SEC - 307

ADVANCED FINANCIAL
MANAGEMENT
(SEMESTER: V)

Prepared By:
Prof. Krupal Acharya
Department of Management
Government BBA College
 UNIT:4 DIVIDEND THEORY

i. Meaning of dividend

ii. Types of dividend policy

iii. Determinants of dividend policy

iv. Dividends theories

Walter model
Gordon model
MM model
Meaning of Dividend
The term ‘dividend’ refers to that portion of company’s earnings that are paid to the
equity shareholders (not preference share holders, since they are entitled to have a
fixed arte of dividend). Dividend policy of firm decide the portion of earning which are
paid as dividends to ordinary shareholders and the portion that is ploughed back in
the firm for investment purpose.

The total net earnings may be paid as a dividends (100% dividend pay out ratio), which may
consequently result in slower growth and lower the market price or when a part of net
earning may be pay as dividends, higher capital gain and higher market price.

When a company used a part of its net earnings for dividend payments then the remaining
earnings are retained. Thus, there is an inverse relationship between retained earning and
payment cash dividend.
Types of Dividend Policies
The following are the various types of dividend policies;
1. Policy of no immediate dividend
2. Stable dividend policy
3. Regular dividend plus extra dividend policy
4. Irregular dividend policy
5. Regular stock dividend policy
6. Regular dividend plus stock dividend policy
7. Liberal dividend policy
1. Policy of No Immediate Dividend: Generally, management follows a policy of paying
no immediate dividend in the beginning of its life, as it requires funds for growth and
expansion. In case, when the outside funds are costlier and when the access to capital
market is difficult for the company and the shareholders are ready to wait for dividend for
sometime, this policy is justified.
2. Regular or Stable Dividend Policy: When a company pays dividend regularly at a fixed
rate, and maintains it for a considerably long time even though the profits may fluctuate ,
it is said to follow regular or stable dividend policy. It raises the prestige of the company
in the eyes of the investors. A firm paying a stable dividend can satisfy its shareholders
and can enhance its credit standing in the market. The dividend may be fixed amount of
share or fixed percentage of net earnings.
3. Regular Dividend + Extra Dividend Policy: A firm paying regular dividends would
continue with its payout ratio. But when the earnings exceed the normal level, the
directors would pay extra dividend in addition to the regular dividend. It would be named
‘extra dividend’ as it should not give an impression that the company enhance rate of
regular dividend. This would give an impression to shareholders that the company has
given extra dividend because it has earned extra profits and would not be repeated in
normal course of business.
4. Irregular Dividend Policy: When the firm does not pay fixed dividend on regular basis
then it known as irregular dividend policy. It may change with the change in earning level.
This policy is based on the management belief that dividend should be paid only when the
earnings and liquidity position of the firm permit. This policy is followed by firms having
unstable earnings, particularly in luxury goods.
5. Regular Stock Dividend Policy: When a firms pays dividend in the form of shares instead
of cash for some years continuously it is said to follow this policy. This stock dividend is
known as bonus shares. When a company is having shortage of money at that time
company is going to follow this kind of policy.
6. Regular Dividend + Stock Dividend Policy: A firm pay certain amount of dividend in
cash and some paid in the form of shares. Thus the dividend is split in to two parts. This
policy is justified when, (1) the company wants to maintain its policy of regular dividend,
(2) it wants to retain some parts of its profit for expansion, (3) company is not having
enough liquidity.
7. Liberal Dividend Policy: The rate of dividend or the amount is not fixed. It varies
according to earnings. The higher the profit, the higher the rate of dividend.
Factors Affecting Dividend Policy
The following are the factors that affect dividend policy;
1. Nature of Earnings: The nature of business has an important bearing on the dividend
policy. The industrial units that are having stability of earnings may formulate stable
or a more consistent dividend policy than other that are having variations in earnings,
because they can predict easily their earnings.
2. Age of Company: The age of company has more impact on distribution of profits as
dividends. A newly started and growing company may require much of its earnings
for financing expansion programs or growth requirements and it may follow inflexible
dividend policy, where in most of the earnings are retained. On the other hand, an old
company with good track record and good name in the public can formulate a clear
cut and more consistent dividend policy.
3. Liquidity Position of Company: Generally dividends are paid in the form of cash,
hence it need cash. Although, a firm may have sufficient profits to declare dividends,
but it may not have sufficient cash to pay dividends. Thus, availability of cash and
sound financial position of the firm is an important factor in taking dividend decision.
4. Equity Shareholder Preference for Current Income: Legally, the board of directors has
judgment to decide the distribution of the earning of the firm. The shareholder who are legal
owner of the firm appoint the BOD’s. Hence, directors have to take into consideration
owners’ preferences, while deciding dividend payment. Shareholders’ preference for current
dividends or capital gain, that is depend on their economic status and the effect of tax
differential on dividends and capital gains.
5. Requirements of Institutional Investors: Institutional investors like LICs, GICs and MFs,
have investment policy, which says that these type of institutes have to invest only in
companies that have a continuous dividend payment record with stability. These purchase
large blocks of shares for relatively to hold a long period of time. Hence, they represent the
significant force in the financial markets, and their demand for company’s securities may
increase share price and there by owners’ wealth. To attract institutional investors firms may
require to follow stable dividend policy.
6. Financial Needs of The Company: This is one of the key factors, which influence the
dividend policy of a firm. Financial needs means funds required for predictable future
investment. The required funds may be determined with the help of long-term financial
forecasts. A firm that has sufficient profitable investment opportunities, it should follow low
dividend payout ratio. On the other hand, a firm that has no profitable investment
opportunities adopts high dividend payout ratio.
7. Access to the Capital Market: Access to the capital market means the firms ability to raise
funds from capital market. A company, which has easy access to the capital market provides
flexibility in deciding dividend policy. Easy access to capital market is possible only
company are well established and hence a profit track record. Generally dividend policy and
investment decisions are interrelated, but in this situation they are independent. The
management may tempt to declare a high rate of dividend that attract investors and maintain
existing shareholders.
8. Inflation: Inflation is the state of economy in which the prices of products or goods have
been increasing. Inflation is a factor that influences dividend policy indirectly. Indian
accounting system is based on historical costs. The funds accumulated from depreciation
may not be sufficient to replace the outdated asset or equipment, since depreciation is
provided based on historical costs. Consequently to replace assets and equipment firm has to
depend upon retained earnings, this leads to the payment of low dividend during inflation
period.
9. Dividend Policy of Competitors: Keeping one eye on the competitors‘ dividend policy is
very important. If the firm wants to retain the existing shareholders or it want to maintain
share price in the market, and if it is planning to raise funds from public for expansion
programs, it has to pay dividend on par with competitors. Hence it is one of the factors that
influence dividend policy of a firm.
10. Past Dividend Rates of the Company: This is the factor that influences the dividend
policy of an existing company. Owners’ and prospective investors prefer stability in
dividends. Generally firms’ tries to maintain stability in dividends that is based on past
dividend rates of the company. Hence, directors will have to keep in mind the past dividend
rates while declaring dividends.
11. Others: Apart from the above discussed there are some other factors, while influence
dividend policy of a firm, such as trade cycles, corporate taxation policy, attitude of
investors group and repayment of loan.
Dividend Theories
There are conflicting theories regarding the impact of dividend decision on the value
of a firm the conflicting opinions are dividend into two schools or groups. They
are;
1. Relevance Theories
2. Irrelevance Theories
Relevance Theory
According to relevance theory dividend decision affects value of a firm. Thus, it is called
as relevance theory.

The advocates of this school include Myron Gordon, Jhon Linter, James Walter and
Richardson. According to them, dividend decision will affect value of a firm as well
as stock price. High dividend payout ratio increases value of a firm, on the other hand
low dividend payout ratio decreases firm value; because payment of dividend is a
positive information about the firm profitability. Therefore a firm which is interested
to maximize shareholders wealth has to declare high dividend payout ratio.

There are two prime theories that says dividend has positive impact on the value of
firm. They are Walter’s model and Gordon’s model.
Walter’s Model
James E. Walter has presented a model of share valuation that supports the view of
dividend policy of an enterprise has a bearing on value of enterprise. The model is
based on:
(i) Return on Investment OR Internal Rate of Return (r)
(ii) Cost of Capital OR Required Rate of Return (Ko)

An enterprise optimal dividend theory is determined based on the relationship between

internal rate of return (r) and cost of capital (Ko). In other words if r exceeds Ko
the firm should retain the earnings, where as it should distribute the earnings as
dividends when r is less then Ko.
The model therefore relates the payment of earnings as dividend or retention of earnongs
to available capital budgeting. Here the model divides firm into three groups; (a)
Growth firms, (b) Normal firms, (c) Declining firms.
a. Growth Firms: Growth firms are those firms which has profitable investment projects,
which provides return that is greater than Ko (i.e. r > Ko). In other words, the firms should
retain all equity earnings, by which the value of share price increases there by value of firm
maximizes.
b. Normal Firms: Normal firms are those firms which have investment projects, who’s rate of
return is equals to cost of capital (i.e. r = Ko). In this situation the value of share price
remains constant for any level of dividend payout ratio.
c. Declining Firms: Declining firms are those firms, which does not have profitable
investment projects. In other words, investment projects return is less than cost of capital
(i.e. r < Ko).

Assumptions:
1. All Profitable investment are financed through retained earnings [internal financing].
2. The firms return on investment and cost of capital are constant.
3. All earnings are either distributed as dividend or reinvested internally immediately.
4. EPS and DPS are remain constant.
5. The firm has perpetual life.
Market Price per Share (Formula):
P = D+ (r / Ko) (E – D)
Ko
Where;
P = Price per equity share
D = Dividend per share
E = Earning per share
(E – D) = Retained earning per share
r = rate of return
Ko = Cost of capital
Gordon’s Model
This is another popular model which argue that dividend are relevant, and dividend
decision of a firm affects its value. It was proposed by Gordon Myron. According to
this model, a firm’s share price is dependent on dividend payout ratio. The model
uses stock valuation using dividend capitalization approach.

Assumptions:
1. The firm is all equity firms and its has no debt.
2. All investment projects are financed by exclusively retained earnings.
3. The rate of return and cost of capital are constant.
4. The firm has perpetual life.
5. The retention ratio and growth rate is constant.
6. There are no corporate tax.
Market price per share (Formula):
P = E (1 – b)
Ko – (b)(r)
Where;
P = Price per share
E = Earning per share
b = Retention ratio
(1 – b) Proportion of the earning of the firm distributed as dividend
Ko = Required return by equity shareholders
r = Rate of return
g = b.r. = Growth rate
Irrelevance Theory (MM Hypothesis)
Miller and Modigliani (MM) are the principle proponents of the dividend irrelevance
theory. They maintain that dividend policy has no effect on the market price of share
and the value of the firm. Value of the firm is determined by its basic earning power
and its business risk. In other words, they argued that the value of the firm depends
exclusively on its earning power and is not influenced by the manner in which it
splits its earnings between dividends and retained earnings.
Assumptions:
1. There are perfect capital market; where investors behave rationally, information is
available to all investors at free of cost, there are no transportation cost.
2. There is no taxation policy.
3. A firm has a fixed investment policy.
4. There is no risk.