MB0045 Slides Unit 115

C o n f i d e n t i a l

MB0045-Financial Management

Unit-15 Dividend Decisions

1

Program : MBA

Semester : II

Subject Code : MB0045

Subject Name : Financial Management

Unit number : 15 55

Unit Title : Dividend Decisions

Lecture Number : 15

Lecture Title : Dividend Decisions

HOME NEXT




2

Financial Management

Objectives:

After studying this unit, you should be able to:

• Explain the importance of dividends to investors

• Analyse the effect of declaring dividends on share prices

• Describe the advantages of a stable dividend policy

• List out the various forms of dividend

• Elucidate reasons for stock split

HOME NEXT PREVIOUS




Lecture Outline

• Introduction

• Traditional Approach

• Dividend Relevance Model

• Walter Model

• Gordon’s Model

• Miller and Modigliani (MM) Model

• Critical Analysis of MM Hypothesis

• Stability of Dividends

• Forms of Dividends

• Stock Split

• Summary

• Check Your Learning

• Activity

3

HOME NEXT PREVIOUS




4

Introduction

Dividends are that portion of a firm’s net earnings which are paid to the shareholders. Preference shareholders are entitled to a fixed rate of

dividend irrespective of the firm’s earnings. Dividend decisions depend on what portion of earnings is to be retained by the firm and what portion is to be paid off. As dividends are distributed out of net profits, the firm’s decisions on retained earnings have a bearing on the amount to be distributed. Retained earnings constitute an important source of financing investment requirements of a firm. Dividend policy has a direct influence on the two components of shareholders’ return – dividends and capital gains. A low payout and high retention may have the effect of accelerating the earnings growth.

In this session, you will learn the importance of dividends to investors,

the effect of declaring dividends on share prices, advantages of stable

dividend policy and the various forms of dividend and reasons for stock

split.

HOME NEXT PREVIOUS




5

According to traditional approach stock value responds positively to high

dividends and negatively to low dividends, that is, the share values of

those companies which pay high dividends, rises considerably and the

prices fall in the event of low dividends paid.

Symbolically, P = [m (D+E/3)]

Where P is the market price

m is the multiplier

D is dividend per share

E is earnings per share

As per this approach, there is a direct relationship between P/E ratios and

dividend pay-out ratio . High dividend pay-out ratio will increase the P/E

ratio and low dividend pay-out ratio will decrease the P/E ratio.

HOME NEXT PREVIOUS

Traditional Approach




6

HOME NEXT PREVIOUS

Dividend relevance models support the view that the dividend policy of the firm has a bearing on share valuation. The two theories of dividend relevance model are:

Dividend Relevance Model

Two theories

Walter Model Gordon Model




7

HOME NEXT PREVIOUS

The following are the assumptions on which the Walter’s model is based:

Walter Model

Assumptions

Financing

Constant rate of

return and cost of capital

100% pay-out

or retention

Constant EPS and

DPS

Life




8

HOME NEXT PREVIOUS

Some assumptions regarding Gordon’s dividend capitalisation model are as follows:

Gordon’s Model

The firm is an all-equity firm with no debt

No external financing is used

Constant return “r”

Constant cost of capital “Ke”

The life of the firm is indefinite

The retention ratio “g = br” is constant forever

Cost of capital is greater than br,




9

Miller and Modigliani Model

HOME NEXT PREVIOUS

The Miller and Modigliani (MM) hypothesis seeks to explain that a firm’s dividend policy is irrelevant and has no effect on the share prices of the firm. Certain assumptions regarding Miller and Modigliani model are as follows:

Assumptions

Existence of perfect capital

markets

No taxes

Constant investment

policy

Certainty about future investments




10

Critical Analysis of MM Hypothesis

HOME NEXT PREVIOUS

The analysis of MM hypothesis considers the following costs transaction cost, floatation cost, under-pricing of shares.

Analysis of MM

hypothesis

Floatation costs

Transaction costs

Under-pricing of

shares

Market conditions




11

Stability of Dividends

HOME NEXT PREVIOUS

Stability of dividends is the consistency in the stream of dividend payments. This method relates to the payment of certain amount of

minimum dividend to the shareholders. The steadiness is a sign of good health of the firm and may take any of the following forms:

Constant dividend per share

Constant dividend policy ratio

Constant dividend per share plus extra dividend




12

Forms of Dividends

HOME NEXT PREVIOUS

Dividends are portions of earnings available to the shareholders. The different forms of dividends are:

Forms of dividends

Cash dividend

Scrip dividend

Bond dividend

Stock dividend




13

Stock Split

HOME NEXT PREVIOUS

A stock split is a method to increase the number of outstanding shares by proportionately reducing the face value of a share. The reason for splitting shares are as follows:

Reasons

To make shares

attractive

Indication of higher future profits

Higher dividend to

shareholders




14

Summary

• Dividends are that portion of a firm’s net earnings which are paid to the shareholders.

• As per traditional approach, there is a direct relationship between P/E ratios and dividend pay-out ratio.

• Dividend relevance models support the view that the dividend policy of the firm has a bearing on share valuation.

• The Miller and Modigliani (MM) hypothesis seeks to explain that a firm’s dividend policy is irrelevant and has no effect on the share prices of the firm.

• The analysis of MM hypothesis considers the transaction cost, floatation cost, under-pricing of shares and market conditions.

• Stability of dividends is the consistency in the stream of dividend payments. This method relates to the payment of certain amount of minimum dividend to the shareholders.

• A stock split is a method to increase the number of outstanding shares by proportionately reducing the face value of a share.

HOME NEXT PREVIOUS




15

Check Your Learning

1. Name two theories of dividend relevance model.

Ans: The two theories of dividend relevance model are:

a. Walter model

b. Gordon model

2. List the different forms of dividends.

Ans: The different forms of dividends are:

a. Cash dividend

b. Scrip dividend

c. Bond dividend

d. Stock dividend

HOME NEXT PREVIOUS




16

Assume that for a firm XYZ Ltd., the dividend pay-outs are relevant and have a bearing on the share prices of the firm. The investment policies of a firm cannot be separated from its dividend policy and both are inter-linked. What dividend model is the firm following? Explain the assumptions based on that model.

Activity

HOME PREVIOUS

MB0045 Slides Unit 115

Documents