Dividends Models

Dividend

Dividend is the return that shareholders (Equity and Preference) expect from the company for the contribution made towards the capital in the company by them

04/28/23 2Dr. Rekha Dhingra, Associate Professor, GIBS

Determinants of Dividend PolicyLegal RestrictionsTrend of EarningsDesire and Type of ShareholdersNature of IndustryAge of the CompanyFuture Financial RequirementsTaxation Policy


Determinants of Dividend PolicyInflationControl ObjectiveRequirement of Institutional InvestorsStability of DividendsLiquid Resources


Type of Dividend PolicyRegular Dividend PolicyStable Dividend Policy

Constant Dividend Per ShareConstant Pay out RatioStable rupee dividend plus extra dividend

Irregular Dividend Policy


DIVIDEND THEORIES There are three main categories advanced: 1.Dividend relevance theories2.Dividend irrelevance theories

DIVIDEND RELEVANCE THEORIESThese are theories whose propagators argue

that the dividend policy of a firm affects the value of the firm. There are two main theorists:James E. Walter (Walter’s model)Myron Gordon (Gordon’s model)

Walter’s Model Shows relationship between a firm’s rate of return r and its

cost of capital k. it is based on the following assumptions: 1.Internal financing – the firm finances all its investments

through retained earnings; debt or new equity is not issued. 2.Constant return and cost of capital – the firm’s rate of

return, r, and its cost of capital k are constant3.100% payout or retention – all earnings are either

distributed as dividends or reinvested internally immediately.

4.Constant EPS and DPS – beginning earnings and dividends never change. The values of the EPS and DPS may be changed in the model to determine results but are assumed to remain unchanged in determining a given value.

5.Infinite time – the firm has a very long or infinite life

Walter’s formula for determining MPS is as follows:

P = (DPS/k) + [r (EPS – DPS)/k]/k Where:

P = market price per share DPS = dividend per share EPS = earnings per share r = firm’s average rate of return k = firm’s cost of capital

the market value is determined as the present value of two sources of income:

1.PV of constant stream of dividend (DPS/k)2.PV of infinite stream of capital gains:

r(EPS-DPS)/kHence the formula can be rewritten as

P = DPS + (r/k) (EPS – DPS)k

Given three types of firms or scenarios of firms the model can be summarized as follows:

1.Growth firm: there are several investment opportunities (r > k) and the firm can reinvest earnings at a higher rate r than that which is expected by shareholders k. thus they will maximize value per share if they reinvest all earnings.

2.Normal firm: there aren’t any investments available for the firm that are yielding higher rates of return (r = k) thus the dividend policy has no effect on market price.

3. Declining firm: there aren’t any profitable investments for the firm to reinvest its earnings, i.e. any investments would earn the firm a rate less than its cost of capital (r < k). The firm will therefore maximize its value per share if it pays out all its earnings as dividend.

Criticisms of Walter’s modelModel assumes investment decisions of the

firm are financed by retained earnings aloneModel assumes a constant rate of return and;constant cost of capital, i.e. disregards the

firm’s risk which changes over time hence the discount rate will change over time in proportion.

Gordon’s Model Assumptions: 1.The firm is an all equity firm, i.e. no debt2.No external financing is available;

consequently retained earnings would be used to finance any expansion of the firm. Similar argument as Walter’s for the dividend and investment policies.

3.Constant cost of capital; model also ignores the risk-effect as Walter’s did

5. Perpetual stream of earnings for the firm6. Corporate taxes do not exist7. Constant retention ratio b, i.e. once decided

upon stays as such forever. The growth rate g = br stays constant in that case.

8. Cost of capital greater than the growth rate (k > br = g); otherwise it is not possible to obtain a meaningful value for the share.

According to Gordon’s model dividend per share is expected to grow when earnings are retained. The dividend per share is equal to the payout ratio multiplied by earnings [EPS X (1-b)]. To determine the value of the firm therefore based on the dividend growth model the value of the firm will be:

P0 = EPS (1 – b) k – g

Where: (1 – b) = the retention ratio of the firm

given b as the payout ratio. g = the growth rate determined as br g is always less than k

The conclusions of Gordon’s model are similar to Walter’s model due to the fact that their sets of assumptions are similar.

1.The market value of P0 increases with retention ratio b, for firms with growth opportunities, i.e. when r > k.

2.The market value of the share P0 increases with payout ratio (1 – b), for declining firms with r < k

3.The market value is not affected by the dividend policy where r = k

Gordon’s Revised Model

AssumptionsInvestors are risk-averseInvestors put a premium on a certain return

and discount/penalize uncertain returns“Bird-in-hand-argument” is discussed in the

revised model i.e. the value of a rupee of dividend income is more than the value of rupee of capital gain.

04/28/23Dr. Rekha Dhingra, Associate Professor, GIBS 19

Dividends Irrelevance The propagators of this school of thought

were France Modigliani and Merton Miller (1961).

They state that the dividend policy employed by a firm does not affect the value of the firm. They argue that the value of the firm is dependent on the firm’s earnings which result from its investment policy, such that when the policy is given the dividend policy is of no consequence.

Conditions that face a firm operating in a perfect capital market, either;

1.The firm has sufficient funds to pay dividend2.The firm does not have sufficient funds to pay

dividend therefore it issues stocks in order to finance payment of dividends

Assumptions of M-M hypothesis Perfect capital markets, i.e. investors behave

rationally, information is freely available to all investors, transaction and floatation costs do not exist, no investor is large enough to influence the price of a share.

Taxes do not exist; or there is no difference in the tax rates applicable to both dividends and capital gains.

The firm has a fixed investment policy The risk of uncertainty does not exist, i.e. all investors

are able to forecast future prices and dividends with certainty and one discount rate is appropriate for all securities over all time periods.

As hypothesised, r should be equal for all the shares otherwise the lower yielding securities will be traded for the higher yielding ones.

This arbitraging or switching continues until the differentials in rates of return are eliminated.

Formulas of MM ModelP0 = D1+P1

1 + Ke

Where P0 = Market Price per share at the beginning

of the period , or prevailing market price per share.

D1 = Dividend to be received at the end of the period

P1 = Market Price at the end of the periodKe = Cost of equity capital or rate of

capitalization


The value of P1 can be derived by the above equation as under:

P1=P0 ( 1+ Ke) –D1

The MM hypothesis can be explained in another from also presuming that investment required by the firm on account of payment of dividends is financed out of the new issue of equity shares. In such a case, the number of shares to be issued can be computed with the help of the following equation.

M= I - ( E-nD1) P1


Further the value of the firm can be ascertained with the help of the following formula

nP0 = (n + m)P1 – (I-E)1+Ke

Where ,m=number of shares to be issued.I= Investment requiredE=Total earnings of the firmP1 = Market price per share at the end of the periodn= Number of shares outstanding at the beginning of the periodD1 = Dividend to be paid at the end of the period.nP0 = Value of the firm


Criticisms? Presence of Market Imperfections: Tax differentials (low-payout clientele) Floatation costs Transaction and agency costs Diversification Uncertainty (high-payout clientele) Desire for steady income No or low taxes on dividends

To sum up,Investors have preference for dividend.Transaction costs involved in conversion of

capital receipt into incomesPossibility of unprofitable investment being

undertaken by the firm, and fear of tax burden at the time of sale of bonus shares suggest that a company should adopt a liberal dividend policy and opt for a higher dividend payout Ratio.

On the other hand, flotation costs, chances of lower issue price than the market price, legal and procedural constraints, market conditions and sentiments suggest that a company should follow a policy of maximum retention and a lower payout ratio.


Overall ConclusionInvestors assign higher value to dividendsA Financial Manager should recognize the

existence of different types of investors.A low payout and consequently higher

retention with higher expected growth will attract and satisfy the risk oriented investors while the high payout ratio and consequently low retention and low growth rate will attract and satisfy the risk averse and conservative investors.

Therefore, neither 100% payout nor 0% will bring the maximum market price. The optimum point lies somewhere in between.


ABC Ltd. Belongs to a risk class for which the appropriate capitalization rate is 10%. It currently has outstanding 5,000 shares selling at Rs. 100 each. The firm is contemplating the declaration of dividend of Rs. 6 per share at the end of the current financial year. The company expects to have a net income of Rs. 50,000 and has a proposal for making new investment of Rs. 1,00,000. Show that under the MM hypothesis, the payment of dividend does not effect the value of the firm.


Dividends Models

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