relevance of dividend policy
TRANSCRIPT
Relevance of dividend policy
dividends paid by the firms are viewed positively both by the investors and the firms. The firms which do not pay dividends are rated in oppositely by investors thus affecting the share price. The people who support relevance of dividends clearly state that regular dividends reduce uncertainty of the shareholders i.e. the earnings of the firm is discounted at a lower rate, ke thereby increasing the market value. However, its exactly opposite in the case of increased uncertainty due to non-payment of dividends.
Two important models supporting dividend relevance are given by Walter and Gordon.
[edit] Walter's model
James E. Walter's model shows the relevance of dividend policy and its bearing on the value of the share.[2]
[edit] Assumptions of the Walter model
1. Retained earnings are the only source of financing investments in the firm, there is no external finance involved.
2. The cost of capital, k e and the rate of return on investment, r are constant i.e. even if new investments decisions are taken, the risks of the business remains same.
3. The firm's life is endless i.e. there is no closing down.
Basically, the firm's decision to give or not give out dividends depends on whether it has enough opportunities to invest the retain earnings i.e. a strong relationship between investment and dividend decisions is considered.
[edit] Model description
Dividends paid to the shareholders are re-invested by the shareholder further, to get higher returns. This is referred to as the opportunity cost of the firm or the cost of capital, ke for the firm. Another situation where the firms do not pay out dividends, is when they invest the profits or retained earnings in profitable opportunities to earn returns on such investments. This rate of return r, for the firm must at least be equal to ke. If this happens then the returns of the firm is equal to the earnings of the shareholders if the dividends were paid. Thus, its clear that if r, is more than the cost of capital ke, then the returns from investments is more than returns shareholders receive from further investments.
Walter's model says that if r<ke then the firm should distribute the profits in the form of dividends to give the shareholders higher returns. However, if r>ke then the investment opportunities reap better returns for the firm and thus, the firm should invest the retained earnings. The relationship between r and k are extremely important to determine the dividend policy. It decides whether the firm should have zero payout or 100% payout.
In a nutshell :
If r>ke, the firm should have zero payout and make investments. If r<ke, the firm should have 100% payouts and no investment of retained earnings. If r=ke, the firm is indifferent between dividends and investments.
[edit] Mathematical representation
Walter has given a mathematical model for the above made statements :
where,
P = Market price of the share D = Dividend per share r = Rate of return on the firm's investments ke = Cost of equity E = Earnings per share'
The market price of the share consists of the sum total of:
the present value if an infinite stream of dividends the present value of an infinite stream of returns on investments made from retained earnings.
Therefore, the market value of a share is the result of expected dividends and capital gains according to Walter.
[edit] Criticism
Although the model provides a simple framework to explain the relationship between the market value of the share and the dividend policy, it has some unrealistic assumptions.
1. The assumption of no external financing apart from retained earnings, for the firm make further investments is not really followed in the real world.
2. The constant r and ke are seldom found in real life, because as and when a firm invests more the business risks change.
[edit] Gordon's ModelMain article: Gordon model
Myron J. Gordon
Myron J. Gordon has also supported dividend relevance and believes in regular dividends affecting the share price of the firm.[2]
[edit] The Assumptions of the Gordon model
Gordon's assumptions are similar to the ones given by Walter. However, there are two additional assumptions proposed by him :
1. The product of retention ratio b and the rate of return r gives us the growth rate of the firm g.2. The cost of capital ke, is not only constant but greater than the growth rate i.e. ke>g.
[edit] Model description
Investor's are risk averse and believe that incomes from dividends are certain rather than incomes from future capital gains, therefore they predict future capital gains to be risky propositions. They discount the future capital gains at a higher rate than the firm's earnings thereby, evaluating a higher value of the share. In short, when retention rate increases, they require a higher discounting rate. Gordon has given a model similar to Walter's where he has given a mathematical formula to determine price of the share.
[edit] Mathematical representation
The market price of the share is calculated as follows:
where,
P = Market price of the share E = Earnings per share b = Retention ratio (1 - payout ratio) r = Rate of return on the firm's investments ke = Cost of equity br = Growth rate of the firm (g)
Therefore the model shows a relationship between the payout ratio, rate of return, cost of capital and the market price of the share.
[edit] Conclusions on the Walter and Gordon Model
Gordon's ideas were similar to Walter's and therefore, the criticisms are also similar. Both of them clearly state the relationship between dividend policies and market value of the firm.
[edit] Capital structure substitution theory & dividends
The capital structure substitution theory (CSS)[3] describes the relationship between earnings, stock price and capital structure of public companies. The theory is based on one simple hypothesis: company managements manipulate capital structure such that earnings-per-share (EPS) are maximized. The resulting dynamic debt-equity target explains why some companies use dividends and others do not. When redistributing cash to shareholders, company managements can typically choose between dividends and share repurchases. But as dividends are in most cases taxed higher than capital gains, investors are expected to prefer capital gains. However, the CSS theory shows that for some companies share repurchases lead to a reduction in EPS. These companies typically prefer dividends over share repurchases.
[edit] Mathematical representation
From the CSS theory it can be derived that debt-free companies should prefer repurchases whereas companies with a debt-equity ratio larger than
should prefer dividends as a means to distribute cash to shareholders, where
D is the company’s total long term debt
is the company’s total equity is the tax rate on capital gains is the tax rate on dividends
Low valued, high leverage companies with limited investment opportunities and a high profitability use dividends as the preferred means to distribute cash to shareholders, as is documented by empirical research.[4]
[edit] Conclusion
The CSS theory provides more guidance on dividend policy to company managements than the Walter model and the Gordon model. It also reverses the traditional order of cause and effect by implying that company valuation ratios drive dividend policy, and not vice-versa. The CSS theory does not have 'invisible' or 'hidden' parameters such as the equity risk premium, the discount rate, the expected growth rate or expected inflation. As a consequence the theory can be tested in an unambiguous way.
[edit] Irrelevance of dividend policy
Franco Modigliani
Merton Miller
The Modigliani and Miller school of thought believes that investors do not state any preference between current dividends and capital gains. They say that dividend policy is irrelevant and is not deterministic of the market value. Therefore, the shareholders are indifferent between the two types of dividends. All they want are high returns either in the form of dividends or in the form of re-investment of retained earnings by the firm. There are two conditions discussed in relation to this approach :
decisions regarding financing and investments are made and do not change with respect to the amounts of dividends received.
when an investor buys and sells shares without facing any transaction costs and firms issue shares without facing any floatation cost, it is termed as a perfect capital market.[5]
Two important theories discussed relating to the irrelevance approach, the residuals theory and the Modigliani and Miller approach.
[edit] Residuals theory of dividends
One of the assumptions of this theory is that external financing to re-invest is either not available, or that it is too costly to invest in any profitable opportunity. If the firm has good investment opportunity available then, they'll invest the retained earnings and reduce the dividends or give no dividends at all. If no such opportunity exists, the firm will pay out dividends.
If a firm has to issue securities to finance an investment, the existence of floatation costs needs a larger amount of securities to be issued. Therefore, the pay out of dividends depend on whether any profits are left after the financing of proposed investments as floatation costs increases the amount of profits used. Deciding how much dividends to be paid is not the concern here, in fact the firm has to decide how much profits to be retained and the rest can then be distributed as dividends. This is the theory of Residuals, where dividends are residuals from the profits after serving proposed investments. [6]
This residual decision is distributed in three steps:
evaluating the available investment opportunities to determine capital expenditures. evaluating the amount of equity finance that would be needed for the investment, basically
having an optimum finance mix. cost of retained earnings<cost of new equity capital, thus the retained profits are used to
finance investments. If there is a surplus after the financing then there is distribution of dividends.
[edit] Extension of the theory
The dividend policy strongly depends on two things:
investment opportunities available to the company amount of internally retained and generated funds which lead to dividend distribution if all
possible investments have been financed.
The dividend policy of such a kind is a passive one, and doesn't influence market price. the dividends also fluctuate every year because of different investment opportunities every year. However, it doesn't really affect the shareholders as they get compensated in the form of future capital gains.
[edit] Conclusion
The firm paying out dividends is obviously generating incomes for an investor, however even if the firm takes some investment opportunity then the incomes of the investors rise at a later stage due to this profitable investment.
[edit] Modigliani-Miller theoremMain article: Modigliani–Miller theorem
The Modigliani–Miller theorem states that the division of retained earnings between new investment and dividends do not influence the value of the firm. It is the investment pattern and consequently the earnings of the firm which affect the share price or the value of the firm.[7]
[edit] Assumptions of the MM theorem
The MM approach has taken into consideration the following assumptions:
1. There is a rational behavior by the investors and there exists perfect capital markets.2. Investors have free information available for them.3. No time lag and transaction costs exist.4. Securities can be split into any parts i.e. they are divisible5. No taxes and floatation costs.6. The investment decisions are taken firmly and the profits are therefore known with certainty.
The dividend policy does not affect these decisions.
[edit] Model description
The dividend irrelevancy in this model exists because shareholders are indifferent between paying out dividends and investing retained earnings in new opportunities. The firm finances opportunities either through retained earnings or by issuing new shares to raise capital. The amount used up in paying out dividends is replaced by the new capital raised through issuing shares. This will affect the value of the firm in an opposite ways. The increase in the value because of the dividends will be offset by the decrease in the value for new capital raising.
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Walter's Dividend Model Assignment Help, Tutor Help:
Walter's Dividend Model
Walter's model supports the principle that dividends are relevant. The investment policy of a firm cannot be separated from its dividend policy and both are inter-related. The choice of an appropriate dividend policy affects the value of an enterprise.
Assumptions of this model:
1. Retained earnings are the only source of finance. This means that the company does not rely upon external funds like debt or new equity capital.
2. The firm's business risk does not change with additional investments undertaken. It implies that r(internal rate of return) and k(cost of capital) are constant.
3. There is no change in the key variables, namely, beginning earnings per share(E), and dividends per share(D). The values of D and E may be changed in the model to determine results, but any given value of E and D are assumed to remain constant in determining a given value.
4. The firm has an indefinite life.
Formula: Walter's model
P = D Ke – g
Where: P = Price of equity shares
D = Initial dividend Ke = Cost of equity
capital g = Growth rate
expected
After accounting for retained earnings, the model would be:
P = D Ke – rb
Where: r = Expected rate of return on firm’s investments
b = Retention rate (E - D)/E
Equation showing the value of a share (as present value of all dividends plus the present value of all capital gains) – Walter's model:
P = D + r/ke (E - D)
ke
Where: D = Dividend per share and E = Earnings per share
Example:
A company has the following facts:Cost of capital (ke) = 0.10Earnings per share (E) = $10Rate of return on investments ( r) = 8%Dividend payout ratio: Case A: 50% Case B: 25%Show the effect of the dividend policy on the market price of the shares.
Solution:
Case A:D/P ratio = 50%When EPS = $10 and D/P ratio is 50%, D = 10 x 50% = $5
P =
5 + [0.08 / 0.10] [10 - 5]
0.10
=> $90
Case B:D/P ratio = 25%When EPS = $10 and D/P ratio is 25%, D = 10 x 25% = $2.5
P =
2.5 + [0.08 / 0.10] [10 - 2.5]
0.10
=> $85
Conclusions of Walter's model:
1. When r > ke, the value of shares is inversely related to the D/P ratio. As the D/P ratio increases, the market value of shares decline. It’s value is the highest when D/P ratio is 0. So, if the firm retains its earnings entirely, it will maximize the market value of the shares. The optimum payout ratio is zero.
2. When r < ke, the D/P ratio and the value of shares are positively correlated. As the D/P ratio increases, the market price of the shares also increases. The optimum payout ratio is 100%.
3. When r = ke, the market value of shares is constant irrespective of the D/P ratio. In this case, there is no optimum D/P ratio.
Limitations of this model:
1. Walter's model assumes that the firm's investments are purely financed by retained earnings. So this model would be applicable only to all-equity firms.
2. The assumption of r as constant is not realistic.3. The assumption of a constant ke ignores the effect of risk on the value of the firm.
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Dividend & Determinants of Dividend Policy Gordon's Dividend Capitalization Model Miller and Modigliani Model
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Dividend and determinants of Dividend Policy
Dividend
Dividend refers to the corporate net profits distributed among shareholders. Dividends can be both preference dividends and equity dividends. Preference dividends are fixed dividends paid as a percentage every year to the preference shareholders if net earnings are positive. After the payment of preference dividends, the remaining net profits are paid or retained or both depending upon the decision taken by the management.
Determinants of Dividend Policy
The main determinants of dividend policy of a firm can be classified into:
1. Dividend payout ratio2. Stability of dividends3. Legal, contractual and internal constraints and restrictions4. Owner's considerations 5. Capital market considerations and6. Inflation.
1. Dividend payout ratio
Dividend payout ratio refers to the percentage share of the net earnings distributed to the shareholders as dividends. Dividend policy involves the decision to pay out earnings or to retain them for reinvestment in the firm. The retained earnings constitute a source of finance. The optimum dividend policy should strike a balance between current dividends and future growth which maximizes the price of the firm's shares. The dividend payout ratio of a firm should be determined with reference to two basic objectives – maximizing the wealth of the firm’s owners and providing sufficient funds to finance growth. These objectives are interrelated.
2. Stability of dividends
Dividend stability refers to the payment of a certain minimum amount of dividend regularly. The stability of dividends can take any of the following three forms:
a. constant dividend per share
b. constant dividend payout ratio orc. constant dividend per share plus extra dividend
3. Legal, contractual and internal constraints and restrictions
Legal stipulations do not require a dividend declaration but they specify the conditions under which dividends must be paid. Such conditions pertain to capital impairment, net profits and insolvency. Important contractual restrictions may be accepted by the company regarding payment of dividends when the company obtains external funds. These restrictions may cause the firm to restrict the payment of cash dividends until a certain level of earnings has been achieved or limit the amount of dividends paid to a certain amount or percentage of earnings. Internal constraints are unique to a firm and include liquid assets, growth prospects, financial requirements, availability of funds, earnings stability and control.
4. Owner's considerations
The dividend policy is also likely to be affected by the owner's considerations of the tax status of the shareholders, their opportunities of investment and the dilution of ownership.
5. Capital market considerations
The extent to which the firm has access to the capital markets, also affects the dividend policy. In case the firm has easy access to the capital market, it can follow a liberal dividend policy. If the firm has only limited access to capital markets, it is likely to adopt a low dividend payout ratio. Such companies rely on retained earnings as a major source of financing for future growth.
6. Inflation
With rising prices due to inflation, the funds generated from depreciation may not be sufficient to replace obsolete equipments and machinery. So, they may have to rely upon retained earnings as a source of fund to replace those assets. Thus, inflation affects dividend payout ratio in the negative side.
Bonus shares and stock splits
Bonus share is referred to as stock dividend. They involve payment to existing owners of dividend in the form of shares. It is an integral part of dividend policy of a firm to use bonus shares and stock splits. A stock split is a method commonly used to lower the market price of shares by increasing the number of shares belonging to each shareholder. Bonus shares may be issued to satisfy the existing shareholders in a situation where cash position has to be maintained.
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Gordon's Dividend Capitalization Model Miller and Modigliani Model Walter's Dividend Model
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Dividend and determinants of Dividend Policy
Dividend
Dividend refers to the corporate net profits distributed among shareholders. Dividends can be both preference dividends and equity dividends. Preference dividends are fixed dividends paid as a percentage every year to the preference shareholders if net earnings are positive. After the payment of preference dividends, the remaining net profits are paid or retained or both depending upon the decision taken by the management.
Determinants of Dividend Policy
The main determinants of dividend policy of a firm can be classified into:
1. Dividend payout ratio2. Stability of dividends3. Legal, contractual and internal constraints and restrictions4. Owner's considerations 5. Capital market considerations and6. Inflation.
1. Dividend payout ratio
Dividend payout ratio refers to the percentage share of the net earnings distributed to the shareholders as dividends. Dividend policy involves the decision to pay out earnings or to retain them for reinvestment in the firm. The retained earnings constitute a source of finance. The optimum dividend policy should strike a balance between current dividends and future growth which maximizes the price of the firm's shares. The dividend payout ratio of a firm should be determined with reference to two basic objectives – maximizing the wealth of the firm’s owners and providing sufficient funds to finance growth. These objectives are interrelated.
2. Stability of dividends
Dividend stability refers to the payment of a certain minimum amount of dividend regularly. The stability of dividends can take any of the following three forms:
a. constant dividend per shareb. constant dividend payout ratio orc. constant dividend per share plus extra dividend
3. Legal, contractual and internal constraints and restrictions
Legal stipulations do not require a dividend declaration but they specify the conditions under which dividends must be paid. Such conditions pertain to capital impairment, net profits and insolvency. Important contractual restrictions may be accepted by the company regarding payment of dividends when the company obtains external funds. These restrictions may cause the firm to restrict the payment of cash dividends until a certain level of earnings has been achieved or limit the amount of dividends paid to a certain amount or percentage of earnings. Internal constraints are unique to a firm and include liquid assets, growth prospects, financial requirements, availability of funds, earnings stability and control.
4. Owner's considerations
The dividend policy is also likely to be affected by the owner's considerations of the tax status of the shareholders, their opportunities of investment and the dilution of ownership.
5. Capital market considerations
The extent to which the firm has access to the capital markets, also affects the dividend policy. In case the firm has easy access to the capital market, it can follow a liberal dividend policy. If the firm has only limited access to capital markets, it is likely to adopt a low dividend payout ratio. Such companies rely on retained earnings as a major source of financing for future growth.
6. Inflation
With rising prices due to inflation, the funds generated from depreciation may not be sufficient to replace obsolete equipments and machinery. So, they may have to rely upon retained earnings as a source of fund to replace those assets. Thus, inflation affects dividend payout ratio in the negative side.
Bonus shares and stock splits
Bonus share is referred to as stock dividend. They involve payment to existing owners of dividend in the form of shares. It is an integral part of dividend policy of a firm to use bonus shares and stock splits. A stock split is a method commonly used to lower the market price of shares by increasing the number of shares belonging to each shareholder. Bonus shares may be issued to satisfy the existing shareholders in a situation where cash position has to be maintained.
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Gordon's Dividend Capitalization Model Miller and Modigliani Model Walter's Dividend Model
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Gordon's Dividend Capitalization Model
Gordon's theory contends that dividends are relevant. This model is of the view that dividend policy of a firm affects its value.
Assumptions of this model:
1. The firm is an all equity firm. No external financing is used and investment programmes are financed exclusively by retained earnings.
2. Return on investment( r ) and Cost of equity(Ke) are constant.3. The firm has perpetual life.4. The retention ratio, once decided upon, is constant. Thus, the growth rate, (g = br) is also
constant.5. Ke > br
Arguments of this model:
1. Dividend policy of the firm is relevant and that investors put a positive premium on current incomes/dividends.
2. This model assumes that investors are risk averse and they put a premium on a certain return and discount uncertain returns.
3. Investors are rational and want to avoid risk.4. The rational investors can reasonably be expected to prefer current dividend. They would
discount future dividends. The retained earnings are evaluated by the investors as a risky promise. In case the earnings are retained, the market price of the shares would be adversely affected. In case the earnings are retained, the market price of the shares would be adversely affected.
5. Investors would be inclined to pay a higher price for shares on which current dividends are paid and they would discount the value of shares of a firm which postpones dividends.
6. The omission of dividends or payment of low dividends would lower the value of the shares.
Dividend Capitalization model:
According to Gordon, the market value of a share is equal to the present value of the future streams of dividends.
P = E(1 - b) Ke - br
Where: P = Price of a share E = Earnings per share b = Retention ratio 1 - b = Dividend payout ratio Ke = Cost of capital or the capitalization rate
br - g = Growth rate (rate or return on investment of an all-equity firm)
Example: Determination of value of shares, given the following data:
Case A Case B D/P Ratio 40 30 Retention Ratio
60 70
Cost of capital 17% 18% r 12% 12% EPS $20 $20
P =
$20 (1 - 0.60) 0.17 – (0.60 x 0.12)
=> $81.63 (Case A)
P =
$20 (1 - 0.70)
0.18 – (0.70 x 0.12)
=> $62.50 (Case B)
Gordon's model thus asserts that the dividend decision has a bearing on the market price of the shares and that the market price of the share is favorably affected with more dividends.
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Miller and Modigliani Model (MM Model)
Miller and Modigliani Model assume that the dividends are irrelevant. Dividend irrelevance implies that the value of a firm is unaffected by the distribution of dividends and is determined solely by the earning power and risk of its assets. Under conditions of perfect capital markets, rational investors, absence of tax discrimination between dividend income and capital
appreciation, given the firm’s investment policy, its dividend policy may have no influence on the market price of the shares, according to this model.
Assumptions of MM model
1. Existence of perfect capital markets and all investors in it are rational. Information is available to all free of cost, there are no transactions costs, securities are infinitely divisible, no investor is large enough to influence the market price of securities and there are no floatation costs.
2. There are no taxes. Alternatively, there are no differences in tax rates applicable to capital gains and dividends.
3. A firm has a given investment policy which does not change. It implies that the financing of new investments out of retained earnings will not change the business risk complexion of the firm and thus there would be no change in the required rate of return.
4. Investors know for certain the future investments and profits of the firm (but this assumption has been dropped by MM later).
Argument of this Model
1. By the argument of arbitrage, MM Model asserts the irrelevance of dividends. Arbitrage implies the distribution of earnings to shareholders and raising an equal amount externally. The effect of dividend payment would be offset by the effect of raising additional funds.
2. MM model argues that when dividends are paid to the shareholders, the market price of the shares will decrease and thus whatever is gained by the investors as a result of increased dividends will be neutralized completely by the reduction in the market value of the shares.
3. The cost of capital is independent of leverage and the real cost of debt is the same as the real cost of equity, according to this model.
4. That investors are indifferent between dividend and retained earnings implies that the dividend decision is irrelevant. With dividends being irrelevant, a firm’s cost of capital would be independent of its dividend-payout ratio.
5. Arbitrage process will ensure that under conditions of uncertainty also the dividend policy would be irrelevant.
MM Model: Market price of the share in the beginning of the period = Present value of dividends paid at the end of the period + Market price of share at the end of the period.
P0 = 1/(1 + ke) x (D1 + P1)
Where: P0 = Prevailing market price of a share ke = cost of equity capital
D1 = Dividend to be received at the end of period 1 and
P1 = Market price of a share at the end of period 1.
Value of the firm, nP0
=
(n + ∆ n) P1 – I + E
(1 + ke)
Where: n = number of shares outstanding at the beginning of the period
∆ n = change in the number of shares outstanding during the period/ additional shares issued.
I = Total amount required for investment E = Earnings of the firm during the period.
Example: A company whose capitalization rate is 10% has outstanding shares of 25,000 selling at $100 each. The firm is expecting to pay a dividend of $5 per share at the end of the current financial year. The company's expected net earnings are $250,000 and the new proposed investment requires $500,000. Prove that using MM model, the payment of dividend does not affect the value of the firm.
Solution:
1. Value of the firm when dividends are paid:
i. Price per share at the end of year 1:
P0 = 1/(1 + ke) x (D1 + P1) $100 = 1/(1 + 0.10) x ($5 + P1) P1 = $105
ii. Amount required to be raised from the issue of new shares:
∆ n P1 = I – (E – nD1) => $500,000 – ($250,000 - $125,000) => $375,000
iii. Number of additional shares to be issued:
∆n = $375,000 / 105 => 3571.42857 shares (unrounded) iv. Value of the firm:
=> (25,000 + 3571.42857) (105) - $500,000 + $250,000
(1 + 0.10) => $2,500,000
2. Value of the firm when dividends are not paid:
i. Price per share at the end of year 1:
P0 = 1/(1 + ke) x (D1 + P1) $100 = 1/(1 + 0.10) x ($0 + P1) P1 = $110
ii. Amount required to be raised from the issue of new shares:
=> $500,000 – ($250,000 -0) = $250,000 iii. Number of additional shares to be issued:
=> $250,000/$110 = 2272.7273 shares (unrounded)iv. Value of the firm:
=> (25,000 + 2272.7273) (110) - $500,000 + $250,000
(1 + 0.10) => $2,500,000
Thus, according to MM model, the value of the firm remains the same whether dividends are paid or not. This example proves that the shareholders are indifferent between the retention of profits and the payment of dividend.
Limitations of MM model:
1. The assumption of perfect capital market is unrealistic. Practically, there are taxes, floatation costs and transaction costs.
2. Investors cannot be indifferent between dividend and retained earnings under conditions of uncertainty. This can be proved at least with the aspects of i) near Vs distant dividends, ii) informational content of dividends, iii) preference for current income and iv) sale of stock at uncertain price.
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Topics under Dividend Decisions:
Dividend & Determinants of Dividend Policy Gordon's Dividend Capitalization Model Walter's Dividend Model
.2.2. Gordon’s Model
Myron Gordon has also proposed a model suggesting that the dividend is relevant and can affect the value of the share and that of the firm. This model is also based on the assumptions similar to that Walter’s model. However, two additional assumptions made by this model are as follows:
The growth rate of firm ‘g’ is the product of retention ratio, b, and its rate of return, r, i.e., r= br, and
The cost of capital besides being constant is more than the growth rate i.e., ke>g
Gordon argues that the investors do have a preference for current dividends and this is a direct relationship between the dividend policy and the market value of the share. The basic premise of the model is that the investors are basically risk averse and they evaluate the future dividends/ capital gains as a risky and uncertain proposition. Dividends are more predictable than capital gains; management can control dividends but it cannot dictate the market price of the share. Investors are certain of receiving incomes than from future capital gains. The incremental risk associated with capital gains implies a higher required rate of return for discounting the capital
gains than for discounting the current dividends. In other words, an investor values, current dividend more highly than an expected future capital gain.
So, the “bird in the hand” argument of this model suggests that the dividend policy is relevant as the investors prefer current dividends as against the future uncertain capital gains. When the investors are certain about their returns, they discount the firms earning at a lower rate and therefore, placing a higher value for the share and that of the firm. So, the investors require a higher rate of return as retention rate increases and this would adversely affect the share price.
Thus, Gordon’s Model is a share valuation model. Under this model, the market price of a share can be calculated as follows:
P = E (1-b)
ke- br
Where,
P = Market price of equity share
E = Earnings per share of the firm
B = Retention ratio (1- payout ratio)
R = Rate of return on investment of the firm
Ke = Cost of Equity share capital, and
Br = g i.e., Growth rate of the firm
This model shows that there is a relationship between payout ratio (i.e., 1-b), cost of capital ke, rate of return, r, and the market value of the share. This can be explained with the help of the following example:
The following information is available in respect of Axis Ltd.
Earning per share (EPS or E) $ 10
Cost of Capital, ke, 10%
Find out the market price of the share under different rate of return, r, of 8%, 10%, and 15% for different payouts of 0%, 40%, 80% and 100%.
ANSWER:
The market price of the share as per Gorden’s model may be calculated as follows:
If r=15% and payout ratio is 40%, then the retention ratio, b, is .6 (i.e. 1-.4) and the growth rate, g= br= .09 (i.e., .6*.15) and the market price of the share is
P = E (1-b)
ke- br
P = 10(1-.6)/.10-.09
P = $ 400
If r= 8% and payout ratio is 80%, then the retention ratio, b, .2 (i.e., 1-.8) and the growth rate, g=br=.016 (i.e., .2*.08) and the market price of the share is
P = 10(1-.2)//10-.016
P = $ 95
Similarly the expected market price under different combinations of ‘r’ and dividend payout ratio have been calculated and shown below:
r = 15% 10% 8%
D/P Ratio 0% 0 0 0
40% $400 $100 $77
80% 114.3 100 95
100% 100 100 100
On the basis of figures given in the table above, it can be seen that if the firm adopts a zero payout then the investor may not be willing to offer any price. For a growth firm (i.e., r>ke>br), the market price decreases when the payout is increased. For a firm having r<ke, the market price increases when the payout is increased.
If r=ke, the dividend policy is irrelevant and the market price remains constant at $100 only. Gordon had also argued that even if r=ke, the dividend payout ratio matters and the investors being risk averse prefer current dividends which are certain to future capital gains which are uncertain. The investors will apply a higher capitalization rate i.e., ke to discount the future capital gains. This will compensate them for the future uncertain capital gain and thus, the market price of the share of a firm which retains profit will be adversely affected.
9.2.1. Walter’s Model
Walter J.E. supports the view that the dividend policy has a bearing on the market price of the share and has presented a model to explain the relevance of dividend policy for valuation of the firm based on the following assumptions:
All investment proposals of the firm are to be financed through retained earnings only and no external finance is available to the firm.
The business risk complexion of the firm remains same even after fresh investment decisions are taken. In other words, the rate of return on investment i.e. ‘r’ and the cost of capital of the firm i.e. ke, are constant.
The firm has an infinite life.
This model considers that the investment decisions and dividend of a firm are interrelated. A firm should or should not pay dividends upon whether it has got the suitable investment opportunities to invest the retained or not.
The model is presented below:
If a firm pays dividend to shareholders, they in turn, will invest this income to get further returns. This expected return to shareholder is the opportunity cost of the firm and hence the cost of capital, ke, to the firm. On the other hand, if the firm does not pay dividends, and instead retains, then these retained earnings will be reinvested by the firm to get return on these retained earnings will be reinvested by the firm to get return on these investment. This rate of return on the investment, r. Of the firm must be at least equal to the cost of capital, ke. If r= ke, the firm is earning a return just equal to what the shareholders could have earned had the dividends been paid to them.
However, what happen if the rate of return, r, is more than the cost of capital, ke? In such case, the firm can earn more by retaining the profits, than the shareholders can earn by investing their dividend income. The Walter’s model, thus says that if r>ke, the firm should refrain from should reinvest the retained earnings and thereby increase the wealth of the shareholders. However, if
the investment opportunities before the firm to reinvest the retained earnings are expected to give a rate of return which is less than the opportunity cost of the shareholders of the firm, then the firm should better distribute the entire profits. This will give opportunity to the shareholders to reinvest this dividend income and get higher returns.
In a nutshell, therefore, the dividend policy of a firm depends upon the relationship between r & k. If r>ke (a case of a growth firm), the firm should have zero payout and reinvest the entire profits to earn more than the investors. If however, r<ke, then the firm should have 100% payout ratio and let the shareholders reinvest their dividend income to earn higher returns, if ‘r’ happens to be just equal to ke, the shareholders will be indifferent whether the firm pays dividends or retain the profits. In such a case, the returns of the firm from reinvesting the retained earnings will be just equal to the earnings available to the shareholders on their investment of dividend income.
Thus, a firm can maximise the market value of its share and the value of the firm by adopting a dividend policy as follows:
If r>ke, the payout ratio should be zero If r<ke, the payout ratio should be 100% and the firm should not retain any profit, and If r=ke, the dividend is irrelevant and the dividend policy is not expected to affect the market
value of the share.
In order to testify the above, Walter has suggested a mathematical valuation model i.e.,
P = D + (r/ke) (E-D)
Ke ke
Where,
P = Market price of equity share
D = Dividend per share paid by the firm.
R = Rate of return on investment of the Firm
Ke = Cost of Equity share capital, and
E = Earnings per share of the firm.
As per the above formula, the market price of a share is the sum of two components i.e.,
The present value of an infinite stream of dividends, and The present value of an infinite stream of return from retained earnings.
Thus, the Walter’s formula shows that the market value of a share is the present value of the expected stream of dividends and capital gains. The effect of varying payout ratio on the market price of the share under different rate of returns, r, have been shown below:
The following information is available in respect of Axis Ltd.
Earning per share (EPS or E) $ 10
Cost of Capital, ke, 10%
Find out the market price of the share under different rate of return, r, of 8%, 10%, and 15% for different payouts of 0%, 40%, 80% and 100%.
Answer:
The market price of the share as per Walter’s Model may be calculated for different combinations of rates and dividend payout ratios (the earnings per share, E, and the cost of capital, ke, taken as constant) as follows:
If the rate of return, r= 15% and the dividend payout ratio is 40%, then
P = D + (r/ke) (E-D)
Ke ke
= 40 + 90
= 130
Similarly, if r= 8% and dividend Payout ratio = 80%, then
P = 80+ 16
= 96
The expected market price of the share under different combinations of ‘r’ and ke have been calculated and presented in the table below:
r = 15% 10% 8%
D/P Ratio 0% $150 $100 $80
40% 130 100 88
80% 110 100 96
100% 100 100 100
It may be seen from the table that for a growth firm (r= 15% and r>ke), the market price is highest at $ 150 when the firm adopts a zero payout and retains the entire earnings. As the payout increases gradually from 0% to 100%, the market price tends to decrease from $ 150 to $ 100 and the firm retains no profit. However if r=ke= 10%, then the price is constant at $ 100 for different payouts ratios. Such a firm does not have any optimum ratio and every payout ratio is good as any other.
Critical Appraisal
The Walter’s model provides a theoretical and simple frame work to explain the relationship between policy and value of the firm. As far as the assumptions underlying the model hold well, the behaviour of the market price of the share in response to the dividend policy of the firm can be explained with the help of this model.
However, the limitation of this model is that these underlying assumptions are too unrealistic. The financing of investments proposals only by retaining earnings and no external financing is seldom found in real life. The assumption of constant ‘r’ and constant ‘ke’ is also unrealistic and does not hold good. As more and more investment is made, the risk complexion of the firm will change and consequently the ke may not remain constant.
Relevance of Dividend Policy
Generally, the firms pay dividend and view such dividend payments positively. The investors also expect and like to receive dividend income on their investments. The firm not paying dividends may be adversely rated by the investors thereby affecting the market value of the share. The basic argument of those supporting the dividend relevance is that because current cash dividends reduce investor’s uncertainty, the investors will discount the firm’s earnings at a lower
rate. Ke, thereby placing a higher value on the shares. If the dividends are not paid then the uncertainty of shareholders/investors will increase, raising the required rate, ke, resulting in relatively lower market value of the share and the value of the firm. The market price of the share will increase if the firm pays dividends, otherwise it may decrease. A firm must therefore pay dividend to shareholders to fulfil the expectations of the shareholders in order to maintain or increase the market price of the share.
Two models representing this argument are discussed below:
ividend Decision And Valuation Of The Firm
9.1 Introduction
Two basic schools of thoughts on dividend policy have been expressed in the theoretical literature of finance. One school, associated with Myron Gordon and John Lintner, holds that the capital gains expected from earnings retention are more risky than dividend expectations. Accordingly, this school suggested that the earnings of a firm with a low payout ratio will typically be capitalized at higher rates than the earnings of a high payout firm. The other school associated with Merton Miller & Franco Modigliani, holds that investors are basically indifferent to returns in the form of dividends or capital gains. Empirically, when firms raise or lower their dividend, their stock prices tend to rise or fall in like manner; does this not prove that investors prefer dividends?
The term dividend refers to that portion of profit (after tax) which is distributed among the owners/shareholders of the firm and the profit which is not distributed is known as retained earnings. A company may have preference share capital as well as equity share capital and dividends may be paid on both types of capital. However there is no decision involved as far as
the dividend payable to preference shareholders is concerned. The reason being is that the preference dividend is more or less, a contractual liability and is payable at a fixed rate. On the other hand a firm has to consider a lot of factors before deciding about the equity dividend. The dividend decision may seem simple enough, but it evokes a surprising amount of controversy, which we will deal with later.
The dividend decision is one of the three basic decisions which a financial manager may be required to take, the other two being the investment and financing decisions.
In dividend decision the financial manager is required to decide one or more of the following:
Should the profits be ploughed back to finance the investments decisions? Whether any dividend should be paid? If yes, how much dividends be paid? When these dividend should be paid? Interim or Final? In what form should the dividends be paid? Cash Dividend or Bonus Share?
All these decisions are inter related and have bearing on the future growth plans of the firm. If a firm pays dividend, it affects the cash flow position of the firm but earns goodwill among the investors who therefore, may be willing to provide additional funds for the financing of investment plans of the firm. On the other hand, the profits which are not distributed as dividends become an easily available source of funds at no explicit cost. Every aspect of the decision has to be critically evaluated. The most important of these considerations is to decide as to what portion of profit should be distributed. This is also known as the dividend payout ratio.
While deciding the dividend payout ratio the firm should consider the effect of such policy on the objective of maximization of shareholders wealth. If the dividend is expected to increase the market value of the share the dividend must be paid, otherwise, the profits may be retained and used as an internal source of finance. So, the firm must find out and establish a relationship between the dividend policy and the market value of the share. There are conflicting views on the relationship between the dividend policy and value of the firm.
Dividend policy and Value of the Firm
Dividend policy is basically concerned with deciding whether to pay dividend in cash now, or to pay increased dividends at a later stage or distribute profits in the form of bonus shares. The current dividend provides liquidity to the investors but the bonus share will bring capital gains to the shareholders. The investor’s preference between the current cash dividend and the future capital gain has been viewed differently. Some are of the opinion that the future gains are more risky than the current dividends while others argue that the investors are indifferent between the current dividend and the future capital gains.
Various models have been proposed to evaluate the dividend policy decision in relation to value of the firm. While agreement is not found among the models as to what is the precise relationship, it is still worthwhile to examine some of these models to gain insight into the effect which the dividend policy might have on the market price of the shares and hence on the wealth
of the shareholders. Two schools of thoughts have emerged on the relationship between the dividend policy and value of the firm.
One school associated with Walter, Gordon, etc holds that the future capital gains are more risky and the investors have preference for current dividends. The investors do have a tilt towards those firms which pay regular dividend. So, the dividend affects the market value of the share and as a result the dividend policy is relevant for the overall value of the firm. On the other hand, the other school of thought associated with Modigliani and Miller holds that the investors are basically indifferent between current cash dividends and capital gains. Both these schools of thought on the relationship between dividend policy and value of the firm have been discussed as follows:
Irrelevance Of Dividend Policy
The other school of thought on dividend policy and valuation argues that what a firm pays as dividend to shareholders is irrelevant and the shareholders are indifferent about receiving current dividends receiving capital in future. The advocates of this school of thought argue that the dividend policy has no effect on the market price of a share. The shareholders do not differentiate between the present dividend or future capital gains. They are basically interested in higher returns earned either by the firm by investing profits in profitable investment opportunity or earned by them by making investment of dividend income.
The conclusion that dividends are not relevant is based on two pre conditions:
That investment and financing decisions are already being made and that these decisions will not be altered by the amount of dividend payments.
That the perfect capital market is there in which an investor can buy and sell the shares without any transaction cost and that the companies can issue shares without any flotation cost.
Two theories have been discussed below to focus the irrelevance of dividend policy for valuation of the firm though it is well accepted that like the capital structure irrelevance proposition, the dividend irrelevance argument has its roots in the Modigliani-Miller Analysis.
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Residuals Theory Of Dividends
This theory is based on the assumption that either he eternal financing is not available to the firm or if available, cannot be used due to its excessive costs of financing the profitable investment opportunities of the firm. Therefore, the firm finances its investments decisions by retaining profits. The quantum of profits to be distributed is a balancing figure and thus depends upon what portions of profits to be retained. If a firm has sufficient profitable investment opportunities, then the wealth of the shareholders will be maximised by retaining profits and reinvesting them in the financing of investment opportunities either by reducing dividend or even by paying no dividend to the shareholder. If a firm has no such investment opportunity, then the profits may be distributes among the shareholders.
Thus firm does not decide how much dividends to be paid rather it decide as to how much profits should be retained. The dividends are a distribution of residual profits after retaining sufficient profit for financing the available opportunities. This is referred to as Residuals Theory of Dividends.