Theories:

The Relevance Concept of Dividend or the Theory of Relevance

WALTER’S MODEL:
This theory is propounded by Professor James E. Walter. It says that dividend policy always affects
the value of the firm.

Water’s model is based on the following assumptions:

(1) The firm finance its entire investments by means of retained earnings. New equity
stock or debenture is not issued to raise funds.
(2) Internal rate of return (r) and cost of capital (Ke) of the firm remain constant.
(3) The firm’s earnings are either distributed as dividends or reinvested internally.
(4) Earnings and dividends of the firm never change.
(5) The firm has long or infinite life.
The formula used by Walter to determine the market price per share is :
P=

D+ r ( E-D)
K
P= _____________________

Where,
P = Market price per share
D = Dividend per share
E = Earnings per share
r = Internal rate of return (Actual capitalization rate)
K = Cost capital (External capitalization rate)

Gordons Model :

Myron Gordon has also developed a model on the lines of Prof. Walter suggesting that
dividends are relevant and the dividend decision of the firm affects its value. His basic
valuation model is based on the following assumptions:
1. The firm is an all equity firm.
2. No external financing is available or used. Retained earnings represent the only source
of financing investment programmes.
3. The rate of return on the firm’s investment r, is constant.
4. The retention ratio, b, once decided upon is constant. Thus, the growth rate of the
firm g = br, is also constant.
5. The cost of capital for the firm remains constant and it is greater than the growth rate,
i.e. k > br.
6. The firm has prepetual life.
7. Corporate taxes do not exist.
Gordon’s basis valuation formula can be simplified as under:
P= E( 1-b)
_______________

Ke - br

P= D
____________

Ke - br

Where,
P = Price of shares
E = Earnings per share
b = Retention Ratio
ke = Cost of equity capital
br = g = growth rate in r, i.e., rate of return on investment of an all-equity firm
D = Dividend per share

The Irrelevance Concept of Dividend or the Theory of Irrelevance

MODIGLIANI-MILLER’S MODEL (M-M’S MODEL) :

Modigliani-Miller’s (M-M’s) thoughts for irrelevance of dividends are most comprehensive
and logical. According to them, dividend policy does not affect the value of a firm and is
therefore, of no consequence. It is the earning potentiality and investment policy of the firm
rather than its pattern of distribution of earnings that affects value of the firm.
Basic Assumptions of M-M Approach
(1) There exists perfect capital market where all investors are rational. Information is available to all
at no cost; there are no transaction costs and floatation costs. There is no such investor as could
alone influence market value of shares.
(2) There does not exist taxes. Alternatively, there is no tax differential between income on dividend
and capital gains.
(3) Firm has uncertainty as to future investments and profits of the firm. Thus, investors are able to
predict future prices and dividend with certainty. This assumption is dropped by M-M later.
Criticism of MM Approach
MM hypothesis has been criticized on account of various unrealistic assumptions as given below.
1. Perfect capital market does not exist in reality.
2. Information about the company is not available to all the persons.
3. The firms have to incur flotation costs while issuing securities.
4. Taxes do exit and there is normally different tax treatment for dividends and capital gain.
5. The firms do not follow a rigid investment policy.
6. The investors have to pay brokerage, fees etc., while doing any transaction.
7. Shareholders may prefer current income as compared to further gains.