Session Objectives:

• Dividend Decision
• Dividend Models
• Traditional Approach
• Walter's Model
• Gordan's Model
• Miller and Modigliani Hypothesis
• Rational Expectations Model
DIVIDEND POLICY

Dividends refer to that portion of a firm’s net earnings which are paid out to the equity
shareholders. The firm has two alternatives in respect of its net earnings: it may retain the
earnings or it may distribute the earnings to the shareholders in the form of dividends.
Retained earnings constitute an easily accessible and important source of financing the
investment requirements of the firm. Hence a conflicting relationship exists between the
retained earnings and the cash dividends. The decision regarding the dividend policy is one of
the major decisions of a firm and it should be guided by the objective of maximizing the
shareholder’s wealth.
The models that study the relationship between the dividend policies of the firm and the value
of the firm are:
i. Traditional Model
ii. Walter Model
iii. Gordon Model
iv. Miller and Modigliani Approach and
v. Rational Expectations Model
Traditional
Approach
This approach was given by B.Graham and D.L.Dodd and it lays emphasis on the relationship
between dividends and the stock market. As per this approach, stock value responds positively
to higher dividends and negatively to lower dividends. The relationship between market price
and the dividends has been mathematically expressed as:

P=m (D+ )

Where, P is the market price,

m is the multiplier
D is dividend per share and
E is earnings per share
The proposition of this approach that high dividends lead to high P/E ratio may not be true in a
number of situations. For example, a firm might have a low dividend payout ratio but its share
price may rise because of its increasing earnings. Similarly a firm having a high dividend
payout ratio but a slow growth rate might not experience an increase in its share price.
Also, there might be certain investors who prefer capital gains to dividends and others who
might prefer dividends to uncertain capital gains. Such factors have not been explained by the
traditional approach.

WALTER’S MODEL:

According to James E. Walter, dividends are relevant and they do affect the share price. Walter
explains the relevance of the dividend policy with the help of the relationship between the
internal rate of return (r) and the required rate of return (ke). Three situations are discussed
under this model:

i. r < ke

When the internal rate of return is less than the required rate of return, it indicates that the
shareholders will be in a better position if earnings are paid out to them so as to enable them
to earn a higher rate of return elsewhere. The optimum dividend policy for firms in this
situation will be a dividend payout ratio of 100% as doing so will maximize the market price of
the shares.
ii. r > ke
When the internal rate of return is greater than the required rate of return then it indicates
that the firm has adequate profitable investment opportunities and it would be able to earn
more than what the investors can if they invest elsewhere. The optimum dividend policy in
such a situation will be a dividend payout ratio of 0. In other words, the firm should plough
back the entire earnings within the firm in order to maximize the market value of the shares.
iii. r = ke
When the internal rate of return is equal to the required rate of return, it is a matter of
insignificance whether the earnings are retained or distributed. There is no optimum dividend
policy for firms in this situation as the market price of the shares will remain constant for all
D/P ratios.
According to the Walter’s Model, the market price of the share is the sum of the present values
of future cash dividends and capital gains.

i.e.

Assumptions:
1. The only source of financing for the firm is retained earnings, i.e. external sources
of funds like debt or additional equity capital are not used.
2. The risk profile of the firm will not be altered by the additional investments that it
undertakes. In other words, r and k remain constant.
3. The key variables, namely Earnings per share (E) and Dividend per share (D) are
assumed to remain constant.
4. The firm has a perpetual life.
Example: The capitalization rate (ke) for Apex Ltd. is 9%. Its Earning per Share is Rs 10. The
assumed rates of return on investments are: (i) 12%, (ii) 8% and (iii) 9%.
Show the effect of the following dividend payout ratios on the market value of the firm:

a. 0 %
b. 40%
c. 100%

Solution:

i. r= 12% and ke = 9% (i.e. r>ke)

a. D/P ratio = 0% i.e. D = 0

= Rs 148.15

b. D/P ratio = 40% i.e. D = Rs 4.

= Rs 133.33

c. D/P ratio = 100% i.e. D = Rs 10.

= Rs111.11

From the above calculations, we can infer that when r > ke, the market price of the share
decreases as the dividend payout ratio increases. Hence the optimum dividend policy in this
situation will be 0%, i.e. the firm should retain all its earnings as it has growth opportunities.

ii. r = 8% and ke = 9% (i.e. r < ke)

a. D/P ratio = 0% i.e. D = 0

= Rs 98.77.

b. eD/P ratio = 40% i.e. D = Rs 4.

= Rs 103.70

c. D/P ratio = 100% i.e. D = Rs 10.

 = Rs 111.11

The above computations indicate that when r < ke, the market price of the share increases as
the dividend payout ratio increases. Hence the optimum dividend payout ratio in this case will
be 100% as the investors will have more profitable avenues than the firm.

ii. r = 9% and ke = 9% (i.e. r = ke)

a. D/P ratio = 0% i.e. D = 0

* = Rs 111.11

b. D/P ratio = 40% i.e. D = Rs 4.

= Rs 111.11

c. D/P ratio = 100% i.e. D = Rs 10.

= Rs 111.11

When r = ke, the market price of the firm will remain constant at all dividend payout ratios.
Limitations:
Walter’s model explains the relevance of dividends under certain simplified assumptions. Some
of these assumptions might not hold good in reality.
1. Walter’s model assumes that the firm’s investments are financed exclusively by
retained earnings and no external financing is used. In such a case, this model will be
applicable only to an all equity firm.
2. This model assumes that the expected rate of return on the firm’s investments
(i.e. r) is constant. This assumption does not hold good in reality as the expected rate
of return changes with increase in investments.
3. The firm’s cost of capital does not remain constant and changes with a change in
the firm’s risk. The present value of the firm’s income moves inversely with the cost of
capital. By assuming the capitalization rate k to be constant, the model ignores the
effect of risk complexion on the value of the firm.
Gordon’s Dividend Capitalization
Model
Just like the Walter model, the Gordon model also opines that the dividend policy of a firm
affects its value. This model is based on the following assumptions:
 i. The firm is an all equity firm and retained earnings are the only source of finance.
ii. The internal rate of return and the required rate of return (ke) are constant.
iii. The firm has a perpetual life.
iv. The retention ratio (b) and the growth rate (g = br) of the firm are constant.
v. The required of return is greater than the growth rate.

Gordon assumes that investors are risk-averse and they put a premium on a certain return and
discount/penalize uncertain returns. Rational investors prefer current dividend to future
dividend as the latter is marked by uncertainty with respect to both amount as well as timing.
This argument of Gordon is based on the ideology that a bird in hand is better than two in a
bush. Thus, investors would be inclined to pay higher price for shares on which current
dividends are paid and they would discount the value of shares of a firm which postpones
dividends. The model also states that
i. when r > ke, the market price of the share is favourably affected with more
retentions.
ii. when r < ke, more retentions would lead to decline in market price.
iii. When r = ke, retentions do not affect the market price of the share.
The market value of a share as per Gordon’s dividend capitalization model is computed as:

P=

where,
E is the earnings per share
b is the retention ratio
D/P = 1-b, is the dividend payout ratio
ke is the cost of capital
and, g=br is the growth rate in the rate of return on investment.
Example: The capitalization rate for A Ltd. is 9% and the earning per share is Rs 12. The
assumed rates of return are (i) 8% (ii) 9% and (iii) 12%. Compute the value of the stock at
the following dividend payout ratios:

a. 25%
b. 50%
c. 85%

Solution:
i. r = 8% and ke = 9% (i.e. r < ke)
(a) D/P ratio is 25%, i.e. retention ratio is 75%

= Rs 100.

b. D/P ratio is 50%, i.e. retention ratio is 50%

 Rs 120.

c. D/P ratio is 85%, i.e. retention ratio is 15%

= Rs 130.77.

ii. r = 9% and ke = 9% (i.e. r = ke)

d. D/P ratio is 25%, i.e. retention ratio is 75%

= Rs 133.33

e. D/P ratio is 50%, i.e. retention ratio is 50%

= Rs 133.33

f. D/P ratio is 85%, i.e. retention ratio is 15%

= Rs 133.33.

iii. r = 11% and ke = 9% (i.e. r > ke)

g. D/P ratio is 25%, i.e. retention ratio is 75%
= Rs 400.

h. D/P ratio is 50%, i.e. retention ratio is 50%

= Rs 171.43.

i. D/P ratio is 85%, i.e. retention ratio is 15%

= Rs 138.78.

From the above computations, we observe that when

i. r > ke, the market price of the share increases with a decrease in the dividend
payout ratio.
ii. r < ke, the market price of the share increases with an increase in the dividend
payout ratio.
iii. r = ke, the market price of the share remains same for all dividend payout ratios.
Miller and Modigliani Approach

The MM (Miller and Modigliani) hypothesis provides the most comprehensive argument in
support of the irrelevance of dividends. According to this approach, the dividend policy has no
effect on the share price of the firm and is therefore of no significance. It is the investment
policy which will be relevant as it is through it that the firm can increase its earnings and
thereby the value of the firm.
Given an investment decision, the firm will have two alternatives (a) retain the earnings to
finance the investment opportunity; (b) distribute the earnings to the investor and raise an
 equal amount by issuing new shares for funding the new investment. If the firm goes for the
second alternative, the effect of dividend payment on the shareholder’s wealth will be exactly
offset by the effect of raising additional share capital. In other words, the second alternative
will lead to an arbitrage process by which the increase in market price of the shares due to
payment of dividends will be completely neutralized by the decrease in the terminal value of
the shares. Hence, according to MM approach, investors would be indifferent
dividends and retention of earnings.
Assumptions:

The hypothesis about irrelevance of dividends is based on the following assumptions:

i. investors are rational.

ii. The capital markets are perfect
iii. There are no taxes.
iv. The financing of the new investments out of retained earnings will not change
the business risk complexion of the firm.

According to MM hypothesis,

where, n is the number of shares outstanding at the beginning of the period

P0 is the prevailing market price of the share. (Hence nP0 is the total capitalized value of the
firm).
is the change in the number of outstanding shares during the period
I is the total investment required
E is the earnings of the firm during the period
ke is the capitalization rate.
Dividends do not figure in the above formula, which clearly implies the irrelevance of dividends
to valuation.
Example: ABC Ltd. is in a risk class for which the appropriate capitalization rate is 9%. At
present, the firm has 50,000 outstanding shares selling at Rs 100 each. The firm is planning to
declare a dividend of Rs 5 per share at the end of the current financial year. The company is
expecting a net income of Rs.4,00,000 this year. It is also planning to take up a new project
for which an investment of Rs.7,15,000 is required. Prove that as per the MM approach the
payment of dividends will not affect the value of the firm.
Solution:

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

i. Price at the end of year 1:

The price at the end of the year can be computed using the following formula:
i.e. 100 =

P1 = Rs. 104.

ii. Amount required to be raised from the issue of new shares

= 7,15,000 – (4,00,000 – 50,000 x 5) = Rs. 5,65,000.

iii. Number of additional shares to be issued

= 5,433 shares approximately.

Hence, value of the firm after the dividends are declared is given by:

= Rs. 50,00,029.
b. The value of the firm when the dividends are not paid:
i. Price of the share at the end of year 1:

i.e. 100 =

i.e. P1= Rs 109.

ii. Amount required to be raised from the issue of new shares
n1p1 = (7,15,000 – 4,00,000) = Rs. 3,15,000.
iii. Number of new shares to be issued

= 2890 shares (approximately).

Hence, the value of the firm can be computed as:

= Rs 50,00,009.

From the above example, we observe that the value of the firm remains the same
(approximately) irrespective of the payment of dividends. This indicates that the shareholders
are indifferent between retention and payment of dividends.
Limitations of MM
approach
The assumptions made under this approach are quite unrealistic. We may not find capital
markets to be perfect in reality. Certain assumptions under the MM hypothesis that are not
relevant are:
1. Tax differential: MM hypothesis assumes that there is no difference between the
tax rate applicable to dividends and capital gains. But in reality, different tax rates are
applicable to dividends and capital gains. Usually, the capital gains tax rate is lower
than the dividends income tax rate. From the tax point of view, a shareholder should
prefer capital gains to current dividends because (a) the capital gains tax rate is less
than the dividends tax rate and (b) the capital gains tax is applicable only when the
shares are actually sold. The effect of favourable tax rate in case of capital gains will
lead to tax savings.
2. Floatation costs: MM hypothesis assumes that there are no financial costs. But
in practice, floatation costs do exist in case of new issues. Hence if the company retains
the earnings, then no floatation costs will be involved but the firm will have to pay
underwriting fee and brokerage charges if it issues new shares. Thus, in the presence of
floatation costs, retention of earnings would be preferred to payment of dividends.
3. Transaction costs: MM hypothesis assumes the absence of transaction costs.
But when a shareholder sells shares, he needs to pay some brokerage fee which is
more in the case of small sales. Hence because of the existence of transaction costs,
the shareholders may prefer dividends to capital gains.
4. Information asymmetry: MM hypothesis assumes the existence of perfect
capital markets in which the information is freely available to all. But in practice,
managers may not share complete information with the shareholders. This might lead
to conflicts between managers and shareholders. The dividend policy helps in reducing
the conflict arising between shareholders and managers due to information asymmetry.
5. Market conditions: Conditions existing in the market tend to influence the
dividend policy. For example: A firm might be having profitable avenues for investment
but it might not be having access to funds due to bad market conditions. This will force
the firm to retain more earnings and follow a less dividend pay-out ratio.
The conditions mentioned above explain the shortcomings of MM approach towards
dividend policy.
Rational Expectations
Model
According to this model, the dividend policy of the firm does not have any impact on its market
price as long as it is declared at the expected rate. However, the market will show some
response if the dividends declared are higher or lower than the expected dividends i.e. the
share price might experience an increase if the dividends declared are more than the expected
dividends and the share price will experience a decrease when the dividends declared are less
than those expected by the investors.
Summary

There are two different schools of thought on the dividend policies of a firm. According to one
school of thought in a perfect market situation investment and financing decisions are
independent and thus, the dividend decisions become irrelevant. The model given by Miller &
Modigliani belongs to this school of thought. They also consider that the share value of the firm
is based on the investment opportunities of the firm. However, the imperfect market conditions
and the uncertainty prevailing in the future earnings do not provide enough support to this
model. The second school of thought explains the relevance of the dividend policy and the
impact of the same on the share value. However, in spite of these dividend models, it should
be noted that investors are risk-averse and prefer current dividend to future earnings. Further,
 with maximization of shareholder wealth being the most important issue, the dividend policies
of a firm will vary, depending on the operational environment.
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