Financial Management Unit 4 Dividend Decision PDF

Youtube : TAS Updates College Telegram : TAS Updates College Financial Management Unit 4 : Dividend Decision MEANING OF DIVIDEND : Dividend is that part of profit After Tax (PAT) which is distributed to the shareholders of the company. Further, the profit earned by a company after payin...

Youtube : TAS Updates College Telegram : TAS Updates College Financial Management Unit 4 : Dividend Decision MEANING OF DIVIDEND : Dividend is that part of profit After Tax (PAT) which is distributed to the shareholders of the company. Further, the profit earned by a company after paying taxes can be used for; i. Distribution of Dividend or ii. Retaining as surplus for further growth FORMS OF DIVIDEND : 1. Cash dividend: It is the most common form of dividend. Cash here means cash, cheque, warrant, demand draft, pay order or directly through Electronic Clearing Services (ECS) but not in kind 2. Stock dividend (Bonus shares): It is a distribution of shares in lieu of cash dividend. When the company issue new shares to its existing shareholders without any consideration it is called bonus shares. Such shares are distributed proportionately thereby retaining proportionate ownership of the company Youtube : TAS Updates College Telegram : TAS Updates College SIGNIFICANCE OF DIVIDEND POLICY :  Long Term Financing Decision : whether to retain or distribute the profits, forms the basis of this decision. Further, payment of cash dividend reduces the amount of funds required to finance profitable investment opportunities thereby restricting its financing options.  Wealth Maximization Decision : management should develop a dividend policy which divides net earnings into dividends and retained earnings in an optimum way so as to achieve the objective of wealth maximization for shareholders. Such a policy will be influenced by investment opportunities available to the firm and value of dividends as against capital gains to shareholders. DETERMINANTS OF DIVIDEND DECISIONS : 1. Availability of funds: If the bushiness is in requirement of funds, then retained earnings could be a good source. The reason being the saving of floatation cost and prevention of dilution of control which happens in case of new issue of equity shares to public. 2. Cost of capital: If the financing requirements are to be executed through debt (relatively cheaper sources of finance), then it would be preferable to distribute more dividend. On the other hand, if the financing is to be done through fresh issue of equity shares, then it is better to use retained earnings as much as possible. Youtube : TAS Updates College Telegram : TAS Updates College 3. Capital structure: An optimum Debt Equity Ratio should also be considered for the dividend decision. 4. Investment opportunities in hand: the dividend decision is also affected if there are investment opportunities in hand. In that situation, the company may prefer to retain more earnings. 5. Trend of industry: The investors depend on some industries for their regular dividend income. Therefore, in such cases, the firms have to pay dividend in order to survive in the market. 6. Expectation of shareholders: The shareholders can be categorized into two categories: (i) those who invests for regular income, & (ii) those who invests for growth. Generally, the investor prefers current dividend over the future growth. THEORIES OF DIVIDEND :  MODIGLIANI AND MILLER (MM) APPROACH : Market value of equity shares of a firm depends solely on its earning power and is not influenced by the manner in which its earnings are split between dividends and retained earnings. Market value of equity shares is not affected by dividend size. Youtube : TAS Updates College Telegram : TAS Updates College ASSUMPTIONS OF (MM) APPROACH  Perfect capital markets: The firm operates in a market in which all investors are rational and information is freely available at all. No taxes: There are no taxes or no tax discrimination between dividend income and capital appreciation (capital gain). It means there is no difference in taxation of dividend income or capital gain. Fixed investment policy: It is necessary to assume that all investment should be financed through equity only, since implication after using debt as a source of finance may be difficult to understand. No floatation or transaction cost: Similarly, these costs may differ from country to country or market to market. Risk of uncertainty does not exist: Investors are able to forecast future prices and dividend with certainty any one discount rate is appropriate for all securities and all time periods. Youtube : TAS Updates College Telegram : TAS Updates College  Walter’s Model : As per Walter’s Model, two factors which influence the market price of a share are (i) Dividend per share and (ii) Relationship between IRR and Ke. ASSUMPTION UNDER WALTER’S : Al investment proposals of the firm are to be financed through retained earnings only. ‘r’ rate of return & ‘ke′ cost of capital are constant. Perfect capital markets: The firm operates in a market in which all investors are rational and information is freely available to all. No taxes or no tax discrimination between dividend income and capital appreciation (capital gain). It means there is no difference in taxation of dividend income or capita gain. Youtube : TAS Updates College Telegram : TAS Updates College No floatation or transaction cost: similarly, these costs may differ country to country or market to market. The firm has perpetual life.  GORDON’S MODEL : According to Gordon’s model, when IRR is greater than cost of capital, the price per share increase and dividend pay-out decreases. On the other hand when IRR is lower than the cost of capital, the price per share decreases and dividend payout increases. ASSUMPTION UNDER GORDON’S MODEL : Firm is an equity firm i.e., no debt. Youtube : TAS Updates College Telegram : TAS Updates College IRR will remain constant, because change in IRR will change the growth rate and consequently the value will be affected. Hence this assumption is necessary. Ke will remain constant, because change in discount rate will affect the present value. Retention ratio(b), once decide upon, is constant i.e., constant dividend payout ratio will be followed. Growth rate (g=br) is also constant, since retention ratio and IRR will remain unchanged and growth, which is the function of these two variable will remain unaffected. Ke > g, this assumption is necessary and based on the principles of series of sum of geometric progression for ‘n’ number of years. All investment proposals of the firm are to be financed through retained earnings only. Youtube : TAS Updates College Telegram : TAS Updates College  GORDON’S REVISED MODEL : Gordon argues that what is available at present is preferable to what may be available in the future. As investors are rational, they want to avoid risk and uncertainty. They would prefer to pay a higher price for shares on which current dividends are paid. Conversely, they would discount the value of shares of a firm which postpones dividends. The discount rate would vary with the retention rate.