Dividend Decision
Dividend decision balances distributing cash today against retaining it for growth. The exam tests residual theory, Walter/Gordon models, MM irrelevance and practical dividend policy.
Core ideas
- Residual dividend: pay out only earnings left after financing the equity portion of the capital budget at the target capital structure.
- Walter model: P = [D + (r/ke)(E − D)]/ke, where r is return on retained earnings and ke is cost of equity.
- Gordon growth model values equity as D1/(ke − g); higher retention raises g only if r > ke.
- MM irrelevance assumes perfect markets, no taxes or flotation costs and fixed investment policy.
- Signalling, clientele, agency and tax effects explain why real payout policy matters. Stable dividends reduce information asymmetry but may constrain reinvestment.
Worked example
Earnings are ₹100 crore; the capital budget is ₹60 crore; target debt is 40%. Equity needed = 60×60% = ₹36 crore. Residual dividend = 100 − 36 = ₹64 crore; payout ratio = 64%. If the firm instead paid ₹90 crore, it would need external equity or extra debt, changing its capital structure.
Traps
Do not pay dividends out of capital unless legally permitted; preference dividends are not ordinary equity dividends; a bonus issue is not a cash dividend; a stock split does not change shareholder wealth; and do not apply Walter’s formula when r and ke assumptions are unrealistic.