Group members:

Serene Ittikunnath M1244Tushar Kharate M1254Wasif Parkar M1261

LINTNER AND MM DIVIDEND MODELS

LINTNER DIVIDEND POLICY Companies tend to set long-run target dividends-

to-earnings ratios according to the amount of positive net-present-value (NPV) projects they have available.

Earnings increases are not always sustainable. As a result, dividend policy is not changed until managers can see that new earnings levels are sustainable.

The theory is based on the assumption that investor will prefer to receive a certain dividend payout now rather than leaving the equivalent amount in an investment whose future value is uncertain.

FORMULA

Dc = CREPSc + (1 – C) D(c-1)

Dc = Dividend per share for Current YearC = adjustment rateR = target payout rateEPSc = Earnings per share of Year

c(current yr)D(c-1)= Dividend rate per share for year

c-1(last yr)

ILLUSTRATION

Modigliani and Miller(MM) hypothesis

MM maintain that dividend policy has no effect on the share prices of the firm and therefore has no consequences.

What matters is the investment policy through which the firm can increase its earnings and thereby the value of the firm.

The crux of their argument is that investors are indifferent between dividend and retained earnings.

FORMULA P0 = (D1 + P1) / (1 + ke)

Where:P0=Prevailing market price of a share

ke=cost of equity capitalD1=Dividend to be received at the end

of period 1 P1=Market price of a share at the end of

period 1.

ASSUMPTIONPerfect capital markets in which all in which all

investors are rational. Information is available to all free of cost; securities are infinitely divisible; no investor is large enough to influence the market price of securities; there are no floatation cost.

There are no taxes. Alternatively, there are no differences in tax rates applicable to capital gains and dividends.

A firm has a given investment policy which does not change

ILLUSTRATION

A company whose capitalization rate is 10% has outstanding shares of 25,000 selling at Rs.100 each. The firm is expecting to pay a dividend of Rs.5 per share at the end of the current financial year.

The company's expected net earnings are Rs.250,000 and the new proposed investment requires Rs.500,000.

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1) Price of the share at the end of the year if dividend is not declared.

=> 100 = 0 + p1/ 1+0.10 = 110

*Amount required to be raised from the issue of new shares:=> 500,000 – (250,000 -0) = Rs. 250,000

Number of additional shares to be issued:=> 250,000/ 110 = 2272.7273 shares

Value of the firm:=> (25,000 + 2272.7273) (110) - 500,000 + 250,000 

(1 + 0.10)=> 2,500,000

2) Value of the firm when dividend are paid.*Price per share at the end of the year. => 100 = 5 + p1/ 1+0.10

= 105

Amount required to be raised from the issue of new shares:

=> 500,000 – ( 250,000 - 125,000)  => 375,000

Number of additional shares to be issued: = 375,000 / 105 => 3571.42857 shares

Value of the firm: => (25,000 + 3571.42857) (105) - 500,000 + 250,000  (1 + 0.10)

=> Rs. 2,500,000

Thus, according to MM model, the value of the firm remains the same whether dividends are paid or not. This example proves that the shareholders are indifferent between the retention of profits and the payment of dividend.

LIMITATION

The assumptions are unrealistic and untenable in practice.

As a result the conclusion that dividend payments and other methods of financing exactly offset each other and hence, the irrelevance of dividends is not a practical proposition.

The validity of MM approach is open to question on two counts. (i) Imperfection of capital market (ii) Resolution of uncertainty.