Dividend Decisions | Financial Management & Economics Finance: CA Intermediate (Old Scheme) PDF Download

 Page 1


 
LEARNING OUTCOMES 
 
 
  
 DIVIDEND DECISIONS  
 
 
? Understand the Meaning of Dividend Decision 
? Understand the importance of Dividend Decision 
? Discuss various Forms of Dividend 
? Discuss various Determinants of Dividend 
? Explain various theories of Dividend Decisions. 
 
 
Financial 
Decision
Financing 
Decision
Investment 
Decision
Dividend Decision
Theories
1.  M. M. Hypothesis
2. Walter Model
3. Gordon Model
4. Traditional theory
5. Linter Model
 
CHAPTER 
9 
Page 2


 
LEARNING OUTCOMES 
 
 
  
 DIVIDEND DECISIONS  
 
 
? Understand the Meaning of Dividend Decision 
? Understand the importance of Dividend Decision 
? Discuss various Forms of Dividend 
? Discuss various Determinants of Dividend 
? Explain various theories of Dividend Decisions. 
 
 
Financial 
Decision
Financing 
Decision
Investment 
Decision
Dividend Decision
Theories
1.  M. M. Hypothesis
2. Walter Model
3. Gordon Model
4. Traditional theory
5. Linter Model
 
CHAPTER 
9 
 
 
9.2 FINANCIAL MANAGEMENT  
 9.1 INTRODUCTION  
Financial management is the process of making financial decisions. Financial 
decision broadly covers three areas: 
i. Financing decision 
ii. Investment decision 
iii. Dividend decision 
Dividend decision is one of the most important areas of management decisions. 
It is easy to understand but difficult to implement. Let’s understand this with the 
help of an example, suppose a company, say X limited, which is continuously paying 
the dividend at a normal growth rate, earns huge profits this year. Now the 
management has to decide whether continue to pay dividend at normal rate or to 
pay at an increasing rate? Why this dilemma? 
The reason is that, if the management decides to pay higher dividend, then it might 
be possible that next year, the company will not achieve such higher growth rate, 
resulting in lower dividend payment in comparison to previous year. However, if 
the company decides to stay on the normal rate of dividend then surplus amount 
of retained earnings would remain idle which will result in over capitalization, if no 
opportunity existing to utilize the funds.  
Also there are more factors which will affect the dividend decision (will be discussed 
later). 
There are few theories which put light on the complexities involved in dividend 
decision. These theories have been discussed under the following two categories: 
Irrelevance theory: MM approach 
Relevance theories: Walter model & Gordon Model 
 9.2 MEANING OF DIVIDEND 
Dividend is that part of profit after tax which is distributed to the shareholders of 
the company. Furthermore, the profit earned by a company after paying taxes can 
be used for: 
i. Distribution of dividend or 
ii. Can be retained as surplus for future growth 
Page 3


 
LEARNING OUTCOMES 
 
 
  
 DIVIDEND DECISIONS  
 
 
? Understand the Meaning of Dividend Decision 
? Understand the importance of Dividend Decision 
? Discuss various Forms of Dividend 
? Discuss various Determinants of Dividend 
? Explain various theories of Dividend Decisions. 
 
 
Financial 
Decision
Financing 
Decision
Investment 
Decision
Dividend Decision
Theories
1.  M. M. Hypothesis
2. Walter Model
3. Gordon Model
4. Traditional theory
5. Linter Model
 
CHAPTER 
9 
 
 
9.2 FINANCIAL MANAGEMENT  
 9.1 INTRODUCTION  
Financial management is the process of making financial decisions. Financial 
decision broadly covers three areas: 
i. Financing decision 
ii. Investment decision 
iii. Dividend decision 
Dividend decision is one of the most important areas of management decisions. 
It is easy to understand but difficult to implement. Let’s understand this with the 
help of an example, suppose a company, say X limited, which is continuously paying 
the dividend at a normal growth rate, earns huge profits this year. Now the 
management has to decide whether continue to pay dividend at normal rate or to 
pay at an increasing rate? Why this dilemma? 
The reason is that, if the management decides to pay higher dividend, then it might 
be possible that next year, the company will not achieve such higher growth rate, 
resulting in lower dividend payment in comparison to previous year. However, if 
the company decides to stay on the normal rate of dividend then surplus amount 
of retained earnings would remain idle which will result in over capitalization, if no 
opportunity existing to utilize the funds.  
Also there are more factors which will affect the dividend decision (will be discussed 
later). 
There are few theories which put light on the complexities involved in dividend 
decision. These theories have been discussed under the following two categories: 
Irrelevance theory: MM approach 
Relevance theories: Walter model & Gordon Model 
 9.2 MEANING OF DIVIDEND 
Dividend is that part of profit after tax which is distributed to the shareholders of 
the company. Furthermore, the profit earned by a company after paying taxes can 
be used for: 
i. Distribution of dividend or 
ii. Can be retained as surplus for future growth 
 9.3 
DIVIDEND DECISIONS 
 9.3 SIGNIFICANCE OF DIVIDEND POLICY 
Dividend policy of a firm is governed by:  
(i) Long Term Financing Decision:  
As we know that one of the financing option is ‘Equity’. Equity can be raised 
externally through issue of equity shares or can be generated internally through 
retained earnings. But retained earnings are preferable because they do not involve 
floatation costs. 
But 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. 
In this backdrop, the decision is based on the following: 
1. Whether the organization has opportunities in hand to invest the amount of 
profits, if retained? 
2. Whether the return on such investment (ROI) will be higher than the expectations 
of shareholders i.e. K e? 
(ii) Wealth Maximization Decision:  
Under this head, we are facing the problem of amount of dividend to be distributed 
i.e. the Dividend Payout ratio (D/P) in relation to Market price of the shares (MPS). 
1. Because of market imperfections and uncertainty, shareholders give higher value 
to near dividends than future dividends and capital gains. Payment of dividends 
influences the market price of the share. Higher dividends increase value of 
shares and low dividends decrease it. A proper balance has to be struck between 
these two approaches.  
2. When the firm increases retained earnings, shareholders' dividends decrease and 
consequently market price is affected. Use of retained earnings to finance 
profitable investments increases future earnings per share. This is because, 
Profit After 
tax
Distributed Dividend
Retained
Retained 
Earnings
Page 4


 
LEARNING OUTCOMES 
 
 
  
 DIVIDEND DECISIONS  
 
 
? Understand the Meaning of Dividend Decision 
? Understand the importance of Dividend Decision 
? Discuss various Forms of Dividend 
? Discuss various Determinants of Dividend 
? Explain various theories of Dividend Decisions. 
 
 
Financial 
Decision
Financing 
Decision
Investment 
Decision
Dividend Decision
Theories
1.  M. M. Hypothesis
2. Walter Model
3. Gordon Model
4. Traditional theory
5. Linter Model
 
CHAPTER 
9 
 
 
9.2 FINANCIAL MANAGEMENT  
 9.1 INTRODUCTION  
Financial management is the process of making financial decisions. Financial 
decision broadly covers three areas: 
i. Financing decision 
ii. Investment decision 
iii. Dividend decision 
Dividend decision is one of the most important areas of management decisions. 
It is easy to understand but difficult to implement. Let’s understand this with the 
help of an example, suppose a company, say X limited, which is continuously paying 
the dividend at a normal growth rate, earns huge profits this year. Now the 
management has to decide whether continue to pay dividend at normal rate or to 
pay at an increasing rate? Why this dilemma? 
The reason is that, if the management decides to pay higher dividend, then it might 
be possible that next year, the company will not achieve such higher growth rate, 
resulting in lower dividend payment in comparison to previous year. However, if 
the company decides to stay on the normal rate of dividend then surplus amount 
of retained earnings would remain idle which will result in over capitalization, if no 
opportunity existing to utilize the funds.  
Also there are more factors which will affect the dividend decision (will be discussed 
later). 
There are few theories which put light on the complexities involved in dividend 
decision. These theories have been discussed under the following two categories: 
Irrelevance theory: MM approach 
Relevance theories: Walter model & Gordon Model 
 9.2 MEANING OF DIVIDEND 
Dividend is that part of profit after tax which is distributed to the shareholders of 
the company. Furthermore, the profit earned by a company after paying taxes can 
be used for: 
i. Distribution of dividend or 
ii. Can be retained as surplus for future growth 
 9.3 
DIVIDEND DECISIONS 
 9.3 SIGNIFICANCE OF DIVIDEND POLICY 
Dividend policy of a firm is governed by:  
(i) Long Term Financing Decision:  
As we know that one of the financing option is ‘Equity’. Equity can be raised 
externally through issue of equity shares or can be generated internally through 
retained earnings. But retained earnings are preferable because they do not involve 
floatation costs. 
But 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. 
In this backdrop, the decision is based on the following: 
1. Whether the organization has opportunities in hand to invest the amount of 
profits, if retained? 
2. Whether the return on such investment (ROI) will be higher than the expectations 
of shareholders i.e. K e? 
(ii) Wealth Maximization Decision:  
Under this head, we are facing the problem of amount of dividend to be distributed 
i.e. the Dividend Payout ratio (D/P) in relation to Market price of the shares (MPS). 
1. Because of market imperfections and uncertainty, shareholders give higher value 
to near dividends than future dividends and capital gains. Payment of dividends 
influences the market price of the share. Higher dividends increase value of 
shares and low dividends decrease it. A proper balance has to be struck between 
these two approaches.  
2. When the firm increases retained earnings, shareholders' dividends decrease and 
consequently market price is affected. Use of retained earnings to finance 
profitable investments increases future earnings per share. This is because, 
Profit After 
tax
Distributed Dividend
Retained
Retained 
Earnings
 
 
9.4 FINANCIAL MANAGEMENT  
shareholders expect that profitable investments made by the company may lead 
to higher return for them in future. 
On the other hand, increase in dividends may cause the firm to forego investment 
opportunities for lack of funds and thereby decrease the future earnings per share.  
Thus, 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. 
 9.4 FORMS OF DIVIDEND 
Generally, the dividend can take any of the following forms (depending upon some 
factors that will be discussed later): 
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 Service (ECS) but not in kind. 
2. Stock dividend (Bonus Shares): It is a distribution of shares in lieu of cash 
dividend to existing shareholders. When the company issues further shares to its 
existing shareholders without consideration it is called bonus shares. Such shares 
are distributed proportionately thereby retaining proportionate ownership of the 
company. If a shareholder owns 100 shares at a time, when 10% dividend is 
declared he will have 10 additional shares thereby increasing the equity share 
capital and reducing reserves and surplus (retained earnings). The total net worth 
is not affected by bonus issue. 
Advantages of Stock Dividend 
There are many advantages both to the shareholders and to the company. Some of 
the important ones are listed as under:  
(1) To Share Holders:  
(a)  Tax benefit –At present there is no tax on dividend received from a 
domestic company. 
(b) Policy of paying fixed dividend per share and its continuation even after 
declaration of stock dividend will increase total cash dividend of the 
shareholders in future. 
Page 5


 
LEARNING OUTCOMES 
 
 
  
 DIVIDEND DECISIONS  
 
 
? Understand the Meaning of Dividend Decision 
? Understand the importance of Dividend Decision 
? Discuss various Forms of Dividend 
? Discuss various Determinants of Dividend 
? Explain various theories of Dividend Decisions. 
 
 
Financial 
Decision
Financing 
Decision
Investment 
Decision
Dividend Decision
Theories
1.  M. M. Hypothesis
2. Walter Model
3. Gordon Model
4. Traditional theory
5. Linter Model
 
CHAPTER 
9 
 
 
9.2 FINANCIAL MANAGEMENT  
 9.1 INTRODUCTION  
Financial management is the process of making financial decisions. Financial 
decision broadly covers three areas: 
i. Financing decision 
ii. Investment decision 
iii. Dividend decision 
Dividend decision is one of the most important areas of management decisions. 
It is easy to understand but difficult to implement. Let’s understand this with the 
help of an example, suppose a company, say X limited, which is continuously paying 
the dividend at a normal growth rate, earns huge profits this year. Now the 
management has to decide whether continue to pay dividend at normal rate or to 
pay at an increasing rate? Why this dilemma? 
The reason is that, if the management decides to pay higher dividend, then it might 
be possible that next year, the company will not achieve such higher growth rate, 
resulting in lower dividend payment in comparison to previous year. However, if 
the company decides to stay on the normal rate of dividend then surplus amount 
of retained earnings would remain idle which will result in over capitalization, if no 
opportunity existing to utilize the funds.  
Also there are more factors which will affect the dividend decision (will be discussed 
later). 
There are few theories which put light on the complexities involved in dividend 
decision. These theories have been discussed under the following two categories: 
Irrelevance theory: MM approach 
Relevance theories: Walter model & Gordon Model 
 9.2 MEANING OF DIVIDEND 
Dividend is that part of profit after tax which is distributed to the shareholders of 
the company. Furthermore, the profit earned by a company after paying taxes can 
be used for: 
i. Distribution of dividend or 
ii. Can be retained as surplus for future growth 
 9.3 
DIVIDEND DECISIONS 
 9.3 SIGNIFICANCE OF DIVIDEND POLICY 
Dividend policy of a firm is governed by:  
(i) Long Term Financing Decision:  
As we know that one of the financing option is ‘Equity’. Equity can be raised 
externally through issue of equity shares or can be generated internally through 
retained earnings. But retained earnings are preferable because they do not involve 
floatation costs. 
But 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. 
In this backdrop, the decision is based on the following: 
1. Whether the organization has opportunities in hand to invest the amount of 
profits, if retained? 
2. Whether the return on such investment (ROI) will be higher than the expectations 
of shareholders i.e. K e? 
(ii) Wealth Maximization Decision:  
Under this head, we are facing the problem of amount of dividend to be distributed 
i.e. the Dividend Payout ratio (D/P) in relation to Market price of the shares (MPS). 
1. Because of market imperfections and uncertainty, shareholders give higher value 
to near dividends than future dividends and capital gains. Payment of dividends 
influences the market price of the share. Higher dividends increase value of 
shares and low dividends decrease it. A proper balance has to be struck between 
these two approaches.  
2. When the firm increases retained earnings, shareholders' dividends decrease and 
consequently market price is affected. Use of retained earnings to finance 
profitable investments increases future earnings per share. This is because, 
Profit After 
tax
Distributed Dividend
Retained
Retained 
Earnings
 
 
9.4 FINANCIAL MANAGEMENT  
shareholders expect that profitable investments made by the company may lead 
to higher return for them in future. 
On the other hand, increase in dividends may cause the firm to forego investment 
opportunities for lack of funds and thereby decrease the future earnings per share.  
Thus, 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. 
 9.4 FORMS OF DIVIDEND 
Generally, the dividend can take any of the following forms (depending upon some 
factors that will be discussed later): 
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 Service (ECS) but not in kind. 
2. Stock dividend (Bonus Shares): It is a distribution of shares in lieu of cash 
dividend to existing shareholders. When the company issues further shares to its 
existing shareholders without consideration it is called bonus shares. Such shares 
are distributed proportionately thereby retaining proportionate ownership of the 
company. If a shareholder owns 100 shares at a time, when 10% dividend is 
declared he will have 10 additional shares thereby increasing the equity share 
capital and reducing reserves and surplus (retained earnings). The total net worth 
is not affected by bonus issue. 
Advantages of Stock Dividend 
There are many advantages both to the shareholders and to the company. Some of 
the important ones are listed as under:  
(1) To Share Holders:  
(a)  Tax benefit –At present there is no tax on dividend received from a 
domestic company. 
(b) Policy of paying fixed dividend per share and its continuation even after 
declaration of stock dividend will increase total cash dividend of the 
shareholders in future. 
 9.5 
DIVIDEND DECISIONS 
(2) To Company:  
(a)  Conservation of cash for meeting profitable investment opportunities. 
(b) Suitable in case of cash deficiency and restrictions imposed by lenders to 
pay cash dividend. 
Limitations of Stock Dividend 
Limitations of stock dividend to shareholders and to company are as follows: 
1.  To Shareholders: Stock dividend does not affect the wealth of shareholders and 
therefore it has no value for them. This is because the declaration of stock 
dividend is a method of capitalising the past earnings of the shareholders and is 
a formal way of recognising earnings which the shareholders already own. It 
merely divides the company's ownership into a large number of share 
certificates. James Porterfield regards stock dividends as a division of corporate 
pie into a larger number of pieces. Stock dividend does not give any extra or 
special benefit to the shareholder. His proportionate ownership in the company 
does not change at all. Stock dividend creates a favourable psychological impact 
on the shareholders and is greeted by them on the ground that it gives an 
indication of the company's growth.  
2.  To Company: Stock dividends are more costly to administer than cash dividends. 
It is disadvantageous if periodic small stock dividends are declared by the 
company as earnings. Also, companies have to pay tax on their distribution. 
9.5 RELATIONSHIP BETWEEN RETAINED EARNINGS 
AND GROWTH 
It can be illustrated with the help of the following equation: 
Growth (g) = br 
Where, 
g = growth rate of the firm 
b = retention ratio 
r = rate of return on investment 
Let’s explain this situation with the help of an example: