Dividend Policy

1. Walter Model
Let,
Return on Investment = r
Cost of capital = k
Walter Model
Let,
Return on Investment = r
Cost of capital = k

EAT or PAT

Own Project Distribute Dividend

Sales
Less: VC
Contribution
Less: FC
EBIT
Less: Interest
EBT
Less: Tax
EAT
Less: Dp
EAESH
EPS = EAESH

No. of Outstanding Equity

Shareholders
Return on Investment = r

Cost of capital =k= the rate at which the

firm borrows capital

1. For Growth firms r > k

Market Price of share increases if firm

retains all earnings
2. For Normal firms r = k

Distribution of dividend has no effect

on Market Price of share.

3. For Declining firms r < k

 Assumptions
1. Retained Earnings only and no
debt or equity is the source of
finance.
2. r and k are constant.
3. Earnings (EPS) are either
reinvested or distributed as
dividends.
4. Perpetual life.
Formula for Walter Model -

P = D + ( r * (E - D)/ke)
ke
2. Gordon Model

Even if r = k then also dividend policy

is important due to current dividend

Bird in hand argument.

Formula for Gordon Model

P = E (1-b)
ke – (b*r)

(b*r ) = g = growth rate

where, b = retention ratio
r = return on investment
3. Modigliani and Miller Model
1. Investment Policy.
2. Assumptions –
a) Rational investors
b) No taxes, floating costs,
transaction costs
c) Securities are infinitely
divisible so no single investor
can affect.
3. Arbitrage
EAT or PAT

Retained Earnings Payment of Dividend

Therefore M P

Raise capital by issuing new shares

Therefore M P
Formula for Modigliani and
Miller Model
I .Value of the firm when dividend is paid

Step I : Calculate P1
P0 = 1 * (D1+P1)
(1+K e )
P0 = Current price per share
P1 = Price per share at the end of the period
D1 = Dividend to be paid at the end of the period
K e = Cost of equity capital
 E (Earnings)

Retained Earnings Payment of Dividend

E – n * D1 n * D1
Step II :
Amount to be raised by the issue of new shares

n1 * P1 = Total Investment required - Retained Earnings

n1 * P1 = I – (E – n D1)

n = No. of Shares Outstanding

n1 = New shares to be issued
I = Total investment required
E = Earnings during the period
n D1= Total Dividends paid
E – n D1= Retained Earnings
Step III :

Number of additional shares to be issued

n1 = I – (E – n * D1)
P1
Step I V :

Value of the firm

( n * P0 ) = (n+n1) * P1 - I + E
(1+k e )
I I. Value of the firm when dividends are
not paid.
Put D1 = 0 in the above formulas
Step I : Calculate P1
P0 = 1 * (D1+P1)
(1+K e )
Putting D1 = 0 in step I above:
P0 = P1
(1+K e )
P0 = Current price per share
P1 = Price per share at the end of year 1
D1 = Dividend to be paid at the end of the year 1 in Rs.
K e = Cost of equity capital
Step II :
Amount to be raised by the issue of new
shares

n1 * P1 = I – (E – n D1)

Putting D1 = 0 in step II above:

n1 * P1 = I – E
Step III :
Number of additional shares to be issued

n1 = I – (E – n * D1)
P1
Putting D1 = 0 in step III above:

n1 = I – E
P1
Step I V :

Value of the firm

( n * P0 ) = (n+n1) * P1 - I + E
(1+k e )
1. The capitalization rate of A1 ltd. is
12%. This company has outstanding
shares to the extent of 25,000 shares
selling at the rate of Rs. 100 each.
Anticipating a net income of Rs. 3,50,000
for the current financial year, A1 ltd. plans
to declare a dividend of Rs. 3 per share.
The company also has a new project the
investment requirement for which is Rs.
5,00,000. Show that under the MM model,
the dividend payment does not affect the
value of the firm.
To prove that the MM model holds good, we
have to show that the value of the firm
remains the same whether the dividends are
paid or not.

I . Value of the firm when dividend is paid

Step I : Calculate P1

P0 = 1 * (D1+P1)
(1+K e )
P0 = 1 * (D1+P1)
(1+K e )

100 = 1 * (3+P1)
(1+0.12 )

P1 = Rs. 109
Step II :
Amount to be raised by the issue of new
shares
n1 * P1 = I – (E – n D1)

= 5,00,000 – (3,50,000 – 3*25000)

n1 * P1 = Rs. 2,25,000
Step III :
Number of additional shares to be issued
n1 = I – (E – n * D1)
P1

n1 * P1 = Rs.2,25,000

n1 = 2,25,000 = 2064.22
109
 Step IV : Value of the firm

( n * P0 )= (n+n1) * P1 - I + E (1+k e )
=(25,000+2064.22) * 109 - 5,00,000 + 3,50,000
(1+0.12 )

Value of the firm =( n * P0 ) = Rs.25,00,000

I I. Value of the firm when dividends are
not paid.
Put D1 = 0 in the above formulas

Step I : Calculate P1

P0 = 1 * (D1+P1)
(1+K e )
Putting D1 = 0 in step I above:

P0 = P1
(1+K e )
 P0 = P1
(1+K e )

100 = P1
(1+0.12 )

P1 = Rs.112
Step II :
Amount to be raised by the issue of new
shares
n1 * P1 = I – (E – n D1)

Putting D1 = 0 in step II above:

n1 * P1 = I – E
n1 * P1 = 5,00,000 – 3,50,000
n1 * P1 = Rs. 1,50,000
Step III :
Number of additional shares to be issued
n1 = I – (E – n * D1)
P1
Putting D1 = 0 in step III above:
n1 = I – E
P1
n1 = I – E
P1

n1 = 5,00,000 – 3,50,000
112

n1 = 1339.29
 Step I V :
Value of the firm
n * P0 = (n+n1) * P1 - I + E (1+k e )
Value of the firm
=(25,000+1339.29) * 112 - 5,00,000 +3,50,000
(1+0.12 )

Value of the firm = n * P0 = Rs.25,00,000

Thus, the value of the firm in both
the cases remains the same.
2. EPS of a company is Rs.10 and
market capitalization rate is 10%. The
company has before it an option of
adopting a payout ratio of 0%, 50%,
75%, 100%. Using Walter’s model of
dividend payout compute the market
value of the Company’s share if the
rate of return on internal investment is
15%.
 Formula for Walter Model –

P = D + (r
* (E - D)/ke)
ke
Here r >ke
When payout ratio = 0%

P = 0 + 0.15 * (10 – 0)/0.10

0.10
P = Rs.150
P = D + (r * (E - D)/ke)
ke

When payout ratio = 50%

P = 5 + 0.15 * (10 - 5)/0.10

0.10

P = Rs.125
 P = D + (r * (E - D)/ke)
ke
When payout ratio = 75%

P = 7.5 + 0.15 * (10 – 7.5)/0.10

0.10

P = Rs.112.50
 P = D + (r * (E - D)/ke)
ke
When payout ratio = 100%

P = 10 + 0.15 * (10 – 10)/0.10

0.10

P = Rs.100
2b. In the above question, Using
Walter’s formula of dividend payout
compute the market value of the
Company’s share if the rate of return
on internal investment is 10%.
 Formula for Walter Model –

P = D + (r
* (E - D)/ke)
ke
Here r = k
When payout ratio = 0%

P = 0 + 0.10 * (10 – 0)/0.10

0.10
P = Rs.100
P = D + (r * (E - D)/ke)
ke

When payout ratio = 50%

P = 5 + 0.10 * (10 - 5)/0.10

0.10

P = Rs.100
 P = D + (r * (E - D)/ke)
ke
When payout ratio = 75%

P = 7.5 + 0.10 * (10 – 7.5)/0.10

0.10

P = Rs.100
 P = D + (r * (E - D)/ke)
ke
When payout ratio = 100%

P = 10 + 0.10 * (10 – 10)/0.10

0.10

P = Rs.100
2c. In the above question, Using
Walter’s formula of dividend payout
compute the market value of the
Company’s share if the rate of return
on internal investment is 8%.
 Formula for Walter Model –

P = D + (r
* (E - D)/ke)
ke
Here r < k
When payout ratio = 0%

P = 0 + 0.08 * (10 – 0)/0.10

0.10
P = Rs.80
P = D + (r * (E - D)/ke)
ke

When payout ratio = 50%

P = 5 + 0.08 * (10 - 5)/0.10

0.10

P = Rs.90
 P = D + (r * (E - D)/ke)
ke
When payout ratio = 75%

P = 7.5 + 0.08 * (10 – 7.5)/0.10

0.10

P = Rs.95
 P = D + (r * (E - D)/ke)
ke
When payout ratio = 100%

P = 10 + 0.08 * (10 – 10)/0.10

0.10

P = Rs.100
Traditional Approach
Given by B Graham and D L Dodd.
The stock value responds positively to higher
dividends and negatively when there are low
dividends.
Formula for Traditional Approach-
P = m * [(D+E)/3]
P = Market Price
m = Multiplier
D = Dividend per share
E = Earnings per share
 Rational Expectations Model

There would be no impact of the

dividend declaration on the market
price of the share as long as it is at
the expected rate.