Management of Surplus & Dividend Policy (Walter, Gordon, MM Hypothesis)
Management of Profits (Surplus)
Profit is the lifeblood of business. It ensures survival, growth, and returns to shareholders. From the perspective of financial management, managing profits is better termed as Management of Earnings.
Earnings refer to the net profit available to equity shareholders. A firm has two choices with these earnings:
Distribute as Dividends: Return profits to shareholders as cash, bonus shares, or buybacks.
Retain as Surplus: Keep the money to reinvest in the business for expansion and growth (Ploughing back of profits).
What is Surplus?
Surplus is the amount of profit remaining after tax and dividends that is retained in the business as a reserve. Efficient management of surplus involves investing it wisely to generate returns higher than what shareholders could earn themselves.
Key Insight: If a company reinvests surplus but fails to generate significant growth, investors are better off receiving dividends.
Dividend Policy
Dividend Policy determines the portion of earnings to be paid out to shareholders vs. the portion to be retained. It is a balancing act between satisfying shareholders’ need for current income and the firm’s need for future growth.
Types of Dividend Policies
Constant Payout Ratio: Paying a fixed percentage of earnings as dividends every year. (e.g., Always pay 50% of profits). Drawback: Dividends fluctuate wildly with earnings.
Regular Dividend Policy: Paying a fixed rupee amount per share every year. This signals stability and reduces uncertainty for investors.
Low Regular & Extra Dividend: Paying a small, guaranteed dividend and adding an “extra” dividend only in years of high profit.
Factors Affecting Dividend Decisions
Capital Gains vs. Dividends: Some investors prefer growth (capital gains), while others (like retirees) need steady income (dividends).
Legal Restrictions: Dividends can only be paid out of current or accumulated profits after providing for depreciation (Sec 205, Companies Act).
Liquidity: A firm may have high profits but low cash (due to inventory/debtors). You need cash to pay dividends.
Theories of Dividend Decisions
Does dividend policy affect the value of the firm? There are conflicting theories.
1. Traditional Approach
Dividends matter. High dividends = High share price.
Formula: $P = m (D + E/3)$
2. Walter’s Model (Relevance Theory)
James E. Walter argues that dividend policy is relevant and affects share price based on the relationship between the firm’s return on investment ($r$) and the cost of capital ($k$).
If $r > k$ (Growth Firm): Retain earnings. 0% payout maximizes value.
If $r < k$ (Declining Firm): Distribute earnings. 100% payout maximizes value.
If $r = k$ (Normal Firm): Dividend policy is irrelevant.
Formula:
3. Gordon’s Model (Relevance Theory)
Myron Gordon also supports relevance. He argues that investors prefer current dividends over future capital gains (Bird-in-hand theory). A higher dividend payout reduces risk and increases share price.
4. Modigliani-Miller (MM) Hypothesis (Irrelevance Theory)
MM argues that dividend policy is irrelevant in a perfect market. The value of the firm depends only on its earnings power and investment policy, not on how it splits earnings between dividends and retention.
Logic (Arbitrage): If a firm pays a dividend, it may need to issue new shares to fund investments. The value gained by shareholders from the dividend is exactly offset by the drop in share price due to the new issue. Thus, shareholder wealth remains unchanged.
Forms of Dividends
Besides cash, firms can distribute value in other ways:
1. Bonus Shares (Stock Dividend)
Issuing new shares to existing shareholders free of cost.
Benefit: Conserves cash for the company while giving shareholders more shares (though the value per share drops proportionally). It signals confidence in future profits.
2. Stock Split
Dividing existing shares into multiple shares (e.g., 1 share of ₹100 becomes 10 shares of ₹10).
Objective: To reduce the market price per share to make it more affordable for small investors and increase liquidity.
3. Stock Repurchase (Buyback)
The firm buys back its own shares from the market.
Impact: Reduces the number of outstanding shares, which increases Earnings Per Share (EPS) and often boosts the market price.
Modigliani-Miller (MM) Hypothesis: A Closer Look
The Argument:
In a perfect market (no taxes, no transaction costs, rational investors), dividend policy does not affect share price. If an investor wants cash, they can sell shares (homemade dividend). If they want growth, they can reinvest dividends.
Deficiencies/Criticisms of MM Hypothesis:
Market Imperfections: Real markets have transaction costs (brokerage) and floatation costs.
Taxes: Dividends and capital gains are taxed differently in the real world.
Uncertainty: Investors value the certainty of current dividends over the uncertainty of future capital gains (“Bird in the hand” argument).
Signaling Effect: Dividends convey information. A cut in dividends is often seen as a bad signal by the market, contrary to MM’s claim.
