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Dividend decisions

y 2 options of a firm to utilize profit after tax

plough back the earnings distribute to shareholders

y Dividend policy is important due to unambiguous relationship

between the dividend policy and the equity returns.

y Models based on above relationship and dividend policies: Traditional position Walter model Gordon model Miller & Modigliani model Rational expectations

TRADITIONAL POSITION y Given by B GRAHAM & DL DODD y Lays emphasis on relationship between dividends and the stock market y Stock value responds positively to higher dividends and negatively when there are low dividends y Relationship between the market price and dividends using a multiplier P=m(D+E/3) P=market price m=multiplier D=dividend per share E=earning per share .

Limitations Of the Traditional Approach y This approach states that P/E ratios are directly related to the dividend payout ratio. Only a few investors of the company who would prefer dividends to the uncertain capital gains and a few who would prefer lower taxed capital gains . y Also. However this might not be true always.

WALTER MODEL .

he studied the relationship between internal rate of return(r) and the cost of capital of the firm(ke). y In this model. 2) r=ke 3) r<ke and .WALTER MODEL y The dividend policy given by James E Walter also considers that dividends are relevant and they do affect the share price. y The model studies the relevance of dividend policy in 3 situations: 1) r>ke.

Assumptions of the model y Retained earnings is the only source of finance available to the firm y r and k are assumed to be constant y Firm has an infinite life y For a given value of the firm. the dividend per share and the earnings per share remain constant .

the market price of the share is taken as the sum of present value of future cash dividends and capital gains.y According to Walter. y Market price of the share is given as P = D + r(E-D)/ke ke ke Where P = Market price per share D = Dividend per share E = Earnings per share r = Internal rate of return ke = Cost of equity capital .

r = 10% iii. 8 Assumed return on investments(r) are as follows: i. r = 12% .Q: Show the effect of the dividend policy on the market price of Zed Ltd¶s shares. using Walter¶s model: Equity capitalization rate(ke) = 12% Earnings per share (E) = Rs. r = 15% ii.

15/0. 67 D/P ratio= 75% P= 6 + (0.12 = Rs.12)(8-0) 0.15/0. 79 D/P ratio = 100% P= 8 + (0. b.12)(8-8) 0.12)(8-2) 0.12)(8-4) 0.12 = Rs. 75 D/P ratio= 25% P= 2 + (0.83 c.15/0.r > ke (r = 15%. D/P ratio= 50% P= 4 + (0.15/0.12 = Rs. .15/0. ke = 12%) a. 70.12)(8-6) 0. D/P ratio= 0 P = 0 + (0.12 = Rs.12 = Rs.83 1.

12)(8-8) 0.56 D/P ratio= 25% P= 2 + (0. .12)(8-2) 0.12 = Rs. 67 b.12 = Rs.2.10/0.10/0. 58 D/P ratio = 100% P= 8 + (0. ke = 12%) a.10/0. r < ke (r = 10%. D/P ratio= 0 P = 0 + (0.12)(8-0) 0.12 = Rs. c.

ke = 12%) a. . D/P ratio= 0 P = 0 + (0. 67 D/P ratio = 100% P= 8 + (0.3.12)(8-8) 0. c. r = ke (r = 12%.12)(8-2) 0.12 = Rs.67 D/P ratio= 25% P= 2 + (0.12/0. 67 b.12/0.12)(8-0) 0.12/0.12 = Rs.12 = Rs.

k cannot be assumed to be constant .Limitations y The assumption of exclusive financing by retained earnings make the model suitable only for all-equity firms. Thus. y The assumption of constant return on investment is not true for firms making high investments. y This model ignores the business risk of the firm which has a direct impact on the value of the firm.

Gordon·s Dividend Capitalization Model .

y The retention ratio remains constant and hence the growth rate is constant(g = br) rate. y K > br i.y The firm will be an all-equity firm with the new investment proposals being financed solely by the retained earnings.e cost of equity capital is greater than growth . remain constant. y Return on investment(r) and the cost of equity (ke) y Firm has an infinite life.

Gordon·s Dividend Capitalization model gave the value of the stock as: P = E(1 ² b) ke ð br P = Share Price E = Earnings per share b = Retention Ratio (1-b) = Dividend pay-out ratio Ke = Cost of equity capital br = Growth rate(g) in the rate of return on investment .

i) r > ke Share price decreases with the increase in Dividend Pay Out Ratio( D/P) ii) r < ke Share price increases with the increase in Dividend Pay Out Ratio. .

INTERPRETATION y RATE OR RETURN > COST OF CAPITAL Growth firms should have higher retention ratio RATE OR RETURN < COST OF CAPITAL Firms should have lower retention ratio and high dividend pay out ratio. .

Miller and Modigliani Model .

y An increase in value of the firm caused by payment of dividend is exactly set off by the decline in the market price of shares because of external financing.MILLER AND MODIGLANI MODEL y Argument given by M&M was Dividend irrelevance. Hence no change in the total wealth of the shareholders. y What matters is the investment policy through which the firm can increase its earnings and thereby the value of the firm. . y Dividend policy has no effect on the share price of the firm.

y Investors are able to forecast future prices and dividends with certainity. . implying that there are no differential tax rates for the dividend income and the capital gains. y There are no taxes .ASSUMPTIONS OF M&M MODEL y There are perfect capital markets in which all investors are rational. y Constant investment policy of the firm.

Show that under the MM Assumptions.00. 2.000 and has a proposal for making new investments of Rs.It currently has outstanding 25.000.50.QUESTION A company belongs to a risk class for which the approximate capitalisation rate is 10 %. . 5. It expects to have a net income of Rs. the payment of dividend does not affect the value of the firm.100 each.000 shares selling at Rs. The firm is contemplating the declaration of a dividend of Rs. 5 per share at the end of the current financial year.

Solution : Value of the firm when dividends are paid : y P= 1 (D1+P1) (1+ ke) 100 = 1 (5+P1) 1. 5.10 P1 = 105 y Amount required to be raised from the issue of new shares :nP1 = I-(E-nD1) = Rs.75. 3.000-1.000) = Rs.000 a) .25.00.000-(2.50.

1 =Rs.000 Shares Rs. 25.75.000 (Rs.00.000 + 75. y Number of additional shares to be issued n = Rs.50.00.CONTD.000 = 75.5.105)-Rs.3.000 .000+Rs.2.105 21 y Value of the firm nP = (n+ n)P1-I+E = (1+ke) 25.000 1 21 1.

00. 5.000) = Rs.000 shares Rs. 2.10 y nP1 = (Rs.000 y n = Rs.00.000 .100 = P1 So . P1 = Rs.000+Rs2.1 = Rs.50.50.00. b ) Value of the firm when dividends are not paid y Rs.000 (Rs110)-Rs5.000 + 25.2.50.110 11 y nP=25.2. 110 1.000-Rs.000 1 11 1.CONTD.000 = 25.50. 25.

ANALYSIS OF ASSUMPTIONS Tax effect Floatation costs Transaction costs Market conditions Underpricing of shares .

.RATIONAL EXPECTATIONS MODEL y No impact of dividend declaration on the market price of share until it is at the expected rate.

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