Under the Guidance of : Dr.

Shashi Srivastava

Presented By: Ravi kumar Vinish kumar singh

Out-line of presentation
Introduction
The Theory Of Irrelevance
MM Model

Dividend Decision and Valuation of Firm The Theory Of Relevance

Walters Approach Gordons Approach

The term dividend refers to a part of profit of a company which is distributed by the company among its stakeholder. It is a reward for the shareholder for the investment made by them in the share of the company.

An investor is generally interested in earning the maximum return on his investment and to maximize his wealth. A company on the other hands needs to provide funds for financing its long term growth. If a company pays out most of the earning as a dividend, so for the further expansion it has to depend on the other sources such as debt or issue of new shares. A firm has basically two option, i.e. either firm can retain the earning or can distribute the same as a dividend.

The first option suited to those firms which want to finance their long term project.

While the second option of declaring the dividend will lead to maximization of shareholder wealth. So the return to the share holder either by the way of dividend or the capital gains are affected by the dividend decision policy of the firm. It is the dividend decision policy of the firm which decide the retention ratio and the pay out ratio. (dividend as a % of profit).

There are basically two school of thought regarding the dividend decision.

The MM-Model (Modigliani & Miller)

The MM-Model has expressed the dividend decision in the most comprehensive manner in support of the theory of irrelevance.
They said that dividend policy has no effect on the market price of the shares, and the value of the firm is determined by the earning capacity of the firm or the investment policy. The splitting of earning between retention and dividend, may be in any manner the firm likes, does not affect the value of the firm.

There are a perfect capital market. Investor behave rationally. Information about the company is available to all without any cost. There is no transaction cost. The MM-approach contain the following formula to prove the irrelevance of the dividend decision.

Price of the share P1=Po(1+Ke)-D1 Where, P1= price of share at end

The no. of shares to be issued can be calculated as I(E-nD1) P1

And the value of the firm as.. (n+m)*P1-(I-E) 1+Ke Where, m= no. of shares to be issued I= Investment required E=total earning of the firm during the period n=no. of shares outstanding at the beginning of the period. nPo=value of the firm

Po= price of the share in beginning

D1= dividend to be received Ke= rate of capitalization

 ABC Ltd. Belongs to a risk class company for which the appropriate capitalization rate is 10%. It currently has the outstanding 5000 shares selling at 100 each. The firm is contemplating the declaration of dividend of Rs.6 per share. The company is expected to have a net income of Rs.50,000 and has proposal for making new investment of 1,00,000. show that under the MMhypothesis, the payment of dividend does not effect the value of the firm.

Value of the firm Value of the firm when dividend are when dividend are paid not paid
1-Price of the share at the end of the year 104 110

2-No. of shares to be issued

3-Value of the firm

80,000/104
5,00,000

50,000/110
5,00,000

This school of thought on dividend decision says that dividend decision considerably affect the value of the firm. Dividend communicate the information about the firms profitability to the investor so it become relevant.

There is basically two theories representing this assumption. 1. 2. Walters Approach Gordons Approach

According to this concept the relationship between the internal rate of return earned by the firm and its cost of capital is very significant in determining the dividend decision policy. It is based on the relationship between the return on investment r, and cost of capital or required rate of return, k. According to Prof. Walter, if r>k i.e. the firm should retain the earning. If r<k, the shareholder would stand to gain if the firm distribute its earnings. If r=k, the dividend policy will not affect the market value of the firm.

The investment of the firm are financed through retained earning only. The internal rate of return and cost of capital is constant. Earning and the dividend do not change while determining the value. The firm has a very long life.

D Ke

r(E-D)/Ke Ke

Where, P= market price per shares D= dividend per shares r= internal rate of return E= earning per share Ke= cost of capital

 The following information is available in respect of the firm: Capitalization rate 10% Earning per share 50 Rs. Assumed rate of return on investment: 1- 12% 2- 8% 3- 10% Show the effect of dividend policy on market price of the share when dividend pay-out ratio is 0%, 20%, 40%, 80%, and 100%.

r=12% D/P is 0% D/P is 20% D/P is 40% D/P is 80% 600 580 560 520

r=8% 400 420 440 480 500

r=10% 500 500 500 500 500

D/P is 100% 500

 Investments are financed through external burrowing. The r also does not remains constant. The k also does not remains constant.

Assumptions:
1. 2. 3. 4. The firm is an all equity firm No external financing is available or used. The rate of return is constant. The retention ratio, b, once decided is constant. 5. The growth rate of the firm g=br, is also constant. 6. The cost of capital is also constant and is greater than the g. 7. Corporate tax does not exist.

 When r>k, the price per share increases as the dividend pay-out ratio decreases. So the firm should retain maximum earning. If r=k, price remain unchanged. dividend decision does not affect it.
If r<k, the price increases as the pay out ratio increases. So the dividend would be 100%.

 The following information is available in respect of the rate of return on investment (r), the cost of capital (k), and earning per share of ABC Ltd. Rate of return= 15%, 12%, 10% Cost of capital= 12% Earning per share=10 Rs. Determine the value of the shares using the Gordon Model.

D/P is 100% Or b=0 D/P is 80% Or b=20% D/P is 40% Or b=60%

r=15% r>k 83.33

88.89 133.33

r=12% r=k 83.33

83.33 83.33

r=10% r<k 83.33

80 66.67