DIVIDEND THEORIES - Relevance and

Irrelevance Theories of Dividend          

        
 DIVIDEND DECISION
• Dividend is that portion of net profits which is distributed among the
shareholders. The dividend decision of the firm is of crucial
importance for the finance manager since it determines the amount
to be distributed among shareholders and the amount of profit to be
retained in the business. Retained earnings are very important for the
growth of the firm. Shareholders may also expect the company to pay
more dividends. So both the growth of company and higher dividend
distribution are in conflict. So the dividend decision has to be taken in
the light of wealth maximisation objective. This requires a very good
balance between dividends and retention of earnings.
• A financial manager may treat the dividend decision in the following two ways:

1) As a long term financing decision:- When dividend is treated as a source of

finance, the firm will pay dividend only when it does not have profitable
investment opportunities. But the firm can also pay dividends and raise an
equal amount by the issue of shares. But this does not make any sense.

2) As a wealth maximisation decision:- Payment of current dividend has a

positive impact on the share price. So to maximise the price per share, the firm
must pay more and more dividends.
 Questions Relating to Dividend
Policies
1. What are the firms financial needs given its growth plans and investment
opportunities?
2. Who are the firms shareholders and what are their preferences with
regard to dividend payments?
3. What are the firms risks – business and financial?
4. What are the firms constraints?
5. Is control a consideration for the firm?
6. Should the firm follow a stable dividend policy?
7. How should the firm pay dividends – cash dividend or bonus shares or
shares buyback?
 STABILITY OF DIVIDENDS
• Stability of dividends is considered a desirable policy by the
management of most companies in practice.

• Stability of dividends means regularity in paying some dividend

annually, even though the amount of dividend may fluctuate over the
years, and may not be related with earnings.
 Forms of Stable Dividends
• Three forms of Stable Dividends may be distinguished:
1. Constant dividend per share or dividend rate;
2. Constant Payout; and
3. Constant dividend per share plus extra dividend.
 Merits of Stability of Dividends
• The stability of dividends has several advantages:
1. Resolution of investors uncertainty;
2. Investors desire for current income;
3. Institutional investors requirements; and
4. Raising additional finances
 Danger of Stability of Dividends
• The greatest danger in adopting a stable dividend policy is that once it
is established, it cannot be changes without affecting investors
attitude and the financial standing of the company.
• The companies with a stable dividend policy create a clientele that
depends on dividend income to meet their living and operating
expenses. A cut in dividend is considered as a cut in ‘salary‘.
 DIVIDEND AND VALUATION
• There are conflicting opinions as far as the impact of dividend
decision on the value of the firm.
According to one school of thought, dividends are relevant to the
valuation of the firm.
Others opine that dividends does not affect the value of the firm and
market price per share of the company.
 RELEVANT THEORIES
• If the choice of the dividend policy affects the value of a firm, it is
considered as relevant. In that case a change in the dividend payout
ratio will be followed by a change in the market value of the firm. If
the dividend is relevant, there must be an optimum payout ratio.
Optimum payout ratio is that ratio which gives highest market value
per share.
1. Walter‘s Model
2. Gordon‘s Model
3. ‘Bird in Hand Argument'
 Walter‘s Model

• Prof. James E Walter argues that the choice of dividend payout ratio
almost always affects the value of the firm.
• Prof. J. E. Walter has studied the significance of the relationship
between internal rate of return (R) and cost of capital (K) in
determining optimum dividend policy which maximizes the wealth of
shareholders.
 Walter‘s Model
• Walter’s model is based on the following assumptions:

1) The firm finances its entire investments by means of retained earnings only.

2) Internal rate of return (R) and cost of capital (K) of the firm remains constant.

3) The firms’ earnings are either distributed as dividends or reinvested

internally.

4) The earnings and dividends of the firm will never change.

5) The firm has a very long or infinite life.

Walter‘s Model
• Walter’s formula to determine the market price per share (P) is as
follows:
• P = D/K +[r(E-D)/K]/K
The above equation clearly reveals that the market price per share is
the sum of the present value of two sources of income:
• i) The present value of an infinite stream of constant dividends, (D/K)
and
• ii) The present value of the infinite stream of stream gains.
• [r (E-D)/K/K]
Walter‘s Model
• According to the theory, the optimum dividend policy depends on the
relationship between the firm’s internal rate of return and cost of
capital. If R>K, the firm should retain the entire earnings, whereas it
should distribute the earnings to the shareholders in case the R<K.
The rationale of R>K is that the firm is able to produce more return
than the shareholders from the retained earnings.
Walter‘s Model
• Walter’s view on optimum dividend payout ratio can be summarized as below:

a) Growth Firms (R>K):- The firms having R>K may be referred to as growth firms. The growth firms are
assumed to have ample profitable investment opportunities. These firms naturally can earn a return which
is more than what shareholders could earn on their own. So optimum payout ratio for growth firm is 0%.

b) Normal Firms (R=K):- If R is equal to K, the firm is known as normal firm. These firms earn a rate of
return which is equal to that of shareholders. In this case dividend policy will not have any influence on the
price per share. So there is nothing like optimum payout ratio for a normal firm. All the payout ratios are
optimum.

c) Declining Firm (R<K):- If the company earns a return which is less than what shareholders can earn on
their investments, it is known as declining firm. Here it will not make any sense to retain the earnings. So
entire earnings should be distributed to the shareholders to maximise price per share. Optimum payout
ratio for a declining firm is 100%.
Walter‘s Model
• So according to Walter, the optimum payout ratio is either 0% (when
R>K) or 100% (when R<K).
 Gordon’s Model
• Another theory, which contends that dividends are relevant, is the Gordon’s model. This model which opines
that dividend policy of a firm affects its value is based on the following assumptions:

a) The firm is an all equity firm (no debt).

b) There is no outside financing and all investments are financed exclusively by retained earnings.

c) Internal rate of return (R) of the firm remains constant.

d) Cost of capital (K) of the firm also remains same regardless of the change in the risk complexion of the firm.

e) The firm derives its earnings in perpetuity.

f) The retention ratio (b) once decided upon is constant. Thus the growth rate (g) is also constant (g=br).

g) K>g.

h) A corporate tax does not exist.

 Gordon’s Model
• Price of the share is determined as follows:

• P = D0(1 + g)/ (k – g) = D1/ (k – g)

Gordon’s Model

• According to Gordon, when R>K the price per share increases as the dividend payout ratio
decreases.

When R<K the price per share increases as the dividend payout ratio increases.

When R=K the price per share remains unchanged in response to the change in the payout ratio.

Thus Gordon’s view on the optimum dividend payout ratio can be summarised as below:

1) The optimum payout ratio for a growth firm (R>K) is zero.

2) There no optimum ratio for a normal firm (R=K).

3) Optimum payout ratio for a declining firm R<K is 100%.

Gordon’s Model

• Thus the Gordon’s Model’s is conclusions about dividend policy are

similar to that of Walter.
 2. Bird-in-the-Hand Theory
• The bird-in-the-hand theory, however, states that dividends are
relevant. Remember that total return (k) is equal to dividend yield
plus capital gains. Myron Gordon and John Lintner (Gordon/Litner)
took this equation and assumed that k would decrease as a
company's payout increased. As such, as a company increases its
payout ratio, investors become concerned that the company's future
capital gains will dissipate since the retained earnings that the
company reinvests into the business will be less.
Bird-in-the-Hand Theory
• Gordon and Lintner argued that investors value dividends more than capital
gains when making decisions related to stocks. The bird-in-the-hand may sound
familiar as it is taken from an old saying: "a bird in the hand is worth two in the
bush." In this theory "the bird in the hand' is referring to dividends and "the
bush" is referring to capital gains.

• A bird in hand is worth two in bush. What is available today is more important
than what may be available in the future. So the rational investors are willing to
pay a higher price for shares on which more current dividends are paid.
Relevant
• Clientele effect
• • Companies with high payouts tend to attract investors who prefer
dividends.
• Counter argument:
• • Existence of such a clientele does not imply a higher firm value.
• Information content
• • High payouts provide a signal to the market that the managers are
confident in the firm an the market in the long run.
• DIVIDEND IRRELEVANCE MODEL
 1. Dividend Irrelevance Theory
• Modigliani and Miller also theorized that, with no taxes or bankruptcy costs, dividend policy is also
irrelevant.

• This is known as the "dividend-irrelevance theory", indicating that there is no effect from dividends on a
company's capital structure or stock price.

• According to MM, the dividend policy of a firm is irrelevant, as it does not affect the wealth of
shareholders. The model which is based on certain assumptions, sidelined the importance of the dividend
policy and its effect thereof on the share price of the firm. According to the theory the value of a firm
depends solely on its earnings power resulting from the investment policy and not influenced by the
manner in which its earnings are split between dividends and retained earnings.
Dividend Irrelevance Theory
• Assumptions:

1. Capital markets are perfect:- Investors are rational information is freely available,
transaction cost are nil, securities are divisible and no investor can influence the market
price of the share.

2. There are no taxes:- No difference between tax rates on dividends and capital gains.

3. The firm has a fixed investment policy which will not change. So if the retained earnings
are reinvested, there will not be any change in the risk of the firm. So K remains same.

4. Floatation cost does not exist.

Does Dividend Policy Matter?
• Irrelevant
• Modigliani-Miller (MM): Dividend-irrelevant argument
• • Dividend policies are irrelevant to firm’s value
• Assumptions:
• • Efficient market: perfect information, well-functioning capital
market
• • Overall cash flow being held constant
• Observation 1:
• • Dividend: residual value after all financial and borrowing decisions
are made.
• • Firms are choosing between using either dividend or new shares to
finance projects.
• Observation 2: Firm’s value
• Suppose firm has $100 million and an investment project.
• Choose:
• • Use $100 million cash to reinvest in the project.
• • Distribute $100 million as dividend to shareholders and issue new
shares to finance the project.
• No matter how you use the $100 million, the cash flow of the project
is not affected. Value of the firm stays unchanged.
• Observation 3: New shareholders
• • Give up cash $100 million
• • Gain in shares that are worth $100 million
• New shareholders are not any better off (or worse off). Transform
their wealth from cash to shares.
• Observation 4: Existing shareholders
• If $100 million distributed as dividend:
• • Gain $100 million of cash.
• • Lose value on existing shares (capital loss).
• As if using “capital loss” to buy “cash.”
• • Definitely not any better off.
• • Not any worse off either!
• – Efficient market: shareholders can always sell the shares and get the
cash. Dividend is not the only way to transform wealth (shares) to
cash.
Dividend Irrelevance Theory
• The substance of MM arguments may be stated as below:

If the company retains the earnings instead of giving it out as dividends, the
shareholders enjoy capital appreciation, which is equal to the earnings, retained.

If the company distributes the earnings by the way of dividends instead of

retention, the shareholders enjoy the dividend, which is equal to the amount by
which his capital would have been appreciated had the company chosen to retain
the earnings.

Hence, the division of earnings between dividends and retained earnings is

irrelevant from the point of view of shareholders.
 Dividend Irrelevance Theory
• MM's dividend-irrelevance theory says that investors can affect their return
on a stock regardless of the stock's dividend. For example, suppose, from an
investor's perspective, that a company's dividend is too big. That investor
could then buy more stock with the dividend that is over the investor's
expectations. Likewise, if, from an investor's perspective, a company's
dividend is too small, an investor could sell some of the company's stock to
replicate the cash flow he or she expected. As such, the dividend is
irrelevant to investors, meaning investors care little about a company's
dividend policy since they can simulate their own.
3. Tax-Preference Theory
• Taxes are important considerations for investors. Remember capital gains are taxed
at a lower rate than dividends. As such, investors may prefer capital gains to
dividends. This is known as the "tax Preference theory".

Additionally, capital gains are not paid until an investment is actually sold. Investors
can control when capital gains are realized, but, they can't control dividend
payments, over which the related company has control.

Capital gains are also not realized in an estate situation. For example, suppose an
investor purchased a stock in a company 50 years ago. The investor held the stock
until his or her death, when it is passed on to an heir. That heir does not have to
pay taxes on that stock's appreciation.
The Dividend-Irrelevance Theory
and Company Valuation
• In the determination of the value of a company, dividends are often used. However, MM's dividend-
irrelevance theory indicates that there is no effect from dividends on a company's capital structure or
stock price.

MM's dividend-irrelevance theory says that investors can affect their return on a stock regardless of
the stock's dividend.

For example, suppose, from an investor's perspective, that a company's dividend is too big. That
investor could then buy more stock with the dividend that is over his or her expectations. Likewise, if,
from an investor's perspective, a company's dividend is too small, an investor could sell some of the
company's stock to replicate the cash flow he or she expected. As such, the dividend is irrelevant to
investors, meaning investors care little about a company's dividend policy since they can simulate
their own.
The Principal Conclusion for
Dividend Policy
• The dividend-irrelevance theory, recall, with no taxes or bankruptcy costs, assumes
that a company's dividend policy is irrelevant. The dividend-irrelevance theory
indicates that there is no effect from dividends on a company's capital structure or
stock price.

MM's dividend-irrelevance theory assumes that investors can affect their return on
a stock regardless of the stock's dividend. As such, the dividend is irrelevant to an
investor, meaning investors care little about a company's dividend policy when
making their purchasing decision since they can simulate their own dividend policy.
How Any Shareholder Can Construct His or Her
Own Dividend Policy.
• Recall that the MM's dividend-irrelevance theory says that investors can affect their
return on a stock regardless of the stock's dividend. As a result, a stockholder can
construct his or her own dividend policy.
• Suppose, from an investor's perspective, that a company's dividend is too big. That
investor could then buy more stock with the dividend that is over the investor's
expectations.
• Likewise, if, from an investor's perspective, a company's dividend is too small, an investor
can sell some of the company's stock to replicate the cash flow the investor expected.
• As such, the dividend is irrelevant to an investor, meaning investors care little about a
company's dividend policy since they can simulate their own.