The study of dividend policy a review of relevance theories

THE STUDY OF DIVIDEND POLICY: A REVIEW OF RELEVANCE THEORIES Dr. Parag Saraf Mrs. Ranpreet Kaur Asst. prof –BVDU, IMED,pune Mb No-9168894699 Email Id-ranpreet.bvu@gmail.com Alternative E-mail id-ranpreet.kaur18@gmail.com TOPIC- THE STUDY OF DIVIDEND POLICY: A REVIEW OF RELEVANCE THEORIES

Publication Details- Cyber times International Journal of Technology & Management, Volume7 issue 1(Part-IV),March 2014,Pg No-994-1001, ISSN2278-7518 impact factor -2.815

Abstract Dividend is considered a crucial and important decision from past decades as decision of dividend is associated with wealth maximization and capital structure of the organizations. Which should be given preference wealth maximization or optimum capital structure? Wealth maximization is said to be financial management practice which focus on increasing the net worth of a company or firm so that return for shareholders can be maximize. Optimum capital structure is said to be state at which cost of capital will be minimum.

No general consensus has yet come out after several decades of examination and study. There is lot of theories which has been contributed to decide dividend policies. Some theories says that there is association between dividend decision and value of firm(relevance theory) and some says there is no such association(irrelevance theory).There are contradictory outlook when the impact of dividend decision on the value of the firm is think about. The main objectives of this research paper are firstly, to define the concept and scope of dividend policy and secondly, to study the relevance theories of dividend policy and Impact of relevance theory dividend policy approach on share prices. For research secondary data has been taken. The CNX Dividend Opportunities Index is taken as population/ Universe and for sample 5 % companies listed in index is considered. The study is sourced by critical and creative analysis (literature review) of research papers and Case Study Method. There are fluctuations in share prices after declaration of dividend

but not positive always and there are other factors which affect share prices.

It will help the organizations to understand the behavioral aspect of shareholders which they can use to add value by having dividend policy approach which leads to wealth maximization as well as profit maximization for them KEYWORDS- capital structure, Dividend policies, relevance theories, wealth maximization INTRODUCTION Dividend is paid to the shareholders in form of return or yield for their Investment in the Companies equity. At the time of dividend it is a crucial question for the Finance manager as how much to pay and how much to retain [4, 13]. As dividend affects the financial position of company as well as reflects how financially sound company is. Two major objectives of financial management are wealth maximization i.e. for shareholders and profit maximization for company survival, growth and expansion. It is vital for organization to have appropriate tradeoff between both the objectives. Dividend decision affects the wealth of shareholders as well as the company‘s capital structure so it is essential to have a dividend policy which will be in the interest of shareholders as well in the company. Managers must not only take into account the difficulty of decision regarding earnings required for investment, but also take deliberation the likely effect of their decisions on share prices (Bishop et al., 2000).[4,10] There are theories of dividends which are contradictory to one another. Some argue that increase in dividend payment increases a firm’s value (relevance theory). Another view states that high dividend payouts have the reverse effect on a firm’s value; i.e. it reduces firm value. The other approach asserts that there is no association between dividend payments and firm’s value (irrelevance theory).This paper is attempted to focus on relevance approach of dividend policy. The major objectives of the paper are1. To define the concept and scope of dividend policy 2. To study the relevance theory approach of dividend policy 3. Impact of relevance theory dividend policy approach on share prices.

LITERATURE REVIEW In early nineteenth century Williams (1938) stated that price of share is find out by the present value of future dividend and the selling price of the share. This thought was also supported by Graham and Dodd (1951) and Gordon (1959) who stressed that a share price is get affected by dividend and earnings. Pruitt and Gitman (1991) asserted that dividend and financing decisions are interconnected [10, 4, and 14]. Dividend policy is considered as a aspect that influences wealth of shareholders and corporate value of firm (Baker et al, 1985; Baker and Powell, 1999) [4, 2]. Thus, dividend policy is associated (relevant) to the value of the company. Relevance dividend theory has been empirically examined by a significant number of surveys conducted by researchers and finance scholars including Lintner (1956), Baker, Farrelly, and Edelm an (1985), Farrelly, Baker and Edelman (1986), Baker and Farrelly (1988), Farrelly and Baker (1989), Pruitt and Gitman (1991), Shelor and Officer (1994) , Baker and Powell (1999, 2000), Baker, Veit, and Powell

(2001), and Baker, Powell, Veit (2002b) and Baker et al. (2007) and most respondents in these surveys indicated that dividend policy of company affects Firm value[2,4,9,10,11]. According to Carlson (2001) dividends constitute the cash payment to shareholders. Gordon and Walter have also supported that the dividend decisions affects share values. They also emphasized that if the expectations of getting dividend amount are greater, than the value of shareholders share will also be greater. Gordon and Lintner asserted that investors value dividends more than capital gains while making decisions of investment in stocks. [4, 11, 13]

THEORETICAL BACKGROUND DIVIDEND-It is defined as- Dividend is the distribution of value to shareholders or yield or return on their investment in company’s shares.

DIVIDEND POLICY- Dividend policy is defined as management practice to decide the payout amount for the shareholders in form of dividend, or, in addition to this it is process of earning distribution in form of cash to the shareholders”.

DIVIDEND RELEVANCE THEORIES –Relevance theories advocates that dividend decisions definitely affect market prices. Relevance theories are explained as follow-[5] WALTER’S MODEL [5] Prof. James E Walter stated that the dividend payout ratio have an effect on the value of the firm.

Prof. J. E. Walter studied the importance of the relationship between cost of capital (k) and internal rate of return (r) in formulating optimum dividend policy which helps in maximizing shareholders wealth.

There are certain assumptions in the model which are as follow-1) The firm finances its investments requirement by way of earnings retained.

2) Cost of capital (K) and Internal rate of return (r) of the firm remains constant.

3) The firms’ earnings are either distributed in form of dividends or reinvested internally for the investments.

4) The dividends and earnings of the firm will be constant or never change.

5) The firm survives extremely long or infinite life.

Mathematical formula to determine the price per share in Walter’s model is as follows: P=D+[r/k](E-D] / k where P = market price per share, E = earnings per share, D = dividend per share, k = cost of capital, r = internal rate of return.

In Accordance with theory, the optimum dividend policy depends on the relationship between the firm’s internal rate of return and cost of capital. Walter’s assert on optimum dividend payout ratio can be summarized as belowA) GROWTH FIRMS (r>k):- If r>k than firm may be referred as growth firms. The growth firms are those who have ample profitable investment prospects. These firms are supposed to earn the return which is more than the return for shareholders. So for them optimum dividend policy will be 100 % retention or zero percent payout. The market price of the shares will be go on increasing when the dividend payout ratios start decreasing B) INDIFFERENT FIRMS (r=k):- If internal rate of return (r) is equal to cost of capital(k), the firm is said to be Indifferent firm. For indifferent firm dividend policy will not affect the market price of share. So there is no optimum payout ratio for Indifferent firm.

C) DECLINING FIRM (r<k):- If the company earns a return which is less than what

shareholders can earn on their investments, it is known as declining firm. So optimum dividend policy will be 100 % payout and zero percent retention The market price of the shares will be go on increasing when the dividend payout ratios start increasing So according to Walter, the optimum payout ratio is either 0% (when r>k) or 100% (when r<k).

GORDON’S MODEL [5] Another theory, which assert that dividends are relevant, is the Gordon’s model. This model also argues that Firm value (market price) is get affected by dividend policy. It is based on the following assumptions: a) The firm is equity firm means no debt in capital structure. b) Firm will only use retained earnings for all its investment and there is no other source for finance except retained earnings. c) r, i.e. internal rate of return of the firm remains unchanged(constant). d) Cost of capital (k) of the firm also remains constant even if there is change in the risk for the firm. e) The firm derives its earnings in perpetuity. f) The retention ratio (b) is also constant. So it can be said that growth rate (g) is also constant as g=br. g) ) Cost of capital will be more than growth rate K>g. h) There is no corporate tax.

Mathematical formula to calculate the price per share is as followP=E (1-b) / k-br P = Market price of share, k = cost of capital, b = retention ratio, E = earnings per share, r = internal rate of return, (1-b) = Dividend payout ratio, growth rate (g) = br It can be summarized from this model1) The optimum payout ratio is zero for a growth firm (r>k).

2) For a normal firm (r=k) no optimum ratio.

3) Optimum payout ratio is 100% for a declining firm r<k.

Gordon’s Model’s also advocates a model which is analogous to Walter Model. This can be due to the similarities of assumptions in the models.

BIRD IN HAND ARGUMENT [5] Gordon restated the basic model later on to consider the components of risk and uncertainty.

Gordon’s model, also advocated the Walter’s model, and asserted that dividend policy is relevant to the firm value. In the model Walter stated that the only in condition of indifferent firm i.e. when r=k, dividend policy will be irrelevant and will not affect the share price. But Gordon argues that t dividend policy influence the price of shares even in the case of r=k. Gordon’s argument is based on the two assumptions, which are stated below 1. Investors do not want to take risk so they are risk averse.

2. They set the premium on the certain return and discount (penalize) uncertain return.

The investors are rational and risk averse to avoid risk they prefer current dividend as compared to the future earnings and return. Investors consider retained earnings risky. So due to same when earnings are retained by the firm, share price would be affected adversely. This behavior of investor is described as “Bird in Hand Argument”. A bird in hand values two in bush as the amount available today is more important than available in the future. So the rational investors

always prefer to pay a higher share price, if current dividend paid on the share will be more. This leads to increase discount rate (K) with retention rate.

RESEARCH METHODOLOGY For the research purpose secondary data has been taken .For collection of secondary data books, journals websites and research paper are referred.NSE (National Stock exchange) website is taken a major source for collection of companies past and current information. Companies listed in CNX Dividend Opportunities Index are considered for the research purpose. The CNX Dividend Opportunities Index is taken as population/ Universe and for sample 5 % companies listed in index is considered. The CNX Dividend Opportunities Index is created to give exposure to the companies with high yield, meeting stability and tradability requirements and listed on NSE .To select the companies in Index Random sampling method is used. Last two years Corporate action(dividend declaration) is taken for the research purpose.

DATA ANALYSIS â&#x20AC;&#x201C; CASE -1 COMPANY-CHAMBAL FERTILIZERS & CHEMICALS LIMITED Chambal Fertilisers and Chemicals Limited is fertilizer Producers Company. It is one of the largest private sector fertilizer producers in India. In the year 1985, Company was promoted by Zuari Industries Limited. [1] CORPORATE ACTION- Dividend Rs 1.90 per Share, Ex- date-16-Aug-2013[7] Open Price

High Price

Low Price

30-Aug-13 29-Aug-13

31.6 32

31.1 31.5

28-Aug-13

32

27-Aug-13 26-Aug-13 23-Aug-13 22-Aug-13

33 33.25 33 32

21-Aug-13 20-Aug-13

33.5 32.3

19-Aug-13 16-Aug-13 14-Aug-13 13-Aug-13 12-Aug-13

33.35 35 36.1 37.5 37.1

8-Aug-13

36.9

33.1 32.8 32.5 5 33.4 5 33.9 33.6 32.3 34.5 5 33.9 33.4 5 38 37.1 38.1 38.2 37.7 5

Date

Last Traded Price

Close Price

Total Traded Quantity

Turnover (in Lakhs)

32.65 31.55

32.6 31.7

1414084 3047753

459.51 971.27

31.25

32.2

32.2

902753

286.29

32.25 32.9 32.25 30.9

32.45 33.7 33.05 31.95

32.4 33.65 33.25 31.9

925469 827769 1689838 1376276

303.75 276.33 559.05 434.37

32.1 32.3

32.35 33.6

32.35 33.6

1363985 937785

451.48 313.01

32 33.05 35.6 35.8 37.1

33 33.25 36.8 36.2 37.7

33.1 33.35 36.75 36.15 37.75

917506 2509272 2692638 1798560 674048

301.93 865.46 981.7 659.81 254.32

36.25

37.65

37.65

985709

367.23

7-Aug-13

35

6-Aug-13

35.65

5-Aug-13

34.35

2-Aug-13

33.45

1-Aug-13

35.5

36.9 35.8 5 35.8 5 34.8 5 36.0 5

34.75

36.75

36.75

1231794

446.63

34.25

35.25

35.25

1322442

464.22

33.8

35.7

35.7

827876

290.32

33.45

34.3

34.35

1789361

614.07

33

33.45

33.55

1536187

524.03

Chambal Fertilizers & Chemicals Limited has declared ex-date of dividend 16 August 2013.from the table it can be said that after declaration of dividend even there is not increase in share prices in future dates even temporary hike is there as high price has gone to 38 from 35 but last traded price for that day even have come down. It can be interpreted from the table that there is no hike in the market prices of shares after declaration of dividend.

CASE -2 ITC LIMITED ITC, with a market capitalization of US $ 45 billion is said to be one of India's leading private sector companies with the turnover of US $ 7 billion. Company has great reputation in private sector and rated amongst the World's Most Reputable Companies by Forbes magazine, Worldâ&#x20AC;&#x2122;s Best Big Companies, and Asiaâ&#x20AC;&#x2122;s 'Fab 50' and among India's Most Valuable Companies by Business Today. [3] CORPORATE ACTION- Dividend Rs.5.25 per Share, Ex- date-31-May-2013[7]

Open Date Price

High Price

14-Jun-13 13-Jun-13

329.4 329.15

333 330.35

12-Jun-13 11-Jun-13

332.8 334.8

333.95 337.25

10-Jun-13

334.05

338

7-Jun-13 6-Jun-13

333 334

338.5 336.75

5-Jun-13 4-Jun-13 3-Jun-13 31-May-13 30-May-13

335.5 335.85 340.65 351.5 342.4

336.95 338.7 341.9 351.5 355.9

Last Low Traded Close Price Price Price 326.2 5 331.1 331.75 323.5 327.7 327 328.0 5 331 331 333 334.75 334.35 333.8 5 337 337 331.1 5 334.3 333.85 330.1 334.7 334.9 330.3 5 334 334 335.1 337.5 337.3 333.2 337 336.05 338.6 338.7 339.9 341.9 355 354.3

Total Traded Quantity

Turnover (in Lakhs)

5404732 8235001

17845.63 26860.5

6736751 6580738

22250.88 22034.16

3183654

10704.88

4348636 4263312

14538.96 14200.75

5576750 6169519 4852028 7417539 11260356

18569.31 20778.65 16282.19 25396.75 39586.87

337.4 29-May-13 341 343.15 5 342.3 342.65 4557875 15536.37 28-May-13 332.65 341.85 332.6 340.4 340 5465004 18460.12 27-May-13 330 334.6 329.5 333.3 333.9 5338990 17727.12 24-May-13 334 334.15 328.7 329.9 329.9 7076620 23402.73 330.3 23-May-13 333.4 335.95 5 332.6 332.5 5150685 17135.99 329.1 22-May-13 329.15 337 5 336.35 335.55 6504976 21715.88 328.8 21-May-13 334 335.4 5 332 331 5137873 17058.9 20-May-13 335 342.1 334 334.5 334.65 7388736 24902.54 17-May-13 338.65 341.45 333.1 334.25 334.9 16268209 54708.59 332.6 16-May-13 341.15 343.5 5 337.2 337 7384778 24844.05 15-May-13 338.05 343.95 336 343.1 342.45 8269645 28163.93 ITC Limited has declared ex-date of dividend 31-May-13.From the table it can be said that after declaration of dividend even there is not increase in share prices in future dates. As from the above table it can be concluded that there is no hike in the market prices of shares after declaration of dividend even there is decline in share prices.

CASE -3 NTPC LIMITED NTPC was set up in 1975 to step up power growth and development in India. It is one of the largest power companies in India. It is rising as an â&#x20AC;&#x2DC;Integrated Power Majorâ&#x20AC;&#x2122;, with a significant and important presence. It has a significance existence in value chain of power generation business and is emerging as a leader [8] CORPORATE ACTION- Interim Dividend Rs.4 per Share, Ex- date-31-Jan-2014[7] Date

Open Price

High Price

Low Price

Last Traded Price

14-Feb-14 13-Feb-14 12-Feb-14 11-Feb-14 10-Feb-14 7-Feb-14 6-Feb-14 5-Feb-14 4-Feb-14 3-Feb-14 31-Jan-14 30-Jan-14 29-Jan-14 28-Jan-14

131.4 131.2 132.2 134.4 135.15 133.7 132 130.6 125.9 126 125.7 127.05 129.75 129.8

132.9 131.45 132.5 134.7 136.6 136.1 134.1 132.7 130.65 126.3 126.95 130.15 130.5 132

129.65 129.65 130.05 130.05 133.3 132.75 130.8 127.1 125.4 125.1 123.5 126.15 127.25 128.15

132.65 130.1 131 131.25 133.8 135.8 133.3 132.5 130.6 126.2 126.2 128.6 127.75 128.4

Close Price

132.25 130.1 130.75 132.15 135.2 135.95 133.6 132.4 130.2 126 126.45 128.2 127.8 128.5

Total Traded Quantity

Turnover (in Lakhs)

2251143 6901586 6154520 3603027 10642466 12080553 8205918 8496884 10508446 2904211 4369223 6001934 4019121 3764855

2971.69 8989.5 8092.31 4815.54 14403.45 16337.43 10901.61 11093.02 13529.59 3651.86 5484.25 7662.97 5177.62 4861.18

27-Jan-14 130.25 130.7 129.1 129.5 129.45 2699822 3499.29 24-Jan-14 130.8 131.9 130.65 131.65 131.5 3080062 4039.77 23-Jan-14 131.75 132.4 130.75 131.3 131.1 3964418 5218.06 22-Jan-14 130.5 133.2 130.5 132.4 132.65 4438582 5886.11 21-Jan-14 131.6 133 129.75 130.7 130.75 9067857 11849.46 20-Jan-14 132 133.5 131.5 131.55 131.85 2288260 3027.99 17-Jan-14 133.2 133.75 131.15 132 131.6 9686445 12881.99 16-Jan-14 132.55 134.2 132.55 133.05 133.15 5238158 7008.06 15-Jan-14 132.25 132.85 131.45 132.1 132.25 5583147 7378.99 NTPC Limited has declared ex-date of dividend 31-Jan-14.from the table it can be said that after declaration of dividend there is increase in share prices in future dates. After data analysis it can be concluded that there is hike in the market prices of shares after declaration of dividend which shows high dividend enhances firm value.

CASE -4 UCO BANK UCO Bank is a commercial bank founded in 1943. It is a Government of India Undertaking. In the Board of Directors of the company there are the memberâ&#x20AC;&#x2122;s representatives from the Government of India and Reserve Bank of India as well as eminent professionals like economists, accountants, management experts, businessmen, etc. [12] CORPORATE ACTION- Interim Dividend Rs.2.70 per Share, Ex- date-20-Jan-2014[7] Open High Low Last Traded Close Total Traded Turnover Date Price Price Price Price Price Quantity (in Lakhs) 31-Jan-14 65 66.7 64.05 66.35 66.05 3345389 2201.44 30-Jan-14 65.25 65.6 64.2 64.8 64.5 3821869 2471.3 29-Jan-14 70 70.9 66.7 66.9 66.95 4142727 2843.4 28-Jan-14 70 72.1 68.2 69 69.05 7835426 5478.42 27-Jan-14 74.15 74.45 69.4 69.7 69.7 5612626 4038.08 24-Jan-14 77.65 78.3 75.25 75.5 75.85 9057843 6924.15 23-Jan-14 75.65 78.1 75.35 78 77.55 3995549 3069.47 22-Jan-14 76 76.55 75.2 75.75 76.15 2364540 1793.36 21-Jan-14 76 76.8 75.25 75.5 75.65 2190326 1662.56 20-Jan-14 74.35 75.9 73.9 75.4 75.2 2418910 1811.52 17-Jan-14 77.25 77.9 75.4 75.5 75.55 2074941 1585.85 16-Jan-14 79.2 79.25 77.15 77.45 77.4 2157420 1679.14 15-Jan-14 76.5 78.8 76.15 78.3 78.3 3174225 2459.16 14-Jan-14 76 77.7 75.55 76 76 3247695 2486.36 13-Jan-14 74.8 77 74.6 76.85 76.3 2810054 2125.56 10-Jan-14 75.65 77 74 74.8 74.45 5047824 3804.06 9-Jan-14 77.95 79.1 75.05 75.25 75.35 5844763 4486.22 8-Jan-14 76.4 78.8 75.05 77.8 77.95 8641432 6657.71 7-Jan-14 77 77.2 74.55 75.45 76.2 4308627 3269.79 6-Jan-14 77.2 77.5 75.5 76.5 76.4 2718761 2077.06 3-Jan-14 75.9 78.2 74.1 77.6 77.6 5785466 4445.92

2-Jan-14 80.2 81.65 75.4 75.6 75.8 5947141 4704.93 1-Jan-14 76 80.55 75.45 80.3 80.1 8173156 6436.14 UCOBANK has declared ex-date of dividend 20-Jan-14.from the table it can be said that after declaration of dividend even there is slightly increase in share prices for few days. But in future dates share prices has again come down. it can be stated from the table that there is not increasing trend in the market prices of shares after declaration of dividend even there is decline in share prices.

CASE -5 MPHASIS LIMITED [6] Mphasis is one of the leading IT solutions providers, offering Applications and Infrastructure services globally through a combination of technology knowhow, Business Process Outsourcing (BPO), domain and process expertise.

CORPORATE ACTION- Dividend Rs.17 per Share, Ex- date-22-Jan-2014[7] Last Total Open High Low Traded Close Traded Turnover Date Price Price Price Price Price Quantity (in Lakhs) 31-Jan-14 370 376 366 370.1 370.45 52033 194.16 30-Jan-14 375.95 385.9 368 369.8 370 44356 165.29 29-Jan-14 380 391.95 371.6 373.15 374.9 102698 393.74 28-Jan-14 383.4 386.2 375.5 378.5 379.85 48151 184.05 27-Jan-14 381.8 383.45 373.3 376 375.55 33887 128.03 24-Jan-14 395.5 395.7 381 383.45 383 45728 176.72 23-Jan-14 395.2 401.9 391.25 392.95 392.9 113379 447.53 22-Jan-14 404 409 395.4 399 397.85 121309 486.16 21-Jan-14 418.05 426.7 413 421.5 421.9 349098 1464.75 20-Jan-14 414.85 419 408.35 418.2 416.5 69589 288.32 17-Jan-14 414.05 419.65 405.1 408.55 409 211060 864.59 16-Jan-14 416.05 423.4 412.1 415.5 416 183635 764.98 15-Jan-14 424.6 427.9 414 414.95 417.85 69256 291.62 14-Jan-14 435.15 439 421.15 423.2 422.75 111241 474.02 13-Jan-14 430 442.5 430 437.75 437.75 201725 883.12 10-Jan-14 437.45 438.8 428 430 429.65 172350 743.1 9-Jan-14 432.7 437.95 431.25 433 433.65 180165 782.53 8-Jan-14 431.05 444 431.05 434 434.3 160354 700.65 7-Jan-14 426.3 439.8 426.3 435 434.1 216678 942.75 6-Jan-14 433 433.3 424.8 426 426.85 129255 551.81 3-Jan-14 424.25 428.45 424 424.65 425.05 88750 377.37 2-Jan-14 436.55 444.95 425.5 429.95 429 32959 143.58 1-Jan-14 442 442 437.2 437.95 438.85 27140 119.38 Mphasis Limited has declared ex-date of dividend 22-Jan-14.From the table it can be said that after declaration of dividend even there is slightly increase in share prices but in same day it has come down and even in future dates there is decline in share prices.

FINDING 1. In data analysis out of five companies four companies share prices has not increased after declaration of dividend.

2. NTPC ltd share prices gone up after dividend declaration. So it can be said that company value is get affected by dividend payment.

3. It can be seen that after declaration of ex-date and dividend even in few cases there is decline in share prices in future date.

4. There are fluctuations in traded Quantity and turnover due to change in share prices.

5. There is decline in last traded price in the shares but in case of NTPC ltd and UCO bank increase in last traded price in the same day of dividend declaration.

6. In long run dividend is more crucial for the companies as well as the shareholders because there is change in the economy cycle as well as reflect sound financial position.

SCOPE OF THE STUDY This study is restricted only of relevance theories of dividend policy and for the same from till date, last declared dividend and its impact on the share prices is considered .The study can be further extended for various sectors and for irrelevance theories also.

CONCLUSION Dividend policy is said to be most imperative decision in corporate finance. Company’s target for optimum capital structure and same time they attempt to maximize shareholders wealth. For the same they attempt to implement optimum dividend policies. In the research outcome there is not positive association between the market prices of share and Firm /company value. So it can be concluded there are fluctuations in share prices after declaration of dividend but not positive always and there are other factors which affects share prices.

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