Dividend policy and firm value

Dividend policy and firm valueIntroductionDividend policy what proportion of earnings is paid to shareholders by the way of dividends and what proportion is ploughed back in the firm for reinvestmentA higher payout may cause shrinkage in funds available for reinvestment -> higher dependence on external borrowingObjective is to maximise the market value of equity shares

Key question: What is the relationship between dividend policy and market price of shares or firm value?Models in which dividend policy and firm value are relatedWalter modelGordon modelWalter model - assumptionsFirm is all equity financed -> firm will rely only on retained earnings for future investment decisions -> investment decision is dependent on dividend decisionThe rate of return on investments is constantThe firm has an infinite lifeWalter model valuation formula P = (D+(E-D)r/k) / kP = price per shareD = dividend per shareE = earnings per shareE-D = retained earnings per sharer = rate of return on investmentk = cost of equity capitalWalter model valuation formulaP = D/k + ((E-D)r/k)/k

Component 1 = D/k = PV of infinite stream of dividendsComponent 2 = ((E-D)r/k)/k = PV of infinite returns from retained earningsWalter model - implicationsGrowth firm: r>k : the price per share increases as the dividend payout ratio decreasesNormal firm : r=k : the price per share does not vary with changes in dividend payout ratioDeclining firm : r investment decision and dividend decision are relatedRate of return on firms investment is constantThe growth rate of firm is product of its retention ratio and its rate of returnThe cost of capital is constant and it is greater than the growth rateThe firm has perpetual lifeTaxes do not existGordon model valuation formula P0 = E1(1-b)/(k-br)P0 : price per share at the end of year 0E1: Earnings per share at the end of year 1(1-b) : fraction of earnings the firm distributes by the way of dividendsb = fraction of earnings the firm retainsk = rate of return required by the shareholdersr = rate of return earned on the investments br = growth rate of earnings and dividends

Gordon model - implicationsGrowth firm: r>k : the price per share increases as the dividend payout ratio decreasesNormal firm : r=k : the price per share does not vary with changes in dividend payout ratioDeclining firm : r