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.