CORPORATE FINANCE – MODULE 5 - DIVIDEND DECISIONS

CONTENTS: Why firms pay dividends- Dimensions of Dividend policy- Dividend policy
formulation-forms of dividend-Factors influencing dividend decisions- legal and procedural
aspects, Bonus shares and stock split-overview of dividend theories.

DIVIDEND is a payment made to shareholders by the company in proportion to the number of

shares they own in the company. It is one form of return that the shareholders expect on equity
they own in the company. Dividend policy is concerned with financial policies regarding
paying cash dividend in the present or paying an increased dividend at a later stage.

Whether to issue dividend, and what amount, is determined mainly on the basis of the company's
un-appropriated profit (excess cash) and influenced by the company's long-term earning power.
If there are no NPV positive opportunities, i.e. projects where returns exceed the hurdle rate, and
excess cash surplus is not needed, then – finance theory suggests – management should return
some or all of the excess cash to shareholders as dividends.
Forms of Dividend

Cash Dividend: On the date of declaration, the board of directors resolve to pay a certain dividend
amount in cash to those investors holding the company's stock on a specific date. The date of
record is the date on which dividends are assigned to the holders of the company's stock. On
the date of payment, the company issues dividend payments. Dividend may be paid
electronically into your bank account or the company may issue cheque/dividend warrants.

Stock Dividend (Bonus Shares): stock dividends are paid out to shareholders by issuing new
shares in the company. These are paid out pro rata, based on the number of shares the investor
owns.

Asset/Property Dividend – a company is not limited to paying distributions to its shareholders in

the form of cash or shares. A company may also pay out other assets such as investment
securities, physical assets, real estate, and others.

A final dividend refers to the dividend declared by a company's board of directors after the
company has issued its full-year financial statements for its fiscal year. The final dividend is
typically larger than any interim dividends that may have been issued during the fiscal year; this
is because the board of directors is not sure of the entire amount of cash that is available for
distribution to shareholders until the final results are available for the full year, and so it tends to
be conservative in the size of any interim dividends that are issued

Issues in Dividend Policy

• Earnings to be Distributed – High Vs. Low Payout.

1
 • Objective – Maximize Shareholders Return.
• Effects – Taxes, Investment and Financing Decision

Determinants of Dividend Payout Ratio

• Funds Requirement of the company
– Additional capital infusion in ongoing projects
– Projects in the pipeline
– Further investment opportunities
• Liquidity
• Access to external sources of financing
• Shareholder preference (Dividend Vs.Capital Gains)
• Difference in the cost of external equity and Retained Earnings
• Control (relying more on Retained Earnings so as to avoid dilution of control)
• Taxes (Dividend distribution tax in the hands of company Vs. LTCG in the hands of
investors)
• Borrowing capacity
• Restrictions imposed on loan agreements
• Inflation
• Legal restrictions
Legal aspects
• According to Sec 123 of the Companies Act 2013, no dividend shall be declared or paid
for any financial year except (a) out of the profits of the company for that financial year
or (b) out of the money provided by the Central Govt. or a State Govt. for the payment of
dividend by the company in pursuance of a guarantee given by that Govt.
• Interim Dividend is declared by directors, unlike the annual dividend, which is declared
by the members in the annual meeting.
• In case the company has incurred loss during the current financial year up to the end of
the quarter immediately preceding the date of declaration of interim dividend, Interim
Dividend shall not be declared at a rate higher than the average dividends declared by the
company in the immediately preceding 3 financial years.

2
Procedural Aspects
• Board Resolution – The Board of Directors (BOD) in a formal meeting should resolve to
pay the dividend.
• Shareholders’ approval – The resolution of the BOD should be approved by the
shareholders in the annual general meeting.
• Record date – Dividend is payable to the shareholders whose name appear in the Register
of Members as on the record date.
• Dividend payment – dividend warrants must be posted within 30 days from the dividend
declaration date. Within a period of 7 days, after the expiry of the 30 days, unpaid
dividends must be transferred to a special account opened with a scheduled bank.
BONUS SHARES
Bonus shares can be issued only out of free reserves built out of genuine profits or share
premium collected in cash only. In the wake of a bonus issue, the shareholders’
proportional ownership remains unchanged. However, the number of shares increases.
The book value per share, the EPS and the market price per share decrease.
Why do companies issue bonus shares?
• Allows the company to declare a dividend without using up the cash that may be used to
finance the profitable investment opportunities within the company and thus company
can maintain its liquidity position
• When a company faces stringent cash difficulty and is not in a position to distribute
dividend in cash, or where certain restrictions to pay dividend in cash are put under loan
agreement, the only way to satisfy the shareholders or to maintain the confidence of the
shareholders is the issue of bonus shares.
• By issuing bonus shares, the rate of dividend is lowered down and consequently share
price in the market is also brought down to a desired range of activity and thus trading
activity would increase in the share market. Now small investors may get an opportunity
to invest their funds in low priced shares.
• The cost of issue of bonus shares is the minimum because no underwriting commission,
brokerage etc. is to be paid on this type of issue. Existing shareholders are allotted bonus
shares in proportion to their present holdings.

3
 Difference between Bonus Shares and Stock Split

Point of difference Bonus Shares Stock Split

Par value per share Declines Declines

Reserves
Shareholders’
proportional ownership
Other effects
Volume of shares &
liquidity in stock market
Reduces since part of it
is capitalized; However,
equity doesn’t change
since it gets added to
share capital
Remains Unchanged
Book value per share,
EPS and Market price
per share declines
Increases since Market
price is now brought
within a more popular
trading range
No effect on Reserves
Remains Unchanged
Book value per share,
EPS and Market price
per share declines
Increases since Market
price is now brought
within a more popular
trading range

MODELS IN WHICH INVESTMENT AND DIVIDEND DECISIONS ARE RELATED

Various models have been developed to help firms analyse and evaluate the perfect dividend
policy. There is no agreement between these schools of thought over the relationship
between dividends and the value of the share or the firm value.

One school consists of people like James E. Walter and Myron J. Gordon who believe that
current cash dividends are less risky than future capital gains. Thus, they say that investors
prefer those firms which pay regular dividends and such dividends affect the market price of
the share.
Another school linked to Modigliani and Miller holds that investors don't really choose
between future gains and cash dividends.
WALTER MODEL
According to Walter Model, market price per share is the sum of the present value of the
infinite stream of constant dividends and present value of the infinite stream of capital
gains.

(r / k )
P  (DIV / k )  (EPS – DIV)
k

4
 𝐷𝐼𝑉 + (𝐸𝑃𝑆 − 𝐷𝐼𝑉)𝑟/𝑘
𝑃=
𝑘
Example :

Declining Firm :
Growing firm : r>k Normal Firm : r=k r<k
Given : r = 20% r = 15% r = 10%
k = 15% k = 15% k = 15%
E=4 E=4 E=4

If company opts for 100%

Dividend payout,
D =4 D =4 D =4

Share
Price= 4 +0*0.2/0.15
0.15

26.66667
26.67 26.67 26.67

IF company opts for a 50%

payout,

D=2 D=2 D=2

Share
Price= 2 + 2*0.2/0.15
0.15

13.333 17.778 13.330 13.333 13.333 8.889

31.111 26.663 22.222

INFERENCES OF WALTER MODEL :

5
GORDON MODEL
Myron Gordon proposed a stock valuation using dividend capitalization approach. According to
Gordon model, market value of a share is equal to the present value of an infinite stream of
dividends to be received by shareholders.
P  EPS(1  b ) /( k  br )

Where, P is the Price per share, b is the fraction of earnings the firm retains (also called as
retention ratio); (1-b) is the fraction of earnings the firm distributes as dividends.
k is the cost of equity (i.e., return required by shareholders)
r is the rate of return on investments earned by the firm.
EXAMPLE:
Kroutzee Ltd. gives you the following information :
EPS is Rs.5. Rate of return required by equity shareholders is 16%. Assuming the Gordon model
holds, what rate of return should be earned on investments to ensure that the market price is
Rs.50 when the dividend payout is 40%?

MILLER AND MODIGLIANI’S PROPOSITION

According to M-M, under a perfect market situation, the dividend policy of a firm is irrelevant as
it does not affect the value of the firm. They argue that the value of the firm depends on firm
earnings which results from its investment policy. Thus when investment decision of the firm is
given, dividend decision is of no significance. Also called, MM DIVIDEND IRRELEVANCE theorem.

6
The substance of the MM argument is as follows: If a company retains earnings instead of giving
it out as dividends, the shareholders enjoy capital appreciation equal to the amount of earnings
retained. If it distributes earnings by way of dividends instead of retaining it, the shareholders
enjoy dividends equal in value to the amount by which his capital would have appreciated had
the company chosen to retain its earnings. Hence, the division of earnings between dividends
and retained earnings is irrelevant from the point of view of shareholders.