Dividend decision theories

DIVIDEND DECISION THEORIES

Ayush Jain

Contents

Factors affecting dividend decision

Walter’s Model

Gordon’s Model

Miller Modigliani Hypothesis

Factors Affecting Dividend Decision

Nature of Entity’s Business

Future investment prospects

Legal Regulations Cash Flow Position Availability of

Finance

Expectations of Shareholders

Past Dividends distributed

Corporate Tax Policy General Economic

Environment (Dividend of other firms)

Types of Dividend Theories

Dividend Decision Theories

Relevant Theories

Walter’s Model

Gordon’s Model

Irrelevant Theories

Miller Modigliani

Theory

Walter’s Model

Assumptions to Walter’s Model

Market Value of share is affected by present values of future expected dividends.

Retained earnings of business affect the expectations from future dividends and consequently the market price of shares.

The firm’s business risk does not change with increase in investment. This implies that the IRR (Ra) of project and Cost of Capital (Rc) are constant.

All future projects to be financed with retained earnings.

The firm has an infinitely long life

Walter’s Formula

Where, P = Market Price per shareD = Dividend per sharer = Rate of return on

investment of the firmKe = Cost of Equity

E = Earnings per share

P = D + (r/Ke)(E-D)

Ke Ke

Walter’s Model – Explanation

As per this formula, if r>Ke, the company should retain all

earnings and invest in available projects; If r>Ke, the company should distribute all

the earnings as the shareholders can earn more than what the company can with retained amount;

if r=Ke, the dividend is irrelevant and the dividend policy would not affect market value of the firm.

Walter’s Model – Explanation (contd.)

Walter’s model states that the market price of shares is the sum of the capitalized value of the true value of the retained earnings (arrived at as a relation between the company’s return and the shareholder’s return) and the capitalized value of dividends

P = D + (r/Ke)(E-D)

Ke Ke

Gordon’s Model

Assumptions to Gordon’s Model

Market Value of share is affected by present values of future expected dividends.

Retained earnings of business affect the expectations from future dividends and consequently the market price of shares.

The firm’s business risk does not change with increase in investment. This implies that the IRR (Ra) of project and Cost of Capital (Ke) are constant. Also, Ke>r

All future projects to be financed with retained earnings. The growth rate of the firm is given by ‘g = br’ where b is the

retention ration The firm has an infinitely long life

Gordon’s Formula

Where, P = Market Price per shareE = Earning per shareb = Retention rationr = rate of return on

investment of the firm

Ke = Cost of equity

br = growth rate of the firm

P=E*(1-b) Ke – br

Gordon’s Model – Explanation

Gordon argues that the investors do have a preference for current dividends and a direct relationship between the dividend policy and the market price per share.

Investors are risk averse and consider only the future dividends better than capital gains, and thus value it based on the expected returns in the future.

Investors have a bird-in-the-hand preference.

Miller Modigliani Hypothesis

Assumptions to MM Approach

Capital Markets are perfect, i.e. Information is freely available to all No transaction/floatation costs No investor large enough to affect the market

price of the shares Investors behave rationally There are no taxes or there is no difference

between the Corporate Taxes and the CDT. The firm has a fixed investment policy Infinitely divisible securities

MM Formula

Where, P0 = Market price per share at the beginning of the year

D1 = Expected dividend at the end of the period

P1 = Market price per share at the end of the year

Ke = Cost of Equity capital

P0=D1 + P1

1+Ke

P1=P0(1+Ke)-D1

MM Approach Explanation

MM approach treats dividend as the irrelevant to the market price of the shares.

The price at the end of the year will be offset by the dividend distributed by the company and in turn shall not affect the market price, so lower the dividend, higher the market price at the end of the period (as clearly visible in the second formula).

Value of firm remains constant even on external finance since the EPS decreases with increase in share capital and thus causing the value of shares to go down.