How do companies decide on the amount of dividend to be paid?

Dividend decisions made by the board of directors and are approved by the shareholders at the general meeting. However, the board of directors are bound to decide the amount of dividend in such a way that it will maximize shareholders wealth and will not affect the long term financing needs of the company.

Dividend policy divides earnings into retained earnings and dividends. Dividends provide a steady flow of income to the shareholders and it also shows the financial stability of the company.

Major theories on Dividend Policy

Financial analysts have different arguments on the relevance of dividend policy. Some analysts claim that dividends are relevant in the determining the value of share while others considered it as irrelevant. Here are some of the famous theories:-

  1. Graham and Dodd ( considers dividend is relevant)

Graham and Dodd argue that the dividends are relevant and the dividend policy has more effect on the price of the shares than retained earnings.

P = m {D + E/3}

i.e. = m {D + (D+R)/3}

     = m {(4D + R)/3}

P= Market price per share;

D = Dividend Per share;

E = Earnings Per share or (Dividend +Retained Earnings);

m = Multiplier;

The formula gives less importance to retained earnings, so it’s been divided by 3. Also other factors such as legal, political, management policy, taxation and contractual obligations affects the rate of dividend which are not considered by Graham and Dodd.

 

  1. Walter Approach ( considers dividend is relevant)

Walter considers that in the long run, price of the share will be affected by the dividend policy of the company. And retentions will affect the price only through their effect on dividend policy. Other factors such as legal, political, management policy, taxation and contractual obligations that affect the rate of dividend are not considered by Walter.

P = D + (E – D)*r/Ke

     ___________

               Ke

P = Market Price of a share

D = Dividend Per share

E = Earnings Per share

r = Rate of return

Ke = Cost of Capital

The formula indicates that the market price of a share will be high if either rate of return on retained earnings or the dividends are high.

Optimum Dividend payout

If r > Ke then optimum payout would be 0 as value of share would be maximum.

If r < Ke then optimum payout would be 100% as value of share would be minimum. It is the limiting factor of value of the shares.

If r = Ke then dividend policy will have no effect on market price. It is indifferent.

 

  1. Gordon Growth or Dividend Growth (constant) Model (considers dividend is relevant)

Gordon’s formula indicates that the price of a share is fully depended on the amount of dividend paid by the company. He states that a person will be ready to buy a share even at a higher price if the rate of dividend is high.

P = Do (1 + g)

     _______

        Ke –g

 

Do = Dividend for current year

g = Constant Growth of dividend

Ke = Cost of capital or expected rate of return

It is based on the assumption that the company has no debt. And IRR, discount rate and dividend growth are constant and Ke > g.

 

  1. Modigliani Miller Approach ( considers dividend is irrelevant)

MM states that a company’s dividend policy has no effect its value of assets and therefore it doesn’t affect the price of the share. He argues that the value of the share depends on the earnings and not the amount of dividend distributed. If the company doesn’t pay dividend they will end up having higher retained earnings and will repurchase their shares or invest in marketable securities thereby increasing the shareholder wealth by capital gains.

P =  P1 + D1

      ____

        1+ Ke

Or

Market Value = P1 (n + m) +E – I

                               ______________

                                    1 + Ke

 

P1 = Market price of next year;

n = number of shares outstanding

m = number of shares to be issued i.e.

=  I + D – E

_______

P1

I = Investment;

E = Earnings;

D1 = Dividend payable next year

It is based on the assumption that the company operates in a perfect capital market and there are no taxes and risk of uncertainty does not exist.

 

  1. Litner’s Model

Litner’s model concludes that even if earnings increase, the board of directors may not increase the amount of dividend payments proportionately mainly due to the fear of maintaining the same amount of dividend.

D1 =  Do + {(EPS * Target Payout) – Do} * Af

D1 = Dividend payable for next year

Do = Dividend for current year

Af = Adjustment Factor

 

  1. Radical Approach

Radical approach is based on the consideration that if tax on capital gains > Dividend distribution tax, then the shareholders will prefer dividend, otherwise capital gains.

 

  1. Dividend Discount(Variable) Model or Dividend Valuation Model (only when growth in dividend is variable)

Value of a share is determined by the net present value of all expected dividend payment discounted at appropriate risk adjusted rate.

P =    D1              D2                                     Pn            Dn

       _____   + _____ + ……+ _____   + _____

     (1+ Ke) 1     (1+ Ke) 2               (1+ Ke) n (1+ Ke) n

 

So a company may consider the above models for dividend distribution depending upon the structure of the company. Also other factors such as management policy, taxation (on dividends), legal and contractual obligations affect the rate of dividend.

  • Legal, financial and contractual obligations

As per section 124 of the companies Act 2013, dividend is to be paid out of current or past profits after setting of the unabsorbed depreciation and losses. A company at its growth stage tends to pay dividends at lower rates than mature companies since their financial needs are higher. Distribution of earnings as dividends reduces the availability of funds of the companies. Companies issue higher dividends when the growth prospects and other obligations reduce. So many companies issue bonus shares instead of dividends in order to offset the dividend expectations of the shareholders.

  • Stability

Even if earnings increase, the board of directors may not increase the amount of dividend payments proportionately mainly due to the fear of maintaining the stability in dividend payments. So companies create Dividend equalisation reserve with an intend to maintain stable dividends even during rough times.

  • Taxation

Companies also factor into consideration the desires of the shareholders on whether to earn steady income through dividends which is subject to dividend distribution tax or higher value in shares which is subject to capital gains tax. As per Income tax Act,1961, tax on short term capital gains(15%) are attracted if shares are sold within a period of one year and no capital gains tax is payable on long term holdings.i.e more than one year. However Securities transaction tax payable on sale.

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