CHAPTER 17
DIVIDEND THEORY
LEARNING OBJECTIVES
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 Highlight
the issues of dividend policy
 Critically evaluate why some experts feel that dividend policy
matters
 Discuss the bird-in-the-hand argument for paying current
dividends
 Explain the logic of the dividend irrelevance
 Identify the market imperfections that make dividend policy
relevant
 Understand information content of dividend policy
INTRODUCTION
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 Dividend
policy involves the balancing of the
shareholders’ desire for current dividends and the
firm’s needs for funds for growth.
Issues in Dividend Policy
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 Earnings
to be Distributed – High Vs. Low
Payout.
 Objective – Maximize Shareholders Return.
 Effects – Taxes, Investment and Financing
Decision.
Relevance Vs. Irrelevance
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 Walter's
Model
 Gordon's Model
 Modigliani and Miller Hypothesis
 The Bird in the Hand Argument
 Informational Content
 Market Imperfections
DIVIDEND RELEVANCE: WALTER’S MODEL
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Walter’s model is based on the following assumptions:
 Internal financing
 Constant return and cost of capital
 100 per cent payout or retention
 Constant EPS and DIV
 Infinite time
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Walter’s formula to determine the market
price per share:
Optimum Payout Ratio
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Firms – Retain all earnings
 Normal Firms – Distribute all earnings
 Declining Firms – No effect
 Growth
Example: Dividend Policy: Application of
Walter’s Model
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Criticism of Walter’s Model
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 No
external financing
 Constant return, r
 Constant opportunity cost of capital, k
DIVIDEND RELEVANCE: GORDON’S MODEL
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Gordon’s model is based on the following assumptions:
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


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
All-equity firm
No external financing
Constant return
Constant cost of capital
Perpetual earnings
No taxes
Constant retention
Cost of capital greater than growth rate
Valuation
 Market
value of a share is equal to the present value
of an infinite stream of dividends to be received by
shareholders.
Example: Application of Gordon’s Dividend
Model
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It is revealed that under Gordon’s model:
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DIVIDEND AND UNCERTAINTY:
THE BIRD-IN-THE-HAND ARGUMENT
 Argument
 Investors
put forward, first of all, by Kirshman
are risk averters. They consider distant
dividends as less certain than near dividends. Rate
at which an investor discounts his dividend stream
from a given firm increases with the futurity of
dividend stream and hence lowering share prices.
DIVIDEND IRRELEVANCE: THE MILLER–MODIGLIANI
(MM) HYPOTHESIS
 According
to M-M, under a perfect market situation, the
dividend policy of a firm is irrelevant as it does not affect the
value of the firm. They argue that the value of the firm
depends on firm earnings which results from its investment
policy. Thus when investment decision of the firm is given,
dividend decision is of no significance.
 It
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is based on the following assumptions:Perfect capital markets
No taxes
Investment policy
No risk
Market Imperfections
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1.
2.
3.
4.
5.
6.
7.
8.
Tax Differential – Low Payout Clientele
Flotation Cost
Transaction and Agency Cost
Information Asymmetry
Diversification
Uncertainty – High Payout Clientele
Desire for Steady Income
No or Low Tax on Dividends
Informational Content of Dividend
 ….
In an uncertain world in which verbal
statements can be ignored or misinterpreted,
dividend action does provide a clear cut means of
‘making a statement’ that speaks louder than a
thousand words. — Solomon