2. DIVIDEND
 Dividend refers to that portion of profit which is
distributed among the owners or shareholders of the
firm. The finance manager has to take few decisions which
are inter – related like investment, financing and dividend
decisions. Dividend decision is related to the shareholder’s
share in the profits of the company

3.  When deciding how much cash to distribute to
stockholders, financial managers must keep in mind that
the firm’s objective is to maximize shareholder value.
 Thus, the target payout ratio should be based on
investor preferences for cash dividends or capital gains.
 If the firm increases the payout ratio, D1 will increase,
resulting in a higher stock price other things being
equal.

4.  However, if the firm increases D1, there will be less
money available for reinvestment causing g to decline
(remember g equals the retention ratio times ROE). If g
falls, this will lower the stock price.
 Therefore, when setting the optimal dividend policy the
financial manager should strike a balance between
current dividends and future growth so as to maximize
the firm’s stock price.

5. WHAT IS “DIVIDEND POLICY”?
 It’s the decision to pay out earnings versus retaining
and reinvesting them. Includes these elements:
1. High or low payout?
2. Stable or irregular dividends?
3. How frequent?
4. Do we announce the policy?

6. DO INVESTORS PREFER HIGH OR LOW
PAYOUTS? THERE ARE THREE THEORIES:
 Dividends are irrelevant: Investors don’t care about
payout.
 Bird in the hand: Investors prefer a high payout.
 Tax preference: Investors prefer a low payout, hence
growth.

7. Theories of Dividend Policy
Irrelevance
Theories
Residual
Theory
Modigliani
and Miller
Approach
Relevanc e
Theories
W
alter’
s
Model
Gordon’
s
Model

8. Theories of Dividend policy
1.Irrelevance Theory : According to irrelevance theory
dividend policy do not affect value of firm, thus it is called
irrelevance theory.
Residual Theory
Modigliani & Miller Approach ( MM Approach)
2.Relevance Theory : According to relevance theory dividend
policy affects value of firm, thus it is called relevance theory.
Walter’
s
Model
Gordon’s
Model

9. DIVIDEND IRRELEVANCE THEORY
 Modigliani-Miller support irrelevance.
 Investors are indifferent between dividends and retention-
generated capital gains.
 If the firm’s cash dividend is too big, you can just take the
excess cash received and use it to buy more of the firm’s
stock. If the cash dividend is too small, you can just sell a
little bit of your stock in the firm to get the cash flow you
want.
 Theory is based on unrealistic assumptions (no taxes or
brokerage costs), hence may not be true. Need empirical
test.

10. BIRD-IN-THE-HAND THEORY
 Investors think dividends are less risky than
potential future capital gains, hence they like
dividends.
 If so, investors would value high payout firms
more highly, i.e., a high payout would result in a
high P0.

11. TAX PREFERENCE THEORY
 Retained earnings lead to long-term capital gains,
which are taxed at lower rates than dividends:
20% vs. up to 39.6%. Capital gains taxes are also
deferred.
 This could cause investors to prefer firms with low
payouts, i.e., a high payout results in a low P0.

12. RESIDUAL THEORY
 According to this theory, dividend policy has no
effect on the wealth of the shareholders or prices
of the shares and hence it is irrelevant so far as
the valuation of the firm is concerned. This
theory regards dividend policy merely as a part of
financial decision because the earnings available
may be retained in the business for reinvestment.
But if the funds are not required in the business
they may be distributed as dividend. Thus, the
decision to pay dividends or retain the earnings
may be taken as residual decision.

13. MODIGLIANI AND MILLER APPROACH
Modigliani-Miller have argued that firm’s dividend policy is
irrelevant to the value of the firm.
According to this approach, the market price of a share is
dependent on the earnings of the firm on its investment
and not on the dividend paid by it. Earnings of the firm
which affect its value, further depends upon the investment
opportunities available to it.