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Theories of Dividend Policy
Theories of Dividend Policy
i) ii)
Traditional Model Walters Model Gordons Dividend Capitalisation Model Bird-in-hand Theory Dividend Signalling Theory Agency Cost Theory
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TRADITIONAL MODEL
MP is positively related to higher dividends. Thus MP would increase if dividends are higher and decline if dividends are lower. P = m (D + E/3) where, P = Market price m = Multiplier D = Dividend per share E = Earnings per share
WALTERS MODEL
Based on the assumptions that all investments are financed through RE, rate of return and cost of capital are constant, the firm either distributes dividends or reinvested internally; Walter put forth the following model for valuation of shares P0 = D + (E D) rlk k P0 = market price per share D = Dividend per share E = Earnings per share E D = Retained earnings per share r = Firms average rate of return k = firms cost o capital From the model it is clear that the market price per share is the sum of two consumptions: i. The first component Dlk is the present value of an infinite stream of cash flows in the form of dividends. ii. The second component (E D)rlk is the present value of an infinite stream of returns k retained earnings.
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BIRD-IN-HAND THEORY
John Lintner propounded this theory in 1962 and Myron Gordon in 1963. The shareholders are not entitled to any fixed return. The return to the shareholders is in the form of dividends and capital gains. Current dividends are relatively certain compared to future capital gains. According to this theory shareholders are risk averse and prefer to receive dividends in the present time period to future capital gains. Modigliani and Miller termed this argument as bird-in-hand fallacy.
P0 = _1___ (D1 + P1 ) (1 + ke) where, P0 = Current market price of the share (t = 0) P1 = Market price of the share at the end of the period (t = 1) D1 = Dividends to be paid at the end of the period (t = 1) ke = Cost of equity capital With no external financing the total value of the firm will be as follows: nP0 = _1___ (nD1 + nP1 ) (1 + ke)
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:According to this theory, dividend policy is irrelevant in determining the firms value. Different firms may follow different dividend policies depending upon their own needs and circumstances. One firm may decide on a higher payout ratio whereas others may decide on lower dividend payout. Similarly,different shareholders may have different needs some may prefer current dividends whereas others may be more interested in capital gains. Those investors who prefer current dividends would like to become shareholders in companies which declare generous dividends whereas those investors who are more interested in capital gains would folk to companies having relatively lower payout ratios. RATIONAL EXPECTATIONS MODEL: According to this model there would be no effect of dividend declaration on the market price as long as the dividend declared is in line with the expected dividends. If dividend <expected dividend MP will decline and vice versa. Thus, so far as dividend declared ratifies the market expectation the dividend policy is not relevant in determining the MP.
DIVIDEND CLIENTELE EFFECT
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Legal Constraints
Contractual Constraints Growth Prospects Owner Considerations Market Considerations Industry Practice Shareholders Expectations
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