CHAPTER

10 Uividend Decision and Valuation of the

Firm
wo basic school of thoughts on dividend policy have been expressed tn ne
theoreticalliterature of finance. One school, associated with Myron Gordon anu
Jon Lintner,holdsthatthe capitalgainsexpected to result from earnngs reren
tons are more risky than are dividend expectations According, thuS schoo
Suggeststhat the earnings of a firm with a low payout ratio willtypicaly De
capitalized athigherratesthantheearningsofahighpayoutfirm. Theothersehool
ssociatedwith MertonMiller& FrancoModigliani, holdsthatinvestorsarebasicalgy
indifferent toreturnsin the form of dividends orcapitalgains.Empirically, when
firmas raiseorlowertheir dividend, theirstockprices tend to rise or fall z ke
mannerdoes this notprovethatinvestors preferdividends

SYNOPSIS
Concept and Significance.
Dividend and Valuation of the Firm.
Relevance of Dividend Policy.
Walter's Model.
Gordon's Model.
Irrelevance of Dividend Policy.
Residuals Theory of Dividend Policy.
Modigliani and Miller Theory.
Graded Illustrations in Dividend and Value ofthe Firm.

DOW JONES

0n J. Fred and Brigham E.F, Managerial Finance, The Dryden Press, Ilinois, Fifth Edition, p. 698
Weston
205
206
PARTV: DIVIDEND DECISION
h e term dividend refers to that portion of profit (after
tax) which is distributed among the owners/share-
holders ofthe firm. The profit which is not distributed
is known as retained earnings. A company may have preter
ence sharecapital aswellas equity share capital and dividends
may be paid on both types of capital. However, there is as
such, no decision involved as far as the dividend payable to
preference shareholders is concerned. The reason being that
thepreference dividend is more or less, a contractual liability
and is payableat a fixed rate. On the other hand, a firm has to
consider a whole lot of factors before deciding for the equity
dividend. The expected level of cash dividend, from the point
of view ofequity shareholders, is the key variable from which
the shareholders and equity investors determine the share
value. The establishment and determination of an effective
dividend policy is therefore, of significant importance to the
tirm's overall objective. However, the development of such a
A whole gamut of considerations
policy is not an easy job.
aftecting the dividend decision is there. The dividend decision
may seem to be simple enough, but it evokes a surprising
amount of controversy.
Concept and Significance: The dividend decision is one of the
three basic decisions which a financial manager may be
required to take, the other two being the investment decisions
and the financing decisions. In each period any earning that
remains after satisftying obligations to the creditors, the Gov-
ernment, and the preference shareholders can either be
retained, or paid out as dividends or bifurcated between
retained earnings and dividends. The retained earnings can
then be invested in assets which will help the firm to increase
or at least maintain its present rate of growth. The dividend
decision requires a financial manager to decide about the
distribution of profits as dividends. The profits may be distrib-
uted either in the form of cash dividends to shareholders or
in the form of stock dividends (also known as bonus shares)
At present, only the cash dividends are being discussed and
the distribution of profit in the form of bonus shares will be
taken up in the next chapter.
In dividend decision, a financial manager is concerned to
decide one or more of the following:
Should the profits be ploughed back to finance the
investmentdecisions?
Whether any dividend be paid? If yes, how much divi-
dends be paid?
When thesedividends be paid? Interim or Final ?
In what form the dividends be paid? Cash dividend or
Bonus Shares?
All these decisions are inter-related and have bearing on the
future growth plans of the firm. If a firm pays dividends, it
affects the cash flow position of the firm but earns a goodwill
among the investors
who therefore, may be willing to provide
of the
additional funds for the financing of investment plans
are not distributed
firm. On the other hand, the profits which
as dividends become an easily available source of funds at no
However, in the case of ploughing
back of
explicit costs.
profits, the firm may loose the goodwill and confidenea
investors and may also defy the standards set by other
Therefore, in taking the dividend decision, the financiat
and analyze various factors
ager has to consider
decision is to be critically evaluate
aspects of dividend
most important of these considerations is to decide asth
portion of profit should be distributed. This is also kngutowha
the dividend payout ratio.
Dividend Policy and Value of the Firm :Dividend pol
whether to pay divide
basically concerned with deciding
cash nowW, or to pay increased dividends at a later sta
distribution of profits in the form of bonus shares
tage o
current dividend provides liquidity to the investors but The
bonus share will bring capital gains to the shareholders 1he
investor's preferences between the current cash dividend. he
the future capital gain have been viewed differently. Some
of the opinion that the future capital gain are more risky th ate
the current dividends while others argue that the invest
are indifferent between the current dividend and the f u t
sture
capital gains.
The basic question to be resolved while framing the divid
policy may be stated simply What is sound rationale
vidend
dividend payments? n the light of the objective of maximi
fo
the value of the share, the question may be restated
zing
follows: Given the firm's investments and financing deg
sions, what is the effect of the firm's dividend policieson th
share price? Does a high dividend paymentdecrease,increas
or does not affect at all the share price. In the first instancei
may be argued that the dividend poicy is important.The
value of the share is defined to be equal to the present valie
of expected future dividends. So, how can now be suggeste
that the dividend is not relevant? The dividend policy has bee
a controversial issue among the financial managers and is
often referred to as a dividend puzzle.
Different models have been proposed to evaluate the divi
dend policy decision in relation to value of the firm. Whie
agreement is not found among the models as to the precise
relationship, it is still worth while to examine some of these
models to gain insight into the effect which the dividend
policy might have on the market price of the share and hence
on the wealth of the shareholders. Two schools of thoughts
have emerged on the relationship betweenthe dividendpoligy
and value of the firm.
One school associated with Walter, Gordon, etc, holdsthat
the future capital gains (expected to result from lowercuma
dividend payout) are more risky and the investors have
preference for current dividends. The investors do have al
towards those firms which pay regular dividend. So, te
dividend payment affects the market value of thesharean
as a result the dividend policy is relevant for the overallvalue
of the firm. On the other hand, the other school of thoug
associated with Modigliani and Miller holds that the investo
are basically indifferent between current cash dividendsa
future capital gains. Both these schools of thought on
relationship between dividend policy and value otthe
have been discussed as follows:
 207
. 10: DIVIDEND DECISION AND VALUATION OF THE FIRM

RELE
/ANCE OF DIVIDEND POLICY of return which is less
a rate
than the
are expected to give the firm
l the firms pay dividends and view shareholders of the firm, then
such opportunity cost of the
Gene Dositively. The investors also expect anddividend
like to
Should better distribute the entire profits.
This will give
dividend
naymidend income
receive
dividend on their
investments. The firms not Opportunity to the
shareholders to reinvest this
dividends may be adversely rated income and get higher returns
Day by the investors
thereby the market value of the share. of a firm depends
aftect of those supporting the dividend The basic Innutshell, therefore, the dividend policy (ie, a case of a
upon the relationship between r & k. If >k,
r
argu ash dividends reduce investors relevance is that growth firm), the firm should have zero payout
and reinvest
will discount the firm's earnings atuncertainty,
a lower
the
toearn more than the investors.If
the entire profits
however,
rate,
inveslacing a higher value on the shares. If dividends arek, ratio and let the
rKk,then the firm should have 100%payout
therethen
not paid then the uncertainty of
shareholders/investors will shareholders reinvest their dividend income to
earn higher
shareholders
ising the required rate of return,
increase, raising returns, IfP happens to be just equal to k, the
atively lower arket price of the share. k, So, resulting
in
it may be be indifferent whether the firm pays dividends or retains
will firm from
arguedthat the dividend policy has an effect on the market the profits. In such a case, the returns to the
to the
value of
the shareand the value of the firm. Afirm reinvesting the retained earnings will be just equal
dividend to areholders to fulfil the expectations shouldof pay
the earnings available to the shareholders on their
investment of

areholders in order to maintain or increase the dividend income.

market
price
of the share. Two models representing this argument and
Thus, a firm can maximize the market value of its share
here.
the value of the firm by adopting a dividend policy as follows
discussed :
may be
WAL.TER'S MODEL: Walter J.E. supports the view that the ( Ifr>k, the payout ratio should be zero (ie, retention of
.
kidend policy has a bearing on the market price of the share the
100% profit). Higher the retention, higher would be
nd has presented a model to explain the relevance of divi
price
Hend policy for valuation of the firm based on the following firm
dend (i) Ifr <k, the payout ratio should be 100% and the
assumptions should not retain any profit, Higher the dividend, higher
( All investment proposals of the firm are to be financed would be the price, and
through retained earnings only and no external finance is (ii) Ifr=k, the dividend is irrelevant and the dividend policy
available to the firm. is not expected to affect the market value of the share.
(iThe business-risk complexion ofthe firm remains same Inorder to testify the above, Walter has suggested amathemati-
even after firesh investment decisions are taken. In other
cal model ie,
words, the rate of return on investment ie, Yand the cost
of capital of the firm ie, k, are constant. D r/k)E-D)
(ii The firm has an infinite life.
This model considers that the investment decision and divi where, P Market price of Equity share
dend decision of a firm are inter-related. A firm should or
Dividend per share paid by the Firm.
should not pay dividends depends upon whether it has got the
Rate of return on Investment of the Firm.
suitable investment opportunities to invest the retained earn-
ings ornot. This model can now be presented as follows: Cost of Equity share capital, and
fa firm pays dividends to shareholders, they in turn, will E Earnings per share of the Firm.
nvest this income to get further returns. This expected return As per the above formula, the market price of a share is the
to shareholders is the opportunity cost of the firm and hence sum of two components Le,
the cost of capital, k, to the firm. On the other hand, if the firm () The present value of an infinite stream of dividends, and
does not pay dividends, and instead retains, then these re
return on (i) The present value of an intinite stream of return tronm
1ained earnings will be reinvested by the firm to get retained earnings.
r, of
nese investment. This rate of return on the investment,Ifr=
tnefirm must be at least equal to the cost of capital, k,. Thus, the Walter's formula shows that the market value of a
firm is just equal to what the share share is the present value of the expected stream of dividends
Athe earning a return
to
OIders could have earned, had the dividends been paid and capital gains. The effect of varying payout ratio on the
them. market price of the share under different rate of returns, r,
of return, r, is more than the have been shown in Example 10.1.
ver, what happen if the rate
firm can earn more by
Capital, k, ? In such a case, the
n g the profits, than the
shareholders can earn by Example 10.1
thus,
ng their dividend income. The Walter's model, The following information is available in respect of ABC Ltd.
and
refrain from dividends
a t itr>k, the firm should and thereby increase Earning per share (EPS or E) R10(Constant)
reinvest the retained earnings Cost of Capital, k,
the wealth of 1the shareholders. However,
if the investment
=10 (Constant)
the retain earnings
nities before the firm to reinvest
 208 PART IV: DIVIDEND DECISION

Find out the market price of the share under different rate of Gordon has also proposed
2. GORDON'S MODEL: Myron
dividend policy is relevant and Can
return, r, of 86, 10% and 15% for different payout ratios of 0%, model suggesting that the
that of the firm. This moda
odel
40%, 80%, and 100%. affect the value of the share and
similar to that made
Solution is also based on the assumptions
additional assumptions male
The market price of the share as per Walter's model may be
Walter's model. However, two nade
calculated for different combinations of rate of return and by this model are as follows:
firm g, is the product of
dividend payout ratios (the earnings per share, E, and the cost () The growth rate of the
of capital, k, taken as constant) as follows retention ratio, and its rate of return, r, iLe, g=br, an
b,
15 more
Ifthe rate of return, r,=15% and the dividend payout ratio is (i) The cost of capital besides being
constant than
406, then the growth rate ie, k, >g
Gordon argues that the investor do
have a preference fo
(r/k)E-D) current dividends and there is a direct relationship between
the dividend policy and the market value of the share. He hae
built the model on the basic premise that the investors are
P (15/.10)(10-4) dividends
the future
.10 10 basically risk averse and they evaluate
40 +90130 capital gains as a risky and uncertain proposition. Dividends
are more predictable than capital gains; management can
Similarly, if r= 8% and Dividend Payout ratio = 80%, then control dividends but it cannot dictate the market price of the
share. Investors are certain of receiving incomes from divi
8 CO8/.10)(10-8) dends than from future capital gains. The incremental isk
.10 10 associated with capital gains implies a higher required rate of
80+ 16=96 return for discounting the capital gains than for discounting

The expected market price of the share under different the current dividends. In other words, an investor values

combinations of r'and payout ratio have been calculated and current dividends more highly than an expected future capi
presented in Table 10.1. tal gain.
TABLE 10.1: MARKET PRICE UNDER WALTER'S So, the 'bird-in-the-hand" argument of this model suggests
MODEL FOR DIFFERENT COMBINATIONS that the dividend policy is relevant as the investors prefer
OF AND PAYOUT RATIO. current dividends as against the future uncertain capital
gains. When the investors are certain about their returns, they
r=15%6 T=10% 8% discount the firm's earnings at a lower rate and therefore
D/P Ratio 0% 150 100 80 placing a higher value for the share and that of the firm. So
40% 130 100 88 the investors require a higher rate of return as retention rate
80% 110 100 96 increases and this would adversely affect the share price
100% 100 100 100
Thus, Gordon's model is a share valuation model (ike that of
It may be seen from Table 10.1 that for a growth firm (r= 15% Walter's). Under this model, the market price of a share can
and r>k), the market price is highest at R 150 when the firm be calculated asfollows
adopts a zero payout and retains the entire earnings. As the
payout increases gradually from 0%o to 10096, the market price P
E(1-b)
tends to decrease from R 150 to R 100. For a firm having r <k. k-br
(ie,r=89), the market price is highest when the payout ratio
is 100% and the firm retains no profit. However,ifr=k=10%, where, P Market price of Equity share.
then the price is constant at R 100 for different payout ratios. E Earnings per share of the Firm.
Such a firm does not have any optimum payout ratio and b Retention Ratio (1 - Payout ratio).
every payout ratio is as good as any other.
Rate of return on Investment of the Fim.
Critical Appraisal : The Walter's model provides a theoretical
and simple frame work to explain the relationship between
k Cost of Equity share capital, and

dividend policy and value of the firm. As far as the assump- br g ie, Growth rate of the firm.
tions underlying the model hold good, the behaviour of the This model shows that there is a relationship between payout
market price of the share in response to the dividend policy of ratio (ie, 1-b), cost of capital k, rate of return, r, and the
the firm can be explained with the help of this model. How market value of the share. This can be explained with the help
ever, the limitation of this model is that these underlying of Example 10.2.
assumptions are unrealistic. The financing of investment
proposals only by retained earnings and no external financing
is seldom found in real life. The assumption of constant r'and Example10.2
constant 'k, is also unrealistic and does not hold good. As The following information is available in respect of XYZ Ltd
more and more investment are made, the risk complexion of
Earning per share (EPS or E) 10 (Constant)
the firm will change and consequently the k. may not remain
Cost of Capital, k .10 (Constant)
constant.
 CH. 10 209
DIVIDEND DECISION AND VALUATION OF THE FIRM
Marke et Drice of the share under
VALUATION OE capital
10% and 15% for different rate of
different payout about receiving current
divídends or receiving
, t ,o f8%
d o u t

Cnt thought argue

ratios of 0%, advocates of thís schoolof
100%
2ains in future. The market price or
has no effect on the
and

n
800,
nat the dividend policy differentiate between the
a share. shareholders do not
The
Soluion are basIcally
ket price
of the share as per Gorden's dividend or capital gains. They the firm by
future
model may be present earned by
he
y l a t e da st o l l o w s

calkulat
Interested in higher returns either
investment opportunity or
tr=150andpay vout ratio is 406, then the reinvesting profits in profitable of diVIdend

owth rate,g=br=retention
investment
ratio, b, earned by themselves by making
6(ie,1-4)and 09 (i.e., 6 X the dividend irrelevance
15) Income. The underlying intuition for
price of the share is: dividends offer
Pthemarket is simple: Firms that pay more
proposition the same total
return to
E(1-b) price appreciation but provide
ess characteristics of the
firm. The
k-br shareholders, given the risk returns in
indifferent of receiving
their
10 (1-6) investors should be of increase in the
the form of current dividends or in the form
=R 400
.10-09 market price of the share.
is based on two pre-
payout ratio is 809% then the The dividends irrelevance argument
retention ratio, b, is have
fr-8%
and
1-8)and the growth rate, g=br=.016(ie,.2X.08) and Conditions: () That
financing decisions
investment and

and that these decisionswillnot be altered

rice of the share is already been made
and (i) That the perfect
by the amount of dividends payment,
t h e
m a r k e t

10 (1-2) investor can buy and sell

=R95 capital market is there in which an
and that the compa-
.10-016 the shares without any transaction cost
flotation cost. Two theories
without any
l the expected market price under different combi nies can issue shares the irrelevance of
have been discussed here to focus
on
Snationsof
fand
r dividend payout ratio have been calculated firm
valuation of the it is well
though
dividend policy for
in Table 10.2. structure irrelevance propost-
andplaced accepted that like the capital
TABLE10.2:MARKET PRICE UNDER GORDON'S MODEL has its roots in the
tion, the dividend irrelevance argument
FOR DIFFERENT COMBINATIONS Modigliani-Miller Analysis.
OF F AND PAYOUT RATIO. This theory is based
1. RESIDUALS THEORY OF DIVIDENDS:
external financing is not
r=15% r= 10% r=8% on the assumption that either the
D/PRatio be used due to its
0
available to the firm or if available, cannot
0 investment oppor-
0% excessive costs for financing the protitable
7400 7 100 77 finances its invest-
40% tunities of the firm. Therefore, the firm
114.3 100 95 to
retaining profits. The quantum profits
80% of
100 100 100
ment decisions by
100%
be distributed is a balancing figure and thus depends upon
firm has
given in Table 10.2, it can be seen that what portions of profits is to be retained. If a
On the basis of figures then the wealth
be sufficient profitable investment opportunities,
if the firm adopts a zero payout then the investor may
not
and
br), of the shareholders will be maximized by retaining profits
willingto offer any price. For a growth firm (ie, r>k,> of investment opportunities
the market price decreases when the payout ratio is in- reinvesting them in the financing
dividend to the
increases either by reducing or even by paying no
creased. Fora firm having r <k, the market price shareholders. If a firm has no such investment opportunity,
when the payout ratio is increased.
then the be distributed among the shareholders.
profits may
the market price
Ifr=k, the dividend policy is irrelevant and
Gordon has argued Thus, if a firm chooses to issue securities than retaining
remains constant at R 100 only. However, matters and the profits, a larger amount of the issue is required
to receive the
ratio
thatevenifr=k, the dividend payout dividends which are
current
net amount for the investment. For example, R 50,00,000 is
if
nvestors being risk averse prefer uncertain. The needed to finance the proposed investment and the flotation
which are
Certain to future capital gains rate Le, k, to cost is 20%6, then the firm will be required make an issue of
to
nvestors will apply a higher pitalization
This will compensate them
62,50,000, so that the net proceeds with the company are
COunt the future capital gains. the market 50,00,000. This means that the new capital will be more
uncertain capital gain and thus,
uture
profit will be expensive than the retention of earnings. In effect, the flota-
the share of
PCe of a firm which retains tion cost eliminates the indifference between financing by
adversely affected. internal capital (ie., retention) and new issue. Given the
the divi-
ordon's conclusionabout the relationship between flotation cost, dividends would be paid only if profits are not
similar to that of
dend
lpolicy and the value of the firm are
completely used for investment purposes ie, only when the
the r e a s o n that the firm has some residual earnings after the financing of new
ter's model. The similarity is due to are same.
models investments. This is referred to as the Residuals Theory of
nderlying mptions of both the
dividends.

HRELEVANCE OF DIVIDEND POLICY Thus, a firm does not decide as to how much dividends be paid
valuation rather it decides as to how much protits should be retained.
on dividend policy and The profits not required to be retained may be distributed as
ofthSChool of thought a firm pays
as
dividends to
what
that indiffer dividends. Therefore, dividend decision is a passive decision.
hareholrgues shareholders are
c r s Is irrelevant and the
 210 PARTV: DIVIDEND DECISION
The dividends are a distribution of residual profits after decision and operatingg cash flows are same no
retaining sufficient profit for financing the available opportu which dividend policy is adopted. matter
nities. Under the Residuals Theory, the firm would treat the The Model: Under thee assumptions stated above, MMar
dividend decision in three stepS that neither the firm paying dividends nor the sharehol
(0 Determining the level of capital expenditures which is receiving the dividends will be adversely affected by 6
determined by the investment opportunities. paying either too little or too much dividends. They hav
the arbitrage process to show that the division of
() Using the optimal financing mix, find out the amount of
equity financing needed to support the capital expendi between dividends and retained earnings is irrelevantprofits
fr
the point of view of the shareholders. The Model shoue
ture in step () above.
a firm will finanee i
(it) As the cost of retained earnings, k, is less than the cost of given the investment opportunities,
either by ploughing back profits or if pays dividends,then
new equitycapital, the retained earnings would be used raise an equal amount of new share capital externally
en wil
tomeet equity portions financing in step (i) above.lt
the b
the available profits are more than this need, then the selling new shares. The amount of dividends paid toexies sting
shareholders will be replaced by new share capital raie
surplus may be distributed as dividends to shareholders. aised
externally. The benefit of increase in market value as a reed
As far as the required equity financing is in excess of the esult
of dividend payment will be offset completely by the decreae
amount of profits available, no dividends would be paid ease
in terminal value of the share. The shareholders therefo
to the shareholders. would be indifferent between the dividend payments
Inthe Residuals Theory, the dividends policy is influenced by retaining the profits. In order to testity their argument, MM
( the company's investment opportunities, and (i) the avail-
ability of internally generated funds, where dividends are paid
have presented the following valuation model:
only after all acceptable investment proposals have been
financed. The dividend policy is totally passive in nature and Po x(D, +P)
(1+k)
(10.1)
has no direct influence on the market price of the share. So,
the Residuals Theory treats the dividend as a passive decision Present market price of the share
where, P%
determined by the availability of profitable investments.
Consequently, the dividends may fluctuate from one year to
k Cost of equity share capital
Expected dividend at the end of year1
an other depending upon the investment opportunity. But the D,
Expected market price of the share at the
shareholders do not show any concern to the fluctuations in P
dividends as they are compensated for reduction in dividends end of year 1
or no dividends at all by future capital gains. The market price If the company has 'n' number of equity shares outstanding
of the share is still taken as the present value of all future then the value of the firm is n times P, or
dividends and the pattern of these dividends does not matter
2. MODIGLIANI AND MILLER APPROACH: The irrelevance of
nP X(nD tnP) (10.2)
dividend policy for valuation of the firm has been most (1+k)
comprehensively presented by Modigliani and Miller (MM). Now, the company can, finance its investment proposal either
They have argued that the market price of a share is affected by retained earnings or by sale of new shares. Say, the
by the earnings of the firm and is not influenced by the patterm company plans to issue 'm'number ot equity shares at a price
of income distribution. The dividend policy is immaterial and P are arising funds equal to mP,, to finance the investment
is of no consequence to the value of the firm. What matters, opportunities at the end of year 1. The value of the fim
on the other hand, is the investment decisions which deter- theretore, may be defined as
mine the earnings of the firm and thus affect the value of the
firm. They argue that subject to a number of assumptions, the nPo X [nD, +nP t mP, -mP]
way a firnm splits its earnings between
dividends and retained (1+k)
earnings has no etfect on the value of the firm. nP x [nD, +(n-tm)P- mP (10.3)
Assumptions of the MM Approach: The MM approach to (1+k)
irrelevance of dividend is based on the following assump- It may be observed that mP, in Equation 10.3 is equal to the
funds raised by the firm by the issue of new shares at year
tions:
This is also equal to the total investment at the end of year
() The capital markets are perfect and the investors behave
less the amount of retained earnings, or
rationally.
(it) All informations are freely available to all the
investors. mP I-(E-nD,)
I-E+nlD, (10.4)
and no time lag.
(it) There is no transaction cost where, Total investment to be made at year
Securities are divisible and can be split into any fraction.
(iv) E Total earnings of the firm.
flotation cost.
(1) There are no taxes and no Equation 10.4 simply states that the firm must issue
fresh
st
investment policy and the future capital of an amount equal to total requirement for n
(v) The firm has a defined The implication is that ment as reduced by the profit retained. And, the profits
profits are known with certainty. the dividend
the investment decisions
unatfected
are by
 211
CH. 10
DIVIDEND DECISION AND VALUATION OF THE
FIRM
ends upon the amount of dividends be? 105, if the
share is expected to
r e t a i n e d
d e p e n d s

of capital furids needs is not

S0, whatever o f
paid ie, nD. So, the market príce of the
(ie, E3-nD) must be
financed by re firm pays dividend of 5.
edhare capital. Subs
launed
earnings financed by the issue of value of D, is 0)
bstituting the Equation 10.4 into 2. 1f dividend of 5 is not pald (the
ltes Equa
t i o n1 0 . 3

P X(D, +P)
X [nD, +(n + m) P, -(1-E (1+k)
nP (1 +k) +nD)] P,(1+k)= D,+P,
1
(1+k tn+ m) P, -I+ E-nD,1 P,(1+k)-D,
100(1.10) =110.
1
(1+k) X [n + m) P - I+E] So, the market price of theshare is expected
to be110,if the
(10.5) firm does not pay dividend of 5 .
is not founddiin Equation 10.5 and other variables i.e, of the shareholders
D,
Since However, in both the cases, the position
E and are all k independent 1 share will be
(ntm) PL
of D, MM have would be same. A shareholder having, say,
luded that thevalue of the firm, nP does not depend on whether the firm pays
having same worth of his holding
dividend decision and hence the dividend dividend or not. In case, the dividend of 7 5 is paid, he will
thea policy is irrel- market price of
evant. receive 5 from the firm as dividend and the
the share would be 105, giving a total worth of 7 110. In case
UnderMM Model del, the number of new equity shares, m, to be share or
found as follows: the dividend is not paid then the market price of the
issuedcan be the worth of the shareholder would be still7 110. So, the
m =I-E-mD,)]P shareholder would be indifferent whether dividend is paid
or

t may be noted that there will not be any change in the MM not to him. The same example can be extended further to
tirm.
nosition whether the new funds are raised by the issue of
analyze the effect of arbitrage process employed by the
fresh shares or by the issue of debt securities. In the capital 1
Say, the firm has total profits of 7 10,00,000 during the year
structure irrelevance theorem (as discussed in Chapter 8), the and is planning to make an investment of 7 20,00,000 at the
MM model has shown that the financing mix is irrelevant for end of the year 1. The arbitrage process and value of the firm
the value of the firm. may be explained as follows:
The success of the MM model depends upon the arbitrage 1.If dividend of 7 5 is paid by the firm at the end of the year 1:
process ie., replacement of amount paid as dividend by the
Total Earnings 10,00,000
issue of fresh capital. The arbitrage process involves twvo
Dividends paid (1,00,000 x 5) 5,00,000
simultaneous actions. With reterence to dividend policy,
thesetwO actions are: Retained Earnings 5,00,000
Total funds required for investment 20,00,000
9 Payment of dividend by the firm, and
Therefore, fresh capital to be issued 15,00,000
(in Raising of fresh capital. Market price at the end of the year 1 105
With the help of arbitrage process, MM have shown that the Number of shares to be issued (I5,00,000/105) 14285.71
dividend payment will not have any effect on the value of the Total number of shares (1,00,000+14,285.7 1) 1,14,285.71
firm. Even if the firm pays dividends, resulting in a increase in Applying Equation 10.5, the value of the firm, nP, is :
market value of the share, the effect on the value of the firm
will be neutralized by the decrease in terminal value of the nPo x [(ntm)P, - +E]

share. The working of the arbitrage process may be substan- (1+k)

tiated as follows: 1 X [1,14,285.7 1)105-20,00,000-+10,00,000
Say, a firm has 1,00,000 shares outstanding and is planning to (1+.10)
declare a dividend ofR 5 at the end of current financial year.
X [120,00,000-20,00,000-+10,00,000]
Thepresent market price of the share is 100. The cost of (1+.10)
equity capital, k, may be taken at 109%. The expected market 100,00,000
price at the end of the year 1 may be found under two options
2. If dividend of R 5 is not paid by the firm at the end of the
( if dividend of T 5 is paid, and (i) if dividend is not paid, as
year 1:
follows:
Total Earnings
i t dividend of 5 is paid (the value of D, is 5): 10,00,000
Dividends paid
Retained Earnings
P x(D +P) Total funds required for investment
10,00,000
(1+k) 20,00,000
Therefore, fresh capital to be issued
10,00,000
P(1+k) D,+P, Market price at the end of the year 1
110
Number of share to be issued
P P,(1+k-D Total number of shares
(10,00,000/110) 9,090.9
100 (1.10)-5 =105. (1,00,000+9,090.9) 1,09,090.9
 DIVIDEND DECISION
212
PART IV
firm, nP, is
Applying Equation 10.5, the value of the
nP X [a+m)P-1+E]
1+k)
I(1,09,090.9) 110-20,00,000+10,00,000]
(1+.10)
1 investors may prefer current
1 to1,20,00,000 -20,00,000+10,00,000]
1+.10)
100,00,000
So, the value of the firm remains same at 7 100,00,000 whether
the dividend is paid or not. With the help of
arbitrage
process,
as explained above, it can be shown that the dividend policy
IS irrelevant for the valuation of the firm. Dividend payment
does not affect the value of the firm.
It may be noted that the Equation 10.5, as used
the current market value of the firm, ie, nP
above, gives
The MM model
shows that whether dividend is paid or not at the end of
current year, the present market value of the firm remains
same at 100,00,000. The same example can be expanded to
find out the expected market value of the firm at the end of
current year as follows
() If dividend ofR 5 is paid:
Total number of shares 1,14,285.71
Market price, P 105
Total market value (1,14,285.71 X 105) 1,20,00,000
(b) If dividend of 5 is not paid:
Total number of shares 1,09,090.90
Market price, P 110
Total market value (1,09,090.90 X 110) 1,20,00,000
Thus, the expected market value at the end of current year is
same at 1,20,00,000, whether the firm pays dividend of
5 or not. The MM model shows therefore, that the current
market value or the expected market value of the firm, both
are unatfected by the dividend decision of the firm.
Critical Appraisal: Under the assumptions set by MM, this
model testifies that dividend is irrelevant and the investors are
indifferent between the current dividends and the future
capital gains. Given these assumptions, the effect of a divi-
dend decision may be stated as: Thatthereis no relationship
between dividend policy and value of the share. One dividend
policy is as good as another. Investors are concerned only with
total returns and are indifferent whether these returns are
coming as dividend income or from capital gains.
The critics of MM model argue that the assumptions under-
lying the model are unrealistic and vulnerable and have
disputed the validity of dividend irrelevance. The assump-
tions needed to arrive at the dividend irrelevance may seem
so onerous that these may be rejected outrightly. In particu-
lar, the MM model may be criticized as follows:
() The assumption of perfect capital market is theoretical
in nature as the perfect capital market is never found in
practice.
(1) No flotation cost and no time lag assumptions are also
unrealistic. In reality, the fact is otherwise and companies
have to incur expenses in raising fresh equity capital from
the market and that too requires a time gap to fulfil
of legal formalities for raising capital,
etc
transaction costs is in
(it) Similarly, theassumptionofno 15iTmag
nary. Some brokerage
commission
or elc. 15
payable
the investors whenever they decide in future to enea
future capitalgain arisingout of bonus shares. Hencee, the cash
dividend.
(iv) Assumption of no tax is also questionable There is eneral
to dividend incom
ly a difference in tax rate applicable
capital gains in the hands shareholdere
of the
and For
example, in India, the dividend income is non-taxable
ole in
the hands of the shareholders while they are required
flat rate of 20% on capital gains arisingod
dto
paid taxes at a gOut
of sale of shares. Moreover, the cost of bonus shares
sis
taken as nil with the result that whole of the selling ms.
of bonus shares is treated as capital gains resulting
price
substantial tax liability of the shareholders. Therefor
in
ore,
the investors may have a preference o r current divi
dends as against the expected capital gains.
() MM have assumed that the investment policy of the fim
is independent of the financing policy. But, some ofthe
firms may undertake only limited investment projects
which can be financed by retained earnings only. Some
companies, even if they are willing, may not find condu
cive conditions to raise capital from the market. There
may be legal constraints in raising capital or the investors
may be less willing to subscribe to the fresh capital in
such situations, the firm will have a tendency to retain as
much profits as possible by lowering the payout ratio.
(v) The MM model may not hold good if the firm is not able
to issue additional equity share capital at thethen prevail
ing current market price when dividends are paid andare
to be replaced by fresh funds. These new shares would
possibly be offered in the capital market and can besold
at a price lower than the then prevailing current market
price. Consequently, the firm would be required tosell
more shares. Thus, the firm may find the retention of
profits as a better option than paying dividends to share
holders and simultaneously raising fresh capital.
Thus, the MM model is not a practical proposition. The
dividend irrelevance argument does not seem to be feasible
when the assumptions underlying the MM model are
relaxed
Conclusion: The discussion of different models is indicative
of the fact that investors do prefer current dividend to
retained earnings. The reason for this is obvious that the
present dividends are certain. Investors assign higher value to
certain stream of dividends. A financial manager should also
recognize the existence of different types of investors. Alow
payout and consequently higher retention with higher ex
pected growth will attract and satisfy the risk oriented inves
tors while the high payout and consequently low retention
and low growth rate will attract and
satisfy the risk averse and
conservative investors.
Therefore, neither 100% payout nor 0% payout will bring the
maximum market price. The
in between. Too much
optimum point lies somewhere
payment inspite of reinvestment op
portunities causes the investor to penalize the share
pric
 213
CH. 10 DIVIDEND DECISION AND VALUATION OF THE RM
FI
httle payout also causes the investors to have less
those firms which
whilet o
still the dividend payout ratio shouldpenalize the dividend payout ratio among
be lower opportunities of growth.
are firms having good growth
among
the
opportunities than the
PoINTS TO REMEMBER

decision is another important decision which a prove to

Dividend
M M Model has introduced arbitrage process
manager has to take, whether the tirm
financial that the value of the firm
remain same

eally,
Basically, dividend decision involves the bifurcation of pays dividends or not.
of thefirm
fi into Dividends and Retained earnings. arbitrage between payment of
profits MM Model involves an
Thedividend decision is also referred to as the dividend dividend and issue of fresh capital
assump
The MM Model is based on certain hypothetical
policy.
ore
There has been a ditterence of opinion on the effect of tions and so it is not a practical proposition.
dividend policy on the value ot the firm. Two schools of be ascer-
rought have emerged on the relationship between the T h e market price under different models may
tained as follows:
dividend policy and value of the firm,

On one hand, there are a few models (e.g. Walters Model r/k)E-D)
Walter's Model P
and Gordons Model which consider dividend as relevant
for the value of the firm. The argument lies on the fact
that investors do have a preterence for current dividend
E(1-b)
Gordon's Model P =

as these are more certain than the future dividends. k-br

On the other hand, the Residuals Theory and the MM 1 X(D, +P)
MM Model P
Model argue that dividend is irrelevant for the value of (1+k)
the firm. What is more important is the retention of profit
for the reinvestment. What is not retained is distributed.

GRADED ILLUSTRATIONS
be better to retain the earnings rather than distributing in
Illustration 10.1 term of dividends, for maximizing the equity shareholder's
Following are the details regarding three companies ALtd, B wealth. The value of the share is the highest 110) when
Ltd. and C Ltd.: D/P ratio is at its lowest (ie, 25%)
A Ltd. B Ltd. Ltd. BLtd. This company is a "declining firm". Therate of return
is less than the cost of capital (ie, r<k).lt will, therefore, be
r=15% r=5% r=10%
appropriate for this company to distribute the earnings among
k= 109% k = 10%
k=109% its shareholders rather than retaining. The value of share of
E=R8 E =R8 E=8 this company goes on increasing with every inerease in the

Calculate the value of an equity share of each of these D/P ratio.

companies applying Walter's formula when dividend pay- C Ltd. This may be characterized as a "normal firm. In case
ratio (D/P ratio) is : () 25%, (b) 50%, () 75%, of this company r= k. Hence, D/P ratio does not have any
ment impact on the value of the company's shares. The value of the
Whatconclusions do you draw? B.Com.(H), D.U, 2013]
share continues to be 80 in all three situations.
Solution
VALUE OF AN EQUITY SHARE AS PER WALTER'S Illustration 10.2
FORMULA
The earnings per share of a share of the face value of 100 of
D (r/k) (E-D) POR Ltd. is R20.It has a rate of return of 25%. Capitalization
P rate of its risk class is 12.5%. If Walter's modelis used
B C (a) What should be the optimum payout ratio?
P-R50 P=R80 (b) What should be the market price per share it the payout
When D/P ratio is 25% P=R110
When D/P ratio is 50% P=R 100
P=R60 P=R80 ratio is zero?
P 70 P=780
() When D/P ratio is 75% P=R90 (c) Suppose, the company has a payout of 25% of EPS, what
would be the price per share?
Conclusion:
lon:
of retur
A Ltd. This is growth
company a
n 1s higher than the cost of capital (ie, r>k). It will
firm. The rate
214 PART IV DIVIDEND DECISION

Are you satisfied with the currentdividend policy of the firmp

Solution
If not, what should be the optimal dividend payout ratio? Use
As per Walter's formula, the price of the share is
Walter's Model. B. Com. (H), D.U. 2011
D (r/k)(E-D) Solution:
Market Price
(a)Ifr> k, the value of share will increase with every Price Earnings Ratiob
EPS
increase in retention. The price of the share would be the
maximum when the firm retains all the earnings. Thus, Market Price
the optimum payout ratio is zero for POR Ltd. 8

(6) Calculation of market price when the payout ratio is zero: So, Market price =
8X5 740
0+(25/0.125)(20) 5,00,000
= R 320 EPS =75
0.125 1,00,000
(Payoutof 25% of EPS i.e., 25% of 2075 per share: 3,00,000
DPS =73
D (r/k) E-D) 1,00,000
DPS
k Dividend payout ratio x 100 X100=60%
EPS
5+(25/0.125)20-5) = 7 280
0.125 Walter's Model: As the P/E ratio is given 8,and the k, is also
defined as the reciprocal of P/E ratio, therefore, the k may be
taken as 1/8 =.125.
lustration 10.3
Since, this is a growth firm having rate of return (15%) > cost
The earnings per share of ABC Ltd. is 10 and rate of
of capital of 12.5%, therefore, the company will maximize its
capitalization applicable to it is 10%. The company has before
market price if it retains 100% of profits. The current market
it the options of adopting apay-out of 20% or 40% or 80%. Using
price of 40 (based on P/Eratio can be increased by reducing
Walter's formula, compute the market value of the company's
the payout ratio. If the company opts for 100% retention (ie,
share if theproductivity of retained earnings is () 20%, (i) 109%,
0% payout), the market price of the share as per Walter's
or (i) 8%.
formula would be as follows
Solution:
Walter's Formula:
D (r/kE-D)
P
D r/k)E - D) k

Dividend per share ()

P
125
(15/.125)-z48
.125
Dividend Payout ratio
So, the firm can increase the market price of the share up to
20% 209% of 7 10 2
48 by increasing the retention ratio to 1006 or in other
40% 409% of 7 10=4
words, the optimal dividend payout for the firm is 0.
80% 80% of 7 10 8
Market Price per share if the Productivity of retained earnings
llustration 10.5
) is
The earnings per share (EPS) of a company is R 10. It has an
(i) at 10% iit) at 8%
a t 20% internal rate of return of 15% and the capitalisation rate of its
(a) 20%Payout ratio (a) 20% Payout ratio
(a) 20% Payout ratio
=R 100 =R84 risk class is 12.5%. If Walter's Model is used
180
40% Payout ratio (b) 40% Payout ratio (b) 40% Payout ratio () What should be the optimum payout ratio of the com-
(b)
160 =R 100 =R88
pany?
(c) 80% Payout ratio (c) 80% Payout ratio
(c)80% Payout ratio
100 96 (i) What would be the price of the share at this payout?
=7 120
(ii) How shall the price of the share be affected, if a different
Illustration 10.4 payout were employed?
Determine the market value of equity shares of the company Solution
from the following information: Walter's Model to determine share value:
Earnings of the company R5,00,000 r/k (E- D)
Market Price pershare P =-
Dividend paid 3,00,000
Number of shares outstanding 1,00,000 where, D = Dividend per share, E Earning per share,

Price-earning ratio 8 Return on Investment and k Capitalization rate

Rate of return on investment 15%
If r>k the value of the share will increase as
retent
increases. The price of the share would be maximum whe
 CH. 10
VIDEND DECISION AND 215
7 e t a i n s all the
earnings. VALUATIONOF THE PIR
is zero. When theThus, the
all

optimum optimum
fim
p m payout value o
he
payment is Which the dividend policy will have no effect on the
o i nt h i s

share is
ofthe zero, the share
price
0+(0.15/0.125) (10-0) 12 Solution
P=- 0.125 0.125 96
Ihe EPS of the firm is 10 (ie, 2,00,000/20,000), 1he
be
t h ef i r mc h o o s e ses a payout oth E is
Ratio given at 12.5 and the cost of capital, k, may
price of the takenattheinverseof P/Eratio. Therefore, k,is 8(1e, 1/ 1
ll fall. Suppose, the firm has a H
payment of 20%, the
share
share will be Ihe firm is distributing total dividends of 7 1,50,000 among
f the dividend share of 7.50. The value
2+(0.15/0.125) (10-2) 20,000 shares, giving a per
Or the share as per Walter's model may be found as follows
11.60
P= 0.125 25 92.80
0.125 D (r/kE-D)
P=-
ustration f0.6 k k
7.50 (10/.08)(10-1) 132.81
ABC
and
has beentollowing a dividend policy which .08 08
can
aximizet h e market value of the firm as
per Walter's model
at dividend time the The firm has dividend payout of 75% (ie, T 1,50,000) out of
dingly, each year,
a

Or capital budget is total earnings of 7 2,00,000. Since, the rate of return of

the
emewea conjunction with the earnings for the periods and theretore, by
alernal
ative investment
opportunities for the shareholders. firm, r, is 10% and it is more than the k, of 8%,
following an
distributing 75% of earnings, the firm is not
arrent year, the tirm expects
earnings of T 5,00,000. It optimal dividend policy.
n d that the firm can earn 1,00,000 if the
issThe profits are would be
In this case, the optimal dividend policy for the firm
etained. . investors have alternative investment opportu- to pay zero dividend and in such a situation, the market price
atwill yield them 10% return. The firm has 50,000
nities would be
res utstanding. hat should be the dividend payout ratio
order to maximizethe wealth of the shareholders? Also find (r/k)E-D)
non P
the current market price of the share. k
t

Solution:
10/.8)(10-0 156.25
The firm is expecting to earn an income of 7 1,00,000 on the 08 .08
stment of the profits of current year ie, 7 5,00,000. So, the increased by follow-
So, the market price of the share can be
rate of return, I, is 20% (ie, 1,00,000/5,00,000). The opportu- ing a zero payout.
nity cost of the shareholders is given at 10%. It means that the The P/Eratio at which the dividend policy will have no etfect
rate of return of the firm, r, is more than the opportunity cost on the value of the firm is such at which the k would be equal
of capital, k to the rate of return, r, of the firm. The k, would be 10% (=
at the P/E ratio of 10. Therefore, at the P/E ratio
of 10, the
The earningsS per share of the firm is 10 (i.e, 7 5,00,000/ of the firm.
effect the value
50,000). Since, r> k, the optimal D/P ratio, in order to dividend would
policy have no on

maximize the wealth of the shareholder, is that the firm need

not distribute any dividend. If no dividend is distributed by llustration10.8
of the
the firm, then, as per Walter's model, the market price ABC Ltd. was starteda year ago with a paid-up equity capital
shareis: of R 40,00,000. The other details are as under:

P /kJE-D) Earnings of the company 4,00,000

Dividend paid R3,20,000
Price-earnings ratio 12.5

.10
(20/.10)(10)-R200
.10
Number of shares 40,000
() Find the company's dividend payout ratio. Find the
market price ot a share ot the company at this payout
llustration 10.7 ratio, using Walter's model.

Om the following information supplied to you, ascertaim (i) Is the company's dividend payout ratio optimal as
dividend policy as
Vether the firm is following an optimal per the Walter's model? Why?
per Walter's Model? (iit) What is the market price of a share of the company
2,00,000
Total Earnings at the 'optimal dividend payout' ratio as per the
20,000 Walter's model? [B.Com. (H,) D.U, 2010
Number of equity shares (of 7 100 each)
1,50,000
Dividend paid 12.5
Solution
Price/Earning ratio on fresh Dividend PayoutRatio
Dividend 3,20,000
The firm is expected
e to maintain its
rate of return Earnings 4,00,000
S the P/E ratio at
hvestmen what should be 800%
et Also find out
 216 PART IV DIVIDEND DECISION

Market price as per Walter's Model: llustration 10.10

r 4,00,000/40,00,000 10% Assuming that rate of return expected by investor is 11
internal rate of return is 12%; and earnings pershareis
k 1/PE Ratio=1/12.5=08 or 8% calculate price per share by 'Gordon Approach method
E 4,00,000+40,000-10 dividend payout ratio is 10% and 30%.
D 3,20,00040,000 8
Solution
(E-D) P, EX1-
D k MPas per Gordons Approach,
=

P k-br
k In the given case, = 116

8 0 8(10-8) r =129%
08
--131.25 EPS 7 15
08
ABC Ltd. has r of 109% and k of 89%. The Walter's Model If Dividend Payout is 10%, then retention ratio, b, is 90%

suggests that when r >k, the company should distribute

lesser and lesser dividends to maximise the MP. So, the
P= 1 5 ( 1 - 9 )
11-12X9
15-750
002
company is not following optimal policy. The optimal policy If Dividend Payout is 309%, then retention ratio, b is 70
tor the company would be to distribute no dividend. In this
case, the MP of the share would be: P=3-)= =173.08
.11-12 X.7 026

P 8 (10-0)
=R 156.25 llustration 10.11
08 08
RST Ltd. has a capital of 7 10,00,000 in equity shares of
100 each. The shares are currently quoted at par. The
lllustration 10.9
company proposes to declare a dividend of R 10 per share at
A company has total investment of 7 5,00,000 assets and the end of the current financial year. The capitalization rate
50,000 outstanding equity shares of 7 10 each. It earns a rate for the risk class to which the company belongs is 129%.What
of 15% on its investments, and has a policy of retaining 509% of will be the market price of the share at the end of the year,if
the earnings. If the appropriate discount rate for the firm is
() Adividend is not declared?
109%, determine the price of its share using Gordon Model.
(i) A dividend is declared?
What shall happen to the price, if the company has a payout
of 80% or 209%? (it) Assuming that the company pays the dividend andhas
net profits of T 5,00,000 and makes new investments of
Solution: F10,00,000 during the period, how many newshares must
The Gordon' share valuation model is as under be issued? Use the MM Model.
Solution:
(EPS) (1- b)
P k-br
Under MM Model, the current market price of equityshares
is
where b = Retention ratio =.50 or .20 or .80
P, x0, +P)
discount
r = rate ofreturn=.15
rate=.10
()
1+k
Ifthe dividends is not declared:
EPS .15X 10=7 1.50
At a payment of 50%, the price of the share is:
100
1+.12 x(0+ P)
(1-0.5)0.15X 10 0.75 100 P
= 30 1.12
Po 0.10-0.15 x0.5 0.025
P=112
At a payment of 80 %, the price of the share is
The market price of the equity share at the end of the year
would be 7112.
(1-0.2)0.15X10 1.20
R17.14 (i) If the dividend is declared:
P 0.10-0.15 X0.2 0.07
When the payment is 20 %, the price of the share is: 100= X (10+ P)
1+0.12
(1-0.8) 0.15 X 10 0.30
=-715 100= 10+P
P 0.10-0.15 X0.8 -0.02 1.12
112 10 +P
In the last case, the share price is negative which is unrealistic.
P 112-10 7 102
 CH. 10
DIVIDEND DECISION AND
A VALUATH OF THE PIRM
217
tnrice of the equity share at
the end of the
T h em a r

would be 102, yeart mx16 5,60,000-80,000

case
firm pays
lhe firm
the dividends of R 10 m 4,80,000/16-30,000 new shares
(i)In of R5,00,000 and plans to per share out of
company should issue 30,000 new
shares at the rateot
total profits make new o,the
fR 10,00,000,the number of shares invest 16 per share in order to finance its investment proposas
to be issued
m e n t

found as tollows:
may be
Total Earnings lfustration 10.13
5,00,000 sharesselling at
Dividends paid Bestbuy Auto Ltd. has outstanding 1,20,000
1,00,000 make a net incomeot
Retained earnings 20 per share. The company hopes to 2014. Thecom
Total funds required 4,00,000 3,50,000 during the year ended 31st March
7 2 per share at the
funds to be raised 10,00,000 pany is, considering to pay a dividend of
Fresh end of curTent year. The capitalisation rate for risk class ofthis
6,00,000
Market price of the share 102 company has been estimated to be 15%. Assuming no taxes,
mber of shares to be issued ( 6,00,000/102) 5 88) 25
Numb answer the questions listed below on the basis of the Modigijan
lo firm should issue 5,885 new shares @
or,th 102 per share Miller Dividend Valuation Model:
its investment proposals ) What will be the price of a share at the end of 31st March,
tofinance
lustration 10.12
2014, if (a) the dividend is paid; and (h) if the dividendis
not paid ?
Ltd. has 80,000 shares outstanding.
The current mar
Texth
(1) How many new shares must the company issue if the
nrice of these shares is I5 each. The Company expect a
dividend is paid and company needs 7,40,000 for an
net profit of R2,40,000 during the year and it belongs toarisk approved investment expenditure during the year?
ass for which the appropriate capitalization rate has been B.Com. (H), D.U, 2014
stimated to be 20%. The Company is considering dividend of
for the current year. Solution
2 per share
id What will be the price of the share at the end of the year As per MM Model, the price of the share (if the dividend is
(if the dividend is paid and (i) if the dividend is not paid? paid)
(b How many new shares must the Co. issue if the dividend D, +P
is paid and the Co. needs 5,60,000 for an approved P (1+k)
investment expenditure during the year? Use MM Model
for the caleulation. 20 2+P
(1+0.15)
Solution:
As per MM Model, the current market price of the share, P P -23-2=721
As per MM Model, the Price of the share if the dividend is not

paid)
4 , +P) 20 0+P
So,if the firm pays a dividendof 2, the price at the end of year
(1+0.15)
1, P, is: P 20(1.15)
P=23
15
1+.20
(2+P) The number of new equity shares can be tound as tollows:

- (2 +P)
m =
[1-NP- nd,)] P
15- 7,40,000-R3,50,000-1,20,000 X 2)
1.20
22
P=716
If the dividend is not paid, the price would be : 6,30,000
=30,000 shares
21
1
P (D, +P,) Thus, 30,000 shares will have to be issued to meet the invest
ment needs of the company.

15 0+P) lustration 10.14

1+20
P, = 18 Diamond Engineering Company has 10,00,000 equity shares
if the company pays a outstanding at the start of the accounting year. The ruling
n e w share, m, to be issued
market price per share is R150. The Board of Directors ofthe
dividend of R2: Company contemplates declaring 7 8 share as dividend at the
mP I-(E-nD,) end of the currentyear The rate of Capitalization appropriate
mXl6 5,60,000-12,40,000-(80,000X2)]
to the risk-class to which the company belongs is 12%.
 218
PART IV DIVIDEND DECISION

() Based on Modigliani-Miller
ket price per share of
Approach, calculate the mar- () If dividend of ? 8 is paid:
the company when the contem-
plated dividend is () declared and (i) not declared.
(6) How many new shares are to be issued the
at the end of the by company
accounting year on the assumption that
nP(+k) x[nD, +(n +m)P-(1-E+nD)]
the Net Income for the
year is 2 crores ? Investment (1 +k ln+m)P -I+E]
budget is 4 crores and the above
() dividends are
distributed and (i) they are not
distributed 11
+ 2 ) I01,/5.000)160-4,00,00,000+2.00.00o
000
(c) Show that the total market value of the shares at
of the
the end
accounting year will remain the same whether =715,00,00,000
dividends areeither distributed or not distributed. Also (b) If dividend of 7 8 is not paid:
find out the current market
value of the firm under both
situations. B.Com. (H), D.U, 2006, 2009 [nD, +(n +m)P, -1-E+nD,)]
Solution: P,d+k) X

()Existing market price share, Po T150 (1+k) l n tm)P, -1+E]

Contemplated DPS, D, 78
Rate of
Capitalization, k, 1
(1+.12) x[(11,19,048)168-4,00,00,000 +2,00,00,0001
0.12
Market price as per MM
approach is
715,00,00,057
Po = 1+k
+P
So, the current market value of the firm is also almost same
whether the dividend of 7 8 is paid by the firm or not at the
(9 If contemplated dividends are declared, then end
of current year.

150 8+P
1+.12 Ilustration 10.15
or,P= R 160 A company belongs to a risk-class for which the appropriate
(i) If dividends are not declared, then capitalization rate is 10%. It currently has outstanding 25,000
shares selling at 7 100 each. The firm is
0+P contemplating the
declaration of dividend of 7 5 per share at the end of the
150
1.12 current financial year. The
company expects to have a net
or, P= R 168 income of2.5 lacs and a
proposal for making new invest
(b) Calculation of number of shares to be issued ments of R 5 lacs.
Show that under the MM assumptions, the
(in '00'000) payment of divi-
dend does not affect the value of the firm.
Dividends Dividends
Distributed not Distributed (B. Com. (H), D.U. 2011]
Net Income
Solution
200 200
Total Dividends 80 (a) Existing market price share, Po 100
Retained Earnings 120 Contemplated DPS, D
200 75
Investment Budget 400 400 Rate of Capitalization,
Amount to be raised by new issues
280 200
k 10
Relevant Market Price ( per share) Market price as per MM approach is
160 168
No. of new shares to be issued
1,75,000 1,19,050
P
D, +P
(c) Total number of shares at the end of the year 1+k
Existing shares 10,00,000 10,00,000 () If contemplated dividends are declared, then
+New shares issued
1,75,000
11,75,000
1,19,048
11,19,048 100 5+P
Market price per share () 160 168 1+10
Market value of share 11,75,000X160 11,19,048X168 or, P= 105
F 18,80,00,000
=18,80,00,064 (i) If dividends are not declared, then
Thus, the total market value of shares remains almost unal-
tered whether dividends are distributed or not distributed at 100 0+P
all. 1+.10
The current market value of the firm, nPunder both the or, P= R110
conditions of dividend may be found with the help of Equa
tion 17.5 as follows:
 CH. 10: DIVIDEND DECISION AND VALUATION OF THE FIRM 219

Calculation of number of shares to be issued: Total shares 28,571.4 27272.7

( Market price per share ) 105 110
Dividends Dividends 28,571.4X 105 27,272.7X110
Distributed not Distributed Market value of share
-30,00,000 -30,00,000

Net Income
2,50,000 2,50,000 Thus, the total market value of shares remains unaffected
Total Dividends
1,25,000 whether dividends are distributed o r not distributed at all. It
Retained Earnings 1,25,000 2,50,000 may be noted that the number of the n e w shares to be issued
Investment Budget 5,00,000 5,00,000 have been taken exact at 3,571.4 and 2,272.4. But the sharees
Amount to be raised by new issues 3,75,000 2,50,000 cannot be issued in fractions. f the numberof new shares to
Relevant Market Price ( per share) 105 110 be issued is taken at integer values of 3,572 and 2,273 respec-
No. of new shares to be issued 3,571.4 2,272.7
tively, then the total market value of the firm would be
(o Total number of shares at the end of the year: 30,00,060(i.e., 28,572X105) and30,00,030 (ie., 27,273 X 110),
Existing shares
which are almost same.
25,000.00 25,000.0
+New shares issued
3,571.4 2,272.7