V UnitDIVIDEND THEORIESDividend decision determines the amount of

earnings to be distributed to share holders and the amount to be retained in the firm

There are two theories regarding dividend Relevant theoriesIrrelevant theories

Walter’s ModelWalter equation is based on the

relationship between the firm’s return on investment or internal rate of return(r) and cost of capital or required rate of return (k).

supports the view of dividend policy of an enterprise has bearing on value of firm. The Model is based on r and K o. it states that dividend policy affects the value of the firm according to him firm is classified into three

Model divides firms into: Growth firms: r>K o

Normal firms: r=K o

Declining firms: r<K o

Classification of firmsAccording to James Walter if r k i.e, the firm

earns a higher return than the cost of capital, it is known as ‘Growth firm’ the growth firm should retain the earnings as much a possible.

In the case of a firm which does not have profitable investment opportunities r k it is a declining firm. The optimum dividend policy for them would be to distribute the entire earnings as dividends.

In the case of firms where r=k it is a normal firm, it is not matter whether the firm retains or distributes its earnings. In their case the value of the firms share would not fluctuate with change in the dividend rates.

Assumptions

The firm does the entire financing through retained earnings. It does not use external sources of funds such as debt or new equity capital

The firm business risk does not change with additional investment it implies that the firms internal rate of return and cost of capital

All earnings are either distributed or retained immediately.

 

P=D+r/k (E-D) KP= Market price of an equity shareD= dividend per sharer= Internal rate of returnE= cost of capital or capitalization rateEx.

Altd Bltd Cltd

R=15% R=5% R=10%

K=10% K=10% K=10%

E=Rs8 E=Rs8 E=Rs8

Calculate the value of an equity share of each of these companiew applying walter’s formula when dividend payment ratio is 1)50% 2)75% 3)25%. And draw conclusions.

GordonGordon supported the relevant approach on

dividend determination i. e. dividend policy of a company will influence its market value according him dividend policy the market value of the company’s equity share is equal to the present valued of an infinite stream of dividend dividends are infinite because equity shares are not bound for time

Gordon’s argument: Gordon’s argument: Investors are risk averse, need premium on uncertain

return divides firms into: Growth firms: r>K o

In this case the returns r are greater than their costs k. when return are greater investors expectation it is more preferable for them to retain as much earnings as possible in the firm because they cannot earn more than that rate so the market value of the share is maximum when retained earnings are higher and vice versa

Normal firms: r=K o

for a normal firm the earnings( r) are just equal to its costs (k). The investor is indifferent between retained earnings and dividends his opportunity cost is also similar to the firm’s earnings so the market value of the share is the same at any amount of dividend or retained earnings.

Declining firms: r<K o

because of lesser returns their costs are known as declining firms there will be lesser returns than earnings so it cannot retain any earnings. If their retain more the earnings to the share holders are lesser. So the market value of t he share is maximum when retained are lesser and minimum when retained earnings are maximum

Where P = Price per share E = Earnings per share b = Retention ratio (1- b) = Proportion of earnings of the

firm distributed as dividends; K o = Capitalization rate or cash of

capital or required return by equity shareholders r = Rate of returns earned an

investment made by the firm g = b. r = growth rate

PE b

K b ro

( )

.

1

Xltd Yltd Zltd

R=15% R=10% R=7%

K=10% K=10% K=10%

E=Rs10 E=Rs10 E=Rs10

Find out the market values when pay out ratio is 40% ,60%,90%.

Assumptions:

– All equity firm; Properties financed by retained earnings; – ‘r’ is constant; – K o remains constant;

– K o>b. r; – Perpetual stream of earnings; – Perpetual life; – Retention ratio constant; – No corporate taxes

MM Theory: Value of Firm is determined by its basic earning power and its business risk.

It states that the dividend decision does not influence the market value of the equity shares/

Modigliani and Miller’s approach:They stated that the price of shares of a firm

is determined by its earnings potentiality and investment policy and never by the pattern of income distribution

they argued that what ever increase in shareholders wealth results from dividend payment, will be exactly offset by the effect of raising additional capital

Where: Po = Market price per share at period ‘o’

D1 = Dividends per share at end of period ‘1’

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

k = Discount rate applicable to the risk less to which the firm belongs to (cost of equity capital)

P1 = Po (1 + Ke) – D1

The total capitalization value of outstanding equity shares of the firm at period ‘0’ is obtained by the use of following formula.

nPo =

Market price per share at the end

Number of shares to be issued

m=I-(E-nD1)/P1m=number of shares to be issuedI= investment requiredE=total earnings of the firm during periodP1 market price per share at the end of the periodD1=Dividend to be paid at the end of the periodN= number of shares outstanding at the beginning

of the period.

Value of the firmnPo = (n+m) P1 – (I-E)/1+KeKe = cost of equity captialnPo = value of the firm

A ltd belongs to a risk class for which the appropriate capitalization rate is 10% It currently has 5,000 shares at 100 each the declaration of dividend is Rs 6 per share The company expects to have a net income of 50,000 and has a proposal for new investments of 1,00,000 show that under the MM hypothesis the payment of dividend does not effect the value of the firm.

dividend payment, will be exactly offset by the effect of raising additional capital

Assumptions: – Existence of perfect capital markets – No taxes – Firm has fixed investment policy – There is no riskArbitrage involving simultaneously into two

transactions which exactly balance each other.Here two transactions are: (i) Payment of dividends (ii) Raising funds externally

Factors Effecting DividendDeterminants of dividend policy:Stability of earnings:Financing policy of the companyLiquidity positionDividend policy of competitorsDividend practiecs of the companyAbility to borrowGrowth needs of the companyProfitabilityLegal restrictionsControl policy\corporate taxation policy

Tax position of shareholdersEffect of trade cyclesDesires of the shareholdersRick shareholdersSmall shareholders Retired persons Institutional investors