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Dividend theory The term dividend theory refers to the part of a company which is distributed by the company among

its shareholder after execution of retained earning it is the reward of the shareholder for the investment made by them in the shares for the other word it is retained that a share holder gets from the company out of profit on his shareholding A major decision of financial management is the dividend in the sense that the firm has to choose between distributing the profits to the shareholder and ploughing them back into the business, the choice would obviously hinge on the effect of the decision on the maximization of shareholder wealth given the objective of financial management of maximizing present values. The firm should be guided by the consideration as to which alternative use is consistent with the goal of wealth maximization that is the firm consideration as to which alternative use is goal of wealth maximization that is the firm is well advised to use net profits for paying dividends to the shareholders if the payment will lead to maximization of wealth of the owners if not the firm should rather them to finance investments programs. The relationship between dividends and the value of the firm should, therefore be the decision criterion There are however conflicting opinions regarding the impact of dividends on the value of the firm. According to one school of thought dividends are irrelevant so that the amount of dividends paid has no effects on the valuation of a firm. On the other hand certain theories consider the dividend decision as relevant of the value of the firm measured in terms of the market price of the shares The value of the firm can be maximized if the shareholders wealth is maximized there are conflicting views regarding the impact of dividend decision on the value of the firm. According to one school of thought dividend decision does not affect the shareholders wealth and hence the valuation of the firm. On the other hand according to the other school of thought, dividend decision materially affects the shareholder wealth and also valuation of the firm The relevance concept of dividend includes: 1,Walters approach 2,Gordons approach

The irrelevance concept of dividend includes: 1,Residual approach 2,Modigliani and miller approach (mm model) Walters model: Prof. Walters approach support the doctrine decisions are relevant and affect the value of the firm. The relationship between the internal rate of return earned by the firm and the cost of capital is very significant in determining the dividend policy to sub serve the ultimate goal of maximizing the wealth of the shareholders. Prof. Walters model is based on the relationship between the firms 1,return on investment (r) To cost of capital k According to prof. Walter if r > k if the firm earns higher rate of return in its investment than the required rate of return the firm should retain earnings, such firms are termed as growth firm and the optimum payout would be zero in the case. This would maximize the value of shares. In case of declining firms which do not have profitable investments where are, r < k the shareholders would stand to gain if the firm distributes its earnings for such firms the optimum payout would be 100% and the firm should distribute the entire earnings as dividends. In case of normal firms where r=k the dividend policy will not affect the market value of shares. As the shareholders will get the same return as expected by them for such firms there is no optimum dividend payout and the value of the firm would not change with the change in dividend rate. P = D Ke g P = Price of equity shares Initial dividend Cost of equity capital Growth rate expected


D = Ke = g =

Gordons model: Myrion garden contended that dividends are relevant. He proposed model of stock valuation use in the dividend capitalization approach according to garden dividend policy of the firm is based on the few following assumptions. Assumptions of gordens model all equity firms the firm is an all equity firm and it has no debt No external financing is available consequently retained earning would be used to finance any expansion thus just an Walters model and gordens model to confounds dividend and investment policy Constant return the internal rate of return r of the firm is constant. This ignores the diminishing marginal efficiency of the investment Constant cost of capital the appropriate discount rate k for the firm remains constant thus Gordons model also ignores the affect of a change in the firms risk class and its effects on k Perpetual earnings the firm and its stream of earnings are perpetual no taxes corporate do not exist Constant retention the return in ratio once decided upon its constant thus the growth rate g=br is constant forever cost of capital greater than growth rate the discount rate is greater than growth rate k > br=g if this condition is not fulfilled we cannot get a meaningful value for the share. Stock Value (P) = D / k G In this formula, "D" 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. Modigliani miller approach to Capital Structure In an article published in 1958, Modigliani and Miller propounded their view which is known as Modigliani-Miller Approach. Their approach is identical with the net operating income approach. They have also concluded that in the absence of taxes, a firms market value and the cost of capital remain constant to the changes in capital structure. In other words, an optimum capital structure does not exits. The net operating income approach leads to the same conclusion, but Modigliani and miller have provided a behavioral justification in favor of this conclusion. That is, they refer to a particular behavior of the investors in support of this conclusion.

Assumptions Their conclusion is based on the following assumptions: The capital market is perfect in the sense that investors have perfect knowledge of market forces; they are free to buy and sell securities; the cost of transactions is zero; and they behave rationally. Firms can be classified into different group consisting of firms having equal business risks. They can be divided into equivalent risk class. Since all investors have complete information, they all use the same figure of net operating income of the firm to ascertain its market value. All firms distribute the entire earning among their shareholders in the form of dividend. It means dividend payout ratio is 100%.

Modigliani and Miller make the following propositions: 1. The total market value of a firm and its cost of capital are independent of its capital structure. The total market value of the firm is given by capitalizing the expected stream of operating earnings at a discount rate considered appropriate for its risk class. 2. The cost of equity (Ke) is equal to capitalization rate of pure equity stream plus a premium for financial risk. The financial risk increases with more debt content in the capital structure. As a result, Ke increases in a manner to offset exactly the use of less expensive source of funds. 3. The cut off rate for investment purpose is completely independent of the way in which the investment is financed.