DIVIDEND POLICY

What is dividend ??? The term dividend refers to that portion of

profit which distributed among the owners/shareholders of the company.

It is the reward of the shareholders for investments made by them in the shares of the company.

The investors are interested in earning the maximum ROI and to maximize their wealth, while a company, on the other hand, needs to provide funds to finance its long-term growth.

What is dividend decision ??? Should the profit be ploughed back to

finance the investment decisions? Whether any dividend be paid? If yes,

how much dividend be paid? When these dividend be paid? Interim or

Final? In what form the dividends be paid?

Cash dividend or stock dividend?

Dividend Policy Dividend policy of a firm affects both the long-

term financing and the wealth of shareholders. It deals with the firm’s decision to pay

dividends must be reached in such a manner so as to equitably apportion the distributed profits and retained earnings.

The company should, therefore, distribute a reasonable amount as dividends to its members and retain the rest for its growth and survival.

Dividend policy and value of the firm

Dividend policy is basically concerned with deciding whether to pay dividend in cash now, or to pay increased dividends at a later stage or distribution of profits in the form of bonus share.

“What is sound rational for dividend payments?” in the light of the objective of maximization of the value of the share

Dividend policy and value of the firm

Different models have been proposed to evaluate the dividend policy decision in relation to value of the firm.

Two schools of thought have emerged on the relationship between the dividend policy and the value of the firm. Relevance of dividend policy. Irrelevance of dividend policy.

Relevance of dividend policy

The firm pay dividend and view such dividend payments positively.

The investors also expect and like to receive dividend income on their investments.

The firms not paying dividends may be adversely rated by the investors.

It may be argued that the dividend policy has an effect on the market value of share and the value of firm.

Walter’s Model Assumption:1. All the investment proposals of the firm

are to be financed through the retained earning only and no external finance is available to the firm.

2. The business risk of the firm remains same even after fresh investment decision are taken. In other words ROI ‘r’ and cost of capital ‘k’ are constant.

3. The firm has an indefinite life.

Walter’s Model This model considers that the investment

decision and dividend decisions are inter-linked.

A firm should or should not pay dividends depends upon whether it has got the suitable investment opportunities to invest the retained earnings or not.

Walter’s Model According to this model, a firm can

maximize the market value of its share and value of the firm by adopting a dividend policy as follows:

1. If r>k - retention of 100% profit2. If r < k – pay 100% profit as dividend3. If r = k – the dividend is irrelevant

D + (E – D) (r/k) k k

P =

Gordon’s Model This model is also based on the

assumption similar to that made in Walter’s model. However, two additional assumptions made by this model are as follows: The growth rate of the firm the firm ‘g’ = br The cost of capital is constant and is more

than growth rate k > g

Gordon’s Model Under this model, the market price of

share is can be calculated as follows:

E(1-b)k – g

The profit which is not distributed to the owners and kept in the business is known as retained earning

P =