

8.6
8.3

10.9
9.4

9.8
8.1

1.273
1.169

65.7
53.4

Average Payout Ratio and Price Earnings Ratio:

Beta:
Average Payout Ratio =

Average Price Earnings =

Total Payout Ratio

No of Years

Total Price Earnings

No of Years

1.273
7

65.7
7

= 0.182

=9.4

Alpha:
Average Payout Ratio =

Average Price Earnings =

Total Payout Ratio

No of Years

Total Price Earnings

No of Years

1.169
7

53.4
7

= 0.167

=7.4

c. Notice first that over the entire seven year period, Beta has a greater dividend payout.
However, if the dividend irrelevance theory is true, this higher payout should make
little difference. Also in the last three years Alpha has paid a better dividend. The
probable reason is that the stock market is responding adversely to Alphas
fluctuating dividend per share history in comparison to Betas non decreasing
dividend per share. Another explanation for the most recent three years in that the
market views the future more favorably for Beta.

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