Dividend Policy

Dividend is irrelevant:

General:

Residual decision as dividend is paid out of excess cash. If the firm can earn higher return
( r ) then its cost of capital ( k) it will retain earnings to finance investment projects.
Excess earnings will be paid as dividend whereas shortage will be raised through the new
issue of debt or equity. Dividend Payout Ratio (D/P) is 0 when abundant opportunities
and will be 100 when no opportunities are available.

MM Hypothesis:

Value of the firm is unaffected by the distribution of dividends and is determined solely
by earning power and risk of its assets.

Assumptions:
1. Perfect Markets.
2. No Tax
3. Investment policy is fixed.
4. Investors are able to forecast future prices and dividend with certainty.

The main argument of MM approach is of arbitrage argument. 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.

Po = 1/(1+Ke)*(D1+P1)

Where :
Po= Prevailing Market price of the share
Ke= Cost of equity capital
D1= Dividend to be received at the end of period 1
P1= Market price of a share at the end of period 1

∆nP1 = I – (E-nD1)

Where:
nP1 = Amount obtained from sale of new shares of finance capital budge
E = Earnings of the firm for the period
nD1 = Total dividend paid
(E – nD1) = Retained earnings

Value of the firm:

nPo= (n+∆n)P1 – I + E – nD1 / (1+ Ke)

Relevance of Dividends:

Shareholders prefer current dividends and there is no direct relationship between

dividend policy and market value of the firm.

1. Walters Model:

Assumptions:
1. All financing is done through retained earnings and no debt or additional equity.
2. Business risk does not change.
3. No change is EPS, Dividend etc.
4. The firm has perpetual life.

P = D+ (r/Ke)(E-D) / Ke

Where:
P = Prevailing Market Price of a share
D = Initial Dividend
E = Earnings per Share
r = The rate of return on the firm’s investment

Gorden’s Model:

Assumption:
1. All equity and no debts.
2. r and Ke are constant
3. Perpetual Life.
4. The growth rate is constant.
5. Ke>br

P= E(1-b)/ (Ke-br)

Where
P= Price of a share
E = Earnings per share
b = Retention ratio (% of earnings retained)
1-b = D/P (% of earnings distributed as dividend)
Ke = Cost of Capital (Capitalisation rate)
br = growth rate = rate of return on investment of all equity firm

Factors determining dividend policy:

1. Dividend Payout Ratio (D/P)
2. Stability of dividends
3. Legal, contractual and internal constraints and restrictions
4. owners considerations
 5. Capital market considerations and
6. inflation

The main features of Dividend Policy in India:

1. Most of the corporates have a policy of long-run dividend pay out ratio.
2. Dividend changes follow shift in the long term sustainable earnings.
3. Dividend policy as a residual decision after meeting the desired investment needs
is endorsed by about 50% of the sample corporates. The corporates which are
creating shareholders value significantly rescind dividend increase in the event of
growth opportunities available to them. Large firms are significantly less willing
to rescind dividend increases.
4. Dividend policy provides a signaling mechanism of the future prospects of the
corporate and to that exact, affects its market value.
5. Investors have different relative risk perceptions of dividend income of capital
gains and are not indifferent between receiving dividend income and capital gains.
Management should be responsive to the shareholders preferences regarding
dividend and the share buy back programme should not replace the dividend
payments of the corporates.
6. Dividend payments provide a bonding mechanism so as to encourage manager to
act in the best interest of the shareholders.
7. The corporate enterprises in India seem to have a tendency to pay relatively less
dividends. In fact, a fairly large number of them hardly pay any dividend. The
foreign controlled companies seem to follow a policy of larger distribution of
profits relative to the domestic companies. Retained earnings are a significant
source of corporate finance.
8. The vast majority of Indian corporates follows stable dividend policy in the sense
that they pay either constant dividend per share in the following year with
fluctuation EPS or increased dividend with increase in EPS.
9. An overwhelming majority of corporates have a long-run target D/P ratio. The
dividend changes follow shift in long-run sustainable earnings. Their dividend
policy is in agreement with the findings of Lintner’s study on dividend policy.
10. Firms which are creating shareholders value are significantly more willing to
rescind dividend increase in the event of growth opportunities available to them.
The larger firms are significantly less willing to rescind dividend increase them to
small firms.
11. Dividend policy provides a signaling mechanism of the future prospects of the
firm and thus affects its market value. The investors are not indifferent between
receiving dividend income and capital gains.
CAPITAL STRUCTURE

Optimum Capital Structure is the capital structure at which the weighted average cost of
capital is minimum and thereby maximum value of the firm.

Cost of Debt Ki = I/B

Value of Debt (B) = I/Ke

Cost of Equity Capital Ke = D1/P0 + g

V=S+B

S = Total Market Value of equity

B = Total Market Value of debt
I = Total Interest Payments
V = Total Market Value of the firm
NI = net income available to equity holders

Net Income Approach:

Net Operating Income Approach

MM Approach

Traditional Approach

Capital Structure Practices in India

1. Indian corporate employ substantial amount of debt in their capital structure in

terms of debt equity ratio as well as total debt to total assets ratio. Nonetheless,
the foreign controlled companies in India use less debt than the domestic
companies. The dependence of the Indian corporate sector on debt as a source of
finance has over the years declined particularly since the mid 90s.
2. The corporate enterprises in India seem to prefer long term borrowings over short
term borrowings. Over the years, they seem to have substituted short term debt for
long term debt. The foreign controlled companies use more long term loans
relatively to the domestic companies.
3. As a result of debt dominated capital structure, the Indian corporates are exposed
to a very high degree of total risk as reflected in high degree of operating leverage
and financial leverage and, consequently are subject to a high cost of financial
distress which includes a broad spectrum of problems ranging from relatively
minor liquidity shortages to extreme cases of bankruptcy. The foreign controlled
companies, however, are exposed to lower overall risk as well as financial risk.
4. The debt service capacity of the sizable segment of the corporate borrower as
measured by i. interest coverage ratio and ii. Debt service coverage ratio is
inadequate and unsatisfactory.
5. retained earnings are the most favoured source of finance. There is significant
difference in the use of internally generated funds by the highly profitable
corporates relative to the low profitable firms. The low profitable firms use
different form of debt funds more than the highly profitable firms.
6. Loan from financial institutions and private placement of debt are the next most
widely used source of finance. The large firms are more likely to issue bonds in
the market than small corporates.
7. The hybrid securities is the least popular source of finance amongst corporate
India. They are more likely to be used by low growth funds. Preference shares are
used more by public sector units and low growth corporates.
8. Equity capital as a source of funds is not preferred across the board.