DIVIDEND THEORIES
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Payment of dividend has two opposing
effects:
1) It increases stock price
2) It reduce the funds available for
investment
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• One school comprises of people like James E.
Walter and Myron J. Gordon, who believe that
current cash dividends are less risky than future
capital gains. Thus, they say that investors prefer
those firms which pay regular dividends and such
dividends affect the market price of the share.
• Another school linked to Modigliani and
Miller holds that investors don't really choose
between future gains and cash dividends.
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DIVIDEND THEORIES
1) Relevance Theory :
❑ Walter’s Model
❑ Gordon’s Model
2) Irrelevance Theory :
❑ Miller & Modigliani Hypothesis ( MM Approach)
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DIVIDEND RELEVANCE THEORIES
• Dividends paid by the firms are viewed positively
both by the investors and the firms. The firms
which do not pay dividends are rated in
oppositely by investors thus affecting the share
price.
• There are two main theorists:
– James E. Walter (Walter’s model)
– Myron Gordon (Gordon’s model)
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Relevance Theory
According to relevance theory dividend decisions affects value
of firm thus it is called relevance theory.
Walter’s Model’s theory :
This model is based on:
1) Return on investment OR Internal rate of return (r).
2) Cost of capital OR Required rate of return.
Here, the model divides the firm into three groups
1) Growth firms
2) Normal firms
3) Declining firms
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Walter’s Model
• Shows relationship b/w a firm’s rate of return r and
its cost of capital k. it is based on the following
assumptions:
1. Internal financing
2. Constant return and cost of capital
3. 100% payout or retention
4. Constant EPS and DPS
5. Infinite time
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• Given three types of firms or scenarios of firms the
model can be summarized as follows:
1. Growth firm: there are several investment
opportunities (r > k) and the firm can reinvest
earnings at a higher rate r than that which is
expected by shareholders k. thus they will maximize
value per share if they reinvest all earnings.
2. Normal firm: there aren’t any investments available
for the firm that are yielding higher rates of return (r
= k) thus the dividend policy has no effect on market
price.
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3. Declining firm: there aren’t any profitable
investments for the firm to reinvest its
earnings, i.e. any investments would earn
the firm a rate less than its cost of capital (r <
k). The firm will therefore maximize its value
per share if it pays out all its earnings as
dividend.
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In a nutshell:
• If r>ke, the firm should have zero payout and
make investments.
• If r<ke, the firm should have 100% payouts
and no investment of retained earnings.
• If r=ke, the firm is indifferent between
dividends and investments.
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Walter concludes:
• The optimum payout ratio is nil in case of
growth firm, the payout ratio of a constant
firm is irrelevant, the optimum payout ratio
for a declining firm is 100 per cent.
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Mathematical representation
• Walter has given a mathematical model for the
above made statements:
Where,
• P = Market price of the share
• D = Dividend per share
• r = Rate of return on the firm's investments
• ke = Cost of equity
• E = Earnings per share'
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Illustration
Compute the market price of XY Ltd’s share
under Walter’s model:
Earning per Share Rs. 5
Dividend per Share Rs. 3
Cost of capital 15%
Internal rate of return 16%
P= 34.22
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Illustration
The earning per share of AB company Ltd. Is Rs.
10 and the rate of capitalisation applicable is
12%. The company has before it an option of
adopting (i) 50% (ii) 75% (iii) 100% dividend
payout ratio. Calculate the market price of the
company’s quoted shares as per Walter’s
model if it can earn a return of (i) 20%.
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Criticisms of Walter’s model
• Model assumes investment decisions of the
firm are financed by retained earnings alone
• Model assumes a constant rate of return and;
• constant cost of capital, i.e. disregards the
firm’s risk which changes over time
• The constant r and ke are seldom found in
real life, because as and when a firm invests
more the business risks change
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Gordon’s Model
Assumptions:
1. The firm is an all equity firm, i.e. no debt
2. No external financing is available; consequently
retained earnings would be used to finance any
expansion of the firm.
3. Constant return which ignores diminishing
marginal efficiency of investment.
4. Constant cost of capital; model also ignores the
risk-effect
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5. Perpetual stream of earnings for the firm
6. Corporate taxes do not exist
7. Constant retention ratio b, i.e. once decided
upon stays as such forever. The growth rate g
= br stays constant in that case.
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• According to Gordon’s model dividend per share
is expected to grow when earnings are retained.
• The dividend per share is equal to the payout
ratio multiplied by earnings [EPS X (1-b)]. To
determine the value of the firm therefore based
on the dividend growth model the value of the
firm will be:
• P0 = EPS (1 – b)
k–g
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Where:
• (1 – b) = the payout ratio of the firm given b as the
retention ratio.
• g = the growth rate determined as br
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The conclusions of Gordon’s model are similar to
Walter’s model due to the fact that their sets of
assumptions are similar.
1. The market value of P0 increases with retention
ratio b, for firms with growth opportunities, i.e.
when r > k.
2. The market value of the share P0 increases with
payout ratio (1 – b), for declining firms with r < k
3. The market value is not affected by the dividend
policy where r = k
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Dividends Irrelevance
• The propagators of this school of thought were
France Modigliani and Merton Miller (1961).
• They state that the dividend policy employed by a
firm does not affect the value of the firm. They
argue that the value of the firm is dependent on
the firm’s earnings which result from its
investment policy, such that when the policy is
given the dividend policy is of no consequence.
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Assumptions of M-M hypothesis
• Perfect capital markets, i.e. investors behave rationally,
information is freely available to all investors,
transaction and floatation costs do not exist, no
investor is large enough to influence the price of a
share.
• Taxes do not exist; or there is no difference in the tax
rates applicable to both dividends and capital gains.
• The firm has a fixed investment policy
• The risk of uncertainty does not exist, i.e. all investors
are able to forecast future prices and dividends with
certainty and one discount rate is appropriate for all
securities over all time periods.
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• Conditions that face a firm operating in a
perfect capital market, either;
1. The firm has sufficient funds to pay dividend
2. The firm does not have sufficient funds to
pay dividend therefore it issues stocks in
order to finance payment of dividends
3. The firm does not pay dividends but the
shareholders need cash.
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• P0 = (D1+ P1)
1+Ke
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Illustration
The capital structure of a company Ltd. is as
follows:
Equity Share capital (Rs. 100 each): Rs. 100 lakhs
Earnings for Equity shareholders: Rs. 10 lakhs
Price of share in the beginning: Rs. 100
Equity Capitalization Rate: 10%
Required:
(a) Calculate the theoretical market price of equity share under
MM Model, if the company is considering a payout of (i) 0%
(ii) 80%
(b) Calculate the value of the firm using MM Model if dividend
payout ratio is (i) 0% (ii) 80%. The company proposes to
make a new investment of Rs. 12,20,000.
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5/4/2024 Dr. Amit Gupta 27
EPS= Rs. 10,00,000/1,00,000= Rs. 10
Market Price under MM model:
P1= P0 (1+Ke)-D1
0% Payout Ratio 80% Payout Ratio
P1= 100 (1+0.1)-0 = 110 P1= 100 (1+0.1)-8 = 102
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Calculation of Value of firm using MM Model
Particulars When Dividend is not declared When Dividend is declared
D1= Dividend per share declared Rs. 0 Rs. 8
P1= P0 (1+Ke)-D1 P1= 100 (1+0.1)-0 = 110 P1= 100 (1+0.1)-8 = 102
n= No. of old shares 1,00,000 1,00,000
Y= Total earnings for equity Rs. 10,00,000 Rs. 10,00,000
shareholders
nD1= Total Dividend declared 1,00,000 x 0 = 0 1,00,000 x 8 = 8,00,000
Y- nD1= Retained earnings 10,00,000-0 = 10,00,000 10,00,000 – 8,00,000= 2,00,000
I= Investment to be made Rs. 12,20,000 Rs. 12,20,000
E= External financing 12,20,000- 10,00,000= 2,20,000 12,20,000-2,00,000 = 10,20,000
Δn = no. of shares to be issued Rs. 2,20,000/110= 2,000 10,20,000/102 = 10,000
n + Δn = Total no. of shares 1,00,000 + 2,000 = 1,02,000 1,00,000 + 10,000 = 1,10,000
Value of firm = nD1 + (n + Δn)P1 - E 0+ (1,02,000 x Rs. 110) – 2,20,000 8,00,000 + (1,10,000 x Rs. 102) –
1+Ke 1.1 10,20,000
= Rs. 100 lakhs 1.1
= Rs. 100 lakhs
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Illustration
The Agro-chemical company belongs to a risk class for which the
appropriate capitalisation is 10%. It currently has 1,00,000
shares
selling at Rs. 100 each. The company is contemplating
declaration of a dividend of Rs. 5 per share at the end of current
fiscal year which has just begun. What will be the price of the
share at the end of the year, if a dividend is not declared? What
will it be if one is declared? Answer on the basis of MM model
and assume there are no taxes?
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(i) Rs. 135 (ii) Rs. 110
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Illustration
Z Ltd. Belongs to a risk class of which the appropriate capitalisation
rate is 10%. It currently has 1,00,000 shares selling at Rs. 100 each.
The company is contemplating declaration of a dividend of Rs. 6 per
share at the end of current fiscal year which has just begun. Answer
the following questions based on MM model and assumption of no
taxes.
(i) What will be the price of the shares at the end of the year if a
dividend is not declared?
(ii) What will be the proce if the dividend is declared?
(iii) Assuming that the company dividend, has net income of Rs. 10
lakhs and makes a new investment of Rs. 20 lakhs during the
period, how many new shares should be issued?
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(i) Rs. 110
(ii) Rs. 104
(iii) If dividend is declared 15,385 shares
(iv) If dividend is not declared 9,091 shares
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Conclusions of the model
• A firm which pays dividends will have to raise
funds externally in order to finance its investment
plans. When a firm pays dividend therefore, its
advantage is offset by external financing.
• This means that the terminal value of the share
declines when dividends are paid. Thus the
wealth of the shareholders – dividends plus the
terminal share price – remains unchanged.
• Thus the shareholders are indifferent between
the payment of dividends and retention of
earnings.
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Criticisms
• Presence of Market Imperfections
• Tax differentials
• Floatation costs
• Transaction and agency costs
• Information asymmetry
• Diversification
• Uncertainty (high-payout clientele)
• No or low taxes on dividends
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Q
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