DIVIDEND POLICIES 1 MM THEORY OF IRRELEVANCE

• DIVIDEND POLICIES
  FOR NET MANAGEMENT/COMMERCE
  FINANCIAL MANAGEMENT
• DIVIDEND POLICY 

1. DIVIDEND POLICY OF A FIRM DETERMINE WHAT PROPORTION OF EARNING IS PAID TO THE SHAREHOLDER BY WAY OF DIVIDEND AND WHAT PROPORTION IS PLOUGHED BACK IN THE FIRM FOR REINVESTMENT PURPOSE.
2. DIVIDEND POLICY HAS A BEARING ON THE CHOICE OF FINANCING. IF A FIRM’S CAPITAL BUDGETING DECISION IS INDEPENDENT ON ITS DIVIDEND POLICY,A HIGHER DIVIDEND PAYMENT WILL ENTAIL A GREATER DEPENDENCE ON EXTERNAL FINANCING AND IF THEY ARE DEPENDENT ON DIVIDEND POLICY THEN HIGHER DIVIDEND WILL CAUSE SHRINKAGE OF THE ITS CAPITAL BUDGET AND VICE VERSA.

• ISSUES IN DIVIDEND POLICY
• THE OBJECTIVE OF THE DIVIDEND POLICY SHOULD BE TO MAXIMIZE A SHAREHOLDER’S RETURN THAT THE VALUE OF HIS INVESTMENT IS MAXIMIZED.
• SHAREHOLDER’S RETURN CONSISTS OF TWO COMPONENTS:

1. DIVIDEND
2. CAPITAL GAINS

·         DIVIDEND POLICY HAS A DIRECT INFLUENCE ON THESE TWO COMPONENTS OF THE RETURN

·         PAYOUT RATIO= % OF EARNING/DIVIDEND PER SHARE AS A PERCENTAGE OF EARNING PER SHARE

·         RETENTION RATIO=100%-PAYOUT RATIO

·         GROWTH RATE=ROEXRETENTION RATIO

• ISSUES IN DIVIDEND POLICY

1. LOW PAYPUT THE GROWTH IS MORE AND IT MIGHT PRODUCE A HIGHER PRICE BECAUSE IT ACCELERATES THE EARNING GROWTH AND VICE VERSA.INVESTORS OF GRWOTH COMPANIEW WILL REALIZE THEIR RETURN MOSTLY IN CAPIAL GAINS AND DIVIDEND YIELD WILL BE LOW(DIVIDEND PER SHARE/MPS) WILL BE LOW. THE IMPACT OF DIVIDEDN POLICY ON CAPITAL GAINS IS VERY COMPLEX.
2. A HIGHER PAYOUT POLICY MEANS MORE CURRENT DIVIDENDS AND LESS RETAINED EARNINGS WHICH MAY CONSEQUENTLY RESULT IN SLOWER GROWTH AND LOWER MARKET PRICE SHARE

• THOERIES

1. THEORIES THAT CONSIDERS DIVIDEND DECISIONS TO BE IRRELEVANT
2. THEORIES THAT CONSIDER DIVIDEND DECISIONS TO BE RELEVANT

• THERE ARE TWO EXTREME VIEWS:

1. DIVIDEND ARE GOOD AS THEY INCREASE THE SHAREHOLDER’S VALUE
2. DIVIDEND ARE BAD SINCE THEY REDUCE THE SHAREHOLDER’S VALUE

• RESIDUAL APPROACH

1. DIVIDEND DECISIONS HAS NO EFFECT ON THE WEALTH OF THE SHAREHOLDERS OR THE PRICES OF THE SHARES AND IRRELEVANT FOR THE VALUATION OF THE FIRM
2. REGARDS DIVIDEND DECISIONS MERELY AS  A PART OF THE FINANCING DECISIONS BECAUSE  THE EARNING AVAILABLE MAY BE RETAINED FOR THE PURPOSE OF REINVESTMENT AND IF THE FUNDS ARE NOT REQUIRED IN THE BUSINESS THEY MAY BE DISTRIBUTED AS DIVIDEND.
3. DECISIONS TO PAY THE DIVIDEND OR RETAIN THE EARNING MAY BE TAKEN AS RESIDUAL DECISIONS
4. THEORY ASSUMES THAT INVESTORS DO NOT DIFFERENTIATE BETWEEN DIVIDEND AND RETENTION BY THE FIRM
5. A FIRM SHOULD RETAIN THE EARNING IF IT HAS PROFITABLE INVESTMENT OPPORTUNITIES OTHERWISE IT SHOULD PAY THEM AS DIVIDEND

• MODIGLIANI AND MILLER APPROACH

1. MERTON MILLER AND FRANCO MODIGLIANI (MM)
2. VALUE OF THE FIRM IS DEPENDENT UPON EARNING CAPACITY OR INVESTMENT POLICY AND IS NOT INFLUENCED BY THE MANNER IN WHICH THE EARNINGS ARE SPLIT BETWEEN DIVIDEND AND RETAINED EARNINGS.
3. NO EFFECT OF DIVIDEND POLICY ON THE MARKET PRICE OF SHARES

• ASSUMPTIONS OF MM HYPOTHESIS

1. PERFECT CAPITAL MARKET
2. RATIONAL INVESTOR
3. AVAILABILITY OF INFORMATION AT ZERO COST
4. NO FLOTATION COST
5. NO TAXES OR IF TAX RATE EXIST THEN NO DIFFERENCE IN TAX RATE APPLICABLE TO DIVIDEND AND CAPITAL GAIN
6. RIGID INVESTMENT POLICY AND IT MEANS THAT THERE IS NO CHANGE IN THE BUSINESS RISK POSITION AND RATE OF RETURN ON THE INVESTMENT IN NEW PROJECTS
7. NO UNCERTAINTY ABOUT THE FUTURE PROFITS. ALL THE INVESTORS ARE CERTAIN ABOUT THE FUTURE INVESTMENTS,DIVIDENDS AND THE PROFITS OF THE FIRM AS THERE IS NO RISK INVOLVED

• LOGIC BEHIND DIVIDEND IRRELEVANCE

• A FIRM OPERATING IN PERFECT CAPITAL MARKET CONDITIONS MAY FACE ONE OF THE FOLLOWING SITUATION:

1. THE FIRM HAVE SUFFICIENT CASH TO PAY DIVIDEND . IN THIS SITUATION WHEN THE FIRM PAYS THE DIVIDEND AND SHAREHOLDERS GET THE CASH BUT THE FIRMS’S ASSETS DECLINE. SO THERE IS TRANSFER OF WEALTH FROM ONE POCKET TO ANOTHER. NO NET GAIN OR LOSS
2. WHEN THE FIRM DOES NOT HAVE SUFFICIENT CASH TO PAY DIVIDEND AND IT ISSUES NEW SHARES TO FINANCE THE PAYMENT OF DIVIDEND.THE EXISTING SHAREHOLDERS GET CASH IN HAND PLUS AN EQUAL AMOUNT OF CAPITAL LOSS AND NEW SHAREHOLDERS PART WITH THEIR CASH IN EXCHANGE FOR NEW SHARES AT FAIR PRICE. THE FAIR PRICE PER SHARE IS THE SHARE PRICE BEFORE THE PAYMENT OF DIVIDEND LESS DIVIDEND PER SHARE. THE EXISTING SHAREHOLDERS TRANSFER A PART OF THEIR CLAIM TO NEW SHAREHOLDERS SO NO NET GAIN OR LOSS
3. IN THE THIRD SITUATION.IF THE FIRM DOES NOT PAY ANY DIVIDEND A SHAREHOLDER CAN CREATE A HOME MADE DIVIDEND BY SELLING A PART OF HIS OR HER SHARES IN THE MARKET AND SHAREHOLDERS WILL HAVE THE LESS NUMBER OF SHARES. AND EXCHANGED A PART OF THE CLAIM ON THE FIRM TO NEW SHAREHOLDER FOR CASH. THE VALUE OF THE FIRM REMAINS THE SAME.

• IMPORTANT POINTS

1. UNDER MM HYPOTHESIS THE VALUE OF r=k ( DISOUNT RATE) AND IDENTICAL FOR ALL SHARES
2. PRICE OF EACH SHARE MUST ADJUST SO THAT THE RATE OF RETURN WHICH IS COMPOSED OF RATE OF DIVIDENDS AND CAPITAL GAINS ON EVVERY SHARE WILL BE EQUAL TO THE DISCOUNT RATE AND BE IDENTICAL FOR ALL THE SHARES
3. RATE OF RETURN=(DIVIDEND + CAPITAL GAINS( LOSS))/SHARE PRICE
4. R= (div+(P₁ - P₀ ))/ P₀
5. P₀  =PURCHASE PRICE AT BEGINNING
6. P₁  = MARKET PRICE PER SHARE AT THE TIME 1

7. AS HYPOTHESIZED BY MM.r SHOULD BE EQUAL FOR ALL THE SHARES
8. IF IT IS NOT SO THE LOW RETURN YIELDING SHARES WILL BE SOLD BY THE INVESTOR AND PURCHASE HIGH YIELDING  SHARES
9. IT WILL REDUCE THE PRICE OF THE LOW RETURN SHARES AND INCREASE THE PRICE OF THE HIGH RETURN SHARES. THIS SWITCHING ARBITRAGE WILL CONTINUE UNTIL THE DIFFERENTIALS ARE ELIMINATED

• LOGIC BEHIND MM HYPOTHESIS

1. INCREASE IN VALUE OF THE FIRM RESULTING FROM PAYMENT OF DIVIDEND WILL BE EXACTLY OFF SET BY THE DECLINE IN THE MARKET PRICE OF SHARES BECAUSE OF EXTERNAL FINANCING AND THERE WILL BE NO CHANGE IN THE TOTAL WEALTH OF SHAREHOLDERS.
2. MARKET PRICE OF A SHARE IN THE BEGINNING OF A PERIOD IS EQUAL TO THE PRESENT VALUE OF DIVIDENDS PAID AT THE END OF THE PERIOD PLUS THE MARKET PRICE OF SHARES AT THE END OF PERIOD. IT CAN BE EXPRESSED IN FOLLOWING FORM;
3. P₀₌ ( D₁+P₁)/ (1+K_E)

• MM APPROACH

1. REST ON THEIR LEVERAGE IRRELEVANCE THEOREM. REAL COST OF THE DEBT AND EQUITY AS PER MM LEVERAGE IRRELEVANCE THEOREM IS THE SAME. MM APPROACH IS NOT VITIATED IF THE FIRM RAISES EXTERNAL FINANCE BY ISSUING DEBT OR COMBINATION OF EQUITY AND DEBT
2. MM DIVIDEND IRRELEVANCE THEOREM DOES NOT IMPLY THAT VALUE OF AN EQUITY SHARES IS NOT EQUAL TO THE PRESENT VALUE OF FUTURE STREAMS OF DIVIDEND EXPECTED FROM ITS OWNERSHIP.IT MERELY SAYS THAT EVEN THOUGH THE DIVIDEND POLICY OF THE FIRM MAY INFLUENCE THE TIMING AN MAGNITUDE OF THE  DIVIDEND PAYMENTS IT CAN NOT CHANGE THE PRESENT VALUE OF TOTAL STREAMS OF DIVIDENDS

• VALUATION MODEL
• P₀₌ ( D₁+P₁)/ (1+k_e)
• P₁= P₀ (1+k_e) –D₁
• _{FORMULA FOR THE COMPUTATION OF NUMBER OF SHARE TO BE ISSUED:-}
• m= (I – (E-nD₁))/ P₁
• FORMULA FOR COMPUTATION OF VALUE OF FIRM
• nP₀= ((n+m) P1-(I-E))/ 1+k_e
•  
•  

• EXPLANATION OF THE SYMBOLS
• WHERE,
• m =NUMBER OF SHARE TO BE ISSUED
• I =INVESTMENT REQUIRED
• E = TOTAL EARNING DURING THAT PERIOD
• P₁ = MARKET PRICE PER SHARE AT THE END OF THE PERIOD
• K_E = COST OF EQUITY CAPITAL
• N = NUMBER OF SHARES OUTSTANDING AT THE BEGINNING OF THE PERIOD
• D₁= DIVIDEND TO BE PAID AT THE END OF THE PERIOD
• NP₀= VALUE OF THE FIRM

• EXAMPLE
• XYZ LTD HAS PRESENTLY 5000 EQUITY SHARES OUTSTANDING SELLING AT RS.100 EACH. THE COMPANY IS PLANNING TO DECLARE DIVIDEND RS 6 PER SHARE AT THE END OF THE CURRENT FINANCIAL YEAR. THE COMPANY EXPECTS TO HAVE A NET INCOME RS 50,000 AND HAS A PROPOSAL FOR MAKING NEW INVESTMENTS OF RS 1,00,000 . CAPITALIZATION RATE IS 10%. SHOW THAT UNDER THE MM HYPOTHESIS THE PAYMENT OF DIVIDEND DOES NOT EFFECT THE VALUE OF THE FIRM.
• IN THIS PROBLEM

1. (N) = 5000
2. P₀  = RS 100
3. K_E  = 10%
4. I = 1,00,000
5. E =50,000
6. D₁  = RS 6

• SOLUTION
• VALUE OF THE FIRM WHEN DIVIDEND ARE PAID
• PRICE OF SHARE AT THE END OF THE CURRENT FINANCIAL YEAR

·         P₁= P₀ (1+K_E) –D₁ , = 100( 1+.10) -6= 104

• NUMBER OF SHARES ISSUED

·         M= (I – (E-ND₁))/ P_1, = 1,OOOOO- ( 50,000-5000*6)/104 = 80,000/104

·         VALUE OF THE FIRM

_·          NP₀= ((N+M) P1-(I-E))/ 1+K_E

·         ( ( 5000+ 80,000/104) X 104- ( 1,OO,OOO-50,000))/1.10

·         (6,00,000-50,000)/1.10= 5,00,000

• VALUE OF THE FIRM WHEN DIVIDEND ARE NOT PAID
• PRICE OF SHARE AT THE END OF THE CURRENT FINANCIAL YEAR

·         P₁= P₀ (1+K_E) –D₁ , = 100( 1+.10) -0= 110

• NUMBER OF SHARES ISSUED

·         M= (I – (E-ND₁))/ P_1, =( 1,OOOOO- ( 50,000-0))/110 = 50,000/110

·         VALUE OF THE FIRM

_·          NP₀= ((N+M) P1-(I-E))/ 1+K_E

·         ( ( 5000+ 50,000/110) X 110- ( 1,OO,OOO-50,000))/1.10

·         (6,00,000-50,000)/1.10= 5,00,000

·         VALUE OF THE FIRM IS SAME IN BOTH THE SITUATION

• CRITICISM
• MM ‘S HYPOTHESIS LACKS PRACTICAL RELEVANCE AND INTERNAL FINANCING AND EXTERNAL FINANCING ARE NOT EQUIVALENT, DIVIDEND POLICY OF THE FIRM MAY AFFECT THE PERCEPTION OF THE SHAREHOLDERS AND MAY NOT REMAIN INDIFFERENT BETWEEN DIVIDEND AND CAPITAL GAINS

1. PERFECT CAPITAL MARKET DOES NOT EXIST IN REALITY
2. THE FIRMS HAVE TO INCUR FLOTATION COSTS WHILE ISSUING SECURITIES
3. TAXES DO EXIST AND THERE IS DIFFERENT TREATMENT FOR DIVIDEND AND CAPITAL GAIN
4. THE FIRMS DO NOT FOLLOW A RIGID INVESTMENT POLICY
5. THE INVESTORS HAVE TO PAY BROKERAGE,FEES ETC
6. SHAREHOLDER MAY PREFER CURRENT INCOME AS COMPARED TO FURTHER GAIN

• IMPORTANT MCQ
• MODI GILANI AND MILLER ARGUE THAT WHEN THE FIRM HAS NO ACCEPTABLE INVESTMENT OPPORTUNITIES. IT SHOULD

1. CLOSE ITS DOORS
2. DISTRIBUTE THE UNNEEDED FUNDS TO THE OWNERS
3. LOWER ITS COST OF CAPITAL
4. RETAIN THE FUNDS UNTIL AN ACCEPTABLE PROJECT ARISES

• THE ANSWER IS B

• ACCORDING TO THE RESIDUAL THEORY OF DIVIDEND IF THE FIRM EQUITY NEED IS LESS THAN AMOUNT OF RETAINED EARNING THE FIRM WOULD

1.  BORROW TO PAY THE CASH DIVIDEND
2. DECLARE DIVIDEND EQUAL TO THE  REMAINING BALANCE
3. PAY NO CASH DIVIDEND
4. NOT NEED TO CONSIDER THE DIVIDEND POLICY

o    THE ANSWER IS II

• THE RESIDUAL THEORY OF DIVIDEND SUGGESTS THAT DIVIDENDS ARE TO THE VALUE OF THE FIRM

1. RESIDUAL
2. RELEVENT
3. IRRELEVENT
4. INTEGRAL

• THE RIGHT ANSWERS IS IRRLEVENT

• PROPONENTS OF THE DIVIDEND IRRELEVANCE THEORY ARGUE THAT ALL ELSE BEING EQUAL ,AN INVESTOR’S REQUIRED RETURN AND THE VALUE OF THE FIRM ARE UNAFFECTED BY DIVIDEND POLICY FOR ALL OF THE FOLLOWING REASONS EXCEPT:-

a)    THE FIRM’S VALUES IS DETERMINED SOLELY BY THE EARNING POWER AND RISK OF THE ASSETS

b)    INVESTOR’S ARE GENERALLY RISK AVERSE AND ATTACH LESS RISK TO CURRENT AS OPPOSED TO FUTURE DIVIDEND OR CAPITAL GAINS

c)    IF DIVIDEND DO AFFECT VALUE THEY DO SO SOLELY BECAUSE OF THEIR INFORMATION CONTENT WHICH SIGNALS MANAGEMENT’S EARNING EXPECTATION

d)    A CLIENTELE EFFECT EXISTS WHICH CAUSES A FIRMS; SHAREHOLDERS TO RECEIVE THE DIVIDENDS THAT THEY EXPECT THE ANSWER IS b

• GORDON’S BIRD IN HAND ARGUMENT SUGGEST THAT DIVIDEND

1. ARE IRRELEVANT
2. FIRM SHOULD HAVE A 100 PERCENT PAYOUT POLICY
3. SHAREHOLDERS ARE GENERALLY RISK AVERSE AND ATTACH LESS RISK TO CURRENT DIVIDEND
4. THE MARKET VALUE OF THE FIRM IS UNAFFECTED BY DIVIDEND POLICY

• THE ANSWER IS III
• WHICH OF THE FOLLOWING EXAMPLES BEST REPRESENTS A PASSIVE DIVIDEND POLICY:
• THE FIRMS SETS A POLICY SUCH THAT THE PROPORTION OF DIVIDEND PAID FROM NET INCOME REMAINS CONSTANT

1. THE FIRM PAYS DIVIDEND WITH WHAT REMAINS OF NET INCOME AFTER TAKING ACCEPTABLE INVESTMENT PROJECTS
2. THE FIRM SETS A POLICY SUCH THAT CONSTANT DIVIDEND PER SHARE IN AMOUNT
3. ALL OF THE EXAMPLE OF VARIOUS TYPES OF PASSIVE DIVIDEND POLICY

• MODIGLIANI AND MILLER ARGUE THAT DIVIDEND DECISIONS :

1. IS RELEVANT AS THE VALUE OF THE FIRM IS BASED ON THE EARNING POWERS OF THE ASSETS
2. IS RELEVANT AS THE VALUE OF THE FIRM IS NOT BASED JUST ON THE EARNING POWER OF THE ASSETS
3. IS IRRELEVANT AS DIVIDEND REPRESENT CASH LEAVING THE FIRM TO SHAREHOLDERS WHO OWNS THE FIRM ANY WAY
4. IT RELEVANT AS CASH OUTFLOW ALWAYS INFLUENCE OTHER DECISIONS

• MM MODEL OF DIVIDEND IRRELEVANCE USES ARBITRAGE BETWEEN :

1. DIVIDEND AND BONUS
2. DIVIDEND AND CAPITAL ISSUES
3. PROFIT AND INVESTMENT
4. NONE OF THE ABOVE