THE DIVIDEND

CONTROVERSY
 Dividend Irrelevance- An Illustration
Balance Sheet Of X Ltd (Market Values)
Debt 0 Cash (Rs1,000 1,000
Equity 10,000 +NPV held for
investment)

Fixed Assets 9,000

Investment NPV
opportunity
(Rs1,000
investment
required)

10,000+NPV 10,000+NPV
 Now suppose the company pays Rs 1,000
as dividend to it shareholders
• Where does the money for the dividend come
from?
• Of course, cash is already there. But the cash is
earmarked for investment.
• Cash is raised by new financing.
• Share or debenture? Let it be share.
Now we examine the balance sheet after the new share is
sold, the dividend is paid, and the investment is
undertaken.
• Sine investment and borrowing policies are unaffected by the
dividend payment, its overall market value would remain same i.e.,
Rs10,000+NPV.

• If the market is efficient, the new shareholders’ share is worth

Rs1,000.

• Thus the value of original shareholders’ shares

• = value of company –value of new shares
• =(10,000+NPV) – 1,000
• =Rs 9,000 + NPV

• The old shareholders have received a Rs1,000 cash dividend and

incurred a Rs 1,000 capital loss.
• Thus dividend policy does not matter.
 Balance sheet after the new share is sold, the
dividend is paid, and the investment is undertaken.

Debt 0 Cash (Rs1,000 held for 1000

investment)
Equity
Existing 9000+NPV Fixed Assets 9000
New 1000 10000+NPV
Investment NPV
opportunity (Rs1,000
investment required)

_________ ________
10000+NPV 10000+NPV
 Calculating Share Price
• Suppose that before this dividend payout the company
had 1,000 shares outstanding and that the project had an
NPV of Rs2,000.

• Then the value of old shares = 10,000+2,000=12,000

• Value per share = 12,000/1000 = Rs12.

• After new share is sold and the dividend is paid out, the
value of old shares = 9,000+2,000=11,000
• Value per share = 11,000/1000=Rs11.

• In other words, the price of the old stock falls by the

amount of Re 1 per share dividend payment.
How many new shares have been
sold?
• If the new shareholders get the fair value,
the company must issue Rs1,000/Rs11 or
91 new shares in order to raise the
Rs1,000 that it needs.
 suppose it is found that the new project is not a positive-NPV venture but a sure loser. Management
announces that the project is to be discarded and that the Rs 1,000 earmarked for it will be paid as an
dividend of Re 1 per share. After the dividend payout, the balance sheet is

Balance Sheet (Market Values)

Debt 0 Cash 0
Equity 9,000 Existing fixed assets 9,000
New Project 0

Total firm value Rs 9,000 Total asset value Rs 9,000

• Since there are 1,000 shares outstanding, the stock price is Rs10,000 /
1,000 = Rs10 before the dividend payment and Rs 9,000 /1,000 = Rs 9 after
the payment.

• Share Repurchase
• What if the company uses the Rs 1,000 to repurchase share instead?
• As long as the the company pays a fair price for the share, the Rs 1,000
buys Rs 1,000/Rs10= 100 shares. That leaves 900 shares worth 900 X
Rs10=Rs 9,000.
 Modigliani and Miller Position

• M-M assert that given the investment

decision of the firm, the dividend-payout
ratio is a mere detail. It does not affect the
wealth of share holders.
• They argue that the value of the firm is
determined by the earning power of the
firm’s assets or its investment policy.
 Critical assumptions

• Perfect capital market

• No taxes
• Investment policy is given
• The MP of a share at the beginning of a period is defined
as equal to the PV of the dividend paid at the end of the
period plus the MP at the end of the period. Thus
• P0 = (D1+P1) / (1+ke) ……..(1)

• Assume that
• n= the number of shares at time t=0
• m= the number of new shares sold at time t=1 at a price
p1
• The equation (1) then can be rewritten as
• nP0= [nD1 + (n+m)P1 – mP1] / (1+ke) …..(2)

• In words, the total value of all shares outstanding at time

t = 0 is the PV of total dividends paid at time t = 1 on
those shares + the total value of all shares outstanding
at time t = 1 – the total value of the new shares issued.
• The total amount of new shares issued is
• mP1 = I – (X - nD1) ………..(3)
• Where I = investment
• X = total net profit
• By substituting Eq(3) in Eq(2), we find
• nP0= [nD1 + (n+m)P1 – {I – (X - nD1) }] / (1+ke)
• = [(n+m)P1 – I +X] / (1+ke)

• Because D1 does not appear directly in the expression and because

X, I, (n+m)P1, and ke are assumed to be independent of D1, MM
conclude that the current value of the firm does not depend on its
current dividend decision.
• How can you explain that
market value of a share is the
PV of expected future
dividends.
• The irrelevance position simply argues
that the present value of future dividends
remain unchanged even though dividend
policy changes their timings.
• It does not argue that dividends are never
paid, only that their postponement is a
matter of indifference when it comes to the
market price per share.
 DIVIDEND RELEVANCE
• Walter’s Model
• Prof James E Walter argues that the choice of dividend policies almost always affect
the value of the firm. The model shows clearly the importance of the relationship
between the firm’s rate of return, r, and its cost of capital, k, in determining the
dividend policy that will maximise the wealth of shareholders.

• Assumptions:
• Internal financing only
• r and k are constant
• Constant EPS and Dividend.
• Walter’s formula to determine the market price per share is as follows:

• P= D+ r ( EPS  D) / k (1)
k k
• D/k = PV of infinite streame of constant dividend.

•
r ( EPS  D) / k = PV of infinite streame of capital gains.
k
• The equation (1) can also be rewritten as follows:

• P= (2)
D  ( r / k )( E  D )
• Consider the following
k table which illustrates the effect of different dividend policies on the value of share
respectively for the growth firm, normal firm and declining firm.

•
 DIVIDEND POLICY AND THE VALUE OF SHARE (WALTER,S MODEL)
Growth Firm, r>k Normal Firm, r=k Declining Firm, r<k
Basic Data
r = 0.15 r = 0.10 r = 0.08
k =0.10 k =0.10 k =0.10
E=Rs10 E=Rs10 E=Rs10

Payout Ratio 0%
D=Re0 D=Re0 D=Re0
P=[0+(0.15/0.10)(10-0)/0.10 P=[0+(0.10/0.10)(10-0)/0.10 P=[0+(0.08/0.10)(10-0)/0.10
= Rs150 = Rs100 = Rs80

Payout Ratio 40%

D=Rs4 D=Rs4 D=Rs4
P=[4+(0.15/0.10)(10-4)/0.10 P=[4+(0.10/0.10)(10-4)/0.10 P=[4+(0.08/0.10)(10-4)/0.10
= Rs130 = Rs100 = Rs88

Payout Ratio 80%

D=Rs8 D=Rs8 D=Rs8
P=[8+(0.15/0.10)(10-8)/0.10 P=[8+(0.10/0.10)(10-8)/0.10 P=[8+(0.08/0.10)(10-8)/0.10
= Rs110 = Rs100 = Rs96

Payout Ratio 100%

D=Rs10 D=Rs10 D=Rs10
P=[10+(0.15/0.10)(10-10)/0.10 P=[10+(0.10/0.10)(10-10)/0.10 P=[10+(0.08/0.10)(10-10)/0.10
= Rs100 = Rs100 = Rs100
• The above table shows that, in the Walter’s model, the dividend
policy of the firm depends on the availability of investment
opportunities and the relationship between the firm’s internal rate of
return, r and its cost of capital, k. Thus

• Retain all earnings, when r>k

• Distribute all earnings, when r<k
• Dividend (or retention) policy has no effect when r=k.

• Thus dividend policy is a financing decision.

 Gordon’s Model (Myron Gordon)

• Assumption
• All equity firm
• No external financing
• Constant return (r ) and cost of capital (k)
• Perpetual earnings
• No taxes
• Constant retention (b)
• k>g
• When we incorporate growth in earnings and dividend, resulting from the
retained earnings, in the dividend-capitalisation model, the present value of
a share is determined by the following formula:

• P0 = D1/(1+k) + D2 /(1+k)2+--------+D∞/(1+k) ∞
• = D1/ (k-g)
• = E(1-b)/(k-rb) ------- (3)
• {when E(1-b)=D, br=g}
• Equation (3) explicitly shows the relationship of expected
earnings E, dividend policy b, internal profitability, r, and
the all equity firm’s cost of capital, k, in determining the
value of the share.

• In case of a normal firm ( when r=k), P0 is not affected by

the dividend policy.
• In case of a growing firm ( when r>k), P0 increase with the
retention ratio b.
• In case of a decline firm ( when r<k), P0 increases with
the payout ratio (1-b).
 Normal Firm ( r=k )

• P0 = E(1-b)/(k-rb) = E(1-b)/(k-kb) = E(1-b)/k(1-b) = E/k =rA /r = A

• (Since EPS = rA, where A = total asset per share)

• Thus P0 is not affected by dividend policy and equal to the book

value of assets per share.

• Thus, when r=k, dividend policy is irrelevant.

 Declining Firm (r < k)
• Equation (3) indicates that if b=0 or pay out ratio is 100%,
• P0 = E/k =rA / k
• If r<k, r/k < 1 or rA / k < A
• i.e., P0 is smaller than the firm’s investment per share in asset, A.

• If b increases i.e., b>0,and r<k, then

• P0 = E(1-b)/(k-rb) = E(1-b)/ k(1-br/k) < E/k
• Or P0 < rA /k
• since r<k, r/k <1, or rb/k <b , or (1-rb/k) > (1-b),
• Or 1> (1-b) / (1-rb/k), or E/k > E(1-b) / k (1-rb/k)

• Thus if b increases, P0 decreases.

 Growth Firm (r>k)
• We have seen that if b=0 or pay out ratio is 100%,
• P0 = E/k =rA / k
• If r>k, r/k > 1 or rA / k > A
• i.e., P0 is greater than the firm’s investment per share in asset, A.

• If b increases i.e., b>0,and r>k, then

• P0 = E(1-b)/(k-rb) = E(1-b)/ k(1-br/k) > E/k
• Or P0 > rA /k
• since r>k, r/k >1, or rb/k >b , or (1-rb/k) < (1-b),
• Or 1< (1-b) / (1-rb/k), or E/k < E(1-b) / k (1-rb/k)

• Thus if b increases, P0 increases.

• But if b=k/r, P0 = E(1-b)/(k-rb) = E(1-b)/(k-rk/r)
= E(1-b)/ 0 =∞
• Again if b=1, k –br <0, making P0 negative.
• These absurd results are obtained because of
the assumption that r and k are constant, which
underlie the model. Thus to get the meaningful
value of the share, according to equation (3) the
value of b should be less than k/r.
 The Rightists
• The Bird-in-the-hand fallacy
• Some investors like dividends
• Dividends operate as an information signal
• Dividends reduce managerial discretion / power.
 TAXES AND THE RADICAL LEFT

• Whenever dividends are taxed more heavily than capital

gains, firms should pay low dividend. Available cash
should be retained or used to repurchase shares.

• Assume the stocks of firms A and B are equally risky.

Investors expect A to be worth Rs 112.5 per share next
year. The share price of B is expected to be only Rs
102.5, but a Rs 10 dividend is also forecasted, and so
the total pretax payoff is the same Rs 112.50
 Firm A (no dividend) Firm B (high dividend)

Next year’s price Rs 112.50 Rs 102.50

Dividend Rs 0 Rs 10.00
Total pretax payoff Rs 112.50 Rs 112.50
Today’s stock price Rs 100 Rs 97.78
Capital gain Rs 12.50 Rs 4.72
Before-tax rate of return 100 x (12.5/100)= 12.50% 100x(14.72 / 97.78)
=15.05%
Tax on dividend at 40% Rs 0 .40 x 10 = Rs 4.00
Tax on capital gains at 20% .20 x 12.50 = Rs 2.50 .20 x 4.72= Re 0.94
Total after-tax income (0+12.50) – 2.50 = Rs10.00 (10.00 +4.72)-(4.00+0.94)
(dividends plus capital gains =Rs 9.78
less taxes)
After-tax rate of return 100 x (9.78/97.78) = 10.0%
100 x (10/100) = 10.0%