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# CHAPTER: DIVIDEND POLICY AND FIRM VALUE

CONTENTS

## DIVIDEND POLICY WHY DIVIDEND POLICY ?

Dividend policy of a firm determines what proportion of earnings is paid to shareholders by way of dividends and what proportion is ploughed back in the firm for investment purposes.

## FIVE SECTIONS OF DIVIDEND POLICY

1. Models in which investment and dividend decisions are related. 2. Traditional positions. 3. Miller and Modigliani position. 4. Radical position. 5. Overall picture.

## 1. Models in which investment and dividend decisions are related.

WALTER MODEL James Walter has proposed a model of share valuation which supports the view that the dividend policy of the firm has the bearing on share valuation. His model is based on the following assumptions:
1.

2. 3.

The firm is an all-equity financed entity. It will rely only on retained earnings to finance its future investments. This means that the investment decision is depend on the dividend decisions. The rate of return on investments is constant. The firm has an infinite life.

Equation:
P = D + (E - D)r/K k P = price per equity share D = dividend per share E = earnings per share (E - D) = retained earnings per share r = rate of return on investments k = cost of capital

## Numerical example for Walter Model

Growth firm: r>k r = 20% k = 15% E = rs. 4 If D= 4 P0= 4+(0).20/.15 0.15 = Rs. 26.67 If D= 2 P0= 2+(0).20/.15 0.15 = Rs. 31.11 Normal firm: r=k Declining firm: r<k r = 15% r = 10% k = 15% k = 15% E = rs. 4 E = rs. 4 If D= 4 If D= 4 P0= 4+(0).15/.15 P0= 4+(0).10/.15 0.15 0.15 = Rs, 26.67 = Rs. 26.67 If D= 2 If D= 2 P0=2+(0).15/.15 P0= 2+(0).10/.15 0.15 0.15 = Rs, 26.67 = Rs. 22.22

## 1. Models in which investment and dividend decisions are related. (cont.)

GORDON MODEL Myron Gordon proposed a model of stock valuation by using the dividend capitalization approach. His model is based on following assumptions:
1. 2. 3. 4. 5. 6.

Retained earnings represent the only source of financing the firm. The rate of return on the firms investment is constant. The growth rate of the firm is the product of its retention ratio and its rate of return. The cost of capital for the firm remains constant and it is greater than the growth rate. The firm has perpetual life. Tax does not exist.

Equation:
P0 = E1 (1 - b) k br P0 =price at the end of the year 0 E1 = earning per share at the end of the year 1 (1 - b) = fraction of earnings the firm distributes by way of dividends b = fraction of earnings the firm retains k = rate of return required by the shareholders r = rate of return earned on investments br = growth rate of earnings and dividends

## Numerical example for Gordon Model

Growth firm: r>k Normal firm: r=k = 15% = 15% = rs. 4 If b=0.25 P0= (0.75)4 0.15-(0.25)(0.15) = Rs, 26.67 If b=Rs. 0.5 P0= (0.50)4 0.15-(0.5)(0.15) = Rs, 26.67 Declining firm: r<k r = 10% k = 15% E = rs. 4 If b=0.25 P0= (0.75)4 0.15-(0.25)(0.10) = Rs. 24.00 If b=Rs. 0.5 P0= (0.50)4 0.15-(0.5)(0.10) = Rs. 20.00 r = 20% r k = 15% k E = rs. 4 E If b=0.25 P0= (0.75)4 0.15-(0.25)(0.20) = Rs. 30 If b=Rs. 0.5 P0= (0.50)4 0.15-(0.5)(0.20) = Rs. 40

The traditional position expounded by Graham and Dodd holds that the stock market places considerably more weight on dividends than on retained earnings.

Equation:
P = m (D + E/3) P = market price per share D = dividend per share E = earnings per share m = multiplier Here, E = (D + R) P = m (D + D + R) 3

Empirical Evidence
Advocates of the traditional position cite the results of cross-section regression analysis like the following: Price = a + b Dividend + c Retained earnings Price = a + b Dividend + c Retained earnings + d Risk

## 3. Miller and Modigliani position.

Miller and Modigliani have advanced the view that the value of a firm depends solely on its earning power and it is not influenced by the manner in which its earnings are split between dividends and retained earnings. The following are the assumptions:
1.

2. 3. 4. 5.

Capital markets are perfect and investors are rational: information is freely available, transactions are instantaneous and costless, securities are divisible, and no investor can influence market prices. Floatation costs are nil. There are no taxes. Investment opportunities and future profits of firms are known with certainty. Investment and dividend decisions are independent.

Equation:
P0 = 1 ( D1 (1 + p) P0 = market price D1 = dividend per P1 = market price + P1) per share at time 0 share at time 1 per share at time 1

Criticisms of MM Position

Information About Prospects Uncertainty and Fluctuations Offering of Additional Equity at Lower Prices Issue Cost Transaction Cost Differential Rates of Taxes Rationing: Self-imposed or Marketimposed Unwise Investments