DIVIDEND

MEANING OF DIVIDEND
The term dividend refers to
the portion of the profits of the
company that are distributed to
the holders of shares in the
company.

GENERAL RULES FOR RECORDING

DIVIDEND
The following are the important rules /
provisions regarding dividend :
1.Dividend is declared by a company by a
resolution passed at the Annual General
Meeting.
2.Payment of dividends is in proportion to the
amount paid on each share.
3.Dividend to be paid only out of profits.

4. Mode of payment of dividend is left to the

company.
5. Dividend is payable only in cash.
6. In case of insufficient profit, no dividend
can be paid.
7. Dividend must be paid only to the
registered shareholders.

Types of Dividend
Dividend can be classified broadly
on the basis of types of securities,
sources, medium and timing of
payments. This may be grouped
into the following:

S.No

Kinds of Dividend

Basis of Distribution

Preference Dividend

Preference Shares

Equity Dividend

Equity Shares

Profit Dividend

Retained Earnings / Profit

Liquidation Dividend

Capital

Interim Dividend

Between two Annual

General Meetings during
a particular period

Regular Dividend

At the end of financial

period

Cash Dividend, Stock Dividend,

Scrip Dividend, Property
Dividend, Bond Dividend

Medium used to pay

dividend

A brief description of different types of dividend

can be distributed according to the mode of
payments:
1. Cash Dividend:
(a) Regular Dividend
(b) Interim Dividend
2. Stock Dividend
3. Scrip Dividend
4. Bond Dividend
5. Property Dividend

Sources Available for Dividend

The following sources are generally available
for the payments of dividends.
1.Earnings from regular operations
2.Earnings accumulated from previous years
3.Income from subsidiaries
4.Profit from the sale of appreciated property
5.Conversion of redundant reserves

6. Surplus from mergers and purchase of

subsidiaries
7. Revaluation of assets
8. Surplus earned by reduction in capital
stock
9. Donated surplus
10. Sale of securities at a premium

Factors Affecting Dividend Policy

The following factors influence the dividend
policy
1.Stability of earnings
2.Liquidity of funds
3.Nature of business
4.Financing policy of the concern
5.Dividend policy of competitive concerns

Maintaining effective control

7. Need for expansion
8. Cash position
9. Taxation policy
10. Legal requirements
11. Investment opportunities
6.

BONUS SHARES
A company may follow a conservative
policy of not distributing all the profits every
year and accumulate large reserves over
time. If the articles so permit, it may convert
a part of these reserves into share capital by
issuing fully paid bonus shares to the
existing shareholders.

Bonus is something given in addition to what

is usually or strictly due. It comes to
shareholders in addition to what they get in
the form of dividend. Bonus is something
given in addition to what is usually or
strictly due. It comes to shareholders in
addition to what they get in the form of
dividend.

Conditions for the Issue of Bonus

Shares
1.The issue of bonus shares must be authorized
by the Articles of the Company.
2.It must be recommended by a Board resolution
and then approved by the shareholders in
Annual General Meeting.
3.It must be permitted by the Controller of
Capital Issues, regardless of the amount
involved.

Advantages of Issue of Bonus

Shares
The important benefits derived from issue of
bonus shares are as follows :
1.The stock dividend allows the firms to declare a
dividend without using up cash that may be
needed for operations or expansion.
2.Stock dividend helps to increase future profits.
3.It helps to boost the credit worthiness of the
company.

4. Shareholders will receive more cash

dividends in future because of additional

shares.
5. Stock dividend helps to reduce the cost of
generating funds.
6. It helps to reduce the market price of the
shares, rendering the shares more
marketable.

7. Stock dividend helps the shareholders to

retain the proportional ownership in the

firm.
8. It is an indication to the prospective
investors about the financial soundness of
the company.
9. It creates positive psychological value
among the shareholders which leads to
encourage further investment in stock.

Disadvantages of Issue of Bonus

Shares
1. It leads to an increase in the capitalization of the

2.
3.
4.
5.

concern without proportionate increase in the

earning capacity of the company.
It leads to an increase in liability in respect of
future dividend on the company.
It excludes the possibility of new investors coming
in contract with the company.
The market value of the existing company goes
down.
Some investors do not like bonus shares due to
low market value of the existing shares.

STOCK SPLITS
A stock split is a method to increase the
number of outstanding shares through a
proportional reduction in the par value of
the share. A stock split affects only the par
value and the number of outstanding
shares, the capitalization of the company is
not changed at all.

Reasons for Stock Split

The following reasons are to be taken
into account for stock split:
1. Provide broader and more stable
market for the stock.
2. Increase marketability of new issues,
the firm generates funds by use of
stock split.

3.

Merger or acquisition of companies

through exchange of stock will often
split its stock to make the transactions
more attractive.
4. Stock split will add to the
marketability
of
shares
of
the
shareholders.

Table 1.Comparison between Bonus Issue and

Stock Split
Stock
S.No
Bonus Issue
Split
1

The value of the stock is

unchanged

The par value of stock is

reduced

A part of reserves is
capitalized

There is no capitalization of
reserves

The stockholders proportional The stockholders

ownership remains
proportional ownership
unchanged
remains unchanged

The book value per share,

the earnings per share and
the market price per share
decline

The market price per share is The market price per share

The book value per share,

the earnings per share, and
the market price per share
decline

RATIO ANALYSIS FOR

DIVIDEND POLICY
To measure the relationship between earning
capacity of a firm, market value of the shares
and payment of dividend on equity shares, the
financial manager can apply the given ratios:
Earnings per Share Ratio
Dividend Pay-out Ratio
Dividend Yield Ratio
Price Earning Ratio

THEORIES OF DIVIDEND
POLICY
Different theories are developed by
many experts regarding dividend
decision on the valuation of a
firm.
The theories can be grouped into
two heads:

(A) Relative Concept of Dividend

1. James Walters Approach

2. Myron Gordons Approach

(B) Irrelevance Concept of Dividend

1. Modigliani Millers Approach

Relevance Concept of Dividend

James Walters Approach
Assumptions James Walters
model is based on the following
assumptions.

1.Retained earnings is the only source of entire

financing of a firm.
2.External sources of funds such as debt or new
equity capital are not used.
3.Return on firms investment (r) and Cost of
Capital (k0) of a firm remain constant.
4.Firms business risk does not change with
additional investment undertaken.
5.The firm has an infinite or very long life.

Formula Based on the assumptions,

the given mathematical equation is
used to determine the market value of
share.
P = D + r (E D)
Ke
Ke

Where,
P =
Market Price of an Equity Share
D =
Dividend per Share
r =
Internal Rate of Return on
Investment
E =
Earnings per Share
E D = Retained Earnings per Share
Ke = Cost of Equity Capital (or)
Capitalization Rate.

Gordons Model
Myron J. Gordon (1979),
suggested a relevance of dividend decision
for valuation of a firm. This model is also
called as dividend capitalization model.
According to this model, dividend policy of a
firm affects its value, and is based on the
following assumptions:

1.The firm is an all equity firm.

2.Retained earnings represent the only
source of a firm for financing its
investment programmes.
3.The rate of return (r) on the firms
investment is constant.
4.The
cost
of
capital
remains
unchanged for all times to come.

5.

The firm has perpetual life.

6. Corporate taxes do not exist.
7. The retention ratio, once decided
upon is constant. Thus, growth rate
(g br) is also constant.
8. Cost of capital is greater than the
growth rate (Ko > br).

Valuation formula
According to Gordons
model, the value of the share is given
by the equation:
Po = E(1 b)
Ko - br

where,
Po = Price per share at the beginning of
the year
E = Earnings per share at the end of the
year
b = Retention ratio
1-b = Dividend payout ratio (Percentage of
earnings distributed as dividends)
Ko = Capitalization rate or cost of capital
br = Growth rate of earning and dividend
r = Rate of return earned on investment
made by the firm.

Irrelevance Concept of Dividend

Miller-Modigliani Theory or MM Hypothesis

MM thoughts on irrelevance concept of

dividend are most comprehensive and
logical. According to them, dividend policy of
a firm does not affect the value of a firm.
Thus, the dividend payout ratio does not
affect the wealth of shareholders.

They emphasize that the value of firm is

determined by the firms investment policy
and earnings power of the firms asset.
Given the investment decision of the firm,
the dividend decision-split-off between
dividend / retained earnings, is irrelevant
and has no significance.

Assumptions of MM hypothesis
The theory of MM hypothesis is based on the
following assumptions:
1. It assumes that capital markets are perfect.
2. Investors behave rationally.
3. Non-existence of brokerage / commission.
4. Availability of free information to all investors.
5. No transaction costs and floating costs.
6. Investment policy of the firm does not change at any
circumstances.
7. Certainty of future prices and dividend can be
predicted by the investors. (This assumption was
dropped by MM later.)

Proof of MM Hypothesis
According to MM theory, the market price of
an equity share at the beginning of a period is
equal to the present value of dividend paid at
the end of the period plus the market price at
the end of the period. This can be expressed
with the help of given equation:
Po =

1
(D1 + P1)
(1 + Ke)

ILLUSTRATION 1
A company belonging to a risk class with
10% capitalization rate is thinking to declare a
dividend of Rs. 4 per share at the end of the
current year. Its total number of equity shares
are 60,000. The current market price of an
equity share is Rs. 80. Compute the value of an
equity share, if dividends are paid using MM
Model.

solution
Value of the firm when dividends are paid

Value of an Equity Share Po =

1
(D1 + P1)
1 + Ke

Where,
Po = Market price of the share at the
beginning of period (Rs.80)
K
= Cost of equity capital (Capitalization
rate for the firm 10%, i.e., 1.10)
D1 = Dividend per share at the end of
period (Rs.4)
P1 = Market price per share at the end of
period.

Thus,
Rs. 80 =

1
(Rs.4 + P1)
1 + 10%
Rs. 80 =
1 (Rs. 4 + P1)
1 + 10
100
Rs. 80 x 1.10 = Rs. 4 + P1
1
Rs. 88 = Rs. 4 + P1
P1 = Rs. 88 Rs. 4 = 84
Market price per share at the end of the
(P1) = Rs. 84

period

ILLUSTRATION 2
ABC Ltd. has currently 25 lakhs outstanding
shares of Rs.100 each. At the end of the year,
the company wants to declare dividend payment
at the rate of Rs.5 per share. The capitalization
rate for the risk class to which the firm belongs
is 10%. It expects to have a net income of
Rs.2,50,00,000 and has a proposal for making
new investment of Rs.5 crores. Show that under
the MM assumptions, the payment of dividend
does not affect the value of the firm.

solution
1. Calculation of Value of Firm when Dividend
are Paid
(a) Price per share at the end of the year:
Po =

1 (D1 + P1)
1 + Ke

Where,
Po = Market price of the share at the
beginning of period (Rs.100)
Ke = Cost of equity capital (Capitalization
rate for the firm 10%, i.e., 1.10)
D1 = Dividend per share at the end of
period (Rs.4)
P1 = Market price per share at the end of
period

Thus,
Rs.100 =

1
(Rs.5 + P 1)
1 + 10%
Rs.100 =
1
(Rs.5 + P 1)
1 + 10
100
Rs.100 x 1.10 (Rs.5 + P1)
1
Rs.110 = Rs.5 + P1
P1 = Rs.110 Rs.5 = Rs.105
Market Price per Share at the end of the
period
(P1) = Rs.105.

(b) Amount required to be raised from the issue of new

shares:
mP1 = I (E nD1)
Where,
m = Number of shares to be issued
P1 = Price at which new issue is to be made
I = Amount of investment required
(Rs.5
crores)
E = Total net profit / Earnings of the firm during
the
period (Rs.2,50,00,000)
nD1 = Total dividends paid during the years
(Rs.1,25,00,000)
E nD1 = Retained earnings

Thus,
mP1 = I (E nD1)
= Rs.5,00,00,000 (Rs.2,50,00,000 Rs.1,25,00,000)

= Rs.3,75,00,000
(c) Number of additional shares to be issued:
Number of additional shares to be issued (n) = Additional amount required during the period
Market price per share at the end of the period
= Rs.3,75,00,000 = Rs.75,00,000 shares
Rs.105

21

(d) Calculation of value of the firm:

npo = (n + m)P1 I + E
I + Ke

25,00,000 + 75,00,000 x Rs.105 Rs.5,00,00,000 + Rs.2,50,00,000 = Rs.27,50,00,000

1

21

1.10

= Rs.25,00,00,000

2. Calculation of Value of firm when Dividends

are not Paid
(a) Price per share at the end of the year 1 :
Po = 1
+ P1
1 + Ke
Rs.100 =
1
+ P1
1 + 10%
Rs.100 =
1
+ P1
1+ 10
100
Rs.100 = P1
1.10
P1 = Rs.100 x 1.10 = Rs.110
Market price per share at the end of the period = Rs.110

(b) Amount Required to be Raised from the Issue of

New Shares:
mP1 = Rs.5,00,00,000 Rs.2,50,00,000
= Rs.2,50,00,000
(c) Number of Additional Shares to be issued:
Number of additional shares to be issued (n) = Additional amount required during the period
Market price per share at the end of the period

= Rs.2,50,00,000
Rs.110
= Rs.25,00,000 shares
11

(d) Calculation of value of the firm:

npo = (n + m)P1 I + E
1 + Ke

25,00,000 + 25,00,000 x Rs.110 Rs.5,00,00,000 Rs.2,50,00,000 = Rs.27,50,00,000

1
11
1.1

= Rs.25,00,00,000
Value of the firm = Rs.25,00,00,000

Comment
From the calculation, it is noted that
whether dividends are paid or not, the value of
the firm is the same as of Rs.25 crores.
Therefore, under both the situation, the value
of the firm remains unchanged indicating that
the shareholders shall be indifferent towards
the declaration of dividend.

Criticism of MM hypothesis
1.Tax differential
2.Existence of floating costs
3.Existence of transaction costs

Problems

1. The following information is available for Avanti

Corporation.
.Earnings per share
:Rs.4.00
.Rate of return on investments
:18 per cent
.Rate of return required by shareholders :15 per cent
What will be the price per share as per the Walter model if the
payout ratio is 40 per cent? 50 per cent? 60 per cent?

Solution
According to the Walter model,
P=D+(E-D)r/k
k
Given E= Rs 4, r=0.18, and k=0.15, the value of P for the three
different payout ratios is the follows:
Payout ratio
P
40 per cent
1.60+(2.40)0.18/0.15= Rs 29.87
0.15
50 per cent
2.00+(2.00)0.18/0.15 = Rs 29.33
0.15
60 per cent
2.40+(1.60)0.18/0.15= Rs 28.80
0.15

2.The following information is available for Kavita

Musicals.
Earnings per share
: Rs. 5.00
Rate of return required by shareholders:16 per cent
Assuming that the Gordon valuation model holds,
what rate of return should be earned on investments
to ensure that the market price is Rs 50 when the
dividend payout is 40 per cent?

Solution

According that the Gordon model

P=E1(1-b)
k-br
Plugging in the various values given, we get
50= 5.0(1-0.6)
0.16-0.6r
Solving this for r, we get
r=0.20=20 per cent
Hence, Kavita Musicals must earn a rate of return of 20 per
cent on its investments.