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Value of Firm
Corporate Finance
Dividend Theories
Dividend Theories
Irrelevanc
Relevance
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• James Walter has proposed a model of share valuation that supports the
view of dividend policy of an enterprise, has a biering on value of enterprise.
• The model is based on:
• Return on investment / Internal rate of return = r
• Cost of capital / required rate of return/ capitalization rate = Ko
Venkat company ltd has capitalization rate (Ko) of 10%. Its earnings per share is Rs 20. the
company declares Rs 10 dividend. You are required to calculate share price assuming 20%
returns on investment.
R>Ko = 20% > 10%
Solution:
• P = {D + (r / Ko) * (E – D)} / Ko
• P = { 10 + ( 0.20 / 0.10) * (20 – 10)} / 0.10
• P = {10 + 2 * 10} / 0.10
• P = {10 + 20} / 0.10
• P = 30/0.10
• P = 300
Example: 2
Venkat company ltd has capitalization rate (Ko) of 10%. Its earnings per share is Rs
20. the company declares Rs 5 dividend. You are required to calculate share price
assuming 20% returns on investment.
Solution:
• P = {D + (r / Ko) * (E – D)} / Ko
• P = { 5 + ( 0.20 / 0.10) * (20 – 5)} / 0.10
• P = {5 + 2 * 15} / 0.10
• P = {5 + 30} / 0.10
• P = 35/0.10
• P = 350
Example: 3
Venkat company ltd has capitalization rate (Ko) of 10%. Its earnings per share is Rs 20.
the company declares Rs 15 dividend. You are required to calculate share price
assuming 20% returns on investment
Solution:
• P = {D + (r / Ko) * (E – D)} / Ko
• P = { 15 + ( 0.20 / 0.10) * (20 – 15)} / 0.10
• P = {15 + 2 * 5} / 0.10
• P = {15 + 10} / 0.10
• P = 25/0.10
• P = 250
Gordon’s Model
• This is another popular model which argues that dividends are relevant and
dividend decision of firms affects its value.
• According to Gordon model firms share price is dependent on dividend pay-out ratio
• Assumptions:
• Firms is all equity firm no debt
• All investments are financed exclusively by retained earnings – no external financing
• Rate of return on firms investment is constant
• Cost of capital remains constant and is greater than growth rate (Ko > b.r)
• Firm has perpetual life
• Retention ratio once decided is constant
• There are no corporate taxes
Gordon’s Model Numerical