Dividend Theories 406e57

Radhakrishna Mishra, GIFT

Objective  Dividend Decision  Dividend Models  Traditional Approach (Relevance)  Walter's Model (Relevance)  Gordan's Model (Relevance)  Miller and Modigliani Hypothesis (Irrelevance)  Rational Expectations Model (Irrelevance)

Radhakrishna Mishra, GIFT

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.  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. Radhakrishna Mishra, GIFT

Theories  Traditional Model  Walter Model  Gordon Model  Miller and Modigliani Approach and  Rational Expectations Model

Radhakrishna Mishra, GIFT

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.  P = m (D + E/3)

P = Market Price of the stock m = Multiplier D = Dividend per share E = Earnings per share Radhakrishna Mishra, GIFT

LIMITATIONS OF THE TRADITIONAL APPROACH  The traditional approach, further states that the P/E

ratios are directly related to the dividend pay-out ratios. But a firm’s share price may rise even in case of a low payout ratio if its earnings are increasing. Here the capital gains for the investor will be higher than the cash dividends.  Similarly for a firm having a high dividend pay-out ratio with a slow growth rate there will be a negative impact on the market price (because of lower earnings).

Radhakrishna Mishra, GIFT

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). i) r < Ke ii) r = Ke iii) r > Ke

Radhakrishna Mishra, GIFT

r < ke

 When the internal rate of return(r) is less than the

required rate of return (ke), 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.

Radhakrishna Mishra, GIFT

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.

Radhakrishna Mishra, GIFT

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.

Radhakrishna Mishra, GIFT

 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.

P = Price of the share, D = Dividend, Ke = Required rate of return, r = Internal rate of return Radhakrishna Mishra, GIFT

Limitations  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.  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.  The firm’s cost of capital does not remain constant and changes with a change in the firm’s risk. Radhakrishna Mishra, GIFT

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: The firm is an all equity firm and retained earnings are the only source of finance. The internal rate of return and the required rate of return (ke) are constant. The firm has a perpetual life. The retention ratio (b) and the growth rate (g = br) of the firm are constant. The required of return is greater than the growth rate.

Radhakrishna Mishra, GIFT

The model also states that:  when r > ke, the market price of the share is favourably affected with more retentions.  when r < ke, more retentions would lead to decline in market price.  When r = ke, retentions do not affect the market price of the share.

Radhakrishna Mishra, GIFT

P= P = Share price E = Earnings per share b = Retention ratio (1 – b) = Dividend pay-out ratio ke = Cost of equity capital (or cost of capital of the firm) br = Growth rate (g) in the rate of return on investment

Radhakrishna Mishra, GIFT

Miller and Modigliani Approach  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.

Radhakrishna Mishra, GIFT

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.

Radhakrishna Mishra, GIFT

• 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. • According to MM approach, investors would be indifferent between dividends and retention of earnings.

Radhakrishna Mishra, GIFT

Assumptions  Investors are rational.  The capital markets are perfect  There are no taxes.  The financing of the new investments out of retained

earnings will not change the business risk complexion of the firm.

Radhakrishna Mishra, GIFT

• According MM hypothesis

n = number of shares at the beginning of the period P0 = prevailing market price of the share. (Hence nP0 is the total capitalized value of the firm). = change in the number of shares during the period I = total investment required E = earnings of the firm during the period Ke = capitalization rate. Radhakrishna Mishra, GIFT

Limitations of MM approach  Taxes  Floatation costs  Transaction costs  Information asymmetry: Inefficient market  Market conditions: market tend to influence the

dividend policy

Radhakrishna Mishra, GIFT

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. Radhakrishna Mishra, GIFT