Theories Of Dividend Policy 441i4k

THEORIES OF DIVIDEND POLICY i) ii)

Dividend Relevance Theories Dividend Irrelevance Theories

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Dividend Relevance Theory

i) ii) iii) iv) v) vi)

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The dividend is a relevant variable in determining the value of the firm, it implies that there exists an optimal dividend policy, which the managers should seek to determine, that maximises the value of the firm. There are three models, which have been developed under this approach. These are: Traditional Model Walter’s Model Gordon’s Dividend Capitalisation Model Bird-in-hand Theory Dividend Signalling Theory Agency Cost Theory 1

TRADITIONAL MODEL

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MP is positively related to higher dividends. Thus MP would increase if dividends are higher and decline if dividends are lower. P = m (D + E/3)

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where,

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P = Market price m = Multiplier D = Dividend per share E = Earnings per share

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WALTER’S MODEL

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Based on the assumptions that all investments are financed through RE, rate of return and cost of capital are constant, the firm either distributes dividends or reinvested internally; Walter put forth the following model for valuation of shares P0 = D + (E – D) rlk k P0 = market price per share D = Dividend per share E = Earnings per share E – D = Retained earnings per share r = Firm’s average rate of return k = firm’s cost o capital From the model it is clear that the market price per share is the sum of two consumptions: i. The first component Dlk is the present value of an infinite stream of cash flows in the form of dividends. ii. The second component (E – D)rlk is the present value of an infinite stream of returns k retained earnings.

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GORDON’S DIVIDEND CAPITALISATION MODEL

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Assumptions : Firm is all-equity, RE are used to finance projects, r and k are constant, there are no taxes, b once decided is constant. Gordon put forward the following valuation model:

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P0 = E1 + (1 – b) k - br where, P0 = Price per share at the end of the year 0 E1 = Earnings per share at the end of year 1 (1 – b) = Fraction of earnings the firm distributes by way of earnings b = Fraction of earnings the firms ploughs back k = Rate of return required by the shareholders r = Rate of return earned on investments made by the firm br = Growth rate of earnings and dividends 4

BIRD-IN-HAND THEORY

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John Lintner propounded this theory in 1962 and Myron Gordon in 1963. The shareholders are not entitled to any fixed return. The return to the shareholders is in the form of dividends and capital gains. Current dividends are relatively certain compared to future capital gains. According to this theory shareholders are risk averse and prefer to receive dividends in the present time period to future capital gains. Modigliani and Miller termed this argument as bird-in-hand fallacy.

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DIVIDEND SIGNALLING THEORY

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Managers have greater access to inside information about the company. They may share this information with the shareholders through an appropriate dividend policy. Constant or increasing dividends convey positive signals about the future prospects of the company resulting in an increase in share price. Similarly, absence of dividends or decreasing dividends convey negative signal resulting in decline in share price. A liberal dividend policy by reducing the agency costs may lead to enhancement of the shareholder value.

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DIVIDEND IRRELEVANCE THEORY

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These theories contend that there are two components of shareholder’returns. a) Dividend Yield (D / P0) b) Capital Yield (P1 / P0) / P0) Suppose a firm issues a Rs.10 par value share at a of Rs.90. In other words, the issue price is Rs.100. If the firm declares a dividend of Rs.3 (the dividend yield is 3%) price at the end of next year is Rs.115, the capital yield is (115 – 100) / 100 = 15 per cent. The total return to the shareholders is 18 per cent. These theories, which argue that dividends are not relevant in determining the value of the firm, are: i. Residual Theory ii. Modigliani and Miller (M&M) Model iii. Dividend Clientele Effect iv. Rational Expectations Model

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DIVIDEND IRRELEVANCE THEORY Residual Theory

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According to this theory a firm will only pay dividends from residual earnings, that is, from earnings left over after all the suitable investment opportunities have been financed.

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Modigliani and Miller (M&M) Model According to the model, it is only the firms’ investment policy that will have an impact on the share value of the firm and hence should be given more importance.

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DIVIDEND IRRELEVANCE THEORY Modigliani and Miller (M&M) Model 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 period.

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P0 = _1___ (D1 + P1 ) (1 + ke) where, P0 = Current market price of the share (t = 0) P1 = Market price of the share at the end of the period (t = 1) D1 = Dividends to be paid at the end of the period (t = 1) ke = Cost of equity capital With no external financing the total value of the firm will be as follows: nP0 = _1___ (nD1 + nP1 ) (1 + ke) 9

DIVIDEND IRRELEVANCE THEORY Modigliani and Miller (M&M) Model

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Simplifying the above equation, we get n1P1 = I – E + nD1 where, I = Total investment required nD1 = Total dividends paid E = Earnings during the period (E - nD1 ) = Retained earnings

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Substituting this value of the new shares in the above equation, we get nP0 = _1___ [nD1 + (n + n1)P1 - I + E - nD1 ] (1 + ke) = nD1 + (n + n1)P1 - I + E - nD1 (1 + ke) nP0 = (n + n1)P1 - I + E (1 + ke) Thus, according to the M&M model, the market value of the share is not affected by the dividend policy and this is clear from the last equation

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:According to this theory, dividend policy is irrelevant in determining the firm’s value. Different firms may follow different dividend policies depending upon their own needs and circumstances. One firm may decide on a higher payout ratio whereas others may decide on lower dividend payout. Similarly,different shareholders may have different needs – some may prefer current dividends whereas others may be more interested in capital gains. Those investors who prefer current dividends would like to become shareholders in companies which declare generous dividends whereas those investors who are more interested in capital gains would folk to companies having relatively lower payout ratios. RATIONAL EXPECTATIONS MODEL: According to this model there would be no effect of dividend declaration on the market price as long as the dividend declared is in line with the expected dividends. If dividend <expected dividend – MP will decline and vice versa. Thus, so far as dividend declared ratifies the market expectation the dividend policy is not relevant in determining the MP.

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DIVIDEND CLIENTELE EFFECT

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PRACTICAL CONSIDERATIONS IN THE FORMULATION OF DIVIDEND POLICY Profitability and Liquidity

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Legal Constraints

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Contractual Constraints

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Growth Prospects

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Owner Considerations

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Market Considerations

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Industry Practice

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Shareholders Expectations

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