Page 301 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 14: Management of Surplus & Dividend Policy

treated as a sign of impending trouble for the company. Many investors will sell their Notes
shares, without checking further and this set up pressure will result in the loss of sentiment
in the market and decline in the market price.
2. Preference of investors: The common shareholders of mature firms generally prefer to
receive steady dividends.
3. Dividend decisions as a routine: By establishing a stable dividend policy, the board of
directors avoids a lengthy discussion on dividend levels.
4. Flexibility of the extra dividend: With a steady dividend policy, the firm can flexibly
handle period temporarily high earnings, by giving a slightly large distribution of earnings
without raising the expectation of investors.
5. Desire for current income by the shareholders: Desire for current income by some investors,
such as, retired persons and widows. Obviously, such group of investors may be willing
to pay a higher share price to avoid the inconvenience of erratic dividend payment, which
disrupts their budgeting. They would place positive utility on stable dividends.

Self Assessment

Fill in the blanks:
4. The regular dividend policy is based on the concept of a ……………..dividend in each
period.
5. A ………………………ratio implies that the percentage of earnings paid out each year is
fixed.
6. When a firm pays regular dividend it is considered as a sign of continued ………….
operations.

14.3 Theories of Dividend Decisions

A few models, which studied the relationship between the dividend policy and the equity
returns, are given below:

14.3.1 Traditional Approach

The traditional approach to the dividend policy was given by Mr. B Graham and D.L. Dodd and
it lays clear relationship between dividends and the stock market prices. According to this
approach, the stock value responds positively to higher dividends and negatively with low
dividends.
The following expression expresses the relationship by using a multiplier:
P = m (D + E/3)
Where, P = Market Price M = Multiplier
D = Dividend per share E = Earnings per share

The traditional approach, further states that the P/E ratio (Price/Earnings Ratio) are directly
related to the dividend payout ratio i.e., a high dividend payout ratio will increase the P/E ratio
and vice versa.

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