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Work+ all categoriesFeaturedRecentPeopleAuthorsStudentsResearchersPublishersGovernment & NonprofitsBusinessesMusiciansArtists & DesignersTeachers+ all categoriesMost FollowedPopularOmega Mbayo We're using Facebook to personalize your experience.Learn MoreDisableHomeMy DocumentsMy CollectionsMy ShelfView Public ProfileMessagesNotificationsSettingsHelpLog OutWelcome to Scribd - Where the world comes to read, discover, and share... Were using Facebook to give you reading recommendations based on what your friends are sharing and the things you like. We ve also made it easy to connect with your friends: you are now following your Facebook friends who are on Scribd, and they are following you! In the future you can access your account using your Facebook login and password.Learn moreNo thanks 1First Page Previous Page Next Page / 12Sections not available Zoom Out Zoom In Fullscreen Exit FullscreenSelect View Mode View ModeSlideshowScroll Readcast Add a Comment Embed & Share Reading should be social! Post a message on your social networks to let others know what you re reading. Select the sites below and start sharing.Link accountReadcast this DocumentReadcast Complete!Click send to Readcast!edit preferencesSet your preferences for next time...Choose auto to readcast without being prompted.Omega MbayoOmega MbayoLink accountAdvancedCancel Add a CommentSubmitshare:Characters: 400 Share & EmbedAdd to Collections Download this Document for FreeAuto-hide: on 1 1 THEORIES OF DIVIDEND POLICY THEORIES OF DIVIDEND POLICY i) i) Dividend Relevance Theories Dividend Relevance Theories ii) ii) Dividend Irrelevance Theories Dividend Irrelevance Theories Dividend Relevance Theory Dividend Relevance Theory The dividend is a relevant variable in determining the value The dividend is a relevant variable in determining the value of the firm, it implies that there exists of the firm, it implies that there exists an optimal dividend policy, which the managers should seek an optimal dividend policy, which the managers should seek to determine, that maximises the to determine, that maximises the value of the firm. There are three models, which have been value of the firm. There are three models, which have been developed under this approach. These are: developed under this approach. These are: i) i) Traditional Model Traditional Model ii) ii) Walters Model Walters Model iii) iii) Gordons Dividend Capitalisation Model Gordons Dividend Capitalisation Model iv) iv) Bird-in-hand Theory Bird-in-hand Theory v) v) Dividend Signalling Theory Dividend Signalling Theory vi) vi) Agency Cost Theory Agency Cost Theory 2 2 TRADITIONAL MODEL TRADITIONAL MODEL MP is positively related to higher dividends. Thus MP would MP is positively related to higher dividends. Thus MP would increase if dividends are higher and decline if dividends are increase if dividends are higher and decline if dividends are lower. lower. P = m (D + E/3) P = m (D + E/3) where, where, P = Market price P = Market price m = Multiplier m

= Multiplier D = Dividend per share D = Dividend per share E = Earnings per share E = Earnings per share 3 3 WALTERS MODEL WALTERS MODEL Based on the assumptions that all investments are financed Based on the assumptions that all investments are financed through RE, rate of return and cost of capital are constant, through RE, rate of return and cost of capital are constant, the firm either distributes dividends or reinvested the firm either distributes dividends or reinvested internally; internally;Walter Walter put forth the following model for put forth the following model for valuation of shares valuation of shares P P0 0= =D + (E D) rlk D + (E D) rlk k k P P0 0= market price per share = market price per share D = Dividend per share D = Dividend per share E = Earnings per share E = Earnings per share E D = Retained earnings per share E D = Retained earnings per share r = Firms average rate of return r = Firms average rate of return k = firms cost o capital k = firms cost o capital From the model it is clear that the market price per share is the From the model it is clear that the market price per share is the sum sum of two consumptions: of two consumptions: i. i. The first component Dlk is the present value of an infinite The first component Dlk is the present value of an infinite stream of cash flows in the form of dividends. stream of cash flows in the form of dividends. ii. ii. The second component The second component(E D)rlk (E D)rlk is the present value of is the present value of an infinite stream of returns k an infinite stream of returns k retained earnings. retained earnings. 4 4 GORDONS DIVIDEND GORDONS DIVIDEND CAPITALISATION MODEL CAPITALISATION MODEL Assumptions : Firm is all-equity, RE are used to finance Assumptions : Firm is all-equity, RE are used to finance projects, r and k are constant, there are no taxes, b projects, r and k are constant, there are no taxes, b once decided is constant. once decided is constant. Gordon put forward the following valuation model: Gordon put forward the following valuation model: P P0 0= E = E1 1 + (1 b) + (1 b) k - br k - br where, where, P P0 0= Price per share at the end of the year 0 = Price per share at the end of the year 0 E E1 1= Earnings per share at the end of year 1 = Earnings per share at the end of year 1 (1 b) = Fraction of earnings the firm distributes by way of (1 b) = Fraction of earnings the firm distributes by way of earnings earnings b = Fraction of earnings the firms ploughs back b = Fraction of earnings the firms ploughs back k = Rate of return required by the shareholders k = Rate of return required by the shareholders r = Rate of return earned on investments made by the firm r = Rate of return earned on investments made by the firm br = Growth rate of earnings and dividends br = Growth rate of earnings and dividends 5 5 BIRD-IN-HAND THEORY BIRD-IN-HAND THEORY John Lintner propounded this theory in 1962 and Myron John Lintner propounded this theory in 1962 and Myron Gordon in Gordon in 1963. The shareholders are not entitled to any fixed return. 1963. The shareholders are not entitled to any fixed return. The return The return to the shareholders is in the form of dividends and capital to the shareholders is in the form of dividends and capital gains. gains. Current dividends are relatively certain compared to future Current dividends are relatively certain compared to future capital capital gains. gains. According to this theory shareholders are risk averse and According to this theory shareholders are risk averse and prefer to prefer to receive dividends in the present time period to future receive dividends in the present time period to future capital gains. capital gains. Modigliani and Miller termed this argument as bird-in-hand Modigliani and Miller termed this argument as bird-in-hand fallacy. fallacy. 6 6 DIVIDEND SIGNALLING THEORY DIVIDEND SIGNALLING THEORY Managers have greater access to inside information about the Managers have greater access to inside information about the company. They may share this information with the

shareholders company. They may share this information with the shareholders through an appropriate dividend policy. Constant or increasing through an appropriate dividend policy. Constant or increasing dividends convey positive signals about the future prospects of the dividends convey positive signals about the future prospects of the company resulting in an increase in share price. Similarly, absence of company resulting in an increase in share price. Similarly, absence of dividends or decreasing dividends convey negative signal resulting dividends or decreasing dividends convey negative signal resulting in in decline in share price. decline in share price. A liberal dividend policy by reducing the agency costs may lead to A liberal dividend policy by reducing the agency costs may lead to enhancement of the shareholder value. enhancement of the shareholder value. 7 7 DIVIDEND IRRELEVANCE THEORY DIVIDEND IRRELEVANCE THEORY These theories contend that there are two components of These theories contend that there are two components of shareholderreturns. shareholderreturns. a) a) Dividend Yield (D / P Dividend Yield (D / P0 0) ) b) b) Capital Yield (P Capital Yield (P1 1/ P / P0 0) /P ) /P0 0) ) Suppose a firm issues a Rs.10 par value share at a Suppose a firm issues a Rs.10 par value share at a premium of Rs.90. premium of Rs.90. In other words, the issue price is Rs.100. If the firm In other words, the issue price is Rs.100. If the firm declares a dividend of Rs.3 (the dividend yield is 3%) declares a dividend of Rs.3 (the dividend yield is 3%) price at the end of next year price at the end of next year is Rs.115, the capital yield is (115 100) / 100 = 15 per is Rs.115, the capital yield is (115 100) / 100 = 15 per cent. The total cent. The total return to the shareholders is 18 per cent. return to the shareholders is 18 per cent. These theories, which argue that dividends are not relevant These theories, which argue that dividends are not relevant in in determining the value of the firm, are: determining the value of the firm, are: i. i. Residual Theory Residual Theory ii. ii. Modigliani and Miller (M&M) Model Modigliani and Miller (M&M) Model iii. iii. Dividend Clientele Effect Dividend Clientele Effect iv. iv. Rational Expectations Model Rational Expectations Model 8 8 DIVIDEND IRRELEVANCE THEORY DIVIDEND IRRELEVANCE THEORY Residual Theory Residual Theory According to this theory a firm will only pay dividends from According to this theory a firm will only pay dividends from residual residual earnings, that is, from earnings left over after all the earnings, that is, from earnings left over after all the suitable suitable investment opportunities have been financed. investment opportunities have been financed. Modigliani and Miller (M&M) Model Modigliani and Miller (M&M) Model According to the model, it is only the firms investment According to the model, it is only the firms investment policy that will have an impact on the share value of policy that will have an impact on the share value of the firm and hence should be given more importance. the firm and hence should be given more importance. 9 9 DIVIDEND IRRELEVANCE THEORY DIVIDEND IRRELEVANCE THEORY Modigliani and Miller (M&M) Model Modigliani and Miller (M&M) Model The current market price of the share is equal to the discounted The current market price of the share is equal to the discounted value of the dividend paid and the market price at the end of the value of the dividend paid and the market price at the end of the period. period. P P0 0= _ = _1___ 1___(D (D1 1+ P + P1 1) ) (1 + k (1 + ke e) ) where, where, P P0 0= Current market price of the share (t = 0) = Current market price of the share (t = 0) P P1 1= Market price of the share at the end of the period (t = 1) = Market price of the share at the end of the period (t = 1) D D1 1 = Dividends to be paid at the end of the period (t = 1) = Dividends to be paid

at the end of the period (t = 1) k ke e= Cost of equity capital = Cost of equity capital With no external financing the total value of the firm will be as With no external financing the total value of the firm will be as follows: follows: nP nP0 0= _ = _1___ 1___(nD (nD1 1 + nP + nP1 1) ) (1 + k (1 + ke e) ) 10 10 DIVIDEND IRRELEVANCE THEORY DIVIDEND IRRELEVANCE THEORY Modigliani and Miller (M&M) Model Modigliani and Miller (M&M) Model Simplifying the above equation, we get Simplifying the above equation, we get n n1 1P P1 1 = I E + nD = I E + nD1 1 where, where, I = Total investment required I = Total investment required nD nD1 1 = Total dividends paid = Total dividends paid E = Earnings during the period E = Earnings during the period (E - nD (E - nD1 1 ) = Retained earnings ) = Retained earnings Substituting this value of the new shares in the above equation, we Substituting this value of the new shares in the above equation, we get get nP nP0 0= _ =_1 1___ [nD ___ [nD1 1 + (n + n + (n + n1 1)P )P1 1 - I + E - nD - I + E - nD1 1] ] (1 + k (1 + ke e) ) = =nD nD1 1 + (n + n + (n + n1 1)P )P1 1 - I + E - nD - I + E - nD1 1 (1 + k (1 + ke e) ) nP nP0 0= =(n + n (n + n1 1)P )P1 1-I+E -I+E (1 + k (1 + ke e) ) Thus, according to the M&M model, the market value of the share is Thus, according to the M&M model, the market value of the share is not not affected by the dividend policy and this is clear from the last equation affected by the dividend policy and this is clear from the last equation 11 11 DIVIDEND CLIENTELE EFFECT DIVIDEND CLIENTELE EFFECT :According to this theory, dividend :According to this theory, dividend policy is irrelevant in determining the firms value. policy is irrelevant in determining the firms value. Different firms may follow different dividend policies Different firms may follow different dividend policies depending upon their own needs and circumstances. depending upon their own needs and circumstances. One firm may decide on a higher payout ratio whereas One firm may decide on a higher payout ratio whereas others may decide on lower dividend payout. others may decide on lower dividend payout. Similarly,different shareholders may have different Similarly,different shareholders may have different needs some may prefer needs some may prefer current dividends whereas current dividends whereas others may be more interested in capital gains. Those others may be more interested in capital gains. Those investors who prefer current dividends would like to investors who prefer current dividends would like to become shareholders in companies which declare become shareholders in companies which declare generous dividends whereas those investors who are generous dividends whereas those investors who are more interested in capital gains would folk to more interested in capital gains would folk to companies having relatively lower payout ratios. companies having relatively lower payout ratios. RATIONAL EXPECTATIONS MODEL RATIONAL EXPECTATIONS MODEL: According to this model there : According to this model there would be no effect of dividend declaration on the would be no effect of dividend declaration on the market price as long as the dividend declared is in line market price as long as the dividend declared is in line with the expected dividends. If dividend <expected with the expected dividends. If dividend <expected dividend MP will decline and vice versa. Thus, so far dividend MP will decline and vice versa. Thus, so far as dividend declared ratifies the market expectation as dividend declared ratifies the market expectation the dividend policy is not relevant in determining the the dividend policy is not relevant in determining the MP. MP. 12 12 PRACTICAL CONSIDERATIONS IN THE PRACTICAL CONSIDERATIONS IN THE FORMULATION OF DIVIDEND POLICY FORMULATION OF DIVIDEND POLICY Profitability

and Liquidity Profitability and Liquidity Legal Constraints Legal Constraints Contractual Constraints Contractual Constraints Growth Prospects Growth Prospects Owner Considerations Owner Considerations Market Considerations Market Considerations Industry Practice Industry Practice Shareholders Expectations Shareholders Expectations Theories of Dividend Policy Download this Document for FreePrintMobileCollectionsReport DocumentReport this document?Please tell us reason(s) for reporting this document Spam or junk Porn adult content Hateful or offensiveIf you are the copyright owner of this document and want to report it, please follow these directions to submit a copyright infringement notice.Report Cancel This is a private document. Info and Rating Reads:13,470Uploaded:03/10/2010Category:Uncategorized.Rated:Copyright:Attributio n Non-commercial agrawalsumeetsShare & Embed Related Documents PreviousNext p. p. p. p. p. p. p. p. p. p. p. p. p. p. p. p. p. p. p. p. p. p. p. p. p. p. p. p. p. p. p. p. p. p. p. p. p. p. p. p. p.

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