Dividend Theories & Policy
Objective
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Dividend Decision
Dividend Models
Traditional Approach (Relevance)
Walter's Model (Relevance)
Gordon's Model (Relevance)
Miller and Modigliani Hypothesis (Irrelevance)
Rational Expectations Model (Irrelevance)
Dividend policy
DIVIDEND
 Dividends refer to that portion of a firm’s net earnings
which are paid out to the equity shareholders.
 The firm has two alternatives in respect of its net
earnings: it may retain the earnings or it may
distribute the earnings to the shareholders in the
form of dividends.
 Retained earnings constitute an easily accessible and
important source of financing the investment
requirements of the firm.
 The decision regarding the dividend policy is one of
the major decisions of a firm and it should be guided
by the objective of maximizing the shareholder’s
wealth.
Theories
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Traditional Model
Walter Model
Gordon Model
Miller and Modigliani Approach and
Rational Expectations Model
Traditional Approach
• This approach was given by B. Graham and D. L.Dodd
and it lays emphasis on the relationship between
dividends and the stock market. As per this
approach, stock value responds positively to higher
dividends and negatively to lower dividends.
• P = m (D + E/3)
P = Market Price of the stock
m = Multiplier
D = Dividend per share
E = Earnings per share
LIMITATIONS OF THE TRADITIONAL
APPROACH
• The traditional approach, further states that the
P/E ratios are directly related to the dividend payout ratios. But a firm’s share price may rise even
in case of a low pay-out ratio if its earnings are
increasing. Here the capital gains for the investor
will be higher than the cash dividends.
• Similarly for a firm having a high dividend pay-out
ratio with a slow growth rate there will be a
negative impact on the market price (because of
lower earnings).
WALTER’S MODEL
Assumptions:
• The firm finances it entire investments by
means of retained earnings only
• IRR (r) and cost of capital(K) of the firm
remains constant
• The firm’s earning either distributed as
dividend or reinvested internally
• Beginning earnings and dividends of the firm
will never change
• The firm has a very long or infinite life
WALTER’S MODEL
P=
𝑟
𝑘
𝐷𝑃𝑆 + (𝐸𝑃𝑆 −𝐷𝑃𝑆)
𝑘
Where P = Market price per share
DPS = Dividend per share
EPS = Earning per share
r = Internal rate of return
k = Cost of capital
WALTER’S MODEL
• According to James E. Walter, dividends are
relevant and they do affect the share price.
Walter explains the relevance of the dividend
policy with the help of the relationship
between the internal rate of return (r) and the
cost of capital (k).
i) r < K
ii) r = K
iii) r > K
r<k
• When the internal rate of return(r) is less than
the cost of capital(k), it indicates that the
shareholders will be in a better position if
earnings are paid out to them so as to enable
them to earn a higher rate of return
elsewhere. The optimum dividend policy for
firms in this situation will be a dividend
payout ratio of 100% as doing so will maximize
the market price of the shares.
r=K
• When the internal rate of return (r) is equal to
the cost of capital (k), it is a matter of
insignificance whether the earnings are
retained or distributed. There is no optimum
dividend policy for firms in this situation as
the market price of the shares will remain
constant for all D/P ratios.
r>K
• When the internal rate of return is greater
than the cost of capital (k) then it indicates
that the firm has adequate profitable
investment opportunities and it would be able
to earn more than what the investors can if
they invest elsewhere. The optimum dividend
policy in such a situation will be a dividend
payout ratio of 0. In other words, the firm
should plough back the entire earnings within
the firm in order to maximize the market value
of the shares.
Limitations
• Walter’s model assumes that the firm’s investments
are financed exclusively by retained earnings and no
external financing is used. In such a case, this model
will be applicable only to an all equity firm.
• This model assumes that the expected rate of return
on the firm’s investments
(i.e. r) is constant. This
assumption does not hold good in reality as the
expected rate of return changes with increase in
investments.
• The firm’s cost of capital (k) does not remain
constant and changes with a change in the firm’s
risk.
Gordon’s Dividend Capitalization Model
Just like the Walter model, the Gordon model also
opines that the dividend policy of a firm affects its
value:
• The firm is an all equity firm and retained
earnings are the only source of finance.
• The internal rate of return and the cost of capital
(k) are constant.
• The firm has a perpetual life.
• The retention ratio (b) and the growth rate (g =
br) of the firm are constant.
• The required of return is greater than the growth
rate.
Gordon’s ……
The model also states that:
• when r > k, the market price of the share is
favourably affected with more retentions.
• when r < k, more retentions would lead to
decline in market price.
• When r = k, retentions do not affect the
market price of the share.
P=
P = Share price
E = Earnings per share
b = Retention ratio
(1 – b) = Dividend pay-out ratio
k = Cost of capital of the firm
br = Growth rate (g) (internal rate of return
multiplied by retention ratio)
DIVIDEND AND UNCERTAINTY:THE
BIRD-IN-THE-HAND ARGUMENT
• Argument was put forward by Kirshman
• Investors are risk averse. 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.
Miller and Modigliani Approach
• According to this approach, the dividend
policy has no effect on the share price of the
firm and is therefore of no significance.
• It is the investment policy which will be
relevant as it is through it that the firm can
increase its earnings and thereby the value of
the firm.
Given an investment decision, the firm will have
two alternatives:
a) retain the earnings to finance the
investment opportunity
b) distribute the earnings to the investor and
raise an equal amount by issuing new shares
for funding the new investment.
If the firm goes for the second alternative, the
effect of dividend payment on the shareholder’s
wealth will be exactly offset by the effect of raising
additional share capital.
Assumptions…MM
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Investors are rational.
The capital markets are perfect
There are no taxes.
The financing of the new investments out of
retained earnings will not change the business
risk complexion of the firm.
According MM hypothesis:
n = number of shares at the beginning of the period
P0 = prevailing market price of the share.
(Hence nP0 is the total capitalized value of the firm).
∆n = change in the number of shares during the period
I = total investment required
E = earnings of the firm during the period
K = capitalization rate.
Limitations of MM approach
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No Taxes
No Floatation costs
No Transaction costs
Information asymmetry: Inefficient market
Market conditions: market tend to influence
the dividend policy
Rational Expectations Model
• According to this model, the dividend policy of the
firm does not have any impact on its market price as
long as it is declared at the expected rate. However,
the market will show some response if the
dividends declared are higher or lower than the
expected dividends i.e. the share price might
experience an increase if the dividends declared are
more than the expected dividends and the share
price will experience a decrease when the dividends
declared are less than those expected by the
investors.
Dividend Policy
• Constant Dividend per shares
• Constant Dividend Pay-out ratio
• Stable rupee dividend plus extra dividend – In
times of prosperity the dividends are higher
than the normal days.
Factors influencing dividend policy
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Nature of business
Age of company
Liquidity position of the company
Equity shareholders preference for current
income
• Requirements of Institutional investors
• Legal rules
• Past dividend rates of the company
• Contractual agreement – Lenders may put
restriction on payment of dividend to equity
share.
• Financial needs of the company
• Access to capital markets
• Control objective
• Inflation
• Dividend policy of competitors
• Others – Trade cycles, Tax structure, Debt
burden etc.
Forms of Dividends
• Cash dividend
• Scrip dividend – The shareholders are issued with
transferable promissory notes for a shorter
maturity period. (Lack of liquidity in the company)
• Bond dividend – same as scrip div (long maturity)
• Stock dividend – Bonus shares