DIVIDEND AND RETENTION

POLICY

By :
Pooja Narwani
Pratik Lalani
Razaali Vakil
Richa Shah
Riddhi Salot
Introduction
:
 What is Dividend?
 What is dividend policy?
 Theories of Dividend Policy
 Relevant Theory
 Walter’sModel
 Gordon’s Model

 Irrelevant Theory
 M-M’s Approach
 Traditional Approach
What is Dividend?

“A dividend is a distribution to shareholders out of

profit or reserve available for this purpose”.

- Institute of Chartered Accountants of India

Forms/Types of
Dividend
 On the basis of Types of Share
 Equity Dividend
 Preference Dividend

 On the basis of Mode of Payment

 Cash Dividend
 Stock Dividend

 Bond Dividend

 Property Dividend

 Composite Dividend
 Cont
d.

 On the basis of Time of

Payment
 InterimDividend
 Regular Dividend

 Special Dividend
What is Dividend
Policy :

 “ Dividend policy determines the division of

earnings between payments to shareholders
and retained earnings”.

- Weston and Bringham

 Cont
d.

Dividend Policies involve the decisions, whether-

 To retain earnings for capital investment and

other purposes; or
 To distribute earnings in the form of dividend
among shareholders; or
 To retain some earning and to distribute
remaining earnings to shareholders.
Factors Affecting Dividend
Policy
 Legal Restrictions
 Magnitude and trend of earnings
 Desire and type of Shareholders
 Nature of Industry
 Age of the company
 Future Financial Requirements
 Taxation Policy
 Stage of Business cycle
 Cont
d.

 Regularity
 Requirements of Institutional Investors
Dimensions of Dividend
Policy
 Pay-out Ratio
 Funds requirement
 Liquidity

 Access to external sources of financing

 Shareholder preference

 Difference in the cost of External Equity and

Retained Earnings
 Control

 Taxes
 Cont
d.

 Stability
 Stable dividend payout Ratio
 Stable Dividends or Steadily changing
Dividends
Types of Dividend
Policy
 Regular Dividend Policy
 Stable Dividend Policy
 Constant dividend per share
 Constant pay out ratio

 Stable rupee dividend + extra

dividend
 Irregular Dividend Policy
 Dividend Theories

Irrelevance Theories
Relevance Theories
(i.e. which consider dividend
(i.e. which consider dividend
decision to be irrelevant as it
decision to be relevant as it
does not affects the value of the
affects the value of the firm)
firm)

Walter’s Gordon’s
Model Model

Modigliani and Traditional

Miller’s Model Approach
Walter’s Model
 Prof. James E Walter argued that in the long-
run the share prices reflect only the present
value of expected dividends. Retentions
influence stock price only through their effect
on future dividends. Walter has formulated this
and used the dividend to optimize the wealth
of the equity shareholders.
 Assumptions of Walter’s
Model:
 Internal Financing
 constant Return in Cost of
Capital
 100% payout or Retention

 Constant EPS and DPS

 Infinite time
Formula of Walter’s Model
D + r (E-D)
P = k
k
Where,
P = Current Market Price of equity share
E = Earning per share
D = Dividend per share
(E-D) = Retained earning per share
r = Rate of Return on firm’s investment or Internal Rate of
Return
k = Cost of Equity Capital
Illustration
:
 Growth Firm (r > k):
r = 20% k = 15% E = Rs. 4
If D = Rs. 4
P = 4+(0) 0.20 /0 .15 = Rs. 26.67
0.15
If D = Rs. 2
P = 2+(2) 0.20 / 0.15 = Rs. 31.11
0.15
Illustration
:
 Normal Firm (r = k):
r = 15% k = 15% E = Rs. 4
If D = Rs. 4
P = 4+(0) 0.15 / 0.15 = Rs. 26.67
0.15
If D = Rs. 2
P = 2+(2) 0.15 / 0.15 = Rs. 26.67
0.15
Illustration
:
 Declining Firm (r < k):
r = 10% k = 15% E = Rs. 4
If D = Rs. 4
P = 4+(0) 0.10 / 0.15 = Rs. 26.67
0.15
If D = Rs. 2
P = 2+(2) 0.10 / 0.15 = Rs. 22.22
0.15
Effect of Dividend Policy on Value of
Share
Case If Dividend Payout If Dividend Payout
ratio Increases Ration decreases

1. In case of Growing Market Value of Share Market Value of a share

firm i.e. where r > k decreases increases

2. In case of Declining Market Value of Share Market Value of share

firm i.e. where r < k increases decreases

3. In case of normal firm No change in value of No change in value of

i.e. where r = k Share Share
Criticisms of Walter’s
Model
 No External Financing
 Firm’s internal rate of return does not always
remain constant. In fact, r decreases as more
and more investment in made.
 Firm’s cost of capital does not always remain
constant. In fact, k changes directly with the
firm’s risk.
 Gordon’s
Model
 According to Prof. Gordon, Dividend Policy
almost always affects the value of the firm. He
Showed how dividend policy can be used to
maximize the wealth of the shareholders.
 The main proposition of the model is that the
value of a share reflects the value of the future
dividends accruing to that share. Hence, the
dividend payment and its growth are relevant in
valuation of shares.
 The model holds that the share’s market price is
equal to the sum of share’s discounted future
dividend payment.
 Assumptions:
 Allequity firm
 No external Financing

 Constant Returns

 Constant Cost of Capital

 Perpetual Earnings

 No taxes

 Constant Retention

 Cost of Capital is greater then growth rate

(k>br=g)
Formula of Gordon’s
Model
E (1 – b)
P =
K - br

 Where,
P = Price
E = Earning per Share
b = Retention Ratio
k = Cost of Capital
br = g = Growth Rate
Illustration
:
 Growth Firm (r > k):
r = 20% k = 15% E = Rs. 4
If b = 0.25
P0 = (0.75) 4 = Rs. 30
0.15- (0.25)(0.20)
If b = 0.50
P0 = (0.50) 4 = Rs. 40
0.15- (0.5)(0.20)
Illustration
:
 Normal Firm (r = k):
r = 15% k = 15% E = Rs. 4
If b = 0.25
P0 = (0.75) 4 = Rs. 26.67
0.15- (0.25)(0.15)
If b = 0.50
P0 = (0.50) 4 = Rs. 26.67
0.15- (0.5)(0.15)
Illustration
:
 Declining Firm (r < k):
r = 10% k = 15% E = Rs. 4
If b = 0.25
P0 = (0.75) 4 = Rs. 24
0.15- (0.25)(0.10)
If b = 0.50
P0 = (0.50) 4 = Rs. 20
0.15- (0.5)(0.10)
Criticisms of Gordon’s
model
 As the assumptions of Walter’s Model
and Gordon’s Model are same so the
Gordon’s model suffers from the same
limitations as the Walter’s Model.
Modigliani & Miller’s Irrelevance
Model

Value of Firm (i.e. Wealth of Shareholders)

Depends on

Firm’s Earnings

Depends on

Firm’s Investment Policy and not on dividend policy

Modigliani and Miller’s
Approach
 Assumption
 Capital Markets are Perfect and people are
Rational
 No taxes

 Floating Costs are nil

 Investment opportunities and future profits of

firms are known with certainty (This assumption
was dropped later)
 Investment and Dividend Decisions are
independent
M-M’s Argument
 If a company retains earnings instead of giving
it out as dividends, the shareholder enjoy
capital appreciation equal to the amount of
earnings retained.
 If it distributes earnings by the way of
dividends instead of retaining it, shareholder
enjoys dividends equal in value to the amount
by which his capital would have appreciated
had the company chosen to retain its earning.
 Hence,
the division of earnings between dividends and
retained earnings is IRRELEVANT from the point
of view of shareholders.
Formula of M-M’s
Approach
1 ( D1+P1 )
P =
(1 + p)
o

Where,
Po = Market price per share at time 0,
D1 = Dividend per share at time 1,
P1 = Market price of share at time 1
 1 (nD1+nP1)
nPo =
(1 + p)

 The expression of the outstanding equity

shares of the firm at time 0 is obtained as:

1 {nD1+(n + m)P1- mP1}

nPo =
(1 + p)
 mP1 = I – (X – nD1)
Where,
X = Total net profit of the firm for year
1

nPo 1 [nD1+ (n + m)P1– {I – (X –

=
nD1)}]
(1 + p)
nPo 1 nD1+ (n + m)P1– I +X – nD1
=
(1 + p)
nPo 1 (n + m)P1– I +X
=
(1 + p)
Criticism of M-M
Model
 No perfect Capital Market
 Existence of Transaction Cost
 Existence of Floatation Cost
 Lack of Relevant Information
 Differential rates of Taxes
 No fixed investment Policy
 Investor’s desire to obtain current
income
Traditional Approach
 This theory regards dividend decision merely
as a part of financing decision because
 The earnings available may be retained in the
business for re-investment
 Or if the funds are not required in the business
they may be distributed as dividends.
 Thus the decision to pay the dividends or
retain the earnings may be taken as a residual
decision
 This theory assumes that the investors do
not differentiate between dividends and
retentions by the firm
 Thus, a firm should retain the earnings if it
has profitable investment opportunities
otherwise it should pay than as dividends.
Synopsis
 Dividend is the part of profit paid to
Shareholders.
 Firm decide, depending on the profit, the
percentage of paying dividend.
 Walter and Gordon says that a Dividend
Decision affects the valuation of the firm.
 While the Traditional Approach and MM’s
Approach says that Value of the Firm is
irrelevant to Dividend we pay.
Bibliograph
y

 Google
 Financial management by prasanna
chandra.