Question

How do companies take dividend decision? Your answer must reflect the growth of dividend decision of theories.

Answer 1

The dividend decisions of a company are affected by below factors:

1. Type of the business; Business like IT, Oil/Mining tend to give more dividend.

2. Future investment decisions: if company want to invest, they tend to provide less dividend.

3. Free cash flows

4. Legal regulations

5. Corporate tax policy: if tax is present for dividend, company look for other options

6. Favourable economic conditions.

There are mainly 3 dividend decsions theories:

1. Walter's model:

P=(D/Ke) + [(r/Ke)(E-D)]/Ke

P= Market price/share ; D=Dividend per share; r=rate of return; Ke=cost of equity; E= Earnings per share

Walters model states that market price of share is the sum of capitalized value of dividend and true value of retained earnings.

From the equation,

if r>Ke ; company should retain all retained earnings and should not pay dividend.

if r<Ke; company should distribute all earnings as share holders can earn more than the company

if r=Ke; doesnt affect if company pay dividend or not

Assumptions of Walters model:

• Value of share depends on present values of future dividends.
• Retained earnings affect the future dividends
• Business risk is constant
• Future investments of company is financed usingretained earnings.
• The firm has an infinitely long life

2. Gordons Model:

P=E*(1-b)/ (Ke – g)

P=price/share ; g=growth rate; r=rate of return; Ke=cost of equity; E= Earnings/share ; b=retention ratio

This model states that there is a direct relation with dividend policy and market price/share and investor prefer future dividends better than capital gains.

Assumptions of Gordons model:

• Value of share correlated with present values of future dividends.
• Retained earnings affect the future dividends
• Business risk is constant.
• IRR of companyand Ke are constant.

3. Miller Modigliani Hypothesis:

States dividend as the irrelevant to the market price of the shares.It states the price at the year end will be offset by the dividend distributed by the company and wont affect the market price, so lower the dividend, higher the market price at the end of the period . This model is currently considered as irrelevant for dividend decisions.