Relevance of dividend policy

dividends paid by the firms are viewed positively both by the investors and the firms. The firms
which do not pay dividends are rated in oppositely by investors thus affecting the share price.
The people who support relevance of dividends clearly state that regular dividends reduce
uncertainty of the shareholders i.e. the earnings of the firm is discounted at a lower rate, ke
thereby increasing the market value. However, its exactly opposite in the case of increased
uncertainty due to non-payment of dividends.
Two important models supporting dividend relevance are given by Walter and Gordon.
[edit] Walter's model

James E. Walter's model shows the relevance of dividend policy and its bearing on the value of
the share.[2]
[edit] Assumptions of the Walter model
1. Retained earnings are the only source of financing investments in the firm, there is no external
finance involved.
2. The cost of capital, k e and the rate of return on investment, r are constant i.e. even if new
investments decisions are taken, the risks of the business remains same.
3. The firm's life is endless i.e. there is no closing down.

Basically, the firm's decision to give or not give out dividends depends on whether it has enough
opportunities to invest the retain earnings i.e. a strong relationship between investment and
dividend decisions is considered.
[edit] Model description

Dividends paid to the shareholders are re-invested by the shareholder further, to get higher
returns. This is referred to as the opportunity cost of the firm or the cost of capital, ke for the
firm. Another situation where the firms do not pay out dividends, is when they invest the profits
or retained earnings in profitable opportunities to earn returns on such investments. This rate of
return r, for the firm must at least be equal to ke. If this happens then the returns of the firm is
equal to the earnings of the shareholders if the dividends were paid. Thus, its clear that if r, is
more than the cost of capital ke, then the returns from investments is more than returns
shareholders receive from further investments.
Walter's model says that if r<ke then the firm should distribute the profits in the form of
dividends to give the shareholders higher returns. However, if r>ke then the investment
opportunities reap better returns for the firm and thus, the firm should invest the retained
earnings. The relationship between r and k are extremely important to determine the dividend
policy. It decides whether the firm should have zero payout or 100% payout.
In a nutshell :

If r>ke, the firm should have zero payout and make investments.
If r<ke, the firm should have 100% payouts and no investment of retained earnings.
If r=ke, the firm is indifferent between dividends and investments.

[edit] Mathematical representation

Walter has given a mathematical model for the above made statements :

where,

P = Market price of the share

D = Dividend per share
r = Rate of return on the firm's investments
ke = Cost of equity
E = Earnings per share'

The market price of the share consists of the sum total of:

the present value if an infinite stream of dividends

the present value of an infinite stream of returns on investments made from retained earnings.

Therefore, the market value of a share is the result of expected dividends and capital gains
according to Walter.
[edit] Criticism

Although the model provides a simple framework to explain the relationship between the market
value of the share and the dividend policy, it has some unrealistic assumptions.
1. The assumption of no external financing apart from retained earnings, for the firm make further
investments is not really followed in the real world.
2. The constant r and ke are seldom found in real life, because as and when a firm invests more the
business risks change.
[edit] Gordon's Model
Main article: Gordon model

Myron J. Gordon

Myron J. Gordon has also supported dividend relevance and believes in regular dividends
affecting the share price of the firm.[2]
[edit] The Assumptions of the Gordon model

Gordon's assumptions are similar to the ones given by Walter. However, there are two additional
assumptions proposed by him :
1. The product of retention ratio b and the rate of return r gives us the growth rate of the firm g.
2. The cost of capital ke, is not only constant but greater than the growth rate i.e. ke>g.
[edit] Model description

Investor's are risk averse and believe that incomes from dividends are certain rather than incomes
from future capital gains, therefore they predict future capital gains to be risky propositions.
They discount the future capital gains at a higher rate than the firm's earnings thereby, evaluating
a higher value of the share. In short, when retention rate increases, they require a higher
discounting rate. Gordon has given a model similar to Walter's where he has given a
mathematical formula to determine price of the share.
[edit] Mathematical representation

The market price of the share is calculated as follows:

where,

P = Market price of the share

E = Earnings per share
b = Retention ratio (1 - payout ratio)
r = Rate of return on the firm's investments
ke = Cost of equity
br = Growth rate of the firm (g)

Therefore the model shows a relationship between the payout ratio, rate of return, cost of capital
and the market price of the share.
[edit] Conclusions on the Walter and Gordon Model

Gordon's ideas were similar to Walter's and therefore, the criticisms are also similar. Both of
them clearly state the relationship between dividend policies and market value of the firm.
[edit] Capital structure substitution theory & dividends

The capital structure substitution theory (CSS)[3] describes the relationship between earnings,
stock price and capital structure of public companies. The theory is based on one simple
hypothesis: company managements manipulate capital structure such that earnings-per-share
(EPS) are maximized. The resulting dynamic debt-equity target explains why some companies
use dividends and others do not. When redistributing cash to shareholders, company
managements can typically choose between dividends and share repurchases. But as dividends
are in most cases taxed higher than capital gains, investors are expected to prefer capital gains.
However, the CSS theory shows that for some companies share repurchases lead to a reduction
in EPS. These companies typically prefer dividends over share repurchases.
[edit] Mathematical representation

From the CSS theory it can be derived that debt-free companies should prefer repurchases
whereas companies with a debt-equity ratio larger than

should prefer dividends as a means to distribute cash to shareholders, where

D is the companys total long term debt

is the companys total equity
is the tax rate on capital gains
is the tax rate on dividends

Low valued, high leverage companies with limited investment opportunities and a high
profitability use dividends as the preferred means to distribute cash to shareholders, as is
documented by empirical research.[4]

[edit] Conclusion

The CSS theory provides more guidance on dividend policy to company managements than the
Walter model and the Gordon model. It also reverses the traditional order of cause and effect by
implying that company valuation ratios drive dividend policy, and not vice-versa. The CSS
theory does not have 'invisible' or 'hidden' parameters such as the equity risk premium, the
discount rate, the expected growth rate or expected inflation. As a consequence the theory can be
tested in an unambiguous way.

[edit] Irrelevance of dividend policy

Franco Modigliani

Merton Miller

The Modigliani and Miller school of thought believes that investors do not state any preference
between current dividends and capital gains. They say that dividend policy is irrelevant and is
not deterministic of the market value. Therefore, the shareholders are indifferent between the two
types of dividends. All they want are high returns either in the form of dividends or in the form
of re-investment of retained earnings by the firm. There are two conditions discussed in relation
to this approach :

decisions regarding financing and investments are made and do not change with respect to the
amounts of dividends received.
when an investor buys and sells shares without facing any transaction costs and firms issue
shares without facing any floatation cost, it is termed as a perfect capital market.[5]

Two important theories discussed relating to the irrelevance approach, the residuals theory and
the Modigliani and Miller approach.
[edit] Residuals theory of dividends

One of the assumptions of this theory is that external financing to re-invest is either not
available, or that it is too costly to invest in any profitable opportunity. If the firm has good
investment opportunity available then, they'll invest the retained earnings and reduce the
dividends or give no dividends at all. If no such opportunity exists, the firm will pay out
dividends.
If a firm has to issue securities to finance an investment, the existence of floatation costs needs a
larger amount of securities to be issued. Therefore, the pay out of dividends depend on whether
any profits are left after the financing of proposed investments as floatation costs increases the
amount of profits used. Deciding how much dividends to be paid is not the concern here, in fact
the firm has to decide how much profits to be retained and the rest can then be distributed as
dividends. This is the theory of Residuals, where dividends are residuals from the profits after
serving proposed investments. [6]
This residual decision is distributed in three steps:

evaluating the available investment opportunities to determine capital expenditures.

evaluating the amount of equity finance that would be needed for the investment, basically
having an optimum finance mix.
cost of retained earnings<cost of new equity capital, thus the retained profits are used to
finance investments. If there is a surplus after the financing then there is distribution of
dividends.

[edit] Extension of the theory

The dividend policy strongly depends on two things:

investment opportunities available to the company

amount of internally retained and generated funds which lead to dividend distribution if all
possible investments have been financed.

The dividend policy of such a kind is a passive one, and doesn't influence market price. the
dividends also fluctuate every year because of different investment opportunities every year.
However, it doesn't really affect the shareholders as they get compensated in the form of future
capital gains.
[edit] Conclusion

The firm paying out dividends is obviously generating incomes for an investor, however even if
the firm takes some investment opportunity then the incomes of the investors rise at a later stage
due to this profitable investment.
[edit] Modigliani-Miller theorem
Main article: ModiglianiMiller theorem

The ModiglianiMiller theorem states that the division of retained earnings between new
investment and dividends do not influence the value of the firm. It is the investment pattern and
consequently the earnings of the firm which affect the share price or the value of the firm.[7]
[edit] Assumptions of the MM theorem

The MM approach has taken into consideration the following assumptions:

1.
2.
3.
4.
5.
6.

There is a rational behavior by the investors and there exists perfect capital markets.
Investors have free information available for them.
No time lag and transaction costs exist.
Securities can be split into any parts i.e. they are divisible
No taxes and floatation costs.
The investment decisions are taken firmly and the profits are therefore known with certainty.
The dividend policy does not affect these decisions.

[edit] Model description

The dividend irrelevancy in this model exists because shareholders are indifferent between
paying out dividends and investing retained earnings in new opportunities. The firm finances
opportunities either through retained earnings or by issuing new shares to raise capital. The
amount used up in paying out dividends is replaced by the new capital raised through issuing
shares. This will affect the value of the firm in an opposite ways. The increase in the value
because of the dividends will be offset by the decrease in the value for new capital raising.

11111111111111111111111111111111111111111111111111111111111111

Walter's Dividend Model Assignment Help, Tutor Help:

Walter's Dividend Model
Walter's model supports the principle that dividends are relevant. The
investment policy of a firm cannot be separated from its dividend
policy and both are inter-related. The choice of an appropriate
dividend policy affects the value of an enterprise.
Assumptions of this model:
1. Retained earnings are the only source of finance. This means that the company does not
rely upon external funds like debt or new equity capital.
2. The firm's business risk does not change with additional investments undertaken. It
implies that r(internal rate of return) and k(cost of capital) are constant.
3. There is no change in the key variables, namely, beginning earnings per share(E), and
dividends per share(D). The values of D and E may be changed in the model to determine
results, but any given value of E and D are assumed to remain constant in determining a
given value.
4. The firm has an indefinite life.

Formula: Walter's model

P =

D
Ke g

Where:

P = Price of equity
shares
D = Initial dividend
Ke = Cost of equity
capital
g = Growth rate
expected

After accounting for retained earnings, the model would be:

P =

D
Ke rb

Where: r = Expected rate of return on firms

investments
b = Retention rate (E - D)/E

Equation showing the value of a share (as present value of all dividends plus the present value of
all capital gains) Walter's model:
P = D + r/ke (E
- D)
ke
Where: D = Dividend per share and
E = Earnings per share
Example:
A company has the following facts:
Cost of capital (ke) = 0.10
Earnings per share (E) = $10
Rate of return on investments ( r) = 8%
Dividend payout ratio: Case A: 50% Case B: 25%
Show the effect of the dividend policy on the market price of the shares.
Solution:
Case A:
D/P ratio = 50%
When EPS = $10 and D/P ratio is 50%, D = 10 x 50% = $5

P =

5 + [0.08 / 0.10] [10 5]

=> $90

0.10
Case B:
D/P ratio = 25%
When EPS = $10 and D/P ratio is 25%, D = 10 x 25% = $2.5

P =

2.5 + [0.08 / 0.10] [10 2.5]

=> $85

0.10

Conclusions of Walter's model:

1. When r > ke, the value of shares is inversely related to the D/P ratio. As the D/P ratio
increases, the market value of shares decline. Its value is the highest when D/P ratio is 0.
So, if the firm retains its earnings entirely, it will maximize the market value of the
shares. The optimum payout ratio is zero.

2. When r < ke, the D/P ratio and the value of shares are positively correlated. As the D/P
ratio increases, the market price of the shares also increases. The optimum payout ratio is
100%.
3. When r = ke, the market value of shares is constant irrespective of the D/P ratio. In this
case, there is no optimum D/P ratio.

Limitations of this model:

1. Walter's model assumes that the firm's investments are purely financed by retained
earnings. So this model would be applicable only to all-equity firms.
2. The assumption of r as constant is not realistic.
3. The assumption of a constant ke ignores the effect of risk on the value of the firm.

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Dividend and determinants of Dividend Policy
Dividend
Dividend refers to the corporate net profits distributed among
shareholders. Dividends can be both preference dividends and equity
dividends. Preference dividends are fixed dividends paid as a percentage every year to the
preference shareholders if net earnings are positive. After the payment of preference dividends,
the remaining net profits are paid or retained or both depending upon the decision taken by the
management.
Determinants of Dividend Policy
The main determinants of dividend policy of a firm can be classified into:
1.
2.
3.
4.
5.
6.

Dividend payout ratio

Stability of dividends
Legal, contractual and internal constraints and restrictions
Owner's considerations
Capital market considerations and
Inflation.

1. Dividend payout ratio

Dividend payout ratio refers to the percentage share of the net earnings distributed to the
shareholders as dividends. Dividend policy involves the decision to pay out earnings or to
retain them for reinvestment in the firm. The retained earnings constitute a source of
finance. The optimum dividend policy should strike a balance between current dividends
and future growth which maximizes the price of the firm's shares. The dividend payout
ratio of a firm should be determined with reference to two basic objectives maximizing
the wealth of the firms owners and providing sufficient funds to finance growth. These
objectives are interrelated.
2. Stability of dividends
Dividend stability refers to the payment of a certain minimum amount of dividend
regularly. The stability of dividends can take any of the following three forms:
a. constant dividend per share

b. constant dividend payout ratio or

c. constant dividend per share plus extra dividend
3. Legal, contractual and internal constraints and restrictions
Legal stipulations do not require a dividend declaration but they specify the conditions
under which dividends must be paid. Such conditions pertain to capital impairment, net
profits and insolvency. Important contractual restrictions may be accepted by the
company regarding payment of dividends when the company obtains external funds.
These restrictions may cause the firm to restrict the payment of cash dividends until a
certain level of earnings has been achieved or limit the amount of dividends paid to a
certain amount or percentage of earnings. Internal constraints are unique to a firm and
include liquid assets, growth prospects, financial requirements, availability of funds,
earnings stability and control.
4. Owner's considerations
The dividend policy is also likely to be affected by the owner's considerations of the tax
status of the shareholders, their opportunities of investment and the dilution of ownership.
5. Capital market considerations
The extent to which the firm has access to the capital markets, also affects the dividend
policy. In case the firm has easy access to the capital market, it can follow a liberal
dividend policy. If the firm has only limited access to capital markets, it is likely to adopt
a low dividend payout ratio. Such companies rely on retained earnings as a major source
of financing for future growth.
6. Inflation
With rising prices due to inflation, the funds generated from depreciation may not be
sufficient to replace obsolete equipments and machinery. So, they may have to rely upon
retained earnings as a source of fund to replace those assets. Thus, inflation affects
dividend payout ratio in the negative side.

Bonus shares and stock splits

Bonus share is referred to as stock dividend. They involve payment to existing owners of
dividend in the form of shares. It is an integral part of dividend policy of a firm to use bonus
shares and stock splits. A stock split is a method commonly used to lower the market price of
shares by increasing the number of shares belonging to each shareholder. Bonus shares may be
issued to satisfy the existing shareholders in a situation where cash position has to be maintained.
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step is performed. This approach of breaking down a problem has been appreciated by majority
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Topics under Dividend Decisions:

Gordon's Dividend Capitalization Model

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Walter's Dividend Model

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Determinants of Dividend Policy Assignment Help, Tutor Help
Dividend and determinants of Dividend Policy
Dividend
Dividend refers to the corporate net profits distributed among
shareholders. Dividends can be both preference dividends and equity
dividends. Preference dividends are fixed dividends paid as a percentage every year to the
preference shareholders if net earnings are positive. After the payment of preference dividends,
the remaining net profits are paid or retained or both depending upon the decision taken by the
management.
Determinants of Dividend Policy
The main determinants of dividend policy of a firm can be classified into:

1.
2.
3.
4.
5.
6.

Dividend payout ratio

Stability of dividends
Legal, contractual and internal constraints and restrictions
Owner's considerations
Capital market considerations and
Inflation.

1. Dividend payout ratio

Dividend payout ratio refers to the percentage share of the net earnings distributed to the
shareholders as dividends. Dividend policy involves the decision to pay out earnings or to
retain them for reinvestment in the firm. The retained earnings constitute a source of
finance. The optimum dividend policy should strike a balance between current dividends
and future growth which maximizes the price of the firm's shares. The dividend payout
ratio of a firm should be determined with reference to two basic objectives maximizing
the wealth of the firms owners and providing sufficient funds to finance growth. These
objectives are interrelated.
2. Stability of dividends
Dividend stability refers to the payment of a certain minimum amount of dividend
regularly. The stability of dividends can take any of the following three forms:
a. constant dividend per share
b. constant dividend payout ratio or
c. constant dividend per share plus extra dividend
3. Legal, contractual and internal constraints and restrictions
Legal stipulations do not require a dividend declaration but they specify the conditions
under which dividends must be paid. Such conditions pertain to capital impairment, net
profits and insolvency. Important contractual restrictions may be accepted by the
company regarding payment of dividends when the company obtains external funds.
These restrictions may cause the firm to restrict the payment of cash dividends until a
certain level of earnings has been achieved or limit the amount of dividends paid to a
certain amount or percentage of earnings. Internal constraints are unique to a firm and
include liquid assets, growth prospects, financial requirements, availability of funds,
earnings stability and control.
4. Owner's considerations
The dividend policy is also likely to be affected by the owner's considerations of the tax
status of the shareholders, their opportunities of investment and the dilution of ownership.
5. Capital market considerations

The extent to which the firm has access to the capital markets, also affects the dividend
policy. In case the firm has easy access to the capital market, it can follow a liberal
dividend policy. If the firm has only limited access to capital markets, it is likely to adopt
a low dividend payout ratio. Such companies rely on retained earnings as a major source
of financing for future growth.
6. Inflation
With rising prices due to inflation, the funds generated from depreciation may not be
sufficient to replace obsolete equipments and machinery. So, they may have to rely upon
retained earnings as a source of fund to replace those assets. Thus, inflation affects
dividend payout ratio in the negative side.

Bonus shares and stock splits

Bonus share is referred to as stock dividend. They involve payment to existing owners of
dividend in the form of shares. It is an integral part of dividend policy of a firm to use bonus
shares and stock splits. A stock split is a method commonly used to lower the market price of
shares by increasing the number of shares belonging to each shareholder. Bonus shares may be
issued to satisfy the existing shareholders in a situation where cash position has to be maintained.
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Gordon's Dividend Capitalization Model
Gordon's theory contends that dividends are relevant. This model is of
the view that dividend policy of a firm affects its value.
Assumptions of this model:
1. The firm is an all equity firm. No external financing is used and investment programmes
are financed exclusively by retained earnings.
2. Return on investment( r ) and Cost of equity(Ke) are constant.
3. The firm has perpetual life.
4. The retention ratio, once decided upon, is constant. Thus, the growth rate, (g = br) is also
constant.
5. Ke > br

Arguments of this model:

1. Dividend policy of the firm is relevant and that investors put a positive premium on
current incomes/dividends.
2. This model assumes that investors are risk averse and they put a premium on a certain
return and discount uncertain returns.
3. Investors are rational and want to avoid risk.
4. The rational investors can reasonably be expected to prefer current dividend. They would
discount future dividends. The retained earnings are evaluated by the investors as a risky
promise. In case the earnings are retained, the market price of the shares would be
adversely affected. In case the earnings are retained, the market price of the shares would
be adversely affected.
5. Investors would be inclined to pay a higher price for shares on which current dividends
are paid and they would discount the value of shares of a firm which postpones
dividends.
6. The omission of dividends or payment of low dividends would lower the value of the
shares.

Dividend Capitalization model:

According to Gordon, the market value of a share is equal to the present value of the future
streams of dividends.
P =

E(1 - b)
Ke - br

Where:
P
E
b
1-b
Ke

=
=
=
=
=

Price of a share
Earnings per share
Retention ratio
Dividend payout ratio
Cost of capital or the capitalization rate
Growth rate (rate or return on investment of an allbr - g =
equity firm)

Example: Determination of value of shares, given the following data:

Case A
40
D/P Ratio
Retention
60
Ratio
Cost of capital 17%
12%
r
$20
EPS

Case B
30
70
18%
12%
$20

$20 (1 0.60)
$81.63
=
=>
0.17 (0.60 x
(Case A)
0.12)
$20 (1 - 0.70)
$62.50
=
=>
0.18 (0.70 x
(Case B)
0.12)

Gordon's model thus asserts that the dividend decision has a bearing on the market price of the
shares and that the market price of the share is favorably affected with more dividends.
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Miller and Modigliani Model (MM Model)
Miller and Modigliani Model assume that the dividends are irrelevant.
Dividend irrelevance implies that the value of a firm is unaffected by
the distribution of dividends and is determined solely by the earning
power and risk of its assets. Under conditions of perfect capital markets,
rational investors, absence of tax discrimination between dividend income and capital

appreciation, given the firms investment policy, its dividend policy may have no influence on
the market price of the shares, according to this model.
Assumptions of MM model
1. Existence of perfect capital markets and all investors in it are rational. Information is
available to all free of cost, there are no transactions costs, securities are infinitely
divisible, no investor is large enough to influence the market price of securities and there
are no floatation costs.
2. There are no taxes. Alternatively, there are no differences in tax rates applicable to capital
gains and dividends.
3. A firm has a given investment policy which does not change. It implies that the financing
of new investments out of retained earnings will not change the business risk complexion
of the firm and thus there would be no change in the required rate of return.
4. Investors know for certain the future investments and profits of the firm (but this
assumption has been dropped by MM later).

Argument of this Model

1. By the argument of arbitrage, MM Model asserts the irrelevance of dividends. Arbitrage
implies the distribution of earnings to shareholders and raising an equal amount
externally. The effect of dividend payment would be offset by the effect of raising
additional funds.
2. MM model argues that when dividends are paid to the shareholders, the market price of
the shares will decrease and thus whatever is gained by the investors as a result of
increased dividends will be neutralized completely by the reduction in the market value
of the shares.
3. The cost of capital is independent of leverage and the real cost of debt is the same as the
real cost of equity, according to this model.
4. That investors are indifferent between dividend and retained earnings implies that the
dividend decision is irrelevant. With dividends being irrelevant, a firms cost of capital
would be independent of its dividend-payout ratio.
5. Arbitrage process will ensure that under conditions of uncertainty also the dividend
policy would be irrelevant.

MM Model:
Market price of the share in the beginning of the period = Present value of dividends paid at the
end of the period + Market price of share at the end of the period.
P0 = 1/(1 + ke) x (D1 + P1)
Where:P0 = Prevailing market price of a share
ke = cost of equity capital
Dividend to be received at the end
D1 =
of period 1 and

P1 =

Market price of a share at the end of

period 1.

Value of the
firm, nP0

(n + n) P1 I
+E
(1 + ke)

Where: n

n=
I
E

=
=

number of shares outstanding at the beginning of the period

change in the number of shares outstanding during the period/
additional shares issued.
Total amount required for investment
Earnings of the firm during the period.

Example:
A company whose capitalization rate is 10% has outstanding shares of 25,000 selling at $100
each. The firm is expecting to pay a dividend of $5 per share at the end of the current financial
year. The company's expected net earnings are $250,000 and the new proposed investment
requires $500,000. Prove that using MM model, the payment of dividend does not affect the
value of the firm.
Solution:
1. Value of the firm when dividends are paid:
i.

Price per share at the end of year 1:

ii.

P0 = 1/(1 + ke) x (D1 + P1)

$100 = 1/(1 + 0.10) x ($5 + P1)
P1 = $105
Amount required to be raised from the issue of new shares:

iii.

n P1 = I (E nD1)
=> $500,000 ($250,000 - $125,000)
=> $375,000
Number of additional shares to be issued:

iv.

n = $375,000 / 105 => 3571.42857 shares (unrounded)

Value of the firm:
=> (25,000 + 3571.42857) (105) - $500,000 + $250,000
(1 + 0.10)
=> $2,500,000

2. Value of the firm when dividends are not paid:

i.

Price per share at the end of year 1:

ii.

P0 = 1/(1 + ke) x (D1 + P1)

$100 = 1/(1 + 0.10) x ($0 + P1)
P1 = $110
Amount required to be raised from the issue of new shares:

iii.

=> $500,000 ($250,000 -0) = $250,000

Number of additional shares to be issued:

iv.

=> $250,000/$110 = 2272.7273 shares (unrounded)

Value of the firm:
=> (25,000 + 2272.7273) (110) - $500,000 + $250,000
(1 + 0.10)
=> $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.
Limitations of MM model:
1. The assumption of perfect capital market is unrealistic. Practically, there are taxes,
floatation costs and transaction costs.
2. Investors cannot be indifferent between dividend and retained earnings under conditions
of uncertainty. This can be proved at least with the aspects of i) near Vs distant dividends,
ii) informational content of dividends, iii) preference for current income and iv) sale of
stock at uncertain price.

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Topics under Dividend Decisions:

.2.2.

Dividend & Determinants of Dividend Policy

Gordon's Dividend Capitalization Model
Walter's Dividend Model

Gordons Model

Myron Gordon has also proposed a model suggesting that the dividend is relevant and can affect
the value of the share and that of the firm. This model is also based on the assumptions similar to
that Walters model. However, two additional assumptions made by this model are as follows:

The growth rate of firm g is the product of retention ratio, b, and its rate of return, r, i.e.,
r= br, and

The cost of capital besides being constant is more than the growth rate i.e., ke>g

Gordon argues that the investors do have a preference for current dividends and this is a direct
relationship between the dividend policy and the market value of the share. The basic premise of
the model is that the investors are basically risk averse and they evaluate the future dividends/
capital gains as a risky and uncertain proposition. Dividends are more predictable than capital
gains; management can control dividends but it cannot dictate the market price of the share.
Investors are certain of receiving incomes than from future capital gains. The incremental risk
associated with capital gains implies a higher required rate of return for discounting the capital
gains than for discounting the current dividends. In other words, an investor values, current
dividend more highly than an expected future capital gain.

So, the bird in the hand argument of this model suggests that the dividend policy is relevant as
the investors prefer current dividends as against the future uncertain capital gains. When the
investors are certain about their returns, they discount the firms earning at a lower rate and
therefore, placing a higher value for the share and that of the firm. So, the investors require a
higher rate of return as retention rate increases and this would adversely affect the share price.
Thus, Gordons Model is a share valuation model. Under this model, the market price of a share
can be calculated as follows:
P = E (1-b)
ke- br
Where,
P=

Market price of equity share

E=

Earnings per share of the firm

B=

Retention ratio (1- payout ratio)

R=

Rate of return on investment of the firm

Ke =

Cost of Equity share capital, and

Br =

g i.e., Growth rate of the firm

This model shows that there is a relationship between payout ratio (i.e., 1-b), cost of capital ke,
rate of return, r, and the market value of the share. This can be explained with the help of the
following example:
The following information is available in respect of Axis Ltd.
Earning per share (EPS or E)

$ 10

Cost of Capital, ke,

10%

Find out the market price of the share under different rate of return, r, of 8%, 10%, and 15% for
different payouts of 0%, 40%, 80% and 100%.
ANSWER:
The market price of the share as per Gordens model may be calculated as follows:
If r=15% and payout ratio is 40%, then the retention ratio, b, is .6 (i.e. 1-.4) and the growth rate,
g= br= .09 (i.e., .6*.15) and the market price of the share is

P = E (1-b)
ke- br
P = 10(1-.6)/.10-.09
P = $ 400
If r= 8% and payout ratio is 80%, then the retention ratio, b, .2 (i.e., 1-.8) and the growth rate,
g=br=.016 (i.e., .2*.08) and the market price of the share is
P = 10(1-.2)//10-.016
P = $ 95
Similarly the expected market price under different combinations of r and dividend payout ratio
have been calculated and shown below:
r=
D/P Ratio

15%

0%

10%

8%

40%

$400

$100

$77

80%

114.3

100

95

100%

100

100

100

On the basis of figures given in the table above, it can be seen that if the firm adopts a zero
payout then the investor may not be willing to offer any price. For a growth firm (i.e., r>ke>br),
the market price decreases when the payout is increased. For a firm having r<ke, the market price
increases when the payout is increased.
If r=ke, the dividend policy is irrelevant and the market price remains constant at $100 only.
Gordon had also argued that even if r=ke, the dividend payout ratio matters and the investors
being risk averse prefer current dividends which are certain to future capital gains which are
uncertain. The investors will apply a higher capitalization rate i.e., ke to discount the future
capital gains. This will compensate them for the future uncertain capital gain and thus, the
market price of the share of a firm which retains profit will be adversely affected.

9.2.1. Walters Model

Walter J.E. supports the view that the dividend policy has a bearing on the market price of the
share and has presented a model to explain the relevance of dividend policy for valuation of the
firm based on the following assumptions:

All investment proposals of the firm are to be financed through retained earnings only and no
external finance is available to the firm.

The business risk complexion of the firm remains same even after fresh investment decisions are
taken. In other words, the rate of return on investment i.e. r and the cost of capital of the firm
i.e. ke, are constant.
The firm has an infinite life.

This model considers that the investment decisions and dividend of a firm are interrelated. A
firm should or should not pay dividends upon whether it has got the suitable investment
opportunities to invest the retained or not.
The model is presented below:
If a firm pays dividend to shareholders, they in turn, will invest this income to get further returns.
This expected return to shareholder is the opportunity cost of the firm and hence the cost of
capital, ke, to the firm. On the other hand, if the firm does not pay dividends, and instead retains,
then these retained earnings will be reinvested by the firm to get return on these retained earnings
will be reinvested by the firm to get return on these investment. This rate of return on the
investment, r. Of the firm must be at least equal to the cost of capital, ke. If r= ke, the firm is
earning a return just equal to what the shareholders could have earned had the dividends been
paid to them.
However, what happen if the rate of return, r, is more than the cost of capital, ke? In such case,
the firm can earn more by retaining the profits, than the shareholders can earn by investing their
dividend income. The Walters model, thus says that if r>ke, the firm should refrain from should
reinvest the retained earnings and thereby increase the wealth of the shareholders. However, if
the investment opportunities before the firm to reinvest the retained earnings are expected to give
a rate of return which is less than the opportunity cost of the shareholders of the firm, then the
firm should better distribute the entire profits. This will give opportunity to the shareholders to
reinvest this dividend income and get higher returns.

In a nutshell, therefore, the dividend policy of a firm depends upon the relationship between r &
k. If r>ke (a case of a growth firm), the firm should have zero payout and reinvest the entire
profits to earn more than the investors. If however, r<ke, then the firm should have 100% payout
ratio and let the shareholders reinvest their dividend income to earn higher returns, if r happens
to be just equal to ke, the shareholders will be indifferent whether the firm pays dividends or
retain the profits. In such a case, the returns of the firm from reinvesting the retained earnings
will be just equal to the earnings available to the shareholders on their investment of dividend
income.
Thus, a firm can maximise the market value of its share and the value of the firm by adopting a
dividend policy as follows:

If r>ke, the payout ratio should be zero

If r<ke, the payout ratio should be 100% and the firm should not retain any profit, and
If r=ke, the dividend is irrelevant and the dividend policy is not expected to affect the market
value of the share.

In order to testify the above, Walter has suggested a mathematical valuation model i.e.,
P =

D + (r/ke) (E-D)

Ke

ke

Where,
P

Market price of equity share

D =

Dividend per share paid by the firm.

Rate of return on investment of the Firm

Ke =

Cost of Equity share capital, and

E =

Earnings per share of the firm.

As per the above formula, the market price of a share is the sum of two components i.e.,

The present value of an infinite stream of dividends, and

The present value of an infinite stream of return from retained earnings.

Thus, the Walters formula shows that the market value of a share is the present value of the
expected stream of dividends and capital gains. The effect of varying payout ratio on the market
price of the share under different rate of returns, r, have been shown below:
The following information is available in respect of Axis Ltd.

Earning per share (EPS or E)

$ 10

Cost of Capital, ke,

10%

Find out the market price of the share under different rate of return, r, of 8%, 10%, and 15% for
different payouts of 0%, 40%, 80% and 100%.
Answer:
The market price of the share as per Walters Model may be calculated for different
combinations of rates and dividend payout ratios (the earnings per share, E, and the cost of
capital, ke, taken as constant) as follows:
If the rate of return, r= 15% and the dividend payout ratio is 40%, then
P

D + (r/ke) (E-D)
Ke

ke

40 + 90

130

Similarly, if r= 8% and dividend Payout ratio = 80%, then

P=
=

80+ 16
96

The expected market price of the share under different combinations of r and ke have been
calculated and presented in the table below:
r=
D/P Ratio

0%

15%
$150

10%
$100

8%
$80

40%

130

100

88

80%

110

100

96

100%

100

100

100

It may be seen from the table that for a growth firm (r= 15% and r>ke), the market price is
highest at $ 150 when the firm adopts a zero payout and retains the entire earnings. As the

payout increases gradually from 0% to 100%, the market price tends to decrease from $ 150 to $
100 and the firm retains no profit. However if r=ke= 10%, then the price is constant at $ 100 for
different payouts ratios. Such a firm does not have any optimum ratio and every payout ratio is
good as any other.
Critical Appraisal

The Walters model provides a theoretical and simple frame work to explain the relationship
between policy and value of the firm. As far as the assumptions underlying the model hold well,
the behaviour of the market price of the share in response to the dividend policy of the firm can
be explained with the help of this model.
However, the limitation of this model is that these underlying assumptions are too unrealistic.
The financing of investments proposals only by retaining earnings and no external financing is
seldom found in real life. The assumption of constant r and constant ke is also unrealistic and
does not hold good. As more and more investment is made, the risk complexion of the firm will
change and consequently the ke may not remain constant.

Relevance of Dividend Policy

Generally, the firms pay dividend and view such dividend payments positively. The investors
also expect and like to receive dividend income on their investments. The firm not paying
dividends may be adversely rated by the investors thereby affecting the market value of the
share. The basic argument of those supporting the dividend relevance is that because current cash
dividends reduce investors uncertainty, the investors will discount the firms earnings at a lower
rate. Ke, thereby placing a higher value on the shares. If the dividends are not paid then the
uncertainty of shareholders/investors will increase, raising the required rate, ke, resulting in
relatively lower market value of the share and the value of the firm. The market price of the
share will increase if the firm pays dividends, otherwise it may decrease. A firm must therefore
pay dividend to shareholders to fulfil the expectations of the shareholders in order to maintain or
increase the market price of the share.

Two models representing this argument are discussed below:

ividend Decision And Valuation Of The Firm

9.1 Introduction

Two basic schools of thoughts on dividend policy have been expressed in the theoretical
literature of finance. One school, associated with Myron Gordon and John Lintner, holds that the
capital gains expected from earnings retention are more risky than dividend expectations.
Accordingly, this school suggested that the earnings of a firm with a low payout ratio will
typically be capitalized at higher rates than the earnings of a high payout firm. The other school
associated with Merton Miller & Franco Modigliani, holds that investors are basically indifferent
to returns in the form of dividends or capital gains. Empirically, when firms raise or lower their
dividend, their stock prices tend to rise or fall in like manner; does this not prove that investors
prefer dividends?

The term dividend refers to that portion of profit (after tax) which is distributed among the
owners/shareholders of the firm and the profit which is not distributed is known as retained
earnings. A company may have preference share capital as well as equity share capital and
dividends may be paid on both types of capital. However there is no decision involved as far as
the dividend payable to preference shareholders is concerned. The reason being is that the
preference dividend is more or less, a contractual liability and is payable at a fixed rate. On the
other hand a firm has to consider a lot of factors before deciding about the equity dividend. The
dividend decision may seem simple enough, but it evokes a surprising amount of controversy,
which we will deal with later.

The dividend decision is one of the three basic decisions which a financial manager may be
required to take, the other two being the investment and financing decisions.
In dividend decision the financial manager is required to decide one or more of the following:

Should the profits be ploughed back to finance the investments decisions?

Whether any dividend should be paid? If yes, how much dividends be paid?
When these dividend should be paid? Interim or Final?
In what form should the dividends be paid? Cash Dividend or Bonus Share?

All these decisions are inter related and have bearing on the future growth plans of the firm. If a
firm pays dividend, it affects the cash flow position of the firm but earns goodwill among the
investors who therefore, may be willing to provide additional funds for the financing of
investment plans of the firm. On the other hand, the profits which are not distributed as dividends
become an easily available source of funds at no explicit cost. Every aspect of the decision has to
be critically evaluated. The most important of these considerations is to decide as to what portion
of profit should be distributed. This is also known as the dividend payout ratio.
While deciding the dividend payout ratio the firm should consider the effect of such policy on
the objective of maximization of shareholders wealth. If the dividend is expected to increase the
market value of the share the dividend must be paid, otherwise, the profits may be retained and
used as an internal source of finance. So, the firm must find out and establish a relationship
between the dividend policy and the market value of the share. There are conflicting views on
the relationship between the dividend policy and value of the firm.
Dividend policy and Value of the Firm
Dividend policy is basically concerned with deciding whether to pay dividend in cash now, or to
pay increased dividends at a later stage or distribute profits in the form of bonus shares. The
current dividend provides liquidity to the investors but the bonus share will bring capital gains to
the shareholders. The investors preference between the current cash dividend and the future
capital gain has been viewed differently. Some are of the opinion that the future gains are more
risky than the current dividends while others argue that the investors are indifferent between the
current dividend and the future capital gains.
Various models have been proposed to evaluate the dividend policy decision in relation to value
of the firm. While agreement is not found among the models as to what is the precise
relationship, it is still worthwhile to examine some of these models to gain insight into the effect
which the dividend policy might have on the market price of the shares and hence on the wealth
of the shareholders. Two schools of thoughts have emerged on the relationship between the
dividend policy and value of the firm.
One school associated with Walter, Gordon, etc holds that the future capital gains are more risky
and the investors have preference for current dividends. The investors do have a tilt towards
those firms which pay regular dividend. So, the dividend affects the market value of the share
and as a result the dividend policy is relevant for the overall value of the firm. On the other hand,

the other school of thought associated with Modigliani and Miller holds that the investors are
basically indifferent between current cash dividends and capital gains. Both these schools of
thought on the relationship between dividend policy and value of the firm have been discussed as
follows:

Irrelevance Of Dividend Policy

The other school of thought on dividend policy and valuation argues that what a firm pays as
dividend to shareholders is irrelevant and the shareholders are indifferent about receiving current
dividends receiving capital in future. The advocates of this school of thought argue that the
dividend policy has no effect on the market price of a share. The shareholders do not
differentiate between the present dividend or future capital gains. They are basically interested in
higher returns earned either by the firm by investing profits in profitable investment opportunity
or earned by them by making investment of dividend income.

The conclusion that dividends are not relevant is based on two pre conditions:

That investment and financing decisions are already being made and that these decisions will
not be altered by the amount of dividend payments.
That the perfect capital market is there in which an investor can buy and sell the shares without
any transaction cost and that the companies can issue shares without any flotation cost.

Two theories have been discussed below to focus the irrelevance of dividend policy for valuation
of the firm though it is well accepted that like the capital structure irrelevance proposition, the
dividend irrelevance argument has its roots in the Modigliani-Miller Analysis.
Email Based Assignment Help in Irrelevance Of Dividend Policy

Residuals Theory Of Dividends

This theory is based on the assumption that either he eternal financing is not available to the firm
or if available, cannot be used due to its excessive costs of financing the profitable investment
opportunities of the firm. Therefore, the firm finances its investments decisions by retaining
profits. The quantum of profits to be distributed is a balancing figure and thus depends upon
what portions of profits to be retained. If a firm has sufficient profitable investment
opportunities, then the wealth of the shareholders will be maximised by retaining profits and
reinvesting them in the financing of investment opportunities either by reducing dividend or even
by paying no dividend to the shareholder. If a firm has no such investment opportunity, then the
profits may be distributes among the shareholders.

Thus firm does not decide how much dividends to be paid rather it decide as to how much profits
should be retained. The dividends are a distribution of residual profits after retaining sufficient
profit for financing the available opportunities. This is referred to as Residuals Theory of
Dividends.