DIVIDEND DECISIONS

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DIVIDEND DECISIONS:

DIVIDEND DECISIONS DIVIDEND Meaning: The term ‘dividend’ refer to that part of divisible profits among its shareholders . In other words, dividend is that portion of company’s profit which is distributed among its shareholders as a percentage of par value of share or at a fixed rate per share according to the decision of its board of directors ..

Dividend Policy ::

Dividend Policy : Dividend Policy : Dividend policy is a very significant financial decision . It determines the divisions of earnings between payments to shareholders and retained earnings. If the value of firm is a function of its dividend-pay-out ratio , the dividend policy will affect directly the firms cost of capital.

Meaning:

Meaning ‘Dividend policy’ is a flexible and wide meaning word. This word is constituted with two words, dividend and policy. Dividend is that portion of profits of company which is distributed among its shareholders whereas policy means plan of action. Thus , the term dividend policy refers to the policy concerning quantum of profits to be distributed as dividend.

Factors influencing dividend policy : :  :

Factors influencing dividend policy : : Factors influencing dividend policy : Age of company Past dividend rate Liquidity of funds Stability in earning Expectations of shareholders Legal restrictions

Relevance Theory : :  :

Relevance Theory : : Relevance Theory : Dividend policy is very essential for any business firm as it affects the overall value of the firm. Dividend policy is relevant & dividend decision form a very integral part of the investment & financing decision of the firm. Shareholders prefer current dividends & hence there is a direct relationships between the dividend policy & the market value of the firm.

Traditional Approach: :

Traditional Approach: Traditional Approach Advocated by Gram & Dodd Arguments: This lays stress on the relationship between the dividend and the value of the share According to traditional approach the stock value responds positively to high dividends and negatively to low dividends, that is the share values of those co’s rises considerably which pay high dividends and the vice versa Weight assigned to DIVIDEND is 3 times the weight assigned to RE {P = m( D + E/3 )}

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Criticism: The emphasis on the direct relationship b/w dividend pay out ratio and price earning ratio doesn’t always hold true. A co’s share prices may rise in spite of low dividends Based on subjective judgment rather than on empirical evidence

Walter’s model,:

Walter’s model, Walter’s model, one of the earlier theoretical models, clearly indicates that the choice of appropriate dividend policy always affects the value of the enterprise. Professor James E. walter Walter has very scholarly studied the significance of the relationship between the firm’s internal rate of return, r, (or actual capitalization rate) and its Cost of Capital, K ( normalcapitalization rate) in determining such dividend policy as will maximize the wealth of the stock holders

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Water’s model is based on the following premises: (1) The firm finance its entire investments by means of retained earnings. New equity stock or debenture is not issued to raise funds. (2) Internal rate of return (r) and cost of capital (K e) of the firm remain constant. (3) The firm’s earnings are either distributed as dividends or reinvested internally. (4) Earnings and dividends of the firm never change. (5) The firm has long or infinite life.

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The formula used by Walter to determine the market price per share is : P=D/ Ke + r/ ke (E-D)/ ke Where, P = Market price per share D = Dividend per share E = Earnings per share r = Internal rate of return (Actual capitalization rate) K = Cost capital (External capitalization rate)

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Limtations of walter’s model; Walter has assumed that investments are exclusively financed by retained earnings and no external financing is required Walter’s model is applicable only to all equity firms also “r” and “ ke ” are assumed to be constant whichs not a realistic assumption &

GORDON’S MODEL : :

GORDON’S MODEL : Myron Gordon has also developed a model on the lines of Prof. Walter suggesting that dividends are relevant and the dividend decision of the firm affects its value. His basic valuation model is based on the following assumptions: 1. The firm is an all equity firm. 2. No external financing is available or used. Retained earnings represent the only source of financing investment programmes . 3. The rate of return on the firm’s investment r, is constant. .

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The retention ratio, b, once decided upon is constant. Thus, the growth rate of the firm g = br , is also constant. 5. The cost of capital for the firm remains constant and it is greater than the growth rate ,i.e. k > br. 6. The firm has prepetual life. 7. Corporate taxes do not exist.

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According to Gordon, the market value of a share is equal to the present value of future stream of dividends Gordon’s basis valuation formula can be simplified as under; P= E(1-b)/ ke-br Where, P = Price of shares E = Earnings per share b = Retention Ratio ke = Cost of equity capital br = g = growth rate in r, i.e., rate of return on investment of an all-equity firm D = Dividend per share

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The implications of Gordon’s basic valuation model may be summarized as below: 1. When the rate of return of firm’s investment is greater than the required rate of return, i.e. when r > k, the price per share increases as the dividend payout ratio decreases. Thus, growth firm should distribute smaller dividends and should retain maximum earnings. 2. When the rate of return is equal to the required rate of return, i.e , when r = k, the price per share remains unchanged and is not affected by dividend policy. Thus, for a normal firm there is no optimum dividend payout.

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MODIGLIANI-MILLER’S MODEL (M-M’S MODEL) : Modigliani-Miller’s (M-M’s) thoughts for irrelevance of dividends are most comprehensive and logical. According to them, dividend policy does not affect the value of a firm and is therefore, of no consequence. It is the earning potentiality and investment policy of the firm rather than its pattern of distribution of earnings that affects value of the firm

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Basic Assumptions of M-M Approach (1) There exists perfect capital market where all investors are rational. Information is available to all at no cost; there are no transaction costs and floatation costs. There is no such investor as could alone influence market value of shares. (2) There does not exist taxes. Alternatively, there is no tax differential between income on dividend and capital gains. (3) Firm has uncertainty as to future investments and profits of the firm. Thus, investors are able to predict future prices and dividend with certainty.

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M-M approach contains the following mathematical formulations to prove irrelevance ofdividend decision. The market value of a share in the beginning of the year is equal to the present value ofdividends paid at the year end plus the market price of the share at the end of the year, this can be expressed as below

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Step 1; po =1/(1+ke)* (D1+P1) Where, P0 = Existing price of a share ke = Cost of equitycapital D1 = Dividend to be received at the year end P1 = Market value of a share at the year end

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If there is no additional financing from external sources, value of the firm (V) will be number of share (n) multiplied by the price of each share (Po). Symbolically: npo = 1/(1+ke)*(nD1+np1) Where n is the no. of existing shares.

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If the firm issues m number of share to raise funds at the end of year 1 so as to finance investment and at price P1, value of the firm at time o will be: Npo =1/(1+ke)*(nd1+(n+n1)p1-n1p1) I= Total amount of investment Required nd1= Total dividends paid. E= earnings during the period (E-ND1) is retained earnings.

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The value of share is therefore; npo = 1/(1+ke)*(nd1+(n+n1)p1- I + E - ND1)

Criticism of MM Approach :

Criticism of MM Approach MM hypothesis has been criticised on account of various unrealistic assumptions as given below. 1. Perfect capital market does not exist in reality. 2. Information about the company is not available to all the persons. 3. The firms have to incur flotation costs while issuing securities. 4. Taxes do exit and there is normally different tax treatment for dividends and capital gain. 5. The firms do not follow a rigid investment policy. 6. The investors have to pay brokerage, fees etc., while doing any transaction. 7. Shareholders may prefer current income as compared to further gains.

STABILITY OF DIVIDENDS:

STABILITY OF DIVIDENDS States that there is a consistency in the stream of dividend payments. The steadiness is a reflector of positive indicator of firms overall growth. Which involves constant dividend per share constant dividend pay out ratio Constant dividend per share plus extra dividend.

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FORMS OF DIVIDENDS; CASH DIVIDENDS; Regular cash dividend – cash payments made directly to stockholders, usually each quarter Special cash dividend – large dividend that won’t be repeated Liquidating dividend – some or all of the business has been sold

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SCRIP DIVIDEND; THIS FORM IS ADOPTED IF THE FIRM HAS EARNED PROFITS & IT TAKES TIME TO CONVERT ITS ASSETS INTO CASH MORE CURRENT SALES THAN CASH SALES PAYEMENT OD DIVIDEND IS DONE ONLY IF THE FIRM IS SUFFERING FROM WEAK LIQUIDITY POSITION.

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BOND DIVIDEND; SCRIP AND BOND ARE SAME EXCEPT THEY DIFFER IN THEIR MATURITY PERIOD BOND DIVIDENDS CARRY LONGER MATURITY PERIOD AND BEAR INTEREST,WHEREAS SCRIP DIVIDENDS MAY OR MAY NOT CARRY INTEREST.

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Sock Dividends ;Pay additional shares of stock to shareholders instead of cash at no additional cost. Increases the number of outstanding shares Small stock dividend Less than 20 to 25% If you own 100 shares and the company declared a 10% stock dividend, you would receive an additional 10 shares Large stock dividend – more than 20 to 25%

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Stock splits – essentially the same as a stock dividend except expressed as a ratio For example, a 2 for 1 stock split is the same as a 100% stock dividend Stock split increases the no. of outstanding shares by proportionately reducing the face value of the share

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Is done To make shares more attractive; to reduce the market price of the share Indication of higher future profits; is basically alarming the investors about the expected high profits in future Higher dividend to shareholders

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