2 Dividend Policy and Firm Value Learning Objectives ‘fer studying this chapter you should be able to: / Fxplain the traditional position on dividend policy and share valuation. 7 Discuss the Walter model and Gordon model and their implications. Y Discuss the MM dividend irrelevance hypothesis and its implications ¥ Explain the radical position on dividend policy and valuation. thedividend policy of a firm determines what proportion of earnings is paid to sharehold- te by way of dividends and what proportion is ploughed back in the firm for reinvest ment if firm’s capital budgeting decision is independent of its dividend policy, a higher divi- dend payment will entail a greater dependence on external financing, Thus the dividend poly has a bearing on the choice of financing, On the other hand, if a firm’s capital budget- ing decision is dependent on its dividend decision, a higher payment will cause shrinkage ofits capital budget and vice versa. In such a case, the dividend policy has a bearing on the cpital budgeting decision. ‘Afion’s dividend payout ratio obviously depends on how earnings are measured. For the sake of simplicity, we look at the accounting measure of earnings. Of course, we are aware that accounting earnings often diverge from economic earnings and may not truly reflect a fins capacity to pay dividends. Since the principal objective of corporate financial management is to maximise the market value of equity shares, the key question of interest to us is: What is the relationship between dividend policy and market price of equity shares? This is one of the most controversial and snnesolved questions in corporate finance. This chapter discusses the various positions on spectrum of views on this issue. 21.1 3 MODELS IN WHICH INVESTMENT AND DIVIDEND DECISIONS ARE RELATED Mog eae na ae a the discussion on dividend policy and firm value assumes that the investment decision ‘m is independent of its dividend decision. However, there are some models whicheget se related. Two such mode, a * Re he % af share valuation which supports model of spare valuation. His model se View ased on Mt hy ‘a Waiter Model ae ‘Walter! has propos: Jadend policy of the firm has a bearing owing assumptions: Pe) equity finances The fim a vestments TNS to finance its ful a onthe dividend decision. : = The rate of return on investments is constant. The firm has an infinite life ; ‘ed on the above assumptions, Walter put forward the ¢. follon Valuation Formula Bast valuation formule) pp _Dyr/ My = k where Pis the price per equity share, Dis the dividend per share, Eis the earni Te tis the retained earnings per share, ri the rate ofreturn on investments sty and kisi cost of equity. ‘As per Eq, (21.1), the price per share is a D, E=Dyr/k ay . k k The first component is the present value of an infinite stream of dividends’; the nds’; the second ‘component is the present value of an infinite streams of returns fro e it i ym retained earnings? Further it will rly only on ret ut hat the investment decision r “eng ePey sum of two components: In jae vaiay ‘James Walter, “Divi rm ividend Policy: Its Influence on the Value of the Firm,” Journal of F i 9 ‘The ey an infinite stream of Dis: “a (ek) asap "P/E 3 The second cot ymponent is derived The return from the first retained as follows: u Time 0 1 earnings, (E—D), would be: The present value Of thi (E- 4 €-Dy ¢-py fret DP (ED) 1 ase : : (ca!po lend Policy and Firm Value pit 21-1 gives numerical examples for the Walt aa — ria fer model for three cases: growth firm, er firm, and declining firm, fe Gahibit 21.1] Numerical Examples for Walter Model Trek ; cou i ‘Normal Firm: =k Declining Firm rk 7 =20 pe r= 15 percent aad = 10 percent = 15 percent k= 15 percent p2t4 E=%4 | wo=t4 O=t4 p= 4410)20/.15 4+(0)45/.15 _ 44 (0).10/.15 15 15 Finer = 2667 26.67 =% 2667 #D=82 2 WD=%2 pe 2i2)20/.15 p= 2+(2).15/.15 15 15 =%31.11 = 26.67 4 Implications From Exhibit 21.1 we find that as per the Walter model: = When the rate of return is greater than the cost of capital (r > k), the price per share increases as the dividend payout ratio decreases. = When the rate of return is equal to the cost of capital (r= k), the price per share does not vary with changes in dividend payout ratio. = When the rate of return is less than the cost of capital (r K) is nil. = The optimal payout ratio for a normal firm (r =f) is irrelevant. = The optimal payout ratio for a declining firm (r< k) is 100 percent. Clearly these policy implications lead to very extreme courses of action which make lim- ited sense in the real world. Despite this simplicity or naivete, the Walter model is a useful tool to show the effects of dividend policy under varying profitability assumptions. (Contd) Likewise the present value of the stream of returns from the third retained earnings would be: ae © k(+k) Soand so forth. ; i Adding the present value of the stream of returns from all retained earnings, we get -Dy | (E-Dy , E-Dy , 0 K(tk) k@+kP k(+k) sum is equal to: (8) (E-D)r ke kjanagement, Financial Managers th Gordon Model ode! of stock Veaedcne: g the divideng Capita) am A ssu] Sah Myron Gordon’ proposed 2 Ti followin source of financing for the f , proach. His model is ba ecole, dession ac Tay Me 1 Retained ore Gordon model ties In a 7 dessa Walter model the irm’s investment is C tors = The rate of return ae isthe product ofits rlention ratio and i, ee © The growth rate 0} thefirsttwo assumptions. cS This se ee firm remains constant andlit is greater than ty, Sr = The cost of cap’ ny = The firm has a perpetual life. = Tax does not exist. 2. Gordon's valuation formula is: Valuation Formula 2 BGs) t Note f Qlyy s id of year 0, F; is the earnings per sha where Py is the price per share at the en ear 0, E; is share ti of year 1, (1 ~1) is the fraction of earnings the fe eistrutes ave of dividends 5.9 fraction of earnings the firm retains, k is the rate oe un ae d by the Shareholder the rate of return earned on investments made by the firm, and br is the growth ray ofeay ings and dividends. Exhibit 21.2 shows numerical examples for the Gordon model Implications From Exhibit 21.2 we find that as per the basic Gordon model: 1. When the rate of retum is greater than the discount rate (r > k), the Price per sha, creases as the dividend payout ratio decreases, 2. When the rate of return is equal to the discount rate (r=k), the price Per share remig unchanged in response to variations in the dividend payout ratio, “TMI. Gordon, Theb i i i MJ. Gordon, Te ioesiment, Financing and Valuation ofthe Corporation, Homewood, III, Richardlnig a hs formula may be derived as follows: sing the divided capitalisati , i 1s 1D Pislisation approach, the price per share is: Py= gee (1+k) “(eke This may be rewritien as; Py= Fil-b), E-bay Gk) sae Gagp ; (+k) gr ee Ell tbr 4 : This on simplification fee = x ee fe Py = Fi(l-b) k~br oeDividend Policy and Firm Value | —_——_lais whenthe rate of return is less tha i = ‘ s aw ee than the discount rate (-<}),teprice per suareinerenses ‘Thus the basic Gordon model leads to dividend policy implications similar to that of walter model: . We rhe optimal payout ratio for a growth firm (r > &) is nil he payout ratio for a normal firm is irrelevant. § The optimal payout ratio for a declining firm (r < ) is 100 percent. Numerical Examples for Gordon Model Normal Firm :r=k Declining Firm : F< k r= 15 percent r= 10 percent k= 15 percent k= 15 percent E=2 4.00 E=€4.00 Ib = 0.25 Wb=0.25 ee py= 0-754 P= 07S 0.16 - (0.25)(0.20) 0.45— (0.25015) 0.15 (0.25)(0.10) 30 =% 26.67 =% 24.00 1b =0.50 Ifb = 0.50 Ifb=0.50 p= (0.504 p= 0.50 p= 0504 °° 0.45-(0.5)(0.20) 0.45~-(0.5(0.18) 0.15 - (0.5(0.10) =% 40.00 =% 26.67 = © 20.00 J 21.2 2 TRADITIONAL POSITION According to the traditional position expounded eloquently by Benjamin Graham and David Doda, the stock market places considerably more weight on dividends than on retained earn- ings. According to them: a the consrlered and continuous verdict of the stock market is overwhelmingly in favour of liberal dividends as against niggardly ones. The common stock investor must take this judgment into account in the valuation of stock for purchase. They added “Itis now becoming standard practice to evaluate common stock by applying one multiplier to that portion of the earnings paid out in dividends and a much smaller multiplier to the undistributed balance.”® Their view is expressed quantitatively in the following, valuation model advanced by them: P=m(D+E/3) 21.4) where Pis the market price per share, D isthe dividend per share, Eis the earnings per share, and m is a multiplier. According to this model, in the valuation of shares the weight attached to dividends is 3 edn, McGraw-Hill Book See °B. Graham and D.L. Dodd, Security Analysis: Principles and Techniques, Company, New York, 1951.nancial Management _ ae as|—— we . weight attached * equa tfour times Lane is replaced by version of Eq. p+R | pem|D+—3 1 retained earnings. Thisis clear fro,» S (D+R). n the fy hy d Dodd are based on their subjective a i i od by Graham an iC : a The weighs pirical analysis Netwithslanding he wetting not Ge major contention of the traditional position is that a liberal pay Sgt weights : tee rrable impact on stock price. ‘ Empirical Evidence ; “Advocates ofthe traditional position cite the resulls of cross-section regression ang) sis the following: Price = a + b Dividends + c Retained Earnings ‘Typically, in such a regression analysis the dividend coefficient, b, is much hy Og the Wiaine earnings coefficient, c.S0 the advocates of traditional position di hypothesis is empirically vindicated. However, a careful look at the above regression suggests that the conclus; the traditionalists is unjustified for the following reasons: onclusion reache’, 1. Eqn. (21.6) is misspecified because, inter alia, it omits risk whi q ; cause, 3 isk which is an i minant of price. A better specified regression equation is: iS an important dey. im that the, tive. Because risk and dividend are inversely correlated — which are simp} fi earnings i soe renee tiNgS minus dividends. In oy asmitted to retained eating downy ee Famings) is subj » 2) Tegression analysis, when a vast ‘Osumup, tees i : and the meas Tisk imy : urems \parts -) to «te coc af characterising esata to b, the coefficient of dividets cated," * higher dividen famnings, Hence eae pps a downwaili Payout ratio eae eau es traditionalists that Stock value cannot be 213 3 MILLER. Merton Miter and fy AND Mop ofa fis nic "4m een tn ay ee STHON Carin, ’ Aereafter) ha: Power and ig eptvanced the view that the val “sy OF influenced by the manner itden ay nd im ae four ea "s, jposngs te split between dividends and retained earnings. This view, referred to as the riiyidend irrelevance” theorem, is presented in their celebrated 1961 article” jnthis article, MM constructed their argument assuming a perfect capital market, wherein Following conditions are assumed: ef formation is freely available to everyone equally. & There are no taxes. = floatation and transaction costs do not exist. 5 There are no contracting or agency costs (These cost conflicts of interest between holders of different securities or betwet holders of securities). » Noone exerts enough power in the market to influence the price of security. ‘This means s refer to the costs of managing en management and ie i participants are price takers «« Investment and financing decisions are independent. 16) The substance of MM argument may be stated as follows: If a company retains earnings a instead of giving it out as dividends, the sharcholders enjoy capital appreciation equal to the er amount of earnings retained, If it distributes earnings by way of dividends instead of retain- it by which his capital anerthe shareholders enjoy dividends equal in value to the amor Te Rea the company chosen to retain its earnings. Hence, the division by would have apprecia earnings between dividends and retained earnings is irrelevant from the point of view of a. the shareholders. To prove their argument, MM begin with the simple valuation model: 7 Po= Gap) Orth? (218) - where Py is the market price per share at time 0, D, is the dividend per share at time 1, P, is i the market price per share at time 1, and pis the discount rate applicable to the risk class to re which the firm belongs (this rate is assumed to remain. unchanged). e From Eq, (21.8) the expression for the Value of outstanding equity shares of the firm at time 0 is obtained: nPy= op (nD, + (n+ m)P ~ mP,) (21.9) where n is the number of outstanding equity shares at time 0, nPpis the total market value of outstanding equity shares at time 0, nD, is the total dividends in year 1 payable on equity shares outstanding at time 0, m is the ‘number of equity shares issued at time 1 at price Py (the prevailing market price at time 1), (1 + m)P, is the total market value of all outstand- ing equity shares at time 1, mP, is tthe market value of shares issued at time 1, and pis the discount rate. What is the total amount of new equity stock issued at time 1, mP,, equal to? It is equal to the total investment at time 1 less the amount of retained earnings. In symbols: mP, =1-(X~ nD,) (21.10) Whee Tis the total investment at the end of year 1, and X is the total net profit of the firm ‘or year 1. eee ite Kee TEFL Miller and F. Modigliani, “Dividend Policy, Growth and the ‘Valuation of Shares,” Journal of Business, Vol. 34 (October 1961).Zz i for mP, in Eq. 21-9), MM get ve value for m? substituting the above ¥ ° P, 1 q@emP,-h- Xx) | nPy= i (+ mPa Ty Xi and p are in iy uation and as ( P 2 920 indo As D; is not found in 1 Pe alue ofthe firm does not depen a im MMreach the conclusion I oF the equity of the firm 2 end of year SoM valu year (D;). Why? The reason ji ye be ote that (n+ Py. the x of the saat by the dividend paid at fe manner. If the firm pays more p> "ip influences P, and mn 2 paneehei the firm pays less D,, P; increases but ,” a el But nnn an te een to demonstra this Point SUPPOre Zeta Comp fins 00 equity chares outstanding selling at © 10.8 share (2 = 3,000 and Py == ya expected earnings and investment need for th ene py ore us nd 2 1,119 oe i (a= 1000 and =€ 110. IfZeta pays adividend of 1 per share next year (p, Phy P, will be & 10 and it will have to issue 111 shares at € 10 per share to finance its yy’ need of 7 1110. This means tte (n+ m) P, = (1,000+111) 10 =@ 11,110 On the other hand, if Zeta does not pay any dividend next year (D, = 0), its p ,, 11 and it will have to issue just 10 shares at 11 each to supplement its retained ene WB % 1000 to support an investment of € 1110 This means: (x + m) P, = (1,000+10) 11 =% 11,110 Thus irrespective of what D, is, (n + m)P, will be € 11,110 Two points may be emphasised here: theorem does not i value of future heal nt fs value of an equity share is not equal to the preet Gia the dividend policy often oor Ownership. It merely syst ividend payments it cannot m may influence the timing and magnitudes ‘ot change the present value of the ital seam of divides They, however, di ler the as: ; assumption toed by i Validity ofthe ee made by MM dividenels re il characterisiy According ~ relevance” theore: hallenging' Ne implications of the imper cone dividends matter ae the cet ture ata time, * features are discus; the capital market, and the existence of Sed below. For this discussion we considet PePoe axion about Prospects Ina world of uncertainty the dividends paid by the company. Be jas tiey are on the judgment of the management about future, convey information motte prospec 1e company. A higher dividend payout ratio may suggest that the pre of the company, as judged by management, is promising. A lower dividend payout tio may suggest that the future of the company as considered by management is uncertain. if, view has been eloquently expressed by Myron J. Gordon. An allied argument is that in jends reduce uncertainty perceived by investors. Hence investors prefer dividends to aja gains. So, shares with higher current dividends, other things being equal, command OF sher price in the market, Nii do not dispute the information content of dividends. They maintain that dividends aerely serve as proxy for the expected future earnings which really determine value. Hence, they argue, dividend policy per se is irrelevant. nd Policy and Firm Value | dpitmevane 9) Uncertainty and Fluctuations Due to uncertainty, share prices tend to fluctuate, sometimes rather widely. When share prices fluctuate, conditions for conversion of current income into pital value and vice versa may not be regarded as satisfactory by investors. Some investors «tt wish to enjoy more current income may be reluctant to sell a portion of their sharehold- ing ina fluctuating market. Such investors would naturally prefer, and value more, a higher payout ratio. Some investors who wish to get less current income may be hesitant to buy Five in a fluctuating market. Such investors would prefer, and value more, a lower payout ratio. Offering of Additional Equity at Lower Prices MM assume that a firm can sell additional equity at the current market price. In practice, firms, guided largely by the advice of merchant bankers, offer additional equity at a price lower than the current market price. This practice of underpricing’ mostly due to market compulsions, ceteris paribus, makes a rupee of retained earnings more valuable than a rupee of dividends. This is because of the following chain of causation: Greater volume of m i Higher dividend underpriced equity issue ery payout to finance a given. ‘equity {evel of investment Issue Cost The MM irrelevance proposition is based on the premise that a rupee of divi- dends can be replaced by a rupee of extemal financing. This is possible when there is no issue cost. In the real world where issue cost in incurred, the amount of external financing has to be greater than the amount of dividend paid. Due to this, other things being equal, itis advanta- geous to retain earnings rather than pay dividends and resort to external finance. Transaction Costs _In the absence of transaction costs, current income (dividends) and capi- tal gains are alike - a rupee of capital value can be converted into arupee of current income and vice versa, In euch a situation if @ shareholdet desires current income (from shares) sreater than the dividends received, he can sell a portion of his capital equal in value to the Additional current income sought. Likewise, if he wishes to enjoy current income less than4 buy a the vidends pad been Oe ne dividends re orld, however, transaction cost In the real w {current in nverted into an equal fier transac not be cor of 299 amount = 100 may fetch a net : buy a share worth € 100. Due to tan ae rent income, would prefer a higher pa} deferred income would prefer a ons ssume tha: Differential Rates of Taxes MM a: hat of dividends and a rupee of capital appreciation. action costs, income and capital gains. In the real world, pre the same for current incom gn eapital gains is lowes than that for current income. Due to this difference, prefer capital gains to current income. i i taxed in the hands of the rec ‘ In India, till 1995-1996 dividend income was f pienton of ihe maga rate applicable to him. From 1996-1997 onwards, the dividend inate been exempted in the hands of the recipient but the to pay a uniform dividend distribution tax which has been around 17 percen, "3 this switch has reduced the effective burden of tax on dividend income in India, ¢ perhaps led to a higher dividend payout rate, as revealed by astudy of Monica Sin, Even with this, the tax burden on dividends is higher than 10 percent, tax rate on long-term capital gains, Rationing: Self-imposed or Market-imposed MM assume that the invest firms is independent of their financing Policy and firms, rational as they the point where the rate of return is equal to the cost of capital. In the real - iments MM assy i Point where the rate of return a ae firms, rat ‘Marginal proj bis has such oe *Mjects because Of eas cisms is tha nt in "ia Sg asm’ inghania, ‘Taxati Om and Corpora "Payout Policy Vikalpa, October-December 200 Financial Manager eee F al in value to the SI ” .dditional ee he Alsfereng ey ats are incurred. Due to th; and vice versa. For exam, io and shareholders who hy lower payout ratio. ement s Pita ah e, a gy hy ction costs and & 101 m3.’ Shae areholders who have py) "qu sh peteteenet ey ve Preteen i investors are indifferent ber, This assumption is true When er effec et et Sion company paying the dividend "hs This og A shan Which is cureniyy tment Polgyg are, invest up tional as they are, do not invest beyond the Cost of capital, In practice, however, many fis Y availabilj i funds.lf A end p icy matters, ae Of internally generated funds 'niggardly dividen ‘areholders would benefit ifthe ids are paid. t the dividend poli : Thept difficulty ; Policy of the firm matters. im converting capital value intoSR Re at ad the possibility of : ne bi Cae sae imps investments, suggest that a liberal payout ratio ould Ha al gains, the low 1g on valuation. On the other hand, the preferential tax treat- See costs) ae of retained earnings vis-a-vis external equity financing pease of Hoa , and unwise capital rationing indicate that a low payout ratio would further the interest of stockholders. Boi jnformational Content ‘the MM’ dividend irrelevance hypothesis is based on the assumption that investors and man- agershave identical views about future prospects (earnings and dividends) of the firm. In real 2 however, different investors hold different views about future prospects and managers re better informed about future prospects than investors. Empirically it has been observed that an increase in dividend is often accompanied by @ rise in the stock price, ‘while a decrease in dividend leads to a fall in the stock price. Some fegard this asa clear evidence of investor preference for dividends over retained earnings MM, however, have argued differently. Since companies are reluctant {0 cut dividends, they will not enhance dividends unless they expect higher future eamings So, an increase in dividend is a signal that the managers perceive the future to be brighter; on the other hand, decrease in dividend is a signal that managers consider the future to be bleaker. Thus, MM argued that the observed response of stock prices fo dividend announcements does not mean that investors prefer dividends to retained earnings. Rather, they reflect the information, or signaling content of such dividend announcements. The Rational Expectations Hypothesis: A Way of Reconciliation John F. Muth wrote a paper entitled “Rational Expectations and the Theory of Price Move- ments,” which was published in 1961. This has been recognised as one of the most influential U ibubiond te eeoriomics in thelast few decades asitchallengss the intellectual foundations ha reditionel macroeconomic theories propounded PY Keynesians as well as monetar- ists. Whatis the central argument of the rational expectations hypothesis? In very simple terms, it says that what matters in ‘economics is not what actually happens but the difference be- tween what actually happensand what was supposed or expected to happen. Hence only the surprises in policy would have the kind of effects the policy maker is striving to achieve. Let us look at the implications of the rational expectations hypothesis for the dividend Policy of a firm. If the dividend announced is equal to what the market had expected, there would be no change in the market price ‘of the share, even if the dividend were higher (or for that matter lower) than the previous dividend. The market, expecting the dividend tobe higher, had discounted it. Put differently, the higher expectation was reflected in the market Price already. Hence the ‘announcement of the higher dividend would not have any impact on the market price. hh What happens if the dividend announced is hi In such a case the market begins to revise its a5se her than what was expected by the market? ament of future earnings. This reappraisalFinancial Management _ ement in the share. Likewise, when Re ket may revise unfayon tt di expected, the mar! nfavou, vig, pounced is lower than what Ws Prean a downward price movement in ged bay’ of future earings. And 1H ional expectations, unexpected divideng 4, *te mi in rnings potential which were ng, "ih neo To sum up, * i anges in ea! would transmit messages about ¢ were the market price earlier. The reappraisal that occurs as a result of these signay, roa the dividends themselves, though th leads la ey 21.12} —— =< ce mov would lead to an upward price 0) ;vements which look like responses to mover vision of the estimate of earnings potential, aa b ed by an underlying re ni Eee es reconciling the practitioners’ view that diy hat dividends do not matter. As Merton 11 ny Mi The above analysis is helpful in very much and the academic view not "Both views are correct in their own ways. The academic is thinking of the ery lay div lg the practitioner of the unexpected.” 21.4 2 RADICAL POSITION Directly or indirectly dividends are generally taxed more hi ctl 5 eavil radicalists argue that firms should pay as little dividend as they sear rapa gins investors arn more by way of capital gains and less by way of dividends” "thot so amuse capital gins ae xed more lightly than dividends, ee hin cieamaatiee fom stocks that provide returns in the form of = ioe idends. Exhibit 21.3 illustrates this. The stocks of fi ital gains cuit 1cks of firms A ‘Sins rater ly risky Investors expect the share of firm A- the firm alinace ae = Plan to pay diy. dend next year - to be wor rth & 120 next year. Fro ~ From a share of firm B, too, i , t00, investors exes which are taxed lightly. Exh , 1 Exhibit when dividends at. ieee 21.3 shows that A and B are sent posttax rate of retum, Pee" and capital gains at eee reese inca tax laws favour ony Percent. Each offers a 15 pe« Pital gains in o el me more way. Ta: Taxes on dividends are payable i mediately but taxes F y On capital gai Bains realised. Thelonger he qos her | The longer th Payable ont le shares n'y When the shares are sold and cipitl Bains lability. Thus th are hel é € effecti eld the 5 Aaa Tat Would be the present value of capidl increases, rate on capit ; senate radical position, a Pita! gains diminishes as the period of hit Seneral form, MUMber of Bien Premium is associ ‘ estimated W0ss-section with high-yield wnt al regression ofthe fol Return = 4 +b, Beta y cs Divideng i es aDividend Policy and Firm Value fp: Vs sees a Bra) Exhibit 21.3] Effect of Dividend Policy on Required Return (Nc ee ae i lo Divi ivi ery pce SDS panne |p pividend 0 z15 |, Total pre-tax payoff 2120 @120 |4.urrent price % 102.86 mete) 5, Capital gain 217.14 7357 6. Pre-tax rate of return 16.67% 18.31% (+64) 7. Taxon dividend - 23 at 20 percent |g. Tax on capital gains e474 70.357 at 10 percent 9, Total post-tax income = 15.426 215.213 [2)}+6)H(7)+(8)) 10. Post-tax rate of return 15.426 = 15% 15.213 = 15% | 102.86 101.43, The hypothesis is that b;, the coefficient of beta, is positive, reflecting the effect of systematic risk on returns and ¢;, the coefficient of dividend yield, is positive, reflecting the tax disadvantage of dividend payments. Most of the studies found that c;, the coefficient of expected dividend yield, was positive suggesting that there is a tax effect and hence evidence in favour of the radical hypothesis. 21.5 2 OVERALL PICTURE nn the relationship between dividend policy and We have examined several points of view 0 share valuation. These points of view may be divided into two ‘broad schools of thought. The first school, the perfect market school to which MM belong, maintains that the dividend policy of the firm is irrelevant because investment and financing decisions are independent, the costs of internal and external financing are equal, and investors and firms are rational. The second school, the imperfect market school, subsuming the other four points of View discussed above, argues that the dividend policy of the firm influences the value of its shares though there are sharp differences within this school as to how the dividend decision influences valuation — recall that the traditionalists believe that ‘dividends are good’ and the radicalists argue that ‘dividends are bad’. This school harps on the imperfections obtaining in the real world: investor preference for current dividends, interdependency between dividend and investment decisions, existence of floatation and transaction costs, irrational behaviour of dividends and capital gains, informational of investors and firms, differential taxation n . asymmetry, and underpricing of equity issues. The relationship between dividend policy and firm value depends on the combined effect of these factors.Financial Management sews on the relationship between dividend policy and shay, views: There are several el argue that a higher dividend payout pg “ay f Water model nd Gordon eee socials greater (lesser) than the cost of * “ey holders when there nal position a generous clividend policy enhances soak According toe a (MM) have advanced the dividend irrelevance hypothess Milles and Mosier independent of its dividend policy. 4 a eet MM agree that, under the assumptions made by MM, dividend, They however aispute the validity of the ‘dividend irrelevance’ theorem assumptions of MM. The radial position argues that a low dividend payout ratio increases share value Sy ate by Stale te 1 State the valuation formla put forward by Jemes Walter. What isthe logic ben mula? i 2. What are the implications of the Walter model? 3. State Gordon’s basic valuation formula. How is it derived? 4. What are the implications of Gordon’s basic model? 5: State the traditional postion onthe relationship between dividend policy and shares 6. Crtcally evaluate the evidence trotted bythe traditionalists in supporto theis per 7. Whats the substance of Miller and Modigliani ‘dividend irrelevance’ theoree 8. Prove the ‘dividend irrelevance’ theorem, - 9. Discuss the criticisms ofthe Miller and Modigliani position, 21.1 The following information "Earnings per share m2 21suring restments soto Mending 0 the Gordon model p= Bai) 2 —br the various values given, we get Plugging ‘in 501-06) solving this for r, we Bet = 0.20 = 20 percent 6 Tax on dividend at 20% ett 38, and k = 0.15, the value of P f = for the three difte ee 5 rent payout r wo! fe . 1.60 + (2.40)0.18 /15 mn i gig) a = heey 2.00 +(2.00)0.18 /. : AS ‘ aah t on =% 28.80 “penit information is available for Kavita Musicals De ings Pet share 285.00 pte of 0 required by shareholders = 16 percent hat the Gordon valuation model hold Is, what rat to ensure that the market price is® 50 when thoaisiuendy Beh seek 9 ayout is 40 percent? rate of return of 20 percent on its investmen ts. ct the share of firm Hence, Kavita Musicals must earn @ 113 Thestocks of firms X and Y are Monsidered to be equally risky. Investors exPe ‘athe firm which does not plan to Pay Gividend to be worth € 180 nex! year Frome 8 share of frm Y, too, investors expect @ payoff of € 180 — Z 15 by way of dividend ‘and & 165 by way of share price a year from now. Dividends are taxed at 20 and capital gains at 10 percent. ‘What will be the current price af the shares of X and Y, if each ‘of them offers an expected post-tax rate ofretum of 15 percent. thssume that the radical position applies: ae i calculated below: the current price per share of X and Py, the current price pershare of ¥ are H Firm X Firm Y 1. Next year’s price 180 aly 2 Dividend a os ‘ Total pre-tax payoff ae p . parce nce a 2 165 -Py Capital gain i x e3 aFi sep es 7. Post-tax dividend Pi ‘g. Tax on capital gains at 19 9, Posttax capital gains 10. Total post-tax return 7) 11, Post-tax rate of return (10)/(4) ee 90(180-Bo) _ 9.15 Py Since 12+.90065-R) _ 5 Re [PRosuens] 21.1 Walter and Gordon Model The following data is available for Parkson Earnings per share Internal rate of return Cost of capital = 12 percent If Walter's valuation formula holds, what will be the ratio is 50 percent? 75 percent? 100 percent? If Gordon's basic valuation formula holds, what Payout is 25 percent, 50 percent, and 75 percent? 24.2 Radical Position The stocks of firms Pand Q areconsi jhe share of firm P ~the firm which does not plan to From the share of firm Q, too, i € 74 by way of share price a year from now. Divi at 10 percent. What will be the ae Pee cere nd ani ime that the radical positi expected post-tax rate of 14 percent? Avan 1e current price of t] wpancial Management cee 0 10180 — P;) 90180 - Px) .90(180 — Px) So, Py = 154.29 So, Py=* 152.85 Company: ion applies Price per share when the divicens Pej will be the price per share when the ive