Some of the major different theories of dividend in financial management are as follows: 1. Walter’s model 2. Gordon’s model 3. Modigliani and Miller’s hypothesis. On the relationship between dividend and the value of the firm different theories have been advanced.

1. Presented By:- Anju Pal
Ashish Kanyal
Gaurav Verma
Sunny Mervyne Baa
DIFFERENT MODELS OF
DIVIDEND POLICY

2. Dividend
Policy
Once a company makes a profit, management must decide on what
to do with those profits.
They could continue to retain the profits within the company, or they
could pay out the profits to the owners of the firm in the form of
dividends.
Once the company decides on whether to pay dividends they may
establish a somewhat permanent dividend policy, which may in turn
impact on investors and perceptions of the company in the financial
markets.
What they decide depends on the situation of the company now and
in the future.
It also depends on the preferences of investors and potential
investors.

3. TYPES OF DIVIDEND/FORM OF
DIVIDEND
Dividend may be distributed among the shareholders in the form of
cash or stock. Hence, Dividends are classified into:
A. Cash dividend
B. Stock dividend
C. Bond dividend
D. Property dividend

4. Cash Dividend
• If the dividend
is paid in the
form of cash to
the
shareholders, it
is called cash
dividend.
• It is paid
periodically out
the business
concerns EAIT
(Earnings after
interest and
tax).
• Cash dividends
are common
and popular
types followed
by majority of
the business
concerns.
Stock Dividend
• Stock dividend
is paid in the
form of the
company stock
due to raising
of more
finance.
• Under this type,
cash is retained
by the business
concern. Stock
dividend may
be bonus issue.
• This issue is
given only to
the existing
shareholders of
the business
concern.
Bond Dividend
• Bond dividend
is also known
as script
dividend.
• If the
company does
not have
sufficient funds
to pay cash
dividend, the
company
promises to pay
the shareholder
at a future
specific date
with the help
of issue of
bond or notes.
Property
Dividend
• Property
dividends are
paid in the
form of some
assets other
than cash. I
• t will
distributed
under the
exceptional
circumstance.
• This type of
dividend is not
published in
India.

5. FACTORS DETERMINING DIVIDEND POLICY
Profitable Position of the Firm
Dividend decision
depends on the
profitable position of
the business concern.
When the firm earns
more profit, they can
distribute more
dividends to the
shareholders.
Uncertainty of Future Income
Future income is a
very important factor,
which affects the
dividend policy.
When the shareholder
needs regular income,
the firm should
maintain regular
dividend policy.
Legal Constrains
The Companies Act
1956 has put several
restrictions regarding
payments and
declaration of
dividends.
Similarly, Income Tax
Act, 1961 also lays
down certain
restrictions on
payment of dividends.
Liquidity
Position
Liquidity position of
the firms leads to easy
payments of dividend.
If the firms have high
liquidity, the firms can
provide cash dividend
otherwise, they have
to pay stock dividend.

6. Sources of
Finance
If the firm
has finance
sources, it will
be easy to
mobilise large
finance. The
firm shall not
go for retained
earnings.
Growth
Rate of
the Firm
High growth
rate implies
that the firm
can distribute
more dividend
to its
shareholders.
Tax Policy
Tax policy of
the government
also affects the
dividend policy
of the firm.
When the
government
gives tax
incentives, the
company pays
more dividend.
Capital
Market
Conditions
Due to the
capital market
conditions,
dividend policy
may be
affected. If the
capital market
is prefect, it
leads to
improve the
higher
dividend.

7. • Regular dividend policy • Stable dividend policy
• Irregular dividend policy • No dividend policy.
Dividend policy depends upon the
nature of the firm, type of
shareholder and profitable position.
On the basis of the dividend
declaration by the firm, the
dividend policy may be classified
under the following types:

8. Regular
Dividend Policy
• Dividend payable at the usual rate is called as regular dividend policy. This type of
policy is suitable to the small investors, retired persons and others.
Stable Dividend
Policy
• Stable dividend policy means payment of certain minimum amount of dividend
regularly.This dividend policy consists of the following three important forms:
Constant dividend per shareConstant payout ratioStable rupee dividend plus extra
dividend.
Irregular
Dividend Policy
• When the companies are facing constraints of earnings and unsuccessful business
operation,they may follow irregular dividend policy. It is one of the temporary
arrangements to meet the financial problems. These types are having adequate
profit. For others no dividend is distributed.
No Dividend
Policy
• Sometimes the company may follow no dividend policy because of its unfavourable
working capital position of the amount required for future growth of the concerns

9. WALTER’S THEORY ON
DIVIDEND POLICY

10. Walter’s theory on dividend policy believes in the
relevance concept of a dividend.
According to this concept, a dividend decision of the
company affects its valuation.
The companies paying higher dividends have more value
as compared to the companies that pay lower dividends
or do not pay at all.
Walter’s theory further explains this concept in a
mathematical model.

11. Crux of Walter’s Model
Prof. James E Walter formed a
model for share valuation that
states that the dividend policy
of a company has an effect on
its valuation.
He categorized two factors that
influence the price of the share
viz. dividend payout ratio of the
company and the relationship
between the internal rate of
return of the company and the
cost of capital.

12. RELATION OF DIVIDEND DECISION AND VALUE OF A FIRM
According to Walter’s theory, the dividend payout in
relation to (Internal Rate of Return) ‘r’ and (Cost of
Capital) ‘k’ will impact the value of the firm in the
following ways:
• Relationship between r and k Increase in Dividend Payout Decrease
in Dividend Payout
• r>k
• Value of the firm decreases Value of the firm increases
• r<k
• Value of the firm increases Value of the firm decreases
• r=k
• No change in the value of the firm No change in the value of the
firm

13. ◾Infinite Life:
The company has an infinite or a very long life
◾100% Retention/ Payout:
All the earnings of the company are either reinvested internally or distributed as dividends.
◾Constant EPS and DPS:
Beginning earnings and dividends of the firm never change. Though different values of EPS and DPS may be
used in the model, but they are assumed to remain constant while determining a value.
◾Constant IRR and Cost of Capital:
The internal rate of return (r) and the cost of capital (k) of the firm are constant. The business risks remain
same for all the investment decisions.
◾Internal Financing:
All the investments are financed by the firm through retained earnings. No new equity or debt is issued for the
same.
Assumptions of the Model:
Walter’s model is based on the following assumptions:

14. P = D/k +
{r*(E-
D)/k}/k,
• P = market price
per share
• D = dividend per
share
• E = earnings per
share
• r = internal rate of
return of the firm
• k = cost of capital
of the firm
Valuation
Formula and
its
Denotations:
Walter’s
formula to
calculate the
market price
per share (P)
is:

15. The mathematical equation
indicates that the market
price of the company’s
share is the total of the
present values of:
◾An infinite flow of
dividends, and
◾An infinite flow of gains
on investments from
retained earnings.
The formula can be used to
calculate the price of the
share if the values of other
variables are available.

16. • Growth firms are characterized by an internal rate of return > cost of the
capital i.e. r > k.
• These firms will have surplus profitable opportunities to invest.
• Because of this, the firms in growth phase can earn more return for their
shareholders in comparison to what the shareholders can earn if they
reinvested the dividends.
• Hence, for growth firms, the optimum payout ratio is 0%.
◾Growth
Firm:
• Normal firms have an internal rate of return = cost of the capital i.e. r = k.
• The firms in normal phase will make returns equal to that of a shareholder.
• Hence, the dividend policy is of no relevance in such a scenario.
• It will have no influence on the market price of the share.
• So, there is no optimum payout ratio for firms in the normal phase. Any
payout is optimum.
◾Normal
Firm:
• Declining firms have an internal rate of return < cost of the capital i.e. r < k.
• Declining firms make returns that are less than what shareholders can make
on their investments.
• So, it is illogical to retain the company’s earnings.
• In fact, the best scenario to maximize the price of the share is to distribute
entire earnings to their shareholders.
• The optimum dividend payout ratio, in such situations, is 100%.
◾Declining
Firm:

17. Criticism of Walter’s Model
Walter’s theory is critiqued for the following unrealistic
assumptions in the model:
◾No External Financing:
• Walter’s assumption of complete internal financing by the firm through retained
earnings is difficult to follow in the real world.
• The firms do require external financing for new investments.
◾Constant r and k:
• It is very rare to find the internal rate of return and the cost of capital to be constant.
• The business risks will definitely change with more investments which are not reflected in this
assumption.

18. Summary
• Though Walter’s theory has some unrealistic assumptions,
• it follows the concept that the dividend policy of a company has
an effect on the market price of its share.
• It explains the impact in the mathematical terms and finds the
value of the share.

19. Gordon’s Theory on Dividend Policy

20. • Gordon’s theory on dividend policy is one of the
theories believing in the ‘relevance of dividends’
concept.
• It is also called as ‘Bird-in-the-hand’ theory that
states that the current dividends are important in
determining the value of the firm.
• Gordon’s model is one of the most popular
mathematical models to calculate the market
value of the company using its dividend policy.

21. Crux of Gordon’s Model
Myron Gordon’s model
explicitly relates the
market value of the
company to its dividend
policy.
The determinants of the
market value of the
share are the perpetual
stream of future
dividends to be paid, the
cost of capital and the
expected annual growth
rate of the company.

22. Relation of Dividend Decision and
Value of a Firm
The Gordon’s theory on dividend
policy states that the company’s
dividend payout policy and the
relationship between its rate of
return (r) and the cost of capital (k)
influence the market price per share
of the company

23. • No change
in the price
per share
• Price per
share
increases
• Price per
share
decreases
Relationship
between r and
k Increase in
Dividend
Payout
r>k
r<kr=k

24. • The model assumes that
the company is an all
equity company, with no
proportion of debt in
the capital structure.
No Debt:
• The model assumes that
all investment of the
company is financed by
retained earnings and no
external financing is
required.
◾No External
Financing:
• The model assumes a
constant Internal Rate
of Return (r), ignoring
the diminishing
marginal efficiency of
the investment.
◾Constant IRR:
• The model is based on
the assumption of a
constant cost of capital
(k), implying the
business risk of all the
investments to be the
same.
◾ Constant
Cost of Capital:
• Gordon’s model
believes in the theory of
perpetual earnings for
the company.
◾Perpetual
Earnings:
• Corporate taxes are not
accounted for in this
model.
◾Corporate
Taxes:
• The model assumes a
constant retention ratio
(b) once it is decided by
the company. Since the
growth rate (g) = b*r,
the growth rate is also
constant by this logic.
◾Constant
Retention Ratio:
• Gordon’s model
assumes that the cost of
capital (k) > growth rate
(g). This is important
for obtaining the
meaningful value of the
company’s share.
◾K>g:
ASSUMPTIONS OF THE MODEL
GORDON’S MODEL IS BASED ON THE FOLLOWING ASSUMPTIONS:

25. Gordon’s formula to calculate the market price per share (P) is
P = {EPS * (1-b)} / (k-g)
Where,
P = market price per share
EPS = earnings per share
b= retention ratio of the firm
(1-b) = payout ratio of the firm
k = cost of capital of the firm
g = growth rate of the firm = b*r
VALUATION FORMULA AND ITS
DENOTATIONS

26. The above model indicates that the market value of the company’s share is the
sum total of the present values of infinite future dividends to be declared.
The Gordon’s model can also be used to calculate the cost of equity, if the
market value is known and the future dividends can be forecasted.
EXPLANATION

27. Implications
• Gordon’s model believes that the dividend policy impacts the company in various
scenarios as follows:
◾Growth Firm:
• A growth firm’s internal rate of return (r) > cost of capital (k). It benefits the
shareholders more if the company reinvests the dividends rather than distributing it.
So, the optimum payout ratio for growth firms is zero.
◾Normal Firm:
• A normal firm’s internal rate of return (r) = cost of the capital (k). So, it does not
make any difference if the company reinvested the dividends or distributed to its
shareholders. So, there is no optimum dividend payout ratio for normal firms.
• However, Gordon revised this theory later and stated that the dividend policy of the
firm impacts the market value even when r=k. Investors will always prefer a share
where more current dividends are paid.
◾Declining Firm:
• The internal rate of return (r) < cost of the capital (k) in the declining firms. The
shareholders are benefitted more if the dividends are distributed rather than
reinvested. So, the optimum dividend payout ratio for declining firms is 100%.

28. Gordon’s theory on dividend policy is criticised mainly for the unrealistic
assumptions made in the model.
◾Constant Internal Rate of Return and Cost of Capital: The model is
inaccurate in assuming that r and k always remain constant. A constant r
means that the wealth of the shareholders is not optimized. A constant k
means the business risks are not accounted for while valuing the firm.
◾No External Financing: Gordon’s belief of all investments being financed
by retained earnings is faulty. This reflects sub-optimum investment and
dividend policies.
CRITICISM OF GORDON’S MODEL

29. Gordon’s theory of dividend policy is one of the prominent theories in the
valuation of the company. Though it comes with its own limitations, it is a
widely accepted model to determine the market price of the share using the
forecasted dividends.
SUMMARY

30. MODIGLIANI- MILLER
THEORY ON DIVIDEND
POLICY

31. Modigliani – Miller theory is a major proponent of ‘Dividend
Irrelevance’ notion. According to this concept, investors do not
pay any importance to the dividend history of a company and
thus, dividends are irrelevant in calculating the valuation of a
company. This theory is in direct contrast to the ‘Dividend
Relevance’ theory which deems dividends to be important in the
valuation of a company.
MODIGLIANI – MILLER THEORY

32. Modigliani – Miller theory was proposed by Franco Modigliani and Merton Miller in 1961. They were
the pioneers in suggesting that dividends and capital gains are equivalent when an investor considers
returns on investment. The only thing that impacts the valuation of a company is its earnings, which is
a direct result of the company’s investment policy and the future prospects. So, according to this
theory, once the investment policy is known to the investor, he will not need any additional input on
the dividend history of the company. The investment decision is, thus, dependent on the investment
policy of the company and not on the dividend policy.
Modigliani – Miller theory goes a step further and illustrates the practical situations where dividends
are not relevant to investors. Irrespective of whether a company pays a dividend or not, the investors
are capable enough to make their own cash flows from the stocks depending on their need for the
cash. If the investor needs more money than the dividend he received, he can always sell a part of his
investments to make up for the difference. Likewise, if an investor has no present cash requirement,
he can always reinvest the received dividend in the stock. Thus, the Modigliani – Miller theory firmly
states that the dividend policy of a company has no influence on the investment decisions of the
investors.
This theory also believes that dividends are irrelevant by the arbitrage argument. By this logic, the
dividends distribution to shareholders is offset by the external financing. Due to the distribution of
dividends, the price of the stock decreases and will nullify the gain made by the investors because of
the dividends. This theory also implies that the cost of debt is equal to the cost of equity as the cost
of capital is not affected by the leverage.
CRUX OF MODIGLIANI-MILLER
MODEL

33. This theory
believes in the
existence of
‘perfect capital
markets’. It
assumes that all
the investors are
rational, they
have access to
free
information,
there are no
floatation or
transaction
costs and no
large investor to
influence the
market price of
the share.
◾Perfect
Capital
Markets:
There is no
existence of
taxes.
Alternatively,
both dividends
and capital gains
are taxed at the
same rate.
◾ No Taxes:
The company
does not change
its existing
investment
policy. This
means that new
investments that
are financed
through
retained
earnings do not
change the risk
and the rate of
required return
of the firm.
◾Fixed
Investment
Policy:
All the investors
are certain
about the future
market prices
and the
dividends. This
means that the
same discount
rate is applicable
for all types of
stocks in all
time periods
◾No Risk of
Uncertainty:
ASSUMPTIONS OF THE MODEL

34. Modigliani – Miller’s valuation model is based on the assumption of same discount rate /
rate of return applicable to all the stocks.
P1 = P0 * (1 + k) – D
Where,
P1 = market price of the share at the end of a period
P0 = market price of the share at the beginning of a period
k = cost of capital
D = dividends received at the end of a period
VALUATION FORMULA AND ITS
DENOTATIONS

35. ◾Perfect capital markets do not
exist. Taxes are present in the
capital markets.
◾According to this theory, there is
no difference between internal and
external financing. However, if the
flotation costs of new issues are
considered, it is false.
◾This theory believes that the
shareholder’s wealth is not affected
by the dividends. However, there
are transaction costs associated
with the selling of shares to make
cash inflows. This makes the
investors prefer dividends.
◾The assumption of no
uncertainty is unrealistic. The
dividends are relevant under the
certain conditions as well.
CRITICISM OF MODIGLIANI
MILLER’S MODEL

36. Modigliani – Miller theory of dividend policy is an interesting and a different
approach to the valuation of shares. It is a popular model which believes in
the irrelevance of the dividends. However, the policy suffers from various
important limitations and thus, is critiqued regarding its assumptions.
SUMMARY