P R A V I N M A N D O R A G R O U P T U I T I O N S

DIVIDEND THEORIES

DIVIDEND RELEVENCE : WALTERS MODEL

According to professor Walter, the choice of dividend policy almost always affect the value of
the enterprise. His model is based on following assumptions:

The firm finances all investment through retained earnings; that is new debt or equity is not
issued.
The firms internal rate of return (r) & its cost of capital (k) are constant.
All earnings are either distributed as dividends or reinvested internally immediately.
Beginning earnings & dividends never change.
The firm has a very long or infinite life.

Walters formula to determine the market price per share is as follows:

DIV [r (EPS DIV) ]/k

P = -------- + -------------------------- ----------------------------- (1)
k k

P = market price per share, DIV = Dividend per share

EPS = Earning per share, r = Internal rate of return
k = Cost of Capital

Equation (1) reveals that the P is the sum of the present value of two sources of income:

The present value of the infinite stream of constant Dividends, DIV/k

The present value of the infinite stream of Capital gains
= r (EPS DIV )/k)/k.

The equation (1) can be rewritten as follows :

DIV (r/k)(EPS DIV)

P = ------- + ------------------------- ------------------------------- (2)
k k

To show the effect of different Dividend policies on the value of share for (1) The growth firm
(2) The normal firm (3) The declining firm.

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M.B.A (FINANCE) , I.C.W.A (INTER)
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DIVIDEND THEORIES

Growth Firm Normal Firm Declining Firm

(r > k) (r = k) (r < k)
r =15%, k =10% r = k = 10% r = 8%, k = 10%
EPS = Rs.10 EPS = Rs.10 EPS = Rs.10

Payout Ratio = 0%
DIV = Rs.0 DIV = Rs.0 DIV = Rs.0
P = Rs.150 P = Rs.100 P = Rs.80
Payout Ratio = 40%
DIV = Rs.4 DIV = Rs.4 DIV = Rs.4
P = Rs.130 P = Rs.100 P = Rs.88
Payout Ratio = 80%
DIV = Rs.8 DIV = Rs.8 DIV = Rs.8
P = Rs.110 P = Rs.100 P = Rs.96
Payout Ratio = 100%
DIV = Rs.10 DIV = Rs.10 DIV = Rs.10
P = Rs.100 P = Rs.100 P = Rs.100

Walters view on Optimum Dividend-payout Ratio can be summarised as follows :

Growth Firm (r > k) : Growth firms are those firms which expand rapidly because of ample
investment opportunities yielding returns higher than the rate expected by shareholders. They
will maximise the value per share if they follow a policy of retaining all earnings for internal
investment. It is very clear from the table that the market value per share is maximum (i.e.,
Rs.150) when it retains 100% earnings & minimum(i.e., Rs.100) when it distributes all earnings.
So the optimum payout ratio for a growth firm is zero. P increases as payout ratio declines
when r > k.

Normal Firm (r = k) : Most of the firms do not have unlimited surplus-generating investment
opportunities. They initially generate returns higher than the cost of capital. After having
exhausted such profitable opportunities, these firms generate return equal to the cost of capital.
For the Normal Firms with r = k, the Dividend Policy has no effect on the market value per
share. It is clear from the table that Normal Firm has market value of Rs.100 which remains
same through out all different payout ratios. Thus, there is no unique optimum payout ratio for
a normal firm. one dividend policy is as good the other one. The market value per share is not
affected by the payout ratio when r = k.

Declining Firm (r < k) : Some of the firms do not have any profitable investment opportunities
to invest the earnings. Such firms would earn on their investments rate of return less than the
cost of capital. Investors of such firm would like earnings to be distributed to them so that they
may either spend it or invest elsewhere to get a rate higher than earned by declining firms.

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M.B.A (FINANCE) , I.C.W.A (INTER)
 P R A V I N M A N D O R A G R O U P T U I T I O N S
DIVIDEND THEORIES

The market value per share will be maximum when the firm distributes the 100% earnings, i.e.,
100% payout ratio. It is very clear from the table that when the payout ratio is 100%, the market
value per share is Rs.100 & it is Rs.80 when payout ratio is zero.
Thus, the optimum payout ratio for a declining firm is 100%. The market value per share, P,
increases as payout ratio increases when r > k.

DIVIDEND RELEVENCE : GORDONS MODEL

This model is based on following assumptions:

The firm is an-all equity firm.

No external financing is available.
The internal rate of return, r, is constant.
The appropriate discount rate, k, remains constant.
The firm & its stream of earnings are perpetual.
The corporate taxes do not exist.
The retention ratio, b, once decided remains constant. Thus the growth rate, g = br, is constant
forever.
The discount rate is greater than growth rate, k > br(= g).

According to Gordons Dividend-Capitalisation Model, the market value of a share is equal to

the present value of an infinite stream of dividend s to be received by the share.

Thus,
DIV1 DIV2 DIV3 DIVn
Po = ---------1 + ---------2 + ----------3 + -- + ---------n --------(1)
(1 + k1) (1 + k2) (1 + k3) (1 + kn)

Where Po = price of a share when retention rate, b, is zero & kt > kt-1.

If the firm is assumed to retain a fraction b of earnings, dividend per share will be equal to (1
b) x EPS1 in the 1st year thus, dividend per share is expected to grow at rate g = br, when
retained earnings are reinvested at r rate of return. Discounting them at corresponding rates
of k1, k2,.. we obtain the following equation:
1 2 3 n
DIV(1+g) DIV(1+g) DIV(1+g) DIV (1+g)
Po = --------------1 + -------------2 + --------------3 + ---- + -----------n -------------(2)
(1 + k1) (1 + k2) (1 + k3) (1 + kn)

DIV1 (1 b) EPS1
Po = --------------- = ---------------------- --------(3)
k-g k br

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M.B.A (FINANCE) , I.C.W.A (INTER)
 P R A V I N M A N D O R A G R O U P T U I T I O N S
DIVIDEND THEORIES

Equation (3) is particularly useful for studying the effects of dividend policy on the value of the
share.

Take the case of Normal Firm ( r = k)

The equation (3) can be represented as follows :

EPS1 (1 b)
Po = --------------------- ------------(4)
k br

rA (1 b)
Po = --------------------- , where A = total assets per share ----(5)
k br

If r = k, then

rA (1 b) rA (1 b)
Po = -------------------= --------------- = A ------------(6)
r br r(1 b)

So the firms value is not affected by dividend policy & is equal to the book value of assets per
share.

Take the case of Declining Firm (r = k) :

As r < k & retention ratio, b, is zero, the value of share is equal to :

rA
Po = -------- -------(7)
k

If r < k then (r/k) < 1 then from equation it is follows that Po is smaller than the firms
investment per share in assets.

Take the case of Growth Firm ( r > k) :

As r > k, the value of share increases as the retention ratio , b , increases. But it is not
clear as to what will be the value of b to maximise the value of share.

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PRAVIN MANDORA MOB : 98258 14701 93757 14701
M.B.A (FINANCE) , I.C.W.A (INTER)
 P R A V I N M A N D O R A G R O U P T U I T I O N S
DIVIDEND THEORIES

A PRACTICAL EXAMPLE :

To show the effect of different Dividend policies on the value of share for (1) The growth
firm (2) The normal firm (3) The declining firm.

Growth Firm Normal Firm Declining Firm

(r > k) (r = k) (r < k)
r =15%, k =10% r = k = 10% r = 8%, k = 10%
EPS1 = Rs.10 EPS1 = Rs.10 EPS1 = Rs.10
_________________________________________________________________________________
Payout Ratio = (1 b) = 40%, Retention Ratio, b = 60%
g = br =(0.6)(0.15) g = br =(0.6)(0.10) g = br =(0.6)(0.08)
g = 0.09 g = 0.06 g = 0.048
P = Rs.400 P = Rs.100 P = Rs.77

Payout Ratio = (1 b) = 60%, Retention ratio, b = 40%

g = br =(0.4)(0.15) g = br =(0.4)(0.10) g = br =(0.4)(0.08)
g = 0.06 g = 0.04 g = 0.032
P = Rs.150 P = Rs.100 P = Rs.88
Payout Ratio = (1 b) = 90%, Retention Ratio, b = 10%
g = br =(0.1)(0.15) g = br =(0.1)(0.10) g = br =(0.1)(0.08)
g = 0.015 g = 0.01 g = 0.008
P = Rs.106 P = Rs.100 P = Rs.98

It is revealed that, under Gordons Model :

The market value of share, Po, increases with the retention ratio, b, for firms with growth
opportunities, i.e., r >k.
The market value of share, Po, increases with the payout ratio, (1 b), for declining firms
with r < k.
The market value of share is not affected by dividend policy when r = k.

DIVIDEND IRRELEVENCE : MODIGLIANI & MILLERS HYPOTHESIS

According to them, Under the condition of perfect capital markets, rational investors, absence
of tax discrimination between dividend income & capital appreciation, given the firms
investment policy, its dividend policy may have no influence on the market price of shares.
Assumptions :

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M.B.A (FINANCE) , I.C.W.A (INTER)
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DIVIDEND THEORIES
There are no taxes. So no possibility of discrimination between dividend income & capital
appreciation.
All investors are rational.
Information is available free of cost.
No transaction costs & no flotation costs.
A firm has given investment policy which does not change.
Investors are able to forecast future prices & dividends with certainty.

The theory is based on arbitrage argument. Arbitrage refers to entering simultaneously into 2
transaction which completely balance or completely offset each other.

Assume that firm has some investment opportunity. Firm has two alternatives: (i) it can retain
its earnings to finance the project. (ii) or to distribute earnings to the shareholders as dividend &
raise the required amount from the issue of new equity shares/debentures/ bonds.

If the firm selects second alternative, the effect of dividend payment on shareholders funds will
be exactly offset by the effect of raising additional capital. When the dividends are paid to the
shareholders, the market price of shares will decrease. What is gained by shareholders as a
result of increased dividends will be neutralized completely by the reduction in the terminal
value of shares.

There would be no difference to the validity of MM premise, if the external funds are raised in
form of debt instead of equity. This is because the cost of capital is independent of leverage.
Proof :

STEP-1 : The market price of a share in the beginning of the period is equal to the present value
of dividends paid at the end of the period plus the market price of the share at the end of the
period. Symbolically,

(D1 + P1)
Po = ----------------- ---------(1)
(1 + ke)

Po = Prevailing market price of share

ke = Cost of Equity Capital
D1 = Dividend to be received at the end of period 1
P1 = Market Price of a share at the end of period 1

STEP-2 : Assuming no external financing, the total capitalized value of the firm would be
simply the number of shares (n) times the price of share (Po). Thus,

(nD1 + nP1)
nPo = ------------------- ---------(2)
(1 + ke)

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PRAVIN MANDORA MOB : 98258 14701 93757 14701
M.B.A (FINANCE) , I.C.W.A (INTER)
 P R A V I N M A N D O R A G R O U P T U I T I O N S
DIVIDEND THEORIES

STEP-3 : If the firms internal sources of financing its investment opportunities fall short of the
funds required, & the n is the number of new shares issued at the end of the year 1 at a price
of P1, eq.2 can be written as :

(nD1 + (n + n) P1- nP1)

nPo = ------------------------------------- ---------(3)
(1 + ke)

where n = number of shares outstanding at the beginning of the period.

n = change in the number of shares outstanding during the period/ additional
shares issued.

Equation implies that the total value of the firm is the capitalized value of the dividends to be
received during the period plus the value of number of shares outstanding at the end of the
period(considering the new shares), less the value of new shares.

STEP-4 : If the firm were to finance all investment proposals, the total amount raised through
new shares issued would be given by :
nP1 = I (E nD1)
nP1 = I E + nD1 ---------(4)
nP1 = Amount obtained from the sale of new shares
I = Total amount/requirement of capital budget
E = Earnings of the firm during the period
nD1 = Total dividends paid, (E nD1) = Retained Earnings

STEP-5 : Substituting the value of eq.4 into eq.3 :

(nD1 + (n + n) P1 - (I E + nD1))
nPo = --------------------------------------------- ---------(5)
(1 + ke)

nD1 + (n + n) P1 - I + E - nD1
nPo = ---------------------------------------------- ---------(6)
(1 + ke)

(n + n) P1 - I E
nPo = ----------------------------------- ---------(7)
(1 + ke)

STEP-6 : Since dividends are not found in eq.7, MM conclude that dividend policy has no effect
on the share price.

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PRAVIN MANDORA MOB : 98258 14701 93757 14701
M.B.A (FINANCE) , I.C.W.A (INTER)
 P R A V I N M A N D O R A G R O U P T U I T I O N S
DIVIDEND THEORIES

DIVIDEND AND UNCERTAINTY : THE BIRD-IN-THE-HAND ARGUMENT

According to Gordon's model, dividend policy is relevant but it may become irrelevant where r
= k, when all other assumptions are held valid. But when the simplifying assumptions are
modified to conform more closely to reality, Gordon concludes that dividend policy does affect
the value of a share even when r = k. This view is based on the assumption that under
conditions of uncertainty, investors tend to discount distant dividends (capital gains) at a higher
rate than they discount near dividends. Investors, behaving rationally, are risk averse and,
therefore, have a preference for near dividends to future dividends. The logic underlying the
'dividend effect on the share value can be described as the bird-in-the-hand argument.

Kirshman, first of all, put forward the bird-in-the-hand argument in the following words:

Of two stocks with identical earnings record, and prospects but the one paying a larger
dividend than the other, the former will undoubtedly command a higher price merely because
stockholders prefer present to future values. Stockholders often act upon the principle that a
bird in the hand is worth two in the bush and for this reason are willing to pay a premium for
the stock with the higher dividend rate, just as they discount the one with the lower rate.

Graham and Dodd also hold a similar view when they state :

The typical investor would most certainly prefer to have his dividend today and let tomorrow
take care of itself. No instances are on record in which the withholding of dividends for the sake
of future profits has been hailed with such enthusiasm as to advance the price of the stock. The
direct opposite has invariably been true. Given two companies in the same general position and with
the same earning power, the one paying the larger dividend will always sell at a higher price.n

Myron Gordon has expressed the bird-in-the-hand argument more convincingly and in formal
terms. According to him, uncertainty increases with futurity; that is, the further one looks into
the future, the more uncertain dividends become. Accordingly, when dividend policy is
considered in the context of uncertainly, the appropriate discount rate, k, cannot be assumed to
be constant. In fact, it increases with uncertainty; investors prefer to avoid uncertainty and
would be willing to pay higher price for the share that pays the greater current dividend, all
other things held constant. In other words, the appropriate discount rate would increase with
the retention rate Thus, distant dividends would be discounted at a higher rate than near
dividends. Symbolically, kt > kt-1 for t = 1,2,... because of increasing uncertainty in the future.
As the discount rate increases with the length of time, a low dividend payment in the beginning
will tend to lower the value of share in future.

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PRAVIN MANDORA MOB : 98258 14701 93757 14701
M.B.A (FINANCE) , I.C.W.A (INTER)