Fin 801, UIL: Dividend Theories and Policies Presentation

This presentation, prepared for a Corporate Finance course (Fin 801) at the University of Ilorin, delves into the critical area of dividend policy. It begins by introducing the core concept: the decision between distributing profits to shareholders versus reinvesting them in the business, emphasizing its impact on shareholder wealth maximization. The presentation explores various dividend types, including regular cash dividends, extra dividends, special dividends, and liquidating dividends, along with bonus shares and stock splits. It then outlines the standard methods of cash dividend payment and the establishment of dividend policies, including the residual dividend approach and the importance of dividend stability. The analysis considers the significance of dividend decisions in financial management and their influence on the overall valuation of a firm. The presentation also provides a detailed explanation of dividend policy objectives and the classification of dividends, alongside the procedures for dividend payments. This comprehensive overview offers a deep understanding of dividend policies and their implications for financial decision-making.

Page1
DIVIDEND THEORIES AND POLICIES
THE RELEVANCE OF THE POLICY ON THE
VALUE OF THE FIRM
COURSE TITLE: CORPORATE FINANCE
COURSE CODE: FIN 801
A PRESENTATION SUBMITTED TO THE DEPARTMENT OF ACCOUNTING AND
FINANCE, FACULTY OF MANAGEMENT SCIENCES, UNIVERSITY OF ILORIIN, KWARA
STATE, NIGERIA.
BY
NASIRUDEEN ABDULLAHI
UIL/PG2020/1432
LECTURER IN CHARGE: DR. I.B ABDULLAHI
OCTOBER, 2021

Page2
DIVIDEND THEORIES AND POLICIES
THE RELEVANCE OF THE POLICY ON THE VALUE OF THE FIRM
Introduction
The dividend policy decision involves the choice between distributing the profits belonging to
the shareholders and their retention by the firm. A major decision area of Financial
management is the dividend policy decision in the sense that the firm has to choose between
distributing the profits to the shareholders and ploughing them back into the business. The
selection would be influenced by the effect on the objective of Financial Management of
maximizing shareholder’s wealth. The firm should pay dividend if the payment will lead to the
maximisation of the wealth of the owners and if not then the firm should retain profits to
finance investment programmes.The relationship between dividends and value of the firm
should, therefore, be the decision criterion.There are conflicting opinions regarding the impact
of dividends on the valuation of a firm. Retained earnings are the most significant internal
sources of financing the growth of the firm. On the other hand, dividends may be considered
desirable from the shareholders’ point of view as they tend to increase their current return.
Dividends, however, constitute the use of the firm’s funds. Dividend policy involves the
balancing of the shareholders’ desire for current dividends and the firms’ needs for funds for
growth.
Objective of dividend policy
A firms’ dividend policy has the effect of dividing its net earnings into two parts:
retained earnings and dividends. The retained earnings provide funds to finance the firm’s long
– term growth. It is the most significant source of financing a firm’s investment in practice.
Dividends are paid in cash. Thus, the distribution of earnings uses the available cash of the
firm. A firm which intends to pay dividends and also needs funds to finance its investment
opportunities will have to use external sources of financing, such as the issue of debt or equity.
Dividends - Classification
The term dividend usually refers to cash paid out of earnings. If a payment is made
from sources other than current or accumulated retained earnings, the term distribution, rather
than dividend, is used. However, it is acceptable to refer to a distribution of earnings as a
dividend and a distribution from capital as a liquidating dividend. More generally, any direct
payment by the corporation to the shareholders may be considered a dividend or a part of
dividend policy.

Page3
Dividends come in several different forms. The basic types of cash dividends are:
 Regular cash dividends
 Extra dividends
 Special dividends
 Liquidating dividends
Cash Dividends
The most common type of dividend is a cash dividend. Commonly, public companies
pay regular cash dividends four times a year. As the name suggests, these are cash payments
made directly to shareholders, and they are made in the regular course of business. In other
words, management sees nothing unusual about the dividend and no reason why it won’t be
continued.
Sometimes firms will pay a regular cash dividend and an extra cash dividend. By
calling part of the payment “extra” management is indicating that the “extra” part may or may
not be repeated in the future. A special dividend is similar, but the name usually indicates that
this dividend is viewed as a truly unusual or one-time event and won’t be repeated. Finally, the
payment of a liquidating dividend usually means that some or all of the business has been
liquidated, that is, sold off. However it is labeled, a cash dividend payment reduces corporate
cash and retained earnings, except in the case of a liquidating dividend.
Bonus Shares (Stock dividend)
An issue of bonus shares is the distribution of shares free of cost to existing
shareholders. Bonus shares are issued in addition to the cash dividend and not in lieu of cash
dividends. Hence, companies may supplement cash dividend by bonus issues. Issuing bonus
shares increase the number of outstanding shares of the company. The bonus shares are
distributed proportionately to the existing shareholder. Hence there is no dilution of ownership.
For example, if a shareholder owns 100 shares at the time when a 10 per cent (ie., 1:10) bonus
issue made, he will receive 10 additional shares. The declaration of the bonus shares will
increase the paid-up share capital and reduce the reserve and surplus earnings of the company.
The total net worth is not affected by the bonus issue.
Stock Split
A stock split is essentially the same thing as a stock dividend, except that a split is
expressed as a ratio instead of a percentage. When a split is declared, each share is split up to
create additional shares. For example, in a three-for-one stock split, each old share is split into
three new shares.

Page4
Standard Method of Cash Dividend Payment
The decision to pay a dividend rests in the hands of the board of directors of the
corporation. When a dividend has been declared, it becomes a debt of the firm and cannot be
rescinded easily. Sometime after it has been declared, a dividend is distributed to all
shareholders as of some specific date. Commonly, the amount of the cash dividend is
expressed in terms of dollars per share (dividends per share). As we have seen in other
chapters, it is also expressed as a percentage of the market price (the dividend yield) or as a
percentage of net income or earnings per share (the dividend payout).
Example of procedure for dividend payment
January 15 January 28 January 30 February 16
(Declaration date) (Ex-Dividend date) (Record date) (Payment date)
Establishing Dividend policies and Decisions
How do firms actually determine the level of dividends they will pay at a particular
time? As we have seen, there are good reasons for firms to pay high dividends and there are
good reasons to pay low dividends. There are three approaches for establishing dividend
policy. These are three types of the dividend policy, such as residual dividend approach,
dividend stability and a compromise dividend policy.
Residual Dividend Approach
 Firms with higher dividend payouts will have to sell stock more often. Such sales are not
very common and they can be very expensive.
 Consistent with this, we will assume that the firm wishes to minimize the need to sell new
equity. We will also assume that the firm wishes to maintain its current capital structure.
 If a firm wishes to avoid new equity sales, then it will have to rely on internally generated
equity to finance new positive NPV projects. Dividends can only be paid out of what is
left over. This leftover is called the residual, and such a dividend policy is called a
residual dividend approach.
 With a residual dividend policy, the firm’s objective is to meet its investment needs and
maintain its desired debt-equity ratio before paying dividends.
Illustrate, imagine that a firm has N1,000 in earnings and a debt-equity ratio of 0.50. Notice
that, because the debt-equity ratio is 0.50, the firm has 50 cents in debt for every N1.50 in total
value. The firm’s capital structure is thus debt and equity.
The first step in implementing a residual dividend policy is to determine the amount of
funds that can be generated without selling new equity. If the firm reinvests the entire N1,000
and pays no dividend, then equity will increase by N1,000. To keep the debt-equity ratio of

Page5
0.50, the firm must borrow an additional N500. The total amount of funds that can be
generated without selling new equity is thus N1,000 + 500 = N1,500.
The second step is to decide whether or not a dividend will be paid. To do this, we
compare the total amount that can be generated without selling new equity (N1,500 in this
case) to planned capital spending.
 If funds needed exceed funds available, then no dividend will be paid. In addition, the firm
will have to sell new equity to raise the needed financing or else postpone some planned
capital spending.
 If funds needed are less than funds generated, then a dividend will be paid. The amount of
the dividend will be the residual, that is, that portion of the earnings that is not needed to
finance new projects.
For example,
Suppose we have N900 in planning capital spending. To maintain the firm’s capital
structure, this N900 must be financed by 2⁄3 equity and 1⁄3debt. So, the firm will actually
borrow 1⁄3 X N900 = N300. The firm will spend 2⁄3 X N900 = N600 of the N1,000 in equity
available. There is a N1,000 - 600 = N400 residual, so the dividend will be N400.
In sum, the firm has after tax earnings of N1,000. Dividends paid are N400. Retained
earnings are N600, and new borrowing totals N300. The firm’s debt-equity ratio is unchanged
at 0.50.
Stability of Dividend
It is considered a desirable policy by the management of most companies in practices.
Many surveys have shown that shareholders also seem generally to favor this policy and value
stable dividends higher than the fluctuating ones. All other things being the same, the stable
dividend policy may have a positive impact on the market price of the share.
It is also meant regularity in paying some dividend annually, even though the amount of
the dividend may fluctuate over the years, and may not relate to earnings. There are a number
of companies, which have records of paying dividend for a long, unbroken period. More
precisely, stability of dividend refers to the amounts paid out regularly. Three forms of such
stability may be distinguished:
a) Constant dividend per share or dividend rate
b) Constant pay out.
c) Constant dividend per share plus extra dividend.

Page6
a. Constant dividend per share or dividend rate
The companies announce dividend as per cent of the paid-up capital per share. A
company follows the policy of paying a fixed rate on paid-up capital as dividend every year,
irrespective of fluctuations in the earnings. This policy does not imply that the dividend per
share or dividend rate will never be increased. When the company reaches new levels of
earnings and expects to maintain them, the annual dividend per share may be increased. The
relationship between earnings per shares and the dividend per share under this policy is shown
below figure
EPS
EPS and DPS
DPS
Constant dividend per share policy Time (Years)
A constant dividend per share policy puts ordinary shareholders at par with preferred
shareholders irrespective of the firm’s investment opportunities or the preference shareholders.
Those investors who have dividends as they only sources of their income may prefer the
constant dividend policy. They do not accord much importance to the changes in share prices.
In the long run, this may help to stabilize the market price of the share.
 Constant Payout
The ratio of dividend to earnings is known as payout ratio. Some companies may
follow a policy of constant payout ratio ie., paying a fixed percentage of net earnings every
year. With this policy of the amount of the dividend will fluctuate in direct proportion to
earnings. If a company adopts a 40 percent payout ratio, then 40 percent of every Birr of net
earnings will be paid out.
For example, if the company earns, 2 Naira per share, the dividend per share will be
0.80 Naira and if it earns 1.5 Birr per share the dividend per share will be 0.60 The relation
between the earnings per share and the dividend per share under the policy is exhibited in the
below figure.
EPS
EPS and DPS DPS
Dividend policy of constant payout ratio

Page7
This policy is related to a company’s ability to pay dividends. If the company incurs
losses, no dividend shall be paid regardless of the desires of shareholders. Internal financing
with retained earnings is automatic when this policy is followed. At any given payout ratio, the
amount of dividends and the additions to retained earnings increase with increasing earnings
and decrease with decrease earnings. This policy does not put any pressure on a company’s
liquidity since dividends are distributed only when the company has profited.
 Constant dividend per share plus Extra dividend
The smallest amount of dividend per share is fixed to reduce the possibility of every
missing a dividend payment. By paying extra dividend in periods of prosperity, an attempt is
made to prevent investors from expecting that the dividend represents an increase in the
established dividend amount. This type of policy enables a company to pay a constant amount
of dividend regularly without a default and allows a great deal of flexibility for supplementing
the income of shareholders only when the company earnings are higher than the usual, without
committing itself to make a larger payments as part of the future fixed dividend.
A Compromise Dividend Policy
In practice, many firms appear to follow a compromise dividend policy. Such a policy
is based on five main goals:
1. Avoid cutting back on positive NPV projects to pay a dividend.
2. Avoid dividend cuts.
3. Avoid the need to sell equity.
4. Maintain a target debt-equity ratio.
5. Maintain a target dividend payout ratio.
These goals are ranked more or less in order of their importance. In our strict residual
approach, we assume that the firm maintains a fixed debt-equity ratio. Under the compromise
approach, the debt-equity ratio is viewed as a long-range goal. It is allowed to vary in the short
run if necessary to avoid a dividend cut or the need to sell new equity.
In addition to having a strong reluctance to cut dividends, financial managers tend to
think of dividend payments in terms of a proportion of income, and they also tend to think
investors are entitled to a “fair” share of corporate income. This share is the long-run target
payout ratio, and it is the fraction of the earnings the firm expects to pay as dividends under
ordinary circumstances. Again, this ratio is viewed as a long-range goal, so it might vary in the
short run if this is necessary. As a result, in the long run, earnings growth is followed by
dividend increases, but only with a lag.

Page8
Factors Determination of Dividend Policies
1. Bond Indentures. Debt contracts often limit dividend payments to earnings generated
after the loan was granted. Also, debt contracts often stipulate that no dividends can be
paid unless the current ratio, times-interest earned ratio, and other safety ratios exceed
stated minimums.
2. Preferred stock restrictions. Typically, common dividends cannot be paid if the
company has omitted its preferred dividend. The preferred average must be satisfied
before common dividends can be resumed.
3. Impairment of capital rule. Dividend payments cannot exceed the balance sheet item
“retained earnings.” This legal restriction, known as the impairment of capital rule, is
designed to protect creditors. Without the rule, a company that is in trouble might
distribute most of its assets to stockholders and leave its debt holders out in the cold.
(Liquidating dividends can be paid out of capital, but they must be indicated as such, and
they must not reduce capital below the limits stated in debt contracts.)
4. Availability of cash. Cash dividends can be paid only with cash. Thus, a shortage of cash
in the bank can restrict dividend payments. However, the ability to borrow can offset this
factor.
5. Penalty tax on improperly accumulated earnings. To prevent wealthy individuals from
using corporations to avoid personal taxes, the Tax Code provides for a special surtax on
improperly accumulated income. Thus, if the IRS can demonstrate that a firm’s dividend
payout ratio is being deliberately held down to help its stockholders avoid personal taxes,
the firm is subject to heavy penalties. This factor is generally relevant only to privately
owned firms.
6. Number of profitable investment opportunities. If a firm typically has a large number
of profitable investment opportunities, this will tend to produce a low target payout ratio,
and vice versa if the firm’s profitable investment opportunities are few in number.
7. Possibility of accelerating or delaying projects. The ability to accelerate or postpone
projects will permit a firm to adhere more closely to a stable dividend policy.
8. Cost of selling new stock. If a firm needs to finance a given level of investment, it can
obtain equity by retaining earnings or by issuing new common stock. If flotation costs
(including any negative signaling effects of a stock offering) are high, ke will be well
above Ks, making it better to set a low payout ratio and to finance through retention rather
than through sales of new common stock. On the other hand, a high dividend payout ratio
is more feasible for a firm whose flotation costs are low.

Page9
9. Flotation costs differ among firm For example, the flotation percentage is generally
higher for small firms, so they tend to set low payout ratios.
10. Ability to substitute debt for equity. A firm can finance a given level of investment
with either debt or equity. As noted above, low stock flotation costs permit a more flexible
dividend policy because equity can be raised either by retaining earnings or by selling new
stock. A similar situation holds for debt policy: If the firm can adjust its debt ratio without
raising costs sharply, it can pay the expected dividend, even if earnings fluctuate, by
increasing its debt ratio.
DETERMINANTS OF DIVIDEND POLICY
The factors determining the dividend policy of a firm are as follows:
(1) Dividend payout (D/P) ratio
(2) Stability of dividends
(3) Legal, contractual and internal constraints and restrictions
(4) Owner’s considerations
(5) Capital market considerations
(6) Inflation
(1) Dividend Payout (D/P) ratio:
The D/P ratio indicates the percentage share of the net earnings distributed to the shareholders
as dividend. Given the objective of wealth maximisation, the D/p ratio should be such can
maximise the wealth of its owners in the long run. In practice, investors, in general, have a
clear cut preference for dividends because of uncertainty and imperfect capital markets.
Therefore, a low D/P ratio may cause a decline in share prices, while a high ratio may lead to a
rise in the market price of the shares.
(2) Stability of dividends:
The second major aspect of the dividend policy of a firm is the stability of dividends. The
investors favour a stable dividend as much as they favour the payment of dividends. Dividend
stability refers to the consistency or lack of variability in the stream of dividends which means
that a certain minimum amount of dividend is paid regularly. The stability of dividends can
take any of the following three forms:
(1) Constant dividend per share
(2) Constant payout ratio
(3) Constant dividend per share plus extra dividend
(3) Legal, Contractual and Internal constraints and restrictions:

Page10
The dividend decision is also affected by certain legal, contractual and internal constraints.
The legal factor stem from certain statutory requirements, the contractual restrictions arise
from certain loan covenants and the internal constraints are the result of the firm’s liquidity
positions.
(4) Owner’s considerations:
The dividend policy is also likely to be affected by the owner’s considerations of
(a) the tax status of the shareholders, (b) their opportunities of investment, and (c) the dilution
of ownership. It is impossible to establish a policy that will maximise each owner’s wealth.
The firm must aim at a dividend policy which has a beneficial effect on the wealth of the
majority of shareholders.
(5) Capital Market Considerations:
Another set of factors that can strongly affect dividend policy is the extent to which the firm
has access to the capital markets. A firm which has easy access to the capital market can follow
a liberal dividend policy, whereas a firm having only limited access to the capital markets is
likely to adopt low dividend payout ratio as they are likely to rely, to a greater extent, on
retained earnings as a source of financing their investments.
(6) Inflation:
Inflation is another factor which affects the firm’s dividend decisions. With rising prices, funds
generated from depreciation may be inadequate to replace obsolete equipments. As a result D/P
ratio tends to be low during period of inflation.
Dividend Theories and Behaviour
a) Irrelevance of Dividend
MM Approach
b) Relevance of Dividend
Walter’s Model
Gordon’s Model
(A) RELEVANCE OF DIVIDENDS
In sharp contrast to the MM hypothesis, there are some theories that consider dividend
decisions to be an active variable in determining the value of the firm. The dividend decision is
therefore relevant. According to this concept, dividend policy is considered to affect the value
of the firm. Dividend relevance implies that shareholders prefer current dividend and there is
no direct relationship between dividend policy and the value of the firm. There are two theories
which support the relevance of dividends namely:

Page11
(i) WALTER’S MODEL
(ii) GORDON’S MODEL
(i) WALTER’S MODEL
Prof. James E. Walter argues that the dividend policy almost always affects the value
of the firm. This model supports the doctrine that dividends are relevant. The investment policy
of a firm cannot be separated from its dividend policy and both are interlinked. The key
argument in support of the relevance of Walter’s model is the relationship between the return
on a firm’s investment (r) and its cost of capital/ required rate of return (k).
If r > k ( growth firms) the firm should retain the earnings or D/P ratio should be zero as it is
able to earn higher than what the shareholders could by investing on their own.
In case r < k (declining firms) it implies that shareholders can earn a higher return by
investing elsewhere. Therefore, the entire earnings (D/P ratio should be 100 percent) should be
distributed to them.
Finally, when r = k (normal firms), it is a matter of indifference whether earnings are
retained or distributed. This is so because for all D/P ratios (ranging between zero and 100) the
market price of shares will remain constant. For such firms, there is no optimum dividend
policy (D/P ratio). By following such a policy in all the three cases, the market price of shares
will be maximised.Walter model is based on the relationship between the following important
factors:
 Rate of return I
 Cost of capital (k)
According to the Walter’s model, if r > k, the firm is able to earn more than what the
shareholders could by reinvesting, if the earnings are paid to them. The implication of r > k is
that the shareholders can earn a higher return by investing elsewhere. If the firm has r = k, it is
a matter of indifference whether earnings are retained or distributed.
Assumptions
Walters model is based on the following important assumptions:
 The firm uses only internal finance.
 The firm does not use debt or equity finance.
 The firm has constant return and cost of capital.
 The firm has 100 recent payout.
 The firm has constant EPS and dividend.
 The firm has a very long life.
Walter has evolved a mathematical formula for determining the value of market share.

Page12
P = (D + (r /Ke) (E-D))
Ke
Where,
P = Market price of an equity share;
D = Dividend per share;
r = Internal rate of return
E = Earning per share;
Ke = Cost of equity capital
Exercise 2
From the following information supplied to you, ascertain whether the firm is following
an optional dividend policy as per Walter’s Model?
Total Earnings 2,00,000
No. of equity shares (of 100 each 20,000)
Dividend paid 1,00,000
P/E Ratio 10
Return Investment 15%
The firm is expected to maintain its rate of return on fresh investments. Also find out
what should be the E/P ratio at which the dividend policy will have no effect on the value of
the share? Will your decision change if the P/E ratio is 7.25 and interest of 10%?
Solution
EPS = Earnings
No.of shares
= 200, 000
20,000 = 10.
PE ratio = 10
Ke = 1
PE ratio = 1 / 10 = 0.10
DPS = Total dividend paid / no of shares
= 100,000 / 20,000 = 5.
The value of the share as per Walter’s Model is
P = (D + (r /Ke) (E-D)) / Ke
= (5 + 0.15 / 0.10 (10 – 5)) / 0.10
= 5 + 7.5 / 0.10 = 12.5

Page13
Dividend payout = DPS / EPS x 100
= 5 / 10 x 100 = 60%
r > Ke therefore by distributing 60% of earnings, the firm is not following an optional dividend
policy. In this case, the optional dividend policy for the firm would be to pay a zero dividend
and the Market Price would be:
P = (5 + 0.15 / 0.10 (10 – 0)) / 0.10
= (5 + 15) / 0.10
P = 200
So, the MP of the share can be increased by following a zero payout, of the P/E is 7.25 instead
of 10 then the Ke =1=0.138 and in this case Ke > r and the MP of the share is 7.25.
P = (5 + 0.15 / 0.138 (10 – 5)) / 0.138
= 5 + 5.435 / 0.138
P = 75.62
Criticism of Walter’s Model
The following are some of the important criticisms against Walter model:
 Walter model assumes that there is no extracted finance used by the firm. It is not
practically applicable.
 There is no possibility of constant return. Return may increase or decrease, depending
upon the business situation. Hence, it is applicable.
 According to Walter model, it is based on constant cost of capital. But it is not
applicable in the real life of the business.
i) Gordon’s Model
Myron Gorden suggests one of the popular models which assume that dividend policy
of a firm affects its value, and it is based on the following important assumptions:
 The firm is an all equity firm.
 The firm has no external finance.
 Cost of capital and return are constant.
 The firm has perpetual life.
 There are no taxes.
 Constant relation ratio (g = br).
 Cost of capital is greater than the growth rate (Ke > br).
Gordon’s model can be proved with the help of the following formula:
P = E (1 – b) / Ke – br)

Page14
Where,
P = Price of a share; E = Earnings per share
1 – b = D/p ratio (i.e., percentage of earnings distributed as dividends)
Ke = Capitalization rate; br = Growth rate = rate of return on investment of an all equity firm.
Exercise 3
ABC company earns a rate of 12% of its total investment of 600,000 in assets. It has
600,000 outstanding common shares at 10 per share. The discount rate of the firm is 10% and
it has a policy of retaining 40% of the earnings. Determine the price of its share using
Gordon’s Model. What shall happen to the price of the share if the company has a payout of
60% (or) 20%?
Solution
According to Gordon’s Model, the price of a share is
P = E (1 – b) / Ke – br)
Given: E = 12% of 10 = 1.20
r = 12% = 0.12
K = 10% = 0.10
t = 10% = 0.10
b = 40% = 0.40
Put the values into the formula
P = 1.20 (1 – 0.40) / 10 – (0.40 x 0.12)
= 1.20 x (0.60) / 0.10 – 0.048
= 0.72 / 0.052
= 13.85
If the firm follows a policy of 60% payout then b = 20% = 0.20
The price is P = 1.20 (1 x 0.20) / 0.1 – (0.20 x 0.12)
= 0.05
r = 4% = 0.04; D =25% of 10 = 2.50
= 2.50 + (0.04 / 0.12 (10 – 2.50)) / 0.12
= 5 / 0.12
= 41.67
If the payout ratio is 50%, D = 50% of 10 = 5
r = 12% = 0.12; D = 50% of 10 = 5
= 5 + (0.12 / 0.12 (10 – 5)) / 0.12
= 5 + 5 / 0.12 = 10 / 0.12

Page15
= 83.33
r = 8% = 0.08; D = 50% of 10 = 5
= 5 + (0.08 / 0.12 (10 – 5)) / 0.12
= 5 + 3.33 / 0.12 = 8.33 / 0.12
= 69.42
r = 4% = 0.04; D = 50% of 10 = 5
= 5 + (0.04 /0.12 (10 – 5)) / 0.12
= 5 + 1.67 / 0.12 = 6.67 / 0.12
= 55.58
Criticism of Gordon’s Model
Gordon’s model consists of the following important criticisms:
 Gordon model assumes that there is no debt and equity finance used by the firm. It is
not applicable to present day business.
 Ke and r cannot be constant in the real practice.
 According to Gordon’s model, there is no tax paid by the firm. It is not practically
applicable.
(B) IRRELEVANCE OF DIVIDEND
The dividend policy has no effect on the share price of the company. There is no
relation between the dividend rate and value of the firm. Dividend decision is irrelevant of the
value of the firm. Modigliani and Miller contributed a major approach to prove the irrelevance
dividend concept.
Modigliani and Miller’s Approach
According to MM, under a perfect market condition, the dividend policy of the
company is irrelevant and it does not affect the value of the firm. “Under conditions of perfect
markets, rational investors, absence of tax discrimination between dividend income and capital
appreciation, given the firm’s investment policy, its dividend policy may have no influence on
the market price of shares”.
Assumptions
MM approach is based on the following important assumptions:
 Perfect capital market.
 Investors are rational.
 There is no tax.

Page16
 The firm has a fixed investment policy.
 No risk or uncertainty.
Proof for MM approach
The MM approach can be proved with the help of the following formula:
Po = D1 + P1 / (1 + Ke)
Where,
Po = Prevailing market price of a share; Ke = Cost of equity capital.
D1 = Dividend to be received at the end of period one.
P1 = Market price of the share at the end of period one.
P1 can be calculated with the help of the following formula.
P1 = Po (1+Ke) – D1
The number of new shares to be issued can be determined by the following formula:
M × P1 = I – (X – nD1)
Where,
M = Number of new shares to be issued;
P1 = Price at which new issue is to be made.
I = Amount of investment required;
X = Total net profit of the firm during the period.
nD1= Total dividend paid during the period.
Exercise 1
X Company Ltd., has 100,000 shares outstanding the current market price of the shares
15 each. The company expects the net profit of 200,000 during the year and it belongs to a rich
class for which the appropriate capitalization rate has been estimated to be 20%. The company
is considering dividend of 2.50 per share for the current year. What will be the price of the
share at the end of the year (i) if the dividend is paid and (ii) if the dividend is not paid.
Solution
Po = D1 + P1 / (1 + Ke)
(i) If the dividend is paid
Po = 15; Ke = 20%; D1 = 2.50; P1 =?
15 = 2.50 + P1 / 1 + 20%
15 = 2.50 + P1 / 1.2
2.50 + P1 =15 x 1.2
P1 = 18 – 2.50 P1 = 15.50
(ii) If the dividend is not paid
Po = 15; Ke = 20%; D1 = 0; P1 = ?

Page17
15 = 0 + P1 / 1 + 20%
15 = 0 + P1 / 1.2
0 + P1 =15 x 1.2
P1 = 18
Criticism of MM approach
 The MM approach consists of certain criticisms also. The following are the major
criticisms of MM approach.
 The MM approach assumes that tax does not exist. It is not applicable in the practical
life of the firm.
 The MM approach assumes that, there is no risk and uncertain of the investment. It is
also not applicable in present day business life.
 The MM approach does not consider floatation cost and transaction cost. It leads to
affect the value of the firm.
 The MM approach considers only single decrement rate, it does not exist in real
practice.
 The MM approach assumes that, investor behaves rationally. But we cannot give
assurance that all the investors will behave rationally.
ALTERNATIVE FORMS OF DIVIDEND
There are ways other than regular or periodic cash dividend to reward shareholders. Three
other ways of rewarding shareholders are very popular. They are as follows:
(1). Bonus Shares
(2). Stock Splits
(3). Share buyback
BONUS SHARES: Involves payment of dividend to existing shareholders in the form of
shares. A bonus share is a free share of stock given to current/existing shareholders in a
company, based upon the number of shares that the shareholder already owns at the time of
announcement of the bonus. Issue of bonus shares is a way of capitalizing reserves into
shares.
STOCK SPLITS: It is a method commonly used to lower the market price of shares by
increasing the number of shares belonging to each shareholder.
SHARE BUYBACK: When firm buys its own shares from whoever wants to sell his
holding at a specified price during a specified period.
REFERENCE

Page18
Barman P. G (2008). An Evaluation of how Dividend Policies Impact on the Share Value of
Selected Companies. A thesis submitted in partial fulfillment of the requirements for
the degree of Magister Technologiae, Nelson Mandela Metropolitan University.
Firer, C. et al. (2012) Fundamentals of Corporate Finance. 5th Edition. Berkshire.McGraw-Hill
Companies, Inc. 3.
Erasmus, P. (2012) The Influence of Dividend Yield and Dividend Stability on Share Return:
Implications for Dividend Policy Formulation. Journal of Economic and Financial
Sciences, 6(1), pp. 13-32.
Modigliani, Franco, and Merton H. Miller, 1958, The Cost of Capital, Corporation Finance and
the Theory of Investment, American Economic Review 48, pp. 261-297.
Allen, F., and Michaely, R. (1995). Price Reactions to Dividend Initiations and
Omissions: Overreaction or Drift? Journal of Finance, 50, 2, pp. 573-608
Gordon, M. (1959), Dividends, Earnings and Stock Prices. Review of Economics and
tatistics, 41, 99-105.
Modigliani, F. and Miller, M. (1961), “Dividend Policy, Growth, and the Valuation of Shares”.
The Journal of Business, Vol. 34, No. 4. pp.411-433.
Malkawi et al (2010), “Dividend Policy: A Review of Theories and Empirical Evidence”,
International Bulletin of Business Administration ,ISSN: 1451-243X Issue 9 , pp. 171-
200.
BLACK, F and SCHOLES, M. (1974) The Effects of Dividend and Dividend Policy on
Common Stock Price And Returns. Journal of Financial Economics, pp. 1-22.
Lintner, J. (1956). Distribution of income of corporation among dividends, retained earnings
and taxes. The American Economic Review, 46, pp. 97−113.
Robinson, J., (2006) “Dividends Policy among Publicly Listed Firms in Barbados”, Journal of
Eastern Caribbean Studies, Vol. 31, pp. 1-36.
BHATTACHARYA, S. (1979) Imperfect information, dividend policy, and “the bird in hand”
fallacy. The Bell Journal of Economics, 10,(1), pp. 259-270
BAKER, K. et al. (2002) Revisiting Managerial Perspectives on Dividend Policy. Journal of
Economics and Finance, 26(3), pp.267-283