Dividend Theory

By SUDIPTA DE

Issues in Dividend Policy

Earnings to be Distributed High Vs. Low Payout. Objective Maximize Shareholders Return. Effects Taxes, Investment and Financing Decision.

Relevance Vs. Irrelevance

Walter's Model Gordon's Model Modigliani and Miller Hypothesis The Bird in the Hand Argument Informational Content Market Imperfections

WALTER MODEL
Assumptions Valuation Optimum Payout Criticism

Ratio

Assumptions

Internal Financing:
The firm finances all investment from retained earning, debt or new equity is not issued.

Constant Return and Cost of Capital:

The firms rate of return (r) and cost of capital (k) are constant.

100% Payout or Retention:

All earnings are either distributed as dividends or reinvested internally immediately.

Constant EPS and DPS:

Beginning earning and dividends never change.

Infinite Time:
The firm has infinite life.

Valuation

Market price per share is the sum of the present value of the infinite stream of constant dividends and present value of the infinite stream of capital gains.

(r / k ) P (DIV / k ) (EPS DIV) k

Example
r 0.15, 0.10, 0.08 k 0.10 EPS Rs 10 DPS 40% (0.15 / 0.1) P (4 / 0.1) (10 4) Rs 130 0.1 (0.10 / 0.1) P (4 / 0.1) (10 4) Rs 100 0.1 (0.08 / 0.1) P (4 / 0.1) (10 4) Rs 88 0.1

Optimum Payout Ratio

When r>k.
Situation of a growth firms which have an abundance of profitable investment opportunities so that return from investments exceeds the cost of capital.

When r<k.
Situation of declining firm which do not have profitable investment opportunities.

When r=k.
Situation of normal firms which generally do not have unlimited profitable investment opportunities.

Criticism of Walter Model:

No external financing. Constant return (r). Constant opportunity cost of capital (k).

GORDONS MODEL
Assumptions Valuation Optimum Criticism

Payout Ratio

Assumptions

All Equity Firm:

The firm is an all equity firm, and it has no debt.

No External Financing:
Retained earning is the only source of fund.

Constant Return and Cost of Capital:

The firms rate of return (r) and cost of capital (k) are constant.

Perpetual Earnings:
The firm and its stream of earnings are perpetual.

Assumptions (Cont.)

No Taxes:
Corporate tax does not exists.

Constant Retention:
The retention ratio (b), once decided upon remain constant. And the growth rate i.e g = br is constant.

Cost of Capital greater than Growth Rate:

The discount rate is greater than growth rate.

Valuation

Market value of a share is equal to the present value of an infinite stream of dividends to be received by shareholders.

P EPS(1 b) /(k br )

Example
r 0.15, 0.10, 0.08 k 0.10 EPS Rs 10 b 60% P (1 0.6) / 0.10 (0.15 * 0.6) = Rs 400 P 10(1 6) / 0.10 (0.10 * 0.6) = Rs 100 P 10(1 0.6) / 0.10 (0.08 * 0.6) = Rs 77

Optimum Payout Ratio

When r>k.
Situation of a growth firms which have an abundance of profitable investment opportunities so that return from investments exceeds the cost of capital.

When r<k.
Situation of declining firm which do not have profitable investment opportunities.

When r=k.
Situation of normal firms which generally do not have unlimited profitable investment opportunities.

The Bird in the Hand

Argument put forward, first of all, by Kirshman Investors are risk averters. They consider distant dividends as less certain than near dividends. Rate at which an investor discounts his dividend stream from a given firm increases with the futurity of dividend stream and hence lowering share prices.

Thank you.