# Dividend Theory

By SUDIPTA DE

 Effects – Taxes.  . Investment and Financing Decision.Issues in Dividend Policy Earnings to be Distributed – High Vs. Low Payout.  Objective – Maximize Shareholders Return.

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 .

  Constant EPS and DPS: – Beginning earning and dividends never change. Infinite Time: – The firm has infinite life. . debt or new equity is not issued.  Constant Return and Cost of Capital: – The firm’s rate of return (r) and cost of capital (k) are constant.Assumptions  Internal Financing: – The firm finances all investment from retained earning.  100% Payout or Retention: – All earnings are either distributed as dividends or reinvested internally immediately.

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 .

0.1 (0.Example r  0.08 k  0.1) P  (4 / 0.15.15 / 0.10.08 / 0.1 (0.10 EPS  Rs 10 DPS  40% (0. 0.1)  (10  4)  Rs 130 0.1)  (10  4)  Rs 100 0.1)  (10  4)  Rs 88 0.1 .10 / 0.1) P  (4 / 0.1) P  (4 / 0.

– Situation of normal firms which generally do not have unlimited profitable investment opportunities.  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.Optimum Payout Ratio  When r>k. – Situation of declining firm which do not have profitable investment opportunities.

 Constant opportunity cost of capital (k).  .  Constant return (r).Criticism of Walter Model: No external financing.

GORDON’S MODEL Assumptions Valuation Optimum Criticism Payout Ratio .

.  Constant Return and Cost of Capital: – The firm’s rate of return (r) and cost of capital (k) are constant.  Perpetual Earnings: – The firm and its stream of earnings are perpetual.  No External Financing: – Retained earning is the only source of fund. and it has no debt.Assumptions  All Equity Firm: – The firm is an all equity firm.

.Assumptions (Cont…. once decided upon remain constant. Constant Retention: – The retention ratio (b). And the growth rate i.)   No Taxes: – Corporate tax does not exists.  Cost of Capital greater than Growth Rate: – The discount rate is greater than growth rate.e g = br is constant.

P  EPS(1  b) /(k  br ) .Valuation  Market value of a share is equal to the present value of an infinite stream of dividends to be received by shareholders.

10 EPS  Rs 10 b  60% P  (1 – 0.6) = Rs 400 P  10(1 – 6) / 0.08 k  0.10 – (0.10 * 0. 0.6) / 0.Example r  0.6) = Rs 100 P  10(1 – 0.10 – (0. 0.15.08 * 0.10.10 – (0.15 * 0.6) / 0.6) = Rs 77 .

Optimum Payout Ratio  When r>k.  When r<k.  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. – Situation of declining firm which do not have profitable investment opportunities. – Situation of normal firms which generally do not have unlimited profitable investment opportunities. .

first of all. by Kirshman  Investors are risk averters.  . 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. They consider distant dividends as less certain than near dividends.The Bird in the Hand Argument put forward.

Thank you. .