Chapter 6: Dividend Policy
Dividend policy determines how much profit a firm distributes to shareholders vs how much it retains for reinvestment. This chapter covers dividend theories, types, factors affecting policy, and dividend practices in Nepal.
6.1 Key Dividend Concepts
| Term | Definition | Formula |
|---|---|---|
| Dividend Per Share (DPS) | Dividend paid per equity share | Total Dividends / Number of Shares |
| Dividend Payout Ratio | % of earnings paid as dividends | DPS / EPS × 100 |
| Retention Ratio | % of earnings retained | 1 - Payout Ratio |
| Dividend Yield | Return from dividend relative to share price | DPS / Market Price × 100 |
6.2 Dividend Theories
| Theory | Proponent | Key Argument | Dividend Relevance |
|---|---|---|---|
| Irrelevance (MM) | Modigliani & Miller | In perfect markets, dividend policy doesn't affect firm value; investors can create "homemade dividends" | Irrelevant |
| Bird-in-Hand | Gordon & Lintner | Investors prefer current dividends (certain) over future capital gains (uncertain) | Relevant — high payout preferred |
| Tax Preference | Litzenberger & Ramaswamy | Capital gains may be taxed lower than dividends; investors prefer retention | Relevant — low payout preferred |
| Signaling | Various | Dividend changes signal management's confidence about future earnings | Relevant — information content |
| Clientele Effect | MM | Different investors prefer different dividend policies; firms attract matching clientele | May not matter in aggregate |
6.3 Walter's Model
P = [D + (r/Ke)(E-D)] / Ke
Where P = market price, D = dividend, E = EPS, r = return on investment, Ke = cost of equity
Example: EPS = NPR 20, Ke = 10%, r = 15%, D = NPR 10
P = [10 + (0.15/0.10)(20-10)] / 0.10 = [10 + 15] / 0.10 = NPR 250
If D = 0: P = [0 + 1.5(20)] / 0.10 = 30/0.10 = NPR 300 (higher — retain when r > Ke)
If D = 20: P = [20 + 1.5(0)] / 0.10 = 20/0.10 = NPR 200
When r > Ke: Retain all (growth firm). When r < Ke: Pay all (declining firm). When r = Ke: Dividend irrelevant.
6.4 Gordon's Growth Model
P0 = D1 / (Ke - g) where g = b × r (growth = retention ratio × return on equity)
6.5 Types of Dividends
| Type | Description | Nepal Practice |
|---|---|---|
| Cash Dividend | Payment in cash | Most common in Nepal; declared as % of par value |
| Stock Dividend (Bonus) | Additional shares instead of cash | Very popular in Nepal; banks frequently issue bonus shares |
| Stock Split | Divide existing shares (e.g., 1:2) | Used to reduce per-share price for liquidity |
| Special Dividend | One-time extra dividend from exceptional profits | Occasional in Nepal |
6.6 Dividend Practices in Nepal
Nepal's dividend landscape: NEPSE-listed companies declare dividends as a percentage of par value (typically NPR 100). For example, "20% cash dividend" means NPR 20 per share. Banks are major dividend payers. Bonus shares are extremely popular — some banks issue 20-50% bonus shares annually. NRB regulates bank dividend policies (banks must maintain minimum capital adequacy before declaring dividends). Tax: 5% tax on dividends for individuals.
6.7 Walter's Model — Complete Analysis at Different Payout Ratios
Data: EPS = NPR 20, Ke = 12%
Case 1: Growth Firm (r = 18% > Ke)
| Payout Ratio | DPS | Retained | Price = [D+(r/Ke)(E-D)]/Ke |
|---|---|---|---|
| 0% | 0 | 20 | [0+1.5(20)]/0.12 = NPR 250 |
| 25% | 5 | 15 | [5+1.5(15)]/0.12 = NPR 229 |
| 50% | 10 | 10 | [10+1.5(10)]/0.12 = NPR 208 |
| 75% | 15 | 5 | [15+1.5(5)]/0.12 = NPR 188 |
| 100% | 20 | 0 | [20+0]/0.12 = NPR 167 |
Optimal: 0% payout (retain all) — when r > Ke, firm creates more value by reinvesting than paying dividends.
Case 2: Declining Firm (r = 8% < Ke)
| Payout Ratio | DPS | Price |
|---|---|---|
| 0% | 0 | [0+0.667(20)]/0.12 = NPR 111 |
| 50% | 10 | [10+0.667(10)]/0.12 = NPR 139 |
| 100% | 20 | [20+0]/0.12 = NPR 167 |
Optimal: 100% payout — when r < Ke, shareholders earn more investing dividends elsewhere.
Case 3: Normal Firm (r = 12% = Ke)
At any payout ratio: Price = [D + 1.0(E-D)]/0.12 = E/0.12 = 20/0.12 = NPR 167 (same regardless of payout — dividend irrelevant)
6.8 Gordon Model — Sensitivity Analysis
Base case: D0 = NPR 10, Ke = 15%, g = 10%
P0 = D1/(Ke-g) = 10(1.10)/(0.15-0.10) = 11/0.05 = NPR 220
| Scenario | Ke | g | P0 | Change from Base |
|---|---|---|---|---|
| Base | 15% | 10% | NPR 220 | — |
| Ke rises to 18% | 18% | 10% | 11/0.08 = NPR 137.5 | -37.5% |
| g rises to 12% | 15% | 12% | 11.2/0.03 = NPR 373 | +69.5% |
| g falls to 5% | 15% | 5% | 10.5/0.10 = NPR 105 | -52.3% |
| Both Ke=18%, g=12% | 18% | 12% | 11.2/0.06 = NPR 187 | -15% |
Key insight: Stock price is extremely sensitive to the gap (Ke - g). As g approaches Ke, the denominator shrinks and price explodes. When g ≥ Ke, the model breaks (gives infinite or negative value — meaning assumptions are violated).
6.9 Factors Affecting Dividend Policy — Comprehensive
| Category | Factor | Effect on Dividend | Nepal Example |
|---|---|---|---|
| Legal | Company Act provisions | Cannot pay from capital; must have adequate profits | Nepal Company Act 2063 restrictions |
| NRB regulations (for banks) | Must maintain capital adequacy before declaring dividends | NRB directive on bank dividend distribution | |
| Tax implications | 5% dividend tax may influence payout preferences | Bonus shares popular partly due to tax treatment | |
| Financial | Liquidity position | Low cash = low dividend; profitable firms may still lack cash | Firms with profit but tied-up receivables delay dividends |
| Investment opportunities | High growth needs = retain more, pay less | Hydropower companies retain for new projects | |
| Market | Shareholder expectations | Regular dividends expected; cuts signal trouble | NEPSE investors expect annual dividends from banks |
| Signaling effect | Dividend increase = positive signal | Bank announcing higher dividend sees share price rise |
6.10 Stock Dividend vs Cash Dividend — Impact Analysis
Before bonus: Company has 10,000 shares, Market price NPR 500, EPS = NPR 50, P/E = 10
Issues 20% bonus shares (2,000 new shares):
New shares = 12,000. If total earnings unchanged:
New EPS = Total earnings / 12,000 = (50 × 10,000) / 12,000 = NPR 41.67
If P/E stays at 10: New price = 41.67 × 10 = NPR 416.67
Shareholder who had 100 shares: Before = 100 × 500 = NPR 50,000. After = 120 × 416.67 = NPR 50,000
Total wealth unchanged! Bonus shares don't create value — they just split the same pie into more pieces. Yet NEPSE investors often celebrate bonus share announcements, temporarily pushing prices up (an irrational market response).
Practice Questions
Short Answer:
1. What is dividend policy? Define DPS, payout ratio, and dividend yield.
2. Explain MM's dividend irrelevance theory.
3. State Walter's model and its implications.
4. What is the bird-in-hand theory?
5. Differentiate cash dividend, stock dividend, and stock split.
Long Answer:
6. Using Walter's model: EPS=NPR 15, Ke=12%, r=18%. Calculate share price at payout ratios of 0%, 25%, 50%, 75%, and 100%. What is the optimal payout? (15 marks)
7. Compare all major dividend theories. Which best explains dividend behavior of Nepali banks? (15 marks)
8. Discuss factors affecting dividend policy decisions. How do NEPSE-listed companies decide their dividends? (15 marks)
9. "Stock dividends (bonus shares) in Nepal are more popular than cash dividends." Discuss reasons and implications. (15 marks)
10. Using Gordon's model, D0=NPR 8, g=10%, Ke=15%. Find P0. What happens if g increases to 12%? (15 marks)
Exam Tips: ✓ Walter's model calculation is frequently asked ✓ Know implications when r>Ke, r