Ø Dividend refers to that part of the profits of a company which is distributed by the company among its shareholders.
Ø Reward of the shareholders for their investment
Ø Investors are interested in earning the Maximum return and to maximize their wealth.
Ø Right of the shareholders to participate in the profits and surplus of the company for their investment in the share capital of the company.
Ø Dividend policy means decision regarding the amount of dividend paid to the shareholders.
Ø If the company pays out dividend most of what it earns, then for business requirements and further expansion it will have to depend the outside resources
Ø Dividend policy of the firm affects the long term financing and wealth of the shareholders.
Ø Hence the company should distribute reasonable amount as dividends to its members and retain the rest for its growth and survival.
DIVIDEND DECISION AND VALUATION OF THE FIRM:
Ø If the shareholders wealth is maximized, the value of the firm can be maximized.
Ø There are conflicting views regarding the impact of dividend decision and valuation of the firm.
Ø The theories are explained the concept of dividend decision and valuation of the firm.
§ Theory of Irrelevance and
§ Theory of Relevance
THEORY OF IRRELEVANCE OR IRRELEVANCE CONCEPT OF DIVIDEND:
a) Residual Approach:
Ø According to this theory, dividend decision has no effect on the wealth of the shareholders
Ø Because dividend decision is part of the financing decision.
Ø Hence it is irrelevant
b) Modigliani and Miller Approach: (MM Model)
Ø Dividend policy has no effect on the market price of the shares and the value of the firm is determined by the earning capacity of the firm.
Ø Argument given by MM is that whatever increase in the value of the firm results from the payment of dividend, will be exactly offset by the decline in the market price of shares because of external financing and there will be no change in the total wealth of the shareholders.
Ø For eg: If the company having investment opportunities, distributes all its earning among its shareholders, it will have to raise additional funds from external sources.
Ø This will result in increase in number of shares or payment of interest charges, resulting in fall in the Earning Per Share in the future.
Ø Thus whatever a shareholders gained on account of dividend payment is neutralized completely by the fall in the market price of the shares due to decline in expected future earning per share.
Ø Market price of a share in the beginning of the period equals to the dividend at the end of the period plus the market price at the end of the period.
Ø This can be put in the formula:
P = Market Price per share at the beginning of the period
D1 = Dividend to be received at the end of the period
P1 = Market Price per share at the end of the period
Ke = Cost of capital
Ø Value of P1 can be derived from the following Formula
P1 = P0 (1+Ke) – D1
Ø On account of payment of dividend investment required by the firm is financed out of new issue of equity shares.
Ø Number of shares to be issued can be computed with the help of the following formula:
Ø Value of the firm can be ascertained:
m = No. of shares to be issued
I = Investment required
E = Total Earnings
P1 = Market price at the end of the period.
Ke = Cost of Equity Capital
N = No. of shares outstanding at the beginning of the period
D1 = Dividend paid at the end of the period
nP0 = Value of the firm
THEORY OF RELEVANCE OR RELEVANCE CONCEPT OF DIVIDEND:
Ø This theory advocates that dividend decision considerable affects the value of the firm.
Ø Because dividend communicated information to the investors about the firm's profitability and hence dividend decision becomes relevant.
Ø The firms which pay higher dividends have the greater value as compared to those which do not pay dividend or have a lower dividend pay out ration.
Ø This theory explained by
o Walter's Approach and
o Gordon's Approach
Ø Prof.Walter's supports that dividend decisions are relevant and affect the value of the firm.
Ø The relationship between internal Rate of return earned by the firm and its cost of capital is determining the dividend policy.
Ø Walter's model is based on the relationship between the firm's
§ Return on investment (r)
§ Cost of capital (k)
Ø If Return on investment is higher than the cost of capital (r>k)the firm should retain the earnings. Such firms are termed as growth firm's and the optimum pay out is zero.
Ø This would maximize the value of the firm.
Ø If Return on investment is lower than the cost of capital (r<k)the firm should distribute the earnings. The optimum pay out is 100%.
Ø If return on investment is equal to the cost of capital, (r=k)the dividend policy will not affect the market value of the shares, and the shareholders will get the same return from the firm as expected by them.
Walter's formula for determining the value of a share:
P = Price of equity share
D = Dividend per share
Ke= Cost of capital
G = Growth rate of dividend
Market price of a share:
P = Market Price per share
D = Dividend per share
Ke= Cost of capital