Dividend Theory

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By Dr. Vikas Garg Associate Prof. in MBA Deptt. Accurate Institute of Management & Technology, Gr. NOida

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Dividend Theory:

Dividend Theory

PowerPoint Presentation:

Dividend refers to the business concerns net profits distributed among the shareholders. It may also be termed as the part of the profit of a business concern, which is distributed among its shareholders. According to the Institutes of Chartered Accountant of India, Dividend is defined as “a distribution to shareholders out of profits or reserves available for this purpose”.

Types/Form of Dividend:

Cash Dividend Stock Dividend Bond Dividend Property Dividend Types/Form of Dividend

Factors Determining Dividend Policy:

Profitable Position of the Firm Uncertainty of Future Income Legal Constrains Liquidity Position Sources of Finance Growth Rate of the Firm Tax Policy Capital Market Conditions Factors Determining Dividend Policy

Types of Dividend Policy:

Regular Dividend Policy Stable Dividend Policy Irregular Dividend Policy No Dividend Policy Types of Dividend Policy

Dividend Theories:

Dividend Theories Relevance Concept of Dividend Irrelevance Concept of Dividend Walter’s Model Gordon’s Model MM Model

Relevance Concept of Dividend:

James Walter, Myron Gordon are mainly associated with the relevance concept of dividend. They hold that there is a direct relationship between the dividend policy of the company and its value in terms of market price of its share. Those firms which pay higher dividends, will have grater value as compared to those which do not pay dividends or have a lower dividend payout ratio. Relevance Concept of Dividend

Walter’s Model:

A theory known as Walter’s Model was presented by James E. Walter for determining dividend policy. His proposition clearly states the relationship between the firm’s Internal Rate of Return (r), Required rate of return (c), Walter’s view on the optimum dividend payout ratio can be summarised as follows: Growth Firm (r>c) Declining Firm (r<c) Normal Firm (r=c) Walter’s Model

PowerPoint Presentation:

Prof. walter has given the following formula to ascertain the market price of a share: P= Where, P stands for theoretical market value of the co.’s equity shares DPS stands for dividend per share r stands for internal rate of return on investment C stands for rate of capitalization in the market DPS + r/c(EPS-DPS) c

PowerPoint Presentation:

Example: The earning per share of Anmol Ltd. Is Rs. 10 and capitalisation rate is 10%. Company have 75% payout ratio. In the above circumstances according the walter’s formula What's the market value of the co.’s equity share if internal rate of return is 15%. Sol: D/P ratio is 75% it means Dividend per share Rs. 7.50 P= = = 112.50 DPS + r/c(EPS-DPS) c 7.5 +0.15/.010(10-7.5) 0.10

Gordon Model:

This is another important theory of dividend evolved by M J Gordon. According to this model current dividend as well as the future expected dividends, are relevant for determining the value of a firm. Gordon’s theory is very much closer to Walter’s model and contends that dividend policy influences the market value of a share of a firm. It gives due importance to growth (g or br) of a company. Gordon Model

PowerPoint Presentation:

Gordon’s formula for determining the value of a share: P= Where, P stands for value of equity shares E stands for Earning per Share b stands for percentage of Earnings Retained (1-b)= D/P ratio r = rate of return earned on investment made by the firm br stands for growth rate of earnings and dividends k stands for Capitalisation Rate E(1-b) (k-br)

PowerPoint Presentation:

Example: Monika Ltd. Follows a policy of fixed dividend payout of 80%. The EPS for 2009-10 is Rs. 5.00 per share and the same is expected to grow by 20% during 2010-11. The firm earns a return of 18% on its investment. The cost of equity of the company is 15%. Compute the value of the share as on 01-04-2010 using the Gordon Model.

PowerPoint Presentation:

Sol: Expected EPS for 2010-11 (E)=5+20% = 6 D/P Ratio (1-b)= 80% = 0.80 b=1-0.80=0.20 r=18%=0.18 k=15%=0.15 P= P= = 42.10 E(1-b) (k-br) 6(0.80) (0.15-0.20*0.18)

Irrelevance Concept of Dividend:

Modigliani and Miller & Solomon Ezra are mainly associated with the irrelevance concept of dividend. According to this concept, dividend decision has no effect on the wealth of the shareholders or the prices of the shares. Irrelevance Concept of Dividend

Modigliani and Miller Model:

Modigliani and miller model is based on the irrelevance of dividend decisions as far as the valuation of a firm is concerned. That’s why M. M. Approach is sometimes termed as “Dividend Irrelevance Model”. According to them, the dividend policy of a firm is irrelevant since it does not have any effect on the price of a shares of a firm, i.e., it does not affect the shareholder’s wealth. Modigliani and Miller Model

Computation of the Market Price of a share :

Po= P1= Po(1+Ke)-D1 Where, Po=Market Price per share at the beginning of the period P1= Market Price per share at the end of the period D1=Dividend per share Ke= Capitalisation Rate Computation of the Market Price of a share D1+P1 1+Ke

Computation of the number of New Shares to be Issued:

m= Where, m= Number of new shares to be issued P1= Market Price per share at the end of the period I=Amount of Investment required x=Total net profit of the firm during period D1=Dividend per share Computation of the number of New Shares to be Issued I-(X-D1) P1

Calculation of value of firm :

nPo = Where, m= Number of new shares to be issued P1= Market Price per share at the end of the period I=Amount of Investment required x=Total net profit of the firm during period Ke= Capitalisation Rate n= Number of new shares at the beginning nPo =Value of the firm Calculation of value of firm ( n+m )P1-(I-X) 1+Ke

PowerPoint Presentation:

Example: Delhi Syntex Limited belongs to a risk class for which the appropriate capitalisation rate is 10%. It currently has outstanding 50,000 shares of Rs.10 each. The firm is contemplating the declaration of dividend at Rs. 0.60 per share at the end of the current financial year. The company expects to have a net income of Rs. 50,000 and has a proposal for making new investments of Rs. 1,00,000. Show that under the M.M. hypothesis, the payments of dividend does not affect the value of the firm.

PowerPoint Presentation:

Sol: Value of the firm when dividends are paid Price of the share at the end: P1= Po(1+Ke)-D1 = 10(1+0.10)-0.60 = 10.40 (ii) Number of shares to be issued: m= = = 7692 Aprox I-(X-D1) P1 100000-[(50000)-(50000*0.60)] 10.40

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(iii) Value of the firm: nPo = = =Rs. 500000 ( n+m )P1-(I-X) 1+Ke [50000+(80000/10.40)]*10.40-(100000-50000) 1+0.10

PowerPoint Presentation:

(B) Value of the firm when dividends are not paid Price of the share at the end: P1= Po(1+Ke)-D1 = 10(1+0.10)-0 = 11 (ii) Number of shares to be issued: m= = = 4545 Aprox I-(X-D1) P1 100000-[(50000)-0] 11

PowerPoint Presentation:

(iii) Value of the firm: nPo = = =Rs. 500000 ( n+m )P1-(I-X) 1+Ke [50000+(50000/11)]*11-(100000-50000) 1+0.10

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