DIVIDEND DECISIONS

Introduction:

DIVIDEND THEORIES

Optimum Payout Ratio

DIVIDEND RELEVANCE

WALTER’S MODEL

Growth Firms – Retain all earnings

Normal Firms – Distribute all earnings

Declining Firms – No effect

Application of Walter’s Model

Example: Dividend Policy

Walter’s formula to determine the market price per share:

**DIVIDEND THEORY AND POLICY**

There are basically two options which a firm

has while utilizing its profits after tax. Firms can either plough back the earnings by retaining them or distribute the same to the shareholders. The first option suits those firms which need funds to finance their long-term projects. However, such projects should have enough growth potential and sufficient profitability. On the other hand, the second option of declaring cash dividends from the profits after tax will lead to maximization of the shareholders wealth.

The returns to the shareholders either by way

of the dividend receipts or capital gains are affected by the dividend policies of the firms. This is mainly due to the fact that the dividend policy decides the retention ratio and pay-out ratio (dividend as a percent of profits). Furthermore, the dividend policy of the firm gains importance especially due to unambiguous relationship that exists between the dividend policy and the equity returns. Thus, a firm’s decision should meet the investors’ expectations.

A few models which studied this relationship and the dividend policies of firms are given below and discussed:

– Traditional Position

– Walter Model

– Gordon Model

– Miller & Modigliani Position

– Rational Expectations Model.

The traditional approach to the dividend policy, which was given by B Graham and D L Dodd lays a clear emphasis on the relationship between the dividends and the stock market. According to this approach, the stock value responds positively to higher dividends and negatively when there are low dividends.

The following expression, given by traditional approach, establishes the relationship between market price and dividends using a multiplier:

P = m (D + E/3)

P=Market Price

m=Multiplier

D=Dividend per share

E=Earnings per share

Walter’s model is based on the following assumptions:

Internal financing

Constant return and cost of capital

100 per cent payout or retention

Constant EPS and DIV

Infinite time

The optimum dividend policy is determined on the basis of reinvestment rate, k. If firm’s reinvestment rate, k exceeds shareholders expectations, r then optimum dividend policy is 100% retention, if k < r then optimum is 100% pay out and when k = r the dividend policy is immaterial.

LIMITATIONS OF THE WALTER’S MODEL

Most of the limitations for this model arise due to the assumptions made.

The first assumption of exclusive financing by retained earnings make the model suitable only for all-equity firms.

Secondly, Walter assumes the return on investments to be constant. This again will not be true for firms making high investments.

Finally, Walter’s model on dividend policy ignores the business risk of the firm which has a direct impact on the value of the firm.

Thus, k cannot be assumed to be constant.

No external financing

Constant return, r

Constant opportunity cost of capital, k

Gordon’s Dividend Capitalization Model

Yet another model that has given importance to the dividend policy of the firm is the Gordon Model. Myron Gordon used the dividend capitalization approach to study the effect of the firms’ dividend policy on the stock price.

Gordon’s Dividend Capitalization Model

ASSUMPTIONS:

The firm will be an all-equity firm with the new investment proposals being financed solely by the retained earnings.

Return on investment (r) and the cost of equity capital (ke) remain constant.

Firm has an infinite life

The retention ratio remains constant and hence the growth rate also is constant (g = br).

k > br i.e. cost of equity capital is greater than the growth rate.

In short, Gordon’s model is based on the following assumptions:

All-equity firm

No external financing

Constant return

Constant cost of capital

Perpetual earnings

No taxes

Constant retention

Cost of capital greater than growth rate

Gordon’s Model assumes that the investors are rational and risk-averse. They prefer certain returns to uncertain returns and thus put a premium to the certain returns and discount the uncertain returns. Thus, investors would prefer current dividends and avoid risk. Retained earnings involve risk and so the investor discounts the future dividends. This risk will also affect the stock value of the firm.

Gordon explains this preference for current income by the bird-in-hand argument. Since a bird-in-hand is worth two in the bush, the investors would prefer the income that they earn currently to that income in future which may or may not be available. Thus, investors would prefer to pay a higher price for the stocks which earn them current dividend income and would discount those stocks which either postpone/ reduce the current income. The discounting will differ depending on the retention rate (percentage of retained earnings) and the time.

Gordon’s dividend capitalization

model gave the value of the stock as:

EXAMPLE

If ke = 10%, and

E = Rs.10

calculate the stock value of Swan Ltd. for

(i) r = 15% (ii) r = 10% (iii) r = 8%

for the various levels of the D/P ratios.

40%, 60%,90%

Application of Gordon’s Dividend Model

Gordon’s Model The Outcome

Like Walter’s model the value of the firm under Gordon’s model is also dependent upon the reinvestment rate and shareholders’ expectations.

Walter’s model keeps the dividend amount constant in each period while Gordon’s model assumes growing dividend in each period.

Gordon’s Model:The Outcome

Like Walter’s model the value of the firm under Gordon’s model is also dependent upon the reinvestment rate and shareholders’ expectations.

Walter’s model keeps the dividend amount constant in each period while Gordon’s model assumes growing dividend in each period.

WACC calculation

Calculate cost of capital

Calculate cost of Debt

Calculate cost of equity

Calculate cost of retained earnings

Calculate cost of preference shares

cost of capital -

K= Ro + b + f

Where, k= cost of capital

Ro=normal rate of return @ zero risk level

b= premium for business risk

f= premium for financial risk

Now calculate WACC by using the data given in the question and from calculation of cost of capital. Here WACC is 8.812

CASE STUDY:

DIVIDEND POLICY OF ONGC INDIA

Dividends are declared at the Annual General Meeting of the shareholders based on the recommendation by the Board. The Board may recommend dividends, at its discretion, to be paid to our members. The Board may also declare interim dividends. Generally, the factors that may be considered by the Board before making any recommendations for the dividend include, but are not limited to, future capital expenditure plans, profits earned during the financial year, cost of raising funds from alternate sources, cash flow position and applicable taxes including tax on dividend, subject to the Government guidelines described below:

As per the guideline dated February 11, 1998 from the Government of India, all profit-making PSUs which are essentially commercial enterprises should declare the higher of a minimum dividend of 20 percent on equity or a minimum dividend payout of 20 percent of post-tax profit. The minimum dividend pay-out in respect of enterprises in the oil, petroleum, chemical and other infrastructure sectors such as us should be 30 percent of post-tax profits

THANK YOU!

All of us from Team H are grateful for the opportunity!

A presentation by:

DCH 03, 19, 24, 38, 41, 43 and 55