Chapter - 17

Dividend Theory

By Akash saxena
Issues in Dividend Policy
 Earnings to be Distributed – High Vs. Low
Payout.
 Objective – Maximize Shareholders Return.
 Effects – Taxes, Investment and Financing
Decision.

By Akash saxena
Relevance Vs. Irrelevance
 Walter's Model
 Gordon's Model
 Modigliani and Miller Hypothesis
 The Bird in the Hand Argument
 Informational Content
 Market Imperfections

By Akash saxena
Walters Model
 Assumptions
 Valuation
 Optimum Payout Ratio
 Criticism

By Akash saxena
Assumptions
 Internal Financing
 Constant Return and Cost of Capital
 100% Payout or Retention
 Constant EPS and DIV
 Infinite Time

By Akash saxena
Valuation
 Market price per share is the sum of the
present value of the infinite stream of
constant dividends and present value of the
infinite stream of capital gains.
(r / k )
P  (DIV / k )  (EPS – DIV)
k

By Akash saxena
Example
r  0.15, 0.10, 0.08
k  0.10
EPS  Rs 10
DPS  40%
(0.15 / 0.1)
P  (4 / 0.1)  (10  4)  Rs 130
0.1
(0.10 / 0.1)
P  (4 / 0.1)  (10  4)  Rs 100
0.1
(0.08 / 0.1)
P  (4 / 0.1)  (10  4)  Rs 88
0.1

By Akash saxena
Optimum Payout Ratio
 Growth Firms – Retain all earnings
 Normal Firms – Distribute all earnings
 Declining Firms – No effect

By Akash saxena
Criticism
 No external Financing
 Constant Rate of Return
 Constant opportunity cost of capital

By Akash saxena
Gordon's Model
 Assumptions
 Valuation
 Optimum Payout Ratio
 Criticism

By Akash saxena
Assumptions
 All Equity Firm
 No External Financing
 Constant Return and Cost of Capital
 Perpetual Earnings
 No Taxes
 Constant Retention
 Cost of Capital greater than Growth Rate

By Akash saxena
Valuation
Market value of a share is equal to the
present value of an infinite stream of
dividends to be received by shareholders
P  EPS(1  b) /(k  br )
Example
r  0.15, 0.10, 0.08
k  0.10
EPS  Rs 10
b  60%
P  (1 – 0.6) / 0.10 – (0.15 * 0.6) = Rs 400
P  10(1 – 6) / 0.10 – (0.10 * 0.6) = Rs 100
P  10(1 – 0.6) / 0.10 – (0.08 * 0.6) = Rs 77

By Akash saxena
Optimum Payout Ratio
 Growth Firms – Retain all earnings
 Normal Firms – Distribute all earnings
 Declining Firms – No effect

By Akash saxena
The Bird in the Hand
Argument put forward, first of all, by Kirshman

Investors are risk averters. They consider

distant dividends as less certain than near
dividends. Rate at which an investor discounts
his dividend stream from a given firm increases
with the futurity of dividend stream and hence
lowering share prices.
Modigliani and Miller
According to M-M, under a perfect market
situation, the dividend policy of a firm is
irrelevant as it does not affect the value of the
firm. They argue that the value of the firm
depends on firm earnings which results from its
investment policy. Thus when investment
decision of the firm is given, dividend decision is
of no significance.
Market Imperfections
 Tax Differential – Low Payout Clientele
 Flotation Cost
 Transaction and Agency Cost
 Information Asymmetry
 Diversification
 Uncertainty – High Payout Clientele
 Desire for Steady Income
 No or Low Tax on Dividends

By Akash saxena
Informational Content of Dividend
…. In an uncertain world in which verbal
statements can be ignored or misinterpreted,
dividend action does provide a clear cut means of
‘making a statement’ that speaks louder than a
thousand words. — Solomon