Dividend Decision

In this chapter… Dividend theories… Modigliani Miller Hypothesis Dividend policies… Dividend policy and share valuation… Corporate dividend practices in India…

Dividend Theories… Relevance Theories

Walter’s Model Gordon’s Model

Irrelevance Theories Miller and Modigliani Hypothesis.

Relevance Theory… When dividend decision affects value of a

firm, it is known as relevance theory. There are two prime theories under this

approach: Walter’s Model Gordon’s Model

Walter’s Model… This model is proposed by James Walter. This model is based on:

Return on investment or internal rate of return [r] and

Cost of Capital or Required Rate of Return [Ko]

Model divides firm into… Growth firms: r>K o

Normal firms: r=K o

Declining firms: r<K o

Assumptions…Only internal source of funds used

r and K o constant

All earnings are paid as dividends or completely reinvested

EPS; and DPS never change

Perpetual life

Formula…

PD r K E D

Kor

D

K

E D r K

K

( )( ) ( )0

0 0 0

Where: P = Price per equity share;D = Dividends per share;E = Earnings per share;

(E–D) = Retained earnings per share;r = Rate of return on investment;K0 = Cost of capital.

Interpretation…

r>K o= Optimum DP Ratio is zero

r=K o= No optimum DP Ratio

r<K o= Optimum DP Ratio 100%

Criticisms…

No external financing

Constant rate of return as investment

Constant cost of capital

Gordon’s Model… According to this model, firm’s share price

is dependent on dividend pay out ratio.

Assumptions…All equity firm; Properties financed by retained earnings;‘r’ is constant;K o remains constant;K o>b. r;Perpetual stream of earnings;Perpetual life;Retention ratio constant;No corporate taxes

Formula…P

E b

K b ro

( )

.

1

Where: P= Price per shareE= Earnings per shareb= Retention ratio(1- b)= Proportion of earnings of the firm distributed as

dividends;K o= Capitalization rate or cash of capital or required return by

equity shareholdersr= Rate of returns earned an investment made by the firmg= b. r = growth rate

Interpretation… r > Ko = Optimal DP Ratio is zero. r = Ko = No Optimal DP Ratio. r < Ko = Optimal DP Ratio is 100%.

MM Hypothesis… According to this theory, value of the firm is

determined by its basic earning power and its business risk.

Assumptions…

Existence of perfect capital markets

No taxes

Firm has fixed investment policy

There is no risk