Structure 15.1 Introduction 15.2 Traditional Approach 15.3 Dividend Relevance Model 15.3.1 15.3.2 Walter Model Gordon’s Dividend Capitalization Model
15.4 Dividend Irrelevance Theory: Miller and Modigliani Model 15.5 Stability of Dividends 15.6 Forms of Dividends 15.7 Stock Split 15.8 Summary Terminal Questions Answers to SAQs and TQs 15.1 Introduction Dividends are that portion of a firm’s net earnings paid to the shareholders. Preference shareholders are entitled to a fixed rate of dividend irrespective of the firm’s earnings. Equity holders’ dividends fluctuate year after year. It depends 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. However, such opportunities should have enough growth potential and sufficient profitability. There is an inverse relationship between these two – larger retentions, lesser dividends and vice versa. Thus two constituents of net profits are always competitive and conflicting. 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 earnings growth. Investors of growth companies realize their money in the form of capital gains. Dividend yield will be low for such companies. The influence of dividend policy on future capital gains is to happen in Sikkim Manipal University
distant future and therefore by all means uncertain. Share prices are a reflection of many factors including dividends. Some investors prefer current dividends to future gains as prophesied by an English saying – A bird in hand is worth two in the bush. Given all these constraints, it is a major decision of financial management. Dividend policy of a firm is a residual decision. In true sense, it means that a firm with sufficient investment opportunities will retain the entire earnings to fund its growth avenues. Conversely, if no such avenues are forthcoming, the firm will payout its entire earnings. So there exists a relationship between return on investments r and the cost of capital k. So long as r exceeds k, a firm shall have good investment opportunities. That is, if the firm can earn a return r higher than its cost of capital k, it will retain its entire earnings and if this source is not sufficient, it will go in for additional sources in the form of additional financing like equity issue, debenture issue or term loans. Thus, the dividend decision is a tradeoff between retained earnings and financing decisions. Different theories have been given by various people on dividend policy. We have the traditional theory and new sets of theories based on the relationship between dividend policy and firm value. The modern theories can be grouped as – (a) theories that consider dividend decision as an active variable in determining the value of the firm and (b) theories that do not consider dividend decision as an active variable in determining the value of the firm.
Learning Objectives: After studying this unit, you should be able to understand the following.
1. Explain the importance of dividends to investors. 2. Discuss the effect of declaring dividends on share prices. 3. Mention the advantages of a stable dividend policy. 4. List out the various forms of dividend. 5. Give reasons for stock split. 15.2 Traditional Approach This approach is given by B. Graham and D. L. Dodd. They ...