DIVIDEND THEORY Chapter 17 INTRODUCTION Dividend policy involves

DIVIDEND THEORY Chapter 17

INTRODUCTION • Dividend policy involves the balancing of the shareholders’ desire for current dividends and the firm’s needs for funds for growth. 2

Issues in Dividend Policy • Earnings to be Distributed – High Vs. Low Payout. • Objective – Maximize Shareholders Return. • Effects – Taxes, Investment and Financing Decision. 3

Relevance Vs. Irrelevance • • • Walter's Model Gordon's Model Modigliani and Miller Hypothesis The Bird in the Hand Argument Informational Content Market Imperfections 4

DIVIDEND RELEVANCE: WALTER’S MODEL 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 5

Walter’s formula to determine the market price per share: 6

Optimum Payout Ratio • Growth Firms – Retain all earnings • Normal Firms – Distribute all earnings • Declining Firms – No effect 7

Example: Dividend Policy: Application of Walter’s Model 8

Criticism of Walter’s Model • No external financing • Constant return, r • Constant opportunity cost of capital, k 9

DIVIDEND RELEVANCE: GORDON’S MODEL Gordon’s model is based on the following assumptions: – 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 10

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 12

It is revealed that under Gordon’s model: 13

DIVIDEND AND UNCERTAINTY: THE BIRD-IN-THE-HAND ARGUMENT • Argument put forward, first of all, by Kirshman • Investors 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 is based on the following assumptions: – – Perfect capital markets No taxes Investment policy No risk

Market Imperfections 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 16

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