Meaning of dividend policy
The term Dividend refers to that part of profits of a company, which is distributed by the company among its shareholders. It is the reward of the shareholders for investments made by them in the shares of the company. The board of directors of the company decides dividend. It can be in percentage or amount form.
Dividend Payout Ratio The dividend payout ratio provides an indication of how much money a company is returning to shareholders versus bow much company is keeping with it to reinvest in growth, pay earnings. The dividend payout ratio can be calculated as
Pay of debt or cash reserves (retained earning)
There are four types of dividend policy.
first is regular dividend policy,
second irregular dividend policy,
third stable dividend policy and
lastly no dividend policy.
The stable dividend policy is further divided into per share constant dividend, pay-out ratio constant, stable dividend plus extra dividend.
Regular dividend policy:Under this type of dividend policy, the company follows the procedure to pay out a dividend to its shareholders every year. If the company earns abnormal profits, then it retains the extra profit. Whereas, if it remains in loss any year, then also it pays a dividend to its shareholders. This type of policy is adopted by the company who are having stable earnings
Stable dividend policy: Under this type of dividend policy, the company follows the procedure to pay out a defined fixed percentage of profits as dividends every year.
No dividend policy :Under this type of dividend policy, the company follows the procedure of paying no dividend to the shareholders irrespective of its profit or loss scenario. The payout ratio will be 0%. The total earning will be retained by the company.
Irregular dividend policy:Under the irregular dividend policy, the company is under no obligation to pay its shareholders and the board of directors can decide what to do with the profits. ... The irregular dividend policy is used by companies that do not enjoy a steady cash flow or lack liquidity.
Theories of Dividend Policy
Now we have discuss Relevance theories
The relevance theory of dividend argues that dividend decision affects the market value of the firm and therefore dividend matters.
Walter Dividend Model
Walter approach is in support of the relevance of dividends firm's dividend policy has affect the stock or its cost of capital. According to him the dividend policy of a firm is based on the relationship between the internal rate of return (r) earned by it and the cost of capital or required rate of return (Ke).
Assumptions of Walter’s Model
All the financing is done through the retained earnings; no external financing is used.
The rate of return (r) and the cost of capital (K) remain constant irrespective of any changes in the investments.
All the earnings are either retained or distributed completely among the shareholders.
The earnings per share (EPS) and Dividend per share (DPS) remains constant.
The firm has a perpetual life.
IMPLICATIONS
If r>K, the firm should retain the earnings because it possesses better investment opportunities and can gain more than what the shareholder can by re-investing. The firms with more returns than a cost are called the “Growth firms” and have a zero payout ratio.
If r<K, the firm should pay all its earnings to the shareholders in the form of dividends, because they have better investment opportunities than a firm. Here the payout ratio is 100%.
If r=K, the firm’s dividend policy has no effect on the firm’s value. Here the firm is indifferent towards how much is to be retained and how much is to be distributed among the shareholders. The payout ratio can vary from zero to 100%
Criticism of Walter’s Model
It is assumed that the investment opportunities of the firm are financed through the retained earnings and no external financing such as debt, or equity is used. In such a case either the investment policy or the dividend policy or both will be below the standards.
The Walter’s Model is only applicable to all equity firms. Also, it is assumed that the rate of return (r) is constant, but, however, it decreases with more investments.
It is assumed that the cost of capital (K) remains constant, but, however, it is not realistic since it ignores the business risk of the firm, that has a direct impact on the firm’s value.
ADVANTAGES of dividend policy
*Investor's preference for stable dividend receipt
*Bird in Hand Fallacy
*Stability
*Benefits without selling
*Temporary Excess Cash
Information Signalling
DISADVANTAGES
*Clientele Effect - Loss of old clientele, if unable to pay dividend for certain period
*Decreased Retained Earnings
*Limits company's growth as it reduces the usable cash
*Logistics - Lot of record keeping
The Gordon growth model (GGM) assumes that a company exists forever and that there is a constant growth in dividends when valuing a company's stock. The GGM works by taking an infinite series of dividends per share and discounting them back into the present using the required rate of return.
ASSUMPTIONS
Gordon's model is based on the following assumptions:
o The firm is an all Equity firm
o No external financing is available
o The internal rate of return (r) of the firm is constant.
of The appropriate discount rate (K) of the firm remains constant.
o The firm and its stream of earnings are perpetual
o The corporate taxes do not exist.
The retention ratio (b), once decided upon, is constant. Thus, the growth rate (g) = br is constant forever.
o k > br = g if this condition is not fulfilled, we cannot get a meaningful value for the share.
Assumptions
1. No Debt
2. No External Financing
3. Constant IRR
4. Constant Cost of Capital
5. Perpetual Earnings 6. No Corporate Taxes
6. Constant Retention Ratio
7 Cost of Capital > Growth Rate
RELATIONSHIP
1. When R > K, Price per share decreases
2. When RK, Price per share increases
3. When R K, No change in Price per share
IMPLICATIONS
1. GROWTH FIRM (R>K): Benefits the shareholders more if the company reinvests the dividends rather than distributing it.
2. NORMAL FIRM (R=K): It does not make any difference the company reinvested the dividends or distributed to shareholders. if
3. DECLINING FIRM (R<K): The shareholders are benefited more if the dividends are distributed rather than reinvested.
Criticism
Criticised due to unrealistic assumptions of constant IRR, Cost of Capital and no external financing
Dividend irrelevance theory holds the belief that dividends don't have any effect on a company's stock price. A dividend is typically a cash payment made from a company's profits to its shareholders as a reward for investing in the company.
Miller and Modigliani Hypothesis or MM Approach
Definition: According to Miller and Modigliani Hypothesis or MM Approach, dividend policy has no effect on the price of the shares of the firm and believes that it is the investment policy that increases the firm's share value.
ASSUMPTIONS
1. Fixed Investment Policy
2. No risk of uncertainty
3. Investor is indifferent between dividend & capital gain income
4. No taxes
5. Capital market is perfect
CRITICISM
1. Perfect Capital Market do not exist. Taxes are present in market
2. The assumption of no uncertainty is unrealistic.
3. Theory believes that the shareholder's wealth is not affected by the dividends.
VALUATION FORMULAE
P1 = P0*(1 + Ke) - D1
Where, P1 Price at the end of the period
P2 Price at the beginning of the period
Ke Cost of Capital
D1 Dividend received at the end of the period
VALUE OF FIRM
nP0 = (n + An) × P1 - I + E / (1+ke)
Where, n = No. of shares outstanding at the end of the period
I = Investment
E = Earnings An = Change in number of shares due to new investment required
PROPOSITIONS WITHOUT TAXES
The capital structure does not influence the value of firm
Debt holders & equity shareholders have same priority.
Financial leverage is in direct proportion to Cost of Equity (Ke).
With rise in debt, the equity shareholders perceive a higher risk.
PROPOSITIONS WITH TAXES
It assumes existence of taxes, therefore, tax benefits due to interest payments are recognized. So, Cost of Debt reduces by Interest Tax Shields
Therefore, change in debt component can affect value of a firm.
0 Comments