Lecture-7 Dividend Policy

Sumon Kumar Mozumdar

Assistant Professor
Dept. of Management Studies, JuU.

What is Dividend?

A dividend is a distribution of profits by a corporation to its shareholders, after which the stock
exchange decreases the price of the stock by the dividend to remove volatility. The market has
no control over the stock price on open on the ex-dividend date, though often it may open
higher.
A dividend is a payment made by a corporation to its shareholders, usually in the form of cash
or additional shares of stock. It is a way for a company to distribute a portion of its profits to
its investors. Dividends are typically paid on a regular basis, such as quarterly, semi-annually,
or annually, though not all companies pay dividends.

Key Points About Dividends

1. Cash Dividends: These are paid out in cash to shareholders, often on a per-share
basis. For example, if a company declares a dividend of $1 per share, a shareholder
with 100 shares would receive $100.
2. Stock Dividends: Instead of cash, a company may issue additional shares of stock to
shareholders. For example, a 5% stock dividend means shareholders would receive 5
additional shares for every 100 shares they already own.
3. Dividend Yield: This is a ratio that shows how much a company is paying out in
dividends relative to its stock price. It is calculated as:

Annual Dividend per Share

Dividend Yield= 100
Stock Price per Share

For example, if a company pays a $2 annual dividend and its stock price is $50, the
dividend yield is 4%.

4. Declaration Date: This is the date on which the company's board of directors
announces that a dividend will be paid.
5. Ex-Dividend Date: This is the date by which an investor must own the stock to be
eligible for the upcoming dividend. If you buy the stock after this date, you won't
receive the dividend.
6. Payment Date: This is when the dividend is actually paid out to shareholders.
7. Payout Ratio: This is the proportion of a company's earnings that are paid out as
dividends. A high payout ratio may indicate that a company is returning a large
portion of its profits to shareholders, but it could also signal that the company is not
reinvesting enough for future growth.

Importance of Dividends

 Income for Investors: Dividends provide a regular income stream for investors,
which is particularly attractive to those who rely on their investments for retirement or
other purposes.
 Signal of Financial Health: Consistent or growing dividends can signal a company's
strong financial position and its ability to generate profits.
 Reinvestment: Shareholders can also choose to reinvest dividends into more shares
of the company's stock, potentially growing their investment over time.
Dividend Policy

A dividend policy refers to the strategy or guidelines that a company follows in determining
how much of its earnings should be distributed to shareholders as dividends, and how much
should be retained for reinvestment or other purposes. It plays a key role in the financial
decisions of a company and impacts investors' expectations and the company's stock price.

Key Aspects of Dividend Policy

1. Dividend Payout Ratio

o This is the percentage of a company's earnings that is distributed as dividends.
For example, if a company earns $10 million in profit and pays out $4 million
in dividends, the payout ratio is 40% ($4M ÷ $10M).
o High payout ratio: A company may have a high payout ratio if it wants to
provide immediate returns to shareholders (e.g., for income-focused investors).
o Low payout ratio: A low payout ratio may indicate that the company is
reinvesting most of its earnings into the business to fund growth, reduce debt,
or expand operations.
2. Stability of Dividends
o Many companies strive for stable or steadily growing dividends because
consistency tends to attract long-term investors. A predictable dividend policy
can be especially appealing to income-seeking investors, such as retirees.
o Constant dividend: Some companies adopt a policy of paying a fixed dollar
amount in dividends, regardless of earnings, which can sometimes be risky if
profits decline.
o Stable dividend: This means that the company aims to maintain a steady payout
(e.g., paying out a constant percentage of earnings).
o Residual dividend: In this model, dividends are paid from the residual or
leftover earnings after all profitable investment opportunities have been funded.
This means dividends can fluctuate based on the company’s investment needs.
3. Retention Ratio
o The retention ratio refers to the proportion of earnings that are retained in the
company, rather than paid out as dividends. It is the inverse of the payout ratio:

Retention Ratio=1−Payout Ratio

If a company is retaining earnings to fund growth or expansion, it may have a low

payout ratio and a high retention ratio.

Types of Dividend Policies

There are a few common approaches to dividend policies that companies may adopt:

1. Stable Dividend Policy

Companies following a stable dividend policy aim to pay a regular dividend that
grows at a steady rate over time. This approach helps signal financial health and
stability, and it is preferred by income-oriented investors.
Example: A company might pay $2 per share annually and aim to increase this
amount by a fixed percentage (e.g., 5% per year) regardless of fluctuations in
earnings.
2. Constant Dividend Payout Ratio
Under this policy, the company pays out a fixed percentage of its earnings as
dividends. As earnings fluctuate, the dividend amount also fluctuates.
 Example: If a company has a payout ratio of 40%, and its earnings increase, the
dividend paid will also increase in proportion to the earnings growth.
3. Residual Dividend Policy
In this approach, a company pays dividends based on its earnings left over after
it has funded all necessary capital expenditures (such as new projects,
acquisitions, or investments).
This policy means the dividend payout can vary widely from year to year
depending on the company’s capital needs. It is more common in companies
that are focused on high growth or capital-intensive industries.
Example: If a company has high investment opportunities in a given year, it
may choose to reduce or skip dividends to retain more earnings for
reinvestment.
4. Hybrid or Flexible Dividend Policy
Many companies adopt a hybrid approach, balancing between paying a base
dividend (for stability) and adjusting it depending on the company's earnings
and investment needs.
This could involve paying a fixed minimum dividend and additional special
dividends when there is excess profit.

Factors Influencing Dividend Policy

1. Profitability
A company's ability to generate consistent profits is a key determinant of its
dividend policy. Companies with higher and more stable profits are more
likely to pay regular dividends.
2. Cash Flow
Even if a company is profitable, it must have sufficient cash flow to pay
dividends. Cash flow is important because a company may need to retain cash
for working capital, debt repayment, or capital expenditures.
3. Growth Opportunities
Companies with high growth prospects may prefer to retain earnings and
reinvest them in the business rather than paying them out as dividends. This is
common in technology, biotech, or emerging-market firms where the focus is
on expansion.
4. Debt Levels
Highly leveraged companies (those with significant debt) may be cautious
about paying high dividends, as they may need to use available funds to
service debt obligations.
5. Tax Considerations
The tax treatment of dividends may influence a company’s dividend policy.
For example, in some countries, dividends are taxed at a higher rate than
capital gains, which may encourage companies to retain earnings or
repurchase stock instead of paying dividends.
6. Shareholder Preferences
Companies often consider the preferences of their shareholders. For instance,
investors in mature companies might prefer a steady dividend, while those in
growth-oriented companies may favor capital appreciation over dividends.
7. Industry Norms
Dividend policies can be influenced by industry norms. For example, utility
companies often have stable, high dividend payouts, while high-growth
industries like tech tend to pay lower or no dividends at all.
Dividend Policy Theories

1. Bird-in-the-Hand Theory
o Proposed by Gordon and Shapiro, this theory suggests that investors prefer the
certainty of dividends over the possibility of future capital gains. In other words,
investors might value a dollar of dividend more highly than a dollar of potential
capital gain because dividends are perceived as less risky.
2. Modigliani-Miller Theorem (Dividend Irrelevance Theory)
o According to the Modigliani-Miller theorem, in a perfect market (with no taxes,
transaction costs, or other market imperfections), a company’s dividend policy
does not affect its valuation. This means that whether a company pays high or
low dividends, or none at all, will not impact its stock price or overall value.
o In the real world, however, market imperfections (such as taxes and investor
preferences) do make dividend policy relevant.
3. Tax Preference Theory
o This theory suggests that investors prefer capital gains to dividends because
capital gains are often taxed at a lower rate than dividends. Therefore,
companies may retain earnings to fuel growth and allow shareholders to benefit
from capital gains rather than paying dividends.

Dividend Policy in Practice

In practice, many companies adopt a conservative dividend policy—paying out only a portion
of their earnings as dividends, with the remainder being reinvested. The goal is to balance
rewarding shareholders with maintaining sufficient funds for growth and financial stability.

For example:

 Blue-chip stocks like Coca-Cola or Procter & Gamble follow a stable dividend policy,
providing consistent and reliable dividends to investors.
 Growth companies like Amazon or Tesla, on the other hand, might have little or no
dividend payout, focusing on reinvesting profits into expansion and innovation.

A company’s dividend policy reflects a balance between rewarding shareholders and ensuring
sufficient capital for reinvestment and future growth. It depends on various factors including
profitability, cash flow, investment opportunities, debt obligations, and market conditions. The
chosen policy can influence investor behavior and affect the company’s stock price, as different
types of investors may have different preferences for dividend payments versus capital
appreciation.

Gordon Growth Model (Dividend Discount Model)

The Gordon Growth Model (also known as the Dividend Discount Model or DDM) is a
method used to determine the value of a company’s stock based on the present value of its
future dividends. It is widely used to value companies that pay regular dividends and are
expected to grow at a constant rate.

The model assumes that dividends will grow at a constant rate forever and that the required
rate of return for investors is greater than the dividend growth rate.
Formula

The basic formula for the Gordon Growth Model is:

𝐷1
Po=
𝑟−𝑔

Where:

 P0 = The price of the stock today (present value of the stock)

 D1 = The dividend expected to be paid in the next period (usually the next year)
 r = The required rate of return (also known as the discount rate or the cost of equity)
 g = The constant growth rate of dividends

Assumptions of the Gordon Growth Model

1. Constant Dividend Growth: The model assumes that dividends will grow at a constant
rate indefinitely. This makes it most applicable to companies that are mature and stable,
such as blue-chip stocks, where dividends tend to grow at a steady, predictable rate.
2. Discount Rate Greater than Growth Rate: The required rate of return rrr must be
greater than the dividend growth rate ggg. If r≤g, the model will not work because the
denominator r−gr - gr−g would be zero or negative, which is not feasible for calculating
the stock price.
3. No Changes in Risk: The model assumes that the company's risk (as reflected in the
required rate of return) remains constant over time.

Application of the Gordon Growth Model

The Gordon Growth Model is primarily useful for valuing dividend-paying stocks that have
a history of stable dividend growth. Here are some situations where the model can be applied:

 Mature Companies: Large, well-established companies with stable and predictable

dividend payments, such as utilities, consumer staples, or other "blue-chip" stocks, are
often suitable for the Gordon Growth Model.
 Long-Term Investment: The model assumes long-term stability in dividend growth,
so it is best suited for investors with a long-term investment horizon.

M&M Model of Dividend Policy

The Modigliani and Miller (M&M) Model of dividend policy, developed by Franco Modigliani
and Merton Miller in 1961, is a foundational theory in corporate finance. The M&M model
presents a no-dividend preference theory, suggesting that, in an idealized world with certain
assumptions, a firm's dividend policy does not affect its value or the cost of capital.

The basic premise of the M&M model is that, under perfect market conditions, the decision to
pay dividends or retain earnings is irrelevant to the shareholders, as the market value of the
firm is determined by its investment decisions (the firm’s overall strategy) and not by its
dividend pay-out. The model challenges traditional views that dividends can influence a
company's stock price and investor's preferences.

Without Taxes (Proposition I): The value of a firm is unaffected by its dividend policy.
Whether a firm pays a dividend or retains earnings, the market value of the firm will remain
the same because investors can adjust their portfolio to reflect their personal preferences for
dividends or capital gains.
V0=Value of the firm=Total value of the firm’s equity
With Taxes (Proposition II): When taxes are introduced into the model, dividend policy
becomes relevant because dividends are taxed differently than capital gains. Typically,
dividends are taxed at a higher rate than capital gains, which means investors may prefer firms
that retain earnings and create capital gains over firms that pay dividends. The tax differential
could lead to a preference for lower dividend payouts or higher capital gains. However, even
with taxes, M&M suggest that the optimal capital structure (and by extension, dividend policy)
would still depend on how the firm finances its operations.

Problem-1 Orbit Ltd. belongs to a risk class for which the appropriate capitalization rate is 10
percent. It has 50000 outstanding shares selling at Tk.200 each. The firm is contemplating the
declaration of Tk .16 dividend at end of the current financial year which has started. According
to Modigliani and Miller Hypothesis, you are required to calculate the followings:
a) What will be the price of share at end of the year, i) if dividend is not declared ii) if
dividend is declared?
b) Assuming that the firm pays dividend, has net income of Tk. 10,00,000.00 and makes
new investment of Tk. 25,00,000.00 during this period, how many new shares must be
issued?
c) What will be value of the firm i) if dividend is not declared ii) if dividend is declared?

Problem-2 The following information is available in respect of paramount Ltd., r=12%,

Ke=11% and E=Tk.20. Determine the value of shares using Gordon model under the following
assumptions:
D/P Ratio Retention Ratio
a. 10% 90%
b. 20% 80%
c. 30% 70%

Problem-3 The earning per share of ABC Ltd. is Tk.20. It has an internal rate of return of 15%
and cost of capital 13%. What will be the price of the shares according to Gordon model If; i)
Dividend of Tk. 15 is declared and ii) Dividend of Tk. 5 is declared.

Problem-4 Magic corporation earns Tk. 20,00,000 in 2023. It follows a stable dividend pay-
out ratio of 45%. It has 50,000 shares of common stock outstanding. Its internal rate of return
is 16% and cost of capital 10%. You are required to calculate; i) EPS, ii) DPS and iii) Market
price of the shares according to Gordon model.