ABDUL SAMEEH

L1F17BSAF0048
SUBMITTED TO: SIR ABID NOOR
SECTION B
 Theories of Dividend Valuation:
If dividends grow at a constant rate, g, forever, the present value of the common stock is the
present value of all future dividends, which – in the unique case of dividends growing at the
constant rate g – becomes what is commonly referred to as the dividend valuation model
(DVM).

Dividend Discount Model:

The dividend discount model (DDM) is a method of valuing a company's stock price based
on the theory that its stock is worth the sum of all of its future dividend payments, discounted
back to their present value.

Properties of Dividend Discount Model:

 When the growth g is zero, the dividend is capitalized.

Po= D1/r

 This equation is also used to estimate the cost of capital by solving for r.

R=D1/Po + g

 Which is equivalent to the formula of the Gordon Growth Model:

Po = D1/(k-g)

Where “Po” stands for the present stock value, “D1” stands for expected dividend per
share one year from the present time, “g” stands for rate of growth of dividends, and “k”
represents the required return rate for the equity investor.

Problems with the model:

 The presumption of a steady and perpetual growth rate less than the cost of capital may
not be reasonable.
 If the stock does not currently pay a dividend, like many growth stocks, more general
versions of the discounted dividend model must be used to value the stock. One
common technique is to assume that the Modigliani-Miller hypothesis of dividend
irrelevance is true, and therefore replace the stocks' dividend D with E earnings per
share. However, this requires the use of earnings growth rather than dividend growth,
which might be different. This approach is especially useful for computing a residual
value of future periods.
  The stock price resulting from the Gordon model is sensitive to the growth rate g
chosen.

Related methods:
 The dividend discount model is closely related to both discounted earnings and
discounted cash flow models. In either of the latter two, the value of a company is based
on how much money is made by the company.
For example, if a company consistently paid out 50% of earnings as dividends,
then the discounted dividends would be worth 50% of the discounted earnings. Also, in the
dividend discount model, a company that does not pay dividends is worth nothing.

Theories of Dividend:
 Walter’s model
 Gordon’s model
 Modigliani and Miller’s model

 Walter’s model:
The choice of dividend policies almost always affects the value of the enterprise. His
model shows clearly the importance of the relationship between the firm’s internal rate of
return (r) and its cost of capital (k) in determining the dividend policy that will maximize
the wealth of shareholders.

Following assumptions:
 The firm finances all investment through retained earnings; that is debt or new equity is

not issued.
 The firm’s internal rate of return (r), and its cost of capital (k) are constant.

 All earnings are either distributed as dividend or reinvested internally immediately.

Beginning earnings and dividends never change. The values of the earnings per share (E),

and the divided per share (D) may be changed in the model to determine results, but any

given values of E and D are assumed to remain constant forever in determining a given

value.

 The firm has a very long or infinite life.

Walter’s formula:

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

The criticisms on the model are as follows:

 Walter’s model of share valuation mixes dividend policy with investment policy of the

firm. The model assumes that the investment opportunities of the firm are financed by

retained earnings only and no external financing debt or equity is used for the purpose

when such a situation exists either the firm’s investment or its dividend policy or both

will be sub-optimum. The wealth of the owners will maximize only when this optimum

investment in made.

 Walter’s model is based on the assumption that r is constant. In fact decreases as more

investment occurs. This reflects the assumption that the most profitable investments are

made first and then the poorer investments are made.

 The firm should step at a point where r = k. This is clearly an erroneous policy and fall to

optimize the wealth of the owners.

 A firm’s cost of capital or discount rate, K, does not remain constant; it changes directly

with the firm’s risk. Thus, the present value of the firm’s income moves inversely with

the cost of capital. By assuming that the discount rate, K is constant, Walter’s model

abstracts from the effect of risk on the value of the firm.

 Gordon’s Model:
One very popular model explicitly relating the market value of the firm to dividend policy

is developed by Myron Gordon.

Assumptions:
Gordon’s model is based on the following assumptions.

 The firm is an all Equity firm.

 No external financing is available.

 The internal rate of return (r) of the firm is constant.

 The appropriate discount rate (K) of the firm remains constant.

 The firm and its stream of earnings are perpetual.

 The corporate taxes do not exist.

 The retention ratio (b), once decided upon, is constant. Thus, the growth rate (g) = br is

constant forever.

 K >br = g if this condition is not fulfilled, we cannot get a meaningful value for the share.

 According to Gordon’s dividend capitalization model, the market value of a share (Pq) is

equal to the present value of an infinite stream of dividends to be received by the share.

Thus

The above equation explicitly shows the relationship of current earnings (E),

dividend policy, (b), internal profitability (r) and the all-equity firm’s cost of capital (k), in
the determination of the value of the share (P0).

Modigliani and Miller’s Model:

According to Modigliani and Miller (M-M), dividend policy of a firm is irrelevant as it

does not affect the wealth of the shareholders. They argue that the value of the firm depends on

the firm’s earnings which result from its investment policy.

 Thus, when investment decision of the firm is given, dividend decision the split of

earnings between dividends and retained earnings is of no significance in determining the value

of the firm. M – M’s hypothesis of irrelevance is based on the following assumptions.

 The firm operates in perfect capital market

 Taxes do not exist

 The firm has a fixed investment policy

 Risk of uncertainty does not exist. That is, investors are able to forecast future prices and

dividends with certainty and one discount rate is appropriate for all securities and all time

periods. Thus, r = K = Kt for all t.

Under M – M assumptions, r will be equal to the discount rate and identical for

all shares. As a result, the price of each share must adjust so that the rate of return, which is

composed of the rate of dividends and capital gains, on every share will be equal to the discount

rate and be identical for all shares.

Criticism:
Because of the unrealistic nature of the assumption, M-M’s hypothesis lacks practical

relevance in the real world situation. Thus, it is being criticized on the following grounds.

 The assumption that taxes do not exist is far from reality.

 M-M argue that the internal and external financing are equivalent. This cannot be true if

the costs of floating new issues exist.

  According to M-M’s hypothesis the wealth of a shareholder will be same whether the

firm pays dividends or not. But, because of the transactions costs and inconvenience

associated with the sale of shares to realize capital gains, shareholders prefer dividends to

capital gains.

 Even under the condition of certainty it is not correct to assume that the discount rate (k)

should be same whether firm uses the external or internal financing.

 If investors have desire to diversify their port folios, the discount rate for external and

internal financing will be different.

 M-M argues that, even if the assumption of perfect certainty is dropped and uncertainty is

considered, dividend policy continues to be irrelevant. But according to number of

writers, dividends are relevant under conditions of uncertainty.

The uses of the dividend valuation models:

The dividend valuation model provides a device in which we can relate the value of a stock

to fundamental characteristics of the company. One use is to associate the company’s stock’s

price-to-earnings ratio to fundamental factor.

Theories:
 The dividend valuation model
 The Gordon growth model
 Modigliani and Miller’s dividend irrelevancy theory

Dividend valuation model:

 This states that the value of a company’s shares is sustained by the expectation of future

dividends. Shareholders acquire shares by paying the current share price and they would not pay

that amount if they did not think that the present value of future inflows (ie dividends) matched

the current share price. The formula for the dividend valuation model provided in the formula

sheet is:

P0 = D0 (1+ g)/(re – g)

Where:

P0 = the ex-div share price at time 0 (ie the current ex div share price)
D0 = the time 0 dividend (ie the dividend that has either just been paid or which is about to be
paid)
re = the rate of return of equity (ie the cost of equity)
g = the future  annual dividend growth rate.

Note the following carefully:

P0 is the ex div market value. The formula is based on an investment costing P0 and which
produces the first inflow after one year and then every year thereafter. If the first income arises
after one year the share value must be ex-div as a cum-div share would pay a dividend very soon
indeed.

The top line of the formula represents the dividend that will be paid at Time 1 and which will
then grow at a rate g. The use of the expression D0(1 + g) has an implicit assumption that the
growth rate, g, will also apply between the current dividend and the Time 1 dividend – but it
need not apply if a change in dividend policy is planned.

The formula can be usefully rewritten as.

P0 = D1 /(re – g)

Where D1 is the Time 1 dividend

It cannot be emphasized enough that g is the future growth rate from Time 1 onwards. Of
course, the growth rate isn’t guaranteed and the future growth rate is always an estimate. In the
absence of other information, the future growth rate is assumed to be equal to the historic growth
rate, but a change in dividend policy will undermine that assumption.

Gordon growth model:

This model examines the cause of dividend growth. Assuming that a company makes neither a
dramatic trading breakthrough (which would unexpectedly boost growth) nor suffers from a
dreadful error or misfortune (which would unexpectedly harm growth), then growth arises from
doing more of the same, such as expanding from four factories to five by investing in more non-
current assets. Apart from raising more outside capital, expansion can only happen if some
earnings are retained. If all earnings were distributed as dividend the company has no additional
capital to invest, can acquire no more assets and cannot make higher profits.

It can be relatively easily shown that both earnings growth and

dividend growth is given by:

g = bR

where b is the proportion of earnings retained  and  R is the rate that profits are earned on new
investment. Therefore, (1 – b) will be the proportion of earnings paid as a dividend. Note that the
higher b is, the higher is the growth rate: more earnings retained allows more investment to that
will then produce higher profits and allow higher dividends.

So, if earnings at time 1 are E1, the dividend will be E1(1 – b) so the dividend growth formula can
become:

P0 = D1 /(re – g) =  E1 (1 – b)/(re – bR) 

If b = 0, meaning that no earnings are retained then P0 = E1/re, which is just the present value
of a perpetuity: if earnings are constant, so are dividends and so is the share price.

If we consider that the dividend policy is represented by b and (1-b), the proportions of
earnings retained and paid out, it looks as though the formula predicts that the share price will
change if b changes, but that is not necessarily the case as we will see below.

Modigliani and Miller’s dividend irrelevancy theory:

This theory states that dividend patterns have no effect on share values. Broadly it suggests
that if a dividend is cut now then the extra retained earnings reinvested will allow futures
earnings and hence future dividends to grow. Dividend receipts by investors are lower now but
this is precisely offset by the increased present value of future dividends.

However, this equilibrium is reached only if the amounts retained are reinvested at the
cost of equity.

Example: 1
Earnings are all paid as dividend
Current position: Earnings = $0.8 per share (all paid out as dividend); RE =20%, the price per
share.

Would be:

P0 = 0.8/0.2 = $4 

(The PV of constant dividends received in perpetuity).

Example : 2

Earnings are reinvested at the cost of equity

So, what would happen if, from Time 1 onwards, half the earnings were paid out as dividend and
half retained AND re = R = 0.2 (meaning that the return required by investors is the return earned
on new investment)?

P0 = E1 (1 – b)/(re – bR) 

P0 = 0.8(1 – 0.5)/(0.2 – 0.5 x 0.2) = $4

So, no change in the share value, and so the dividends are irrelevant.

Example: 3
 Earnings are reinvested at more than the cost of
equity
For example, the company has made a technological breakthrough and invests the retained
earnings to make use of the enhanced opportunities. As you might be able to predict, this piece
of good fortune must increase the share price.

re = 0.2 (as before) and R = 0.3

P0 = 0.8(1 – 0.5)/(0.2 – 0.5 x 0.3) = $8

In this case, the share price rises because the extra earnings retained have been invested in a
particularly valuable way.

Example 3:

Earnings are reinvested at less than the cost of equity:

For example,

The company invests the retained earnings in a way that turns out to be poor. It has
messed up. As you might be able to predict, this piece of bad luck or carelessness must decrease
the share price.

re = 0.2 (as before) and R = 0.1

P0 = 0.8(1 – 0.5)/(0.2 – 0.5 x 0.1) = $2.67

I. Dividend irrelevancy theory:

The dividend irrelevancy theory asserts that dividend policy has no effect on either the price of
the firm or its cost of capital.

 The dividend irrelevancy theory put forward by Modigliani &Miller (M&M) argues that
in a perfect capital market (no taxation, no transaction costs, no market imperfections),
 existing shareholders will only be concerned about increasing their wealth, but will be
uninterested as to whether that increase comes in the form of a dividend or through
capital growth.

 As a result, a company can pay any level of dividend, with any funds shortage being met
through a new equity issue, provided it is investing in all available positive NPV projects.

 If they need cash, then any investor requiring a dividend could "manufacture" their own
by selling part of their shareholding. Equally, any shareholder wanting retentions when a
dividend is paid can buy more shares with the dividend received.

II. Dividend relevance theory:

 If the choice of the dividend policy affects the value of a firm, it is considered as relevant.
In that case a change in the dividend payout ratio will be followed by a change in the
market value of the firm. If the dividend is relevant, there must be an optimum payout
ratio. Optimum payout ratio is that ratio which gives highest market value per share.
 Practical influences, including market imperfections, mean that changes in dividend
policy, particularly reductions in dividends paid, can have an adverse effect on
shareholder wealth:
 Reductions in dividend can convey 'bad news' to shareholders (dividend signaling)
 Changes in dividend policy, particularly reductions, may conflict with investor liquidity
requirements (selling shares to 'manufacture dividends' is not a costless alternative to
being paid the dividend).
 Changes in dividend policy may upset investor tax planning (e.g. income v capital gain if
shares are sold). Companies may have attracted a certain clientele of shareholders
precisely because of their preference between income and growth.