FINANCIAL ANALYSIS

ASSIGNMENT NO # 4
SUBMITTED TO : SIR ABID NOOR
SUBMITTED BY : USVA SALEEM
REGISTRATION # L1F17BSAF0080
SECTION : B

Q- WHAT ARE THE DIFFERENT THEORIES FOR DIVIDEND VALUATION?WHICH

THEORY YOU SEEMS AS A BEST FOR THE CORPORATION AND WHY? SUPPORT

YOUR ANSWER WITH EXAMPLE .

 Dividend Theories
Dividends and share price growth are the two ways in which wealth can be provided to
shareholders. There is an interaction between dividends and share price growth: if all earnings
are paid out as dividends, none can be reinvested to create growth, so all profitable
companies have to decide on what fraction of earnings they should pay out to investors as
dividends and what fraction of earnings should be retained.

There are two Dividend valuation Theories:

1. Relevance Theories

-The dividend valuation model

-The Gordon growth model

2.Irrelevance Theories

-Modigliani and Miller’s dividend irrelevancy theory .

Relevance Theories

1. The 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 emphasised 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.

2. The 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.

Irrelevance Theories
3. 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 4: 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

 In summary
 If the company retains earnings and uses those to ‘do more of the same’ then the share
price should not be affected.
 If the company retains earnings and uses those to produce higher returns than
demanded by investors (and that could be through expanding current operations to
become more efficient and cost effective) then dividends should be cut as that will
increase shareholder value.
 If the company retains earnings and uses those to produce lower returns than
demanded by investors (and that could be through keeping excess cash in the bank,
earning very little) then dividends should be increased to avoid the share price falling. If
the company can think of no good use

 for its earnings, it should distribute them to shareholders who can then decide for
themselves what to do with them.

Practical considerations
As so often occurs, theoretical outcomes do not always match practical considerations. So too with dividend irrelevancy.
Perhaps this is because investors do not understand or believe the theory or perhaps it is because, to derive the theory,
simplifying assumptions have to be made, such as the existence of perfect markets with no transaction costs and perfect
information.

The practical matters are:

 Signalling. The announcement of a dividend is the release of a piece of publically
available information. The semi-strong form of the efficient market hypothesis says that
the share price will react to this information. The problem is: what signal does a change
in dividend give out and therefore how should share prices move? For example, does a
cut in dividend mean that the company is conserving cash because it expects hard times
or does it mean that the company sees a great investment opportunity? There is
inevitably information asymmetry as the directors will almost certainly be in possession
of information that is not in the
 public domain. Almost always shareholders will be unsettled by abrupt changes in
dividend policy.
 Lack of trust in directors’ forecasts or justifications for dividend cuts. Really, this point
follows on from above. Directors might have been very open about a dividend policy but
if investors do not share directors’ optimism about the future success of the company,
the share price will be affected.
 Investors’ preference for current consumption rather than future promises (the ‘bird in
the hand’ argument). Here, it is argued that a current dividend means that investors
have safely received cash. Whereas, if the dividend were deferred, they are at the mercy
of future events and risks. This argument is very persuasive, but it is incorrect. Market
forces should mean that a share price has been correctly set for the level of risk and
returns made. If more cash is paid out as dividend the investor has to decide how to
invest that cash. It could be spent on another investment which has higher returns and
higher risk or on one where both returns and risks are lower. In either case, diversified
investors should be happy with the deal because the capital asset pricing model states
that extra risk is correctly compensated for by extra returns.
 The clientele effects. This idea suggests that investors buy shares that ‘suit’ their needs.
So, a pension fund will base much of its investment portfolio on its need to produce
income to pay to pensioners. It will therefore invest heavily in shares that pay regular,
relatively predictable dividends. Similarly, tax can affect investment decisions if gains are
taxed less severely than income. If a company abruptly changes its dividend policy it will
disturb investors’ carefully constructed portfolios and investors will have to adjust their
mix of shares incurring transaction costs. It is sometimes argued that if a cut in dividend
reduces an investor’s income, the investor can sell some shares to manufacture
‘income’. Of course, this will again incur transaction costs and different tax treatment.
 Company liquidity. Irrespective of all the potential share price movements that a change
in dividend policy might cause, companies have to ensure that their liquidity is sound
and might have dividend reductions forced on them if they are to stay solvent.
 Borrowing covenants. Sometimes lenders put clauses in loan agreements which limit
dividend payments, for example to a certain fraction of earnings. This is the lender
trying to ensure that the loan is more secure.

 If less cash is paid as dividends, liquidity might be better (though, of course, cash can still
be consumed on the purchase of non-current assets).
  Legal constraints. No distributable reserves mean no dividends.
 Here is perhaps a good place to mention scrip dividends. These allow shareholders to
choose to receive shares as full or partial replacement of a cash dividend. The number
of shares received is linked to the dividend and the market price of the shares so that
roughly equivalent value is received. This choice allows investors to acquire new shares
(if they don’t need the cash dividend) without transactions costs and the company can
conserve its cash and liquidity. There can also be beneficial tax effects in some
countries.

Conclusion
Dividends and dividend policy will be a continuing cause of debate and comment. The
theoretical position is clear: provided retained earnings are reinvested at the cost of equity, or
higher, shareholder wealth is increased by cutting dividends. However, in the real world,
where not necessarily all investors are logical and where transaction costs and other market
imperfections intervene, determining a successful and popular dividend policy is rather more
difficult.