Relevance of dividend policy

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Relevance of dividend policy

  1. 1. Relevance of dividend policydividends paid by the firms are viewed positively both by the investors and the firms. The firmswhich do not pay dividends are rated in oppositely by investors thus affecting the share price.The people who support relevance of dividends clearly state that regular dividends reduceuncertainty of the shareholders i.e. the earnings of the firm is discounted at a lower rate, kethereby increasing the market value. However, its exactly opposite in the case of increaseduncertainty due to non-payment of dividends.Two important models supporting dividend relevance are given by Walter and Gordon.[edit] Walters modelJames E. Walters model shows the relevance of dividend policy and its bearing on the value ofthe share.[2][edit] Assumptions of the Walter model 1. Retained earnings are the only source of financing investments in the firm, there is no external finance involved. 2. The cost of capital, k e and the rate of return on investment, r are constant i.e. even if new investments decisions are taken, the risks of the business remains same. 3. The firms life is endless i.e. there is no closing down.Basically, the firms decision to give or not give out dividends depends on whether it has enoughopportunities to invest the retain earnings i.e. a strong relationship between investment anddividend decisions is considered.[edit] Model descriptionDividends paid to the shareholders are re-invested by the shareholder further, to get higherreturns. This is referred to as the opportunity cost of the firm or the cost of capital, ke for thefirm. Another situation where the firms do not pay out dividends, is when they invest the profitsor retained earnings in profitable opportunities to earn returns on such investments. This rate ofreturn r, for the firm must at least be equal to ke. If this happens then the returns of the firm isequal to the earnings of the shareholders if the dividends were paid. Thus, its clear that if r, ismore than the cost of capital ke, then the returns from investments is more than returnsshareholders receive from further investments.Walters model says that if r<ke then the firm should distribute the profits in the form ofdividends to give the shareholders higher returns. However, if r>ke then the investmentopportunities reap better returns for the firm and thus, the firm should invest the retainedearnings. The relationship between r and k are extremely important to determine the dividendpolicy. It decides whether the firm should have zero payout or 100% payout.In a nutshell :
  2. 2. If r>ke, the firm should have zero payout and make investments. If r<ke, the firm should have 100% payouts and no investment of retained earnings. If r=ke, the firm is indifferent between dividends and investments.[edit] Mathematical representationWalter has given a mathematical model for the above made statements :where, P = Market price of the share D = Dividend per share r = Rate of return on the firms investments ke = Cost of equity E = Earnings per shareThe market price of the share consists of the sum total of: the present value if an infinite stream of dividends the present value of an infinite stream of returns on investments made from retained earnings.Therefore, the market value of a share is the result of expected dividends and capital gainsaccording to Walter.[edit] CriticismAlthough the model provides a simple framework to explain the relationship between the marketvalue of the share and the dividend policy, it has some unrealistic assumptions. 1. The assumption of no external financing apart from retained earnings, for the firm make further investments is not really followed in the real world. 2. The constant r and ke are seldom found in real life, because as and when a firm invests more the business risks change.[edit] Gordons ModelMain article: Gordon model
  3. 3. Myron J. GordonMyron J. Gordon has also supported dividend relevance and believes in regular dividendsaffecting the share price of the firm.[2][edit] The Assumptions of the Gordon modelGordons assumptions are similar to the ones given by Walter. However, there are two additionalassumptions proposed by him : 1. The product of retention ratio b and the rate of return r gives us the growth rate of the firm g. 2. The cost of capital ke, is not only constant but greater than the growth rate i.e. ke>g.[edit] Model descriptionInvestors are risk averse and believe that incomes from dividends are certain rather than incomesfrom future capital gains, therefore they predict future capital gains to be risky propositions.They discount the future capital gains at a higher rate than the firms earnings thereby, evaluatinga higher value of the share. In short, when retention rate increases, they require a higherdiscounting rate. Gordon has given a model similar to Walters where he has given amathematical formula to determine price of the share.[edit] Mathematical representationThe market price of the share is calculated as follows:where,
  4. 4. P = Market price of the share E = Earnings per share b = Retention ratio (1 - payout ratio) r = Rate of return on the firms investments ke = Cost of equity br = Growth rate of the firm (g)Therefore the model shows a relationship between the payout ratio, rate of return, cost of capitaland the market price of the share.[edit] Conclusions on the Walter and Gordon ModelGordons ideas were similar to Walters and therefore, the criticisms are also similar. Both ofthem clearly state the relationship between dividend policies and market value of the firm.[edit] Capital structure substitution theory & dividendsThe capital structure substitution theory (CSS)[3] describes the relationship between earnings,stock price and capital structure of public companies. The theory is based on one simplehypothesis: company managements manipulate capital structure such that earnings-per-share(EPS) are maximized. The resulting dynamic debt-equity target explains why some companiesuse dividends and others do not. When redistributing cash to shareholders, companymanagements can typically choose between dividends and share repurchases. But as dividendsare in most cases taxed higher than capital gains, investors are expected to prefer capital gains.However, the CSS theory shows that for some companies share repurchases lead to a reductionin EPS. These companies typically prefer dividends over share repurchases.[edit] Mathematical representationFrom the CSS theory it can be derived that debt-free companies should prefer repurchaseswhereas companies with a debt-equity ratio larger thanshould prefer dividends as a means to distribute cash to shareholders, where D is the company’s total long term debt is the company’s total equity is the tax rate on capital gains is the tax rate on dividendsLow valued, high leverage companies with limited investment opportunities and a highprofitability use dividends as the preferred means to distribute cash to shareholders, as isdocumented by empirical research.[4]
  5. 5. [edit] ConclusionThe CSS theory provides more guidance on dividend policy to company managements than theWalter model and the Gordon model. It also reverses the traditional order of cause and effect byimplying that company valuation ratios drive dividend policy, and not vice-versa. The CSStheory does not have invisible or hidden parameters such as the equity risk premium, thediscount rate, the expected growth rate or expected inflation. As a consequence the theory can betested in an unambiguous way.[edit] Irrelevance of dividend policyFranco Modigliani
  6. 6. Merton MillerThe Modigliani and Miller school of thought believes that investors do not state any preferencebetween current dividends and capital gains. They say that dividend policy is irrelevant and isnot deterministic of the market value. Therefore, the shareholders are indifferent between the twotypes of dividends. All they want are high returns either in the form of dividends or in the formof re-investment of retained earnings by the firm. There are two conditions discussed in relationto this approach : decisions regarding financing and investments are made and do not change with respect to the amounts of dividends received. when an investor buys and sells shares without facing any transaction costs and firms issue shares without facing any floatation cost, it is termed as a perfect capital market.[5]Two important theories discussed relating to the irrelevance approach, the residuals theory andthe Modigliani and Miller approach.[edit] Residuals theory of dividendsOne of the assumptions of this theory is that external financing to re-invest is either notavailable, or that it is too costly to invest in any profitable opportunity. If the firm has goodinvestment opportunity available then, theyll invest the retained earnings and reduce thedividends or give no dividends at all. If no such opportunity exists, the firm will pay outdividends.If a firm has to issue securities to finance an investment, the existence of floatation costs needs alarger amount of securities to be issued. Therefore, the pay out of dividends depend on whetherany profits are left after the financing of proposed investments as floatation costs increases theamount of profits used. Deciding how much dividends to be paid is not the concern here, in factthe firm has to decide how much profits to be retained and the rest can then be distributed asdividends. This is the theory of Residuals, where dividends are residuals from the profits afterserving proposed investments. [6]This residual decision is distributed in three steps: evaluating the available investment opportunities to determine capital expenditures. evaluating the amount of equity finance that would be needed for the investment, basically having an optimum finance mix. cost of retained earnings<cost of new equity capital, thus the retained profits are used to finance investments. If there is a surplus after the financing then there is distribution of dividends.[edit] Extension of the theoryThe dividend policy strongly depends on two things:
  7. 7. investment opportunities available to the company amount of internally retained and generated funds which lead to dividend distribution if all possible investments have been financed.The dividend policy of such a kind is a passive one, and doesnt influence market price. thedividends also fluctuate every year because of different investment opportunities every year.However, it doesnt really affect the shareholders as they get compensated in the form of futurecapital gains.[edit] ConclusionThe firm paying out dividends is obviously generating incomes for an investor, however even ifthe firm takes some investment opportunity then the incomes of the investors rise at a later stagedue to this profitable investment.[edit] Modigliani-Miller theoremMain article: Modigliani–Miller theoremThe Modigliani–Miller theorem states that the division of retained earnings between newinvestment and dividends do not influence the value of the firm. It is the investment pattern andconsequently the earnings of the firm which affect the share price or the value of the firm.[7][edit] Assumptions of the MM theoremThe MM approach has taken into consideration the following assumptions: 1. There is a rational behavior by the investors and there exists perfect capital markets. 2. Investors have free information available for them. 3. No time lag and transaction costs exist. 4. Securities can be split into any parts i.e. they are divisible 5. No taxes and floatation costs. 6. The investment decisions are taken firmly and the profits are therefore known with certainty. The dividend policy does not affect these decisions.[edit] Model descriptionThe dividend irrelevancy in this model exists because shareholders are indifferent betweenpaying out dividends and investing retained earnings in new opportunities. The firm financesopportunities either through retained earnings or by issuing new shares to raise capital. Theamount used up in paying out dividends is replaced by the new capital raised through issuingshares. This will affect the value of the firm in an opposite ways. The increase in the valuebecause of the dividends will be offset by the decrease in the value for new capital raising.
  8. 8. 11111111111111111111111111111111111111111111111111111111111111Walters Dividend Model Assignment Help, Tutor Help: Walters Dividend ModelWalters model supports the principle that dividends are relevant. Theinvestment policy of a firm cannot be separated from its dividendpolicy and both are inter-related. The choice of an appropriatedividend policy affects the value of an enterprise.Assumptions of this model: 1. Retained earnings are the only source of finance. This means that the company does not rely upon external funds like debt or new equity capital. 2. The firms business risk does not change with additional investments undertaken. It implies that r(internal rate of return) and k(cost of capital) are constant. 3. There is no change in the key variables, namely, beginning earnings per share(E), and dividends per share(D). The values of D and E may be changed in the model to determine results, but any given value of E and D are assumed to remain constant in determining a given value. 4. The firm has an indefinite life.Formula: Walters modelP = D Ke – gWhere: P = Price of equity shares D = Initial dividend Ke = Cost of equity capital g = Growth rate expectedAfter accounting for retained earnings, the model would be:P = D Ke – rbWhere: r = Expected rate of return on firm‟s investments b = Retention rate (E - D)/E
  9. 9. Equation showing the value of a share (as present value of all dividends plus the present value ofall capital gains) – Walters model:P = D + r/ke (E - D) keWhere: D = Dividend per share and E = Earnings per shareExample:A company has the following facts:Cost of capital (ke) = 0.10Earnings per share (E) = $10Rate of return on investments ( r) = 8%Dividend payout ratio: Case A: 50% Case B: 25%Show the effect of the dividend policy on the market price of the shares.Solution:Case A:D/P ratio = 50%When EPS = $10 and D/P ratio is 50%, D = 10 x 50% = $5 5 + [0.08 / 0.10] [10 - 5]P = => $90 0.10Case B:D/P ratio = 25%When EPS = $10 and D/P ratio is 25%, D = 10 x 25% = $2.5 2.5 + [0.08 / 0.10] [10 - 2.5]P = => $85 0.10Conclusions of Walters model: 1. When r > ke, the value of shares is inversely related to the D/P ratio. As the D/P ratio increases, the market value of shares decline. It‟s value is the highest when D/P ratio is 0. So, if the firm retains its earnings entirely, it will maximize the market value of the shares. The optimum payout ratio is zero.
  10. 10. 2. When r < ke, the D/P ratio and the value of shares are positively correlated. As the D/P ratio increases, the market price of the shares also increases. The optimum payout ratio is 100%. 3. When r = ke, the market value of shares is constant irrespective of the D/P ratio. In this case, there is no optimum D/P ratio.Limitations of this model: 1. Walters model assumes that the firms investments are purely financed by retained earnings. So this model would be applicable only to all-equity firms. 2. The assumption of r as constant is not realistic. 3. The assumption of a constant ke ignores the effect of risk on the value of the firm.Online Live Tutor Walters Dividend Model:We have the best tutors in accounts in the industry. Our tutors can break down a complexWalter‟s Dividend Model problem into its sub parts and explain to you in detail how each step isperformed. This approach of breaking down a problem has been appreciated by majority of ourstudents for learning Walter‟s Dividend Model concepts. You will get one-to-one personalizedattention through our online tutoring which will make learning fun and easy. Our tutors arehighly qualified and hold advanced degrees. Please do send us a request for Walter‟s DividendModel tutoring and experience the quality yourself.Online Walters Dividend Model Help:If you are stuck with a Walters Dividend Model Homework problem and need help, we haveexcellent tutors who can provide you with Homework Help. Our tutors who provide WaltersDividend Model help are highly qualified. Our tutors have many years of industry experienceand have had years of experience providing Walter‟s Dividend Model Homework Help. Pleasedo send us the Walters Dividend Model problems on which you need Help and we will forwardthen to our tutors for review.Topics under Dividend Decisions: Dividend & Determinants of Dividend Policy Gordons Dividend Capitalization Model Miller and Modigliani Model
  11. 11. Determinants of Dividend Policy Homework Help, TutoringHome > Finance > Dividend Decisions > Determinants of Dividend Policy Determinants of Dividend Policy Assignment Help, Tutor Help Dividend and determinants of Dividend PolicyDividendDividend refers to the corporate net profits distributed amongshareholders. Dividends can be both preference dividends and equitydividends. Preference dividends are fixed dividends paid as a percentage every year to thepreference shareholders if net earnings are positive. After the payment of preference dividends,the remaining net profits are paid or retained or both depending upon the decision taken by themanagement.Determinants of Dividend PolicyThe main determinants of dividend policy of a firm can be classified into: 1. Dividend payout ratio 2. Stability of dividends 3. Legal, contractual and internal constraints and restrictions 4. Owners considerations 5. Capital market considerations and 6. Inflation. 1. Dividend payout ratio Dividend payout ratio refers to the percentage share of the net earnings distributed to the shareholders as dividends. Dividend policy involves the decision to pay out earnings or to retain them for reinvestment in the firm. The retained earnings constitute a source of finance. The optimum dividend policy should strike a balance between current dividends and future growth which maximizes the price of the firms shares. The dividend payout ratio of a firm should be determined with reference to two basic objectives – maximizing the wealth of the firm‟s owners and providing sufficient funds to finance growth. These objectives are interrelated. 2. Stability of dividends Dividend stability refers to the payment of a certain minimum amount of dividend regularly. The stability of dividends can take any of the following three forms: a. constant dividend per share
  12. 12. b. constant dividend payout ratio or c. constant dividend per share plus extra dividend 3. Legal, contractual and internal constraints and restrictions Legal stipulations do not require a dividend declaration but they specify the conditions under which dividends must be paid. Such conditions pertain to capital impairment, net profits and insolvency. Important contractual restrictions may be accepted by the company regarding payment of dividends when the company obtains external funds. These restrictions may cause the firm to restrict the payment of cash dividends until a certain level of earnings has been achieved or limit the amount of dividends paid to a certain amount or percentage of earnings. Internal constraints are unique to a firm and include liquid assets, growth prospects, financial requirements, availability of funds, earnings stability and control. 4. Owners considerations The dividend policy is also likely to be affected by the owners considerations of the tax status of the shareholders, their opportunities of investment and the dilution of ownership. 5. Capital market considerations The extent to which the firm has access to the capital markets, also affects the dividend policy. In case the firm has easy access to the capital market, it can follow a liberal dividend policy. If the firm has only limited access to capital markets, it is likely to adopt a low dividend payout ratio. Such companies rely on retained earnings as a major source of financing for future growth. 6. Inflation With rising prices due to inflation, the funds generated from depreciation may not be sufficient to replace obsolete equipments and machinery. So, they may have to rely upon retained earnings as a source of fund to replace those assets. Thus, inflation affects dividend payout ratio in the negative side.Bonus shares and stock splitsBonus share is referred to as stock dividend. They involve payment to existing owners ofdividend in the form of shares. It is an integral part of dividend policy of a firm to use bonusshares and stock splits. A stock split is a method commonly used to lower the market price ofshares by increasing the number of shares belonging to each shareholder. Bonus shares may beissued to satisfy the existing shareholders in a situation where cash position has to be maintained.Online Live Tutor Determinants of Dividend Policy:We have the best tutors in accounts in the industry. Our tutors can break down a complexDeterminants of Dividend Policy problem into its sub parts and explain to you in detail how each
  13. 13. step is performed. This approach of breaking down a problem has been appreciated by majorityof our students for learning Determinants of Dividend Policy concepts. You will get one-to-onepersonalized attention through our online tutoring which will make learning fun and easy. Ourtutors are highly qualified and hold advanced degrees. Please do send us a request forDeterminants of Dividend Policy tutoring and experience the quality yourself.Online Determinants of Dividend Policy Help:If you are stuck with a Determinants of Dividend Policy Homework problem and need help, wehave excellent tutors who can provide you with Homework Help. Our tutors who provideDeterminants of Dividend Policy help are highly qualified. Our tutors have many years ofindustry experience and have had years of experience providing Determinants of DividendPolicy Homework Help. Please do send us the Determinants of Dividend Policy problems onwhich you need Help and we will forward then to our tutors for review.Topics under Dividend Decisions: Gordons Dividend Capitalization Model Miller and Modigliani Model Walters Dividend ModelDeterminants of Dividend Policy Homework Help, TutoringHome > Finance > Dividend Decisions > Determinants of Dividend Policy Determinants of Dividend Policy Assignment Help, Tutor Help Dividend and determinants of Dividend PolicyDividendDividend refers to the corporate net profits distributed amongshareholders. Dividends can be both preference dividends and equitydividends. Preference dividends are fixed dividends paid as a percentage every year to thepreference shareholders if net earnings are positive. After the payment of preference dividends,the remaining net profits are paid or retained or both depending upon the decision taken by themanagement.Determinants of Dividend PolicyThe main determinants of dividend policy of a firm can be classified into:
  14. 14. 1. Dividend payout ratio2. Stability of dividends3. Legal, contractual and internal constraints and restrictions4. Owners considerations5. Capital market considerations and6. Inflation.1. Dividend payout ratio Dividend payout ratio refers to the percentage share of the net earnings distributed to the shareholders as dividends. Dividend policy involves the decision to pay out earnings or to retain them for reinvestment in the firm. The retained earnings constitute a source of finance. The optimum dividend policy should strike a balance between current dividends and future growth which maximizes the price of the firms shares. The dividend payout ratio of a firm should be determined with reference to two basic objectives – maximizing the wealth of the firm‟s owners and providing sufficient funds to finance growth. These objectives are interrelated.2. Stability of dividends Dividend stability refers to the payment of a certain minimum amount of dividend regularly. The stability of dividends can take any of the following three forms: a. constant dividend per share b. constant dividend payout ratio or c. constant dividend per share plus extra dividend3. Legal, contractual and internal constraints and restrictions Legal stipulations do not require a dividend declaration but they specify the conditions under which dividends must be paid. Such conditions pertain to capital impairment, net profits and insolvency. Important contractual restrictions may be accepted by the company regarding payment of dividends when the company obtains external funds. These restrictions may cause the firm to restrict the payment of cash dividends until a certain level of earnings has been achieved or limit the amount of dividends paid to a certain amount or percentage of earnings. Internal constraints are unique to a firm and include liquid assets, growth prospects, financial requirements, availability of funds, earnings stability and control.4. Owners considerations The dividend policy is also likely to be affected by the owners considerations of the tax status of the shareholders, their opportunities of investment and the dilution of ownership.5. Capital market considerations
  15. 15. The extent to which the firm has access to the capital markets, also affects the dividend policy. In case the firm has easy access to the capital market, it can follow a liberal dividend policy. If the firm has only limited access to capital markets, it is likely to adopt a low dividend payout ratio. Such companies rely on retained earnings as a major source of financing for future growth. 6. Inflation With rising prices due to inflation, the funds generated from depreciation may not be sufficient to replace obsolete equipments and machinery. So, they may have to rely upon retained earnings as a source of fund to replace those assets. Thus, inflation affects dividend payout ratio in the negative side.Bonus shares and stock splitsBonus share is referred to as stock dividend. They involve payment to existing owners ofdividend in the form of shares. It is an integral part of dividend policy of a firm to use bonusshares and stock splits. A stock split is a method commonly used to lower the market price ofshares by increasing the number of shares belonging to each shareholder. Bonus shares may beissued to satisfy the existing shareholders in a situation where cash position has to be maintained.Online Live Tutor Determinants of Dividend Policy:We have the best tutors in accounts in the industry. Our tutors can break down a complexDeterminants of Dividend Policy problem into its sub parts and explain to you in detail how eachstep is performed. This approach of breaking down a problem has been appreciated by majorityof our students for learning Determinants of Dividend Policy concepts. You will get one-to-onepersonalized attention through our online tutoring which will make learning fun and easy. Ourtutors are highly qualified and hold advanced degrees. Please do send us a request forDeterminants of Dividend Policy tutoring and experience the quality yourself.Online Determinants of Dividend Policy Help:If you are stuck with a Determinants of Dividend Policy Homework problem and need help, wehave excellent tutors who can provide you with Homework Help. Our tutors who provideDeterminants of Dividend Policy help are highly qualified. Our tutors have many years ofindustry experience and have had years of experience providing Determinants of DividendPolicy Homework Help. Please do send us the Determinants of Dividend Policy problems onwhich you need Help and we will forward then to our tutors for review.Topics under Dividend Decisions: Gordons Dividend Capitalization Model Miller and Modigliani Model Walters Dividend Model
  16. 16. Gordons Dividend Capitalization Model Homework Help, TutoringHome > Finance > Dividend Decisions > Gordons Dividend Capitalization Model Gordons Dividend Capitalization Model Assignment Help, Tutor Help: Gordons Dividend Capitalization ModelGordons theory contends that dividends are relevant. This model is ofthe view that dividend policy of a firm affects its value.Assumptions of this model: 1. The firm is an all equity firm. No external financing is used and investment programmes are financed exclusively by retained earnings. 2. Return on investment( r ) and Cost of equity(Ke) are constant. 3. The firm has perpetual life. 4. The retention ratio, once decided upon, is constant. Thus, the growth rate, (g = br) is also constant. 5. Ke > brArguments of this model: 1. Dividend policy of the firm is relevant and that investors put a positive premium on current incomes/dividends. 2. This model assumes that investors are risk averse and they put a premium on a certain return and discount uncertain returns. 3. Investors are rational and want to avoid risk. 4. The rational investors can reasonably be expected to prefer current dividend. They would discount future dividends. The retained earnings are evaluated by the investors as a risky promise. In case the earnings are retained, the market price of the shares would be adversely affected. In case the earnings are retained, the market price of the shares would be adversely affected. 5. Investors would be inclined to pay a higher price for shares on which current dividends are paid and they would discount the value of shares of a firm which postpones dividends. 6. The omission of dividends or payment of low dividends would lower the value of the shares.
  17. 17. Dividend Capitalization model:According to Gordon, the market value of a share is equal to the present value of the futurestreams of dividends. E(1 - b)P = Ke - brWhere: P =Price of a share E =Earnings per share b =Retention ratio 1-b =Dividend payout ratio Ke =Cost of capital or the capitalization rate Growth rate (rate or return on investment of an all- br - g = equity firm)Example: Determination of value of shares, given the following data: Case A Case BD/P Ratio 40 30Retention 60 70RatioCost of capital 17% 18%r 12% 12%EPS $20 $20 $20 (1 - 0.60) $81.63P = => 0.17 – (0.60 x (Case A) 0.12) $20 (1 - 0.70) $62.50P = => 0.18 – (0.70 x (Case B) 0.12)
  18. 18. Gordons model thus asserts that the dividend decision has a bearing on the market price of theshares and that the market price of the share is favorably affected with more dividends.Online Live Tutor Gordons Dividend Capitalization Model:We have the best tutors in accounts in the industry. Our tutors can break down a complexGordons Dividend Capitalization Model problem into its sub parts and explain to you in detailhow each step is performed. This approach of breaking down a problem has been appreciated bymajority of our students for learning Gordons Dividend Capitalization Model concepts. You willget one-to-one personalized attention through our online tutoring which will make learning funand easy. Our tutors are highly qualified and hold advanced degrees. Please do send us a requestfor Gordons Dividend Capitalization Model tutoring and experience the quality yourself.Online Gordons Dividend Capitalization Model Help:If you are stuck with a Gordons Dividend Capitalization Model Homework problem and needhelp, we have excellent tutors who can provide you with Homework Help. Our tutors whoprovide Gordon‟s Dividend Capitalization Model help are highly qualified. Our tutors havemany years of industry experience and have had years of experience providing GordonsDividend Capitalization Model Homework Help. Please do send us the Gordons DividendCapitalization Model problems on which you need Help and we will forward then to our tutorsfor review.Topics under Dividend Decisions: Dividend & Determinants of Dividend Policy Miller and Modigliani Model Walters Dividend ModelMiller and Modigliani Model Homework Help, TutoringHome > Finance > Dividend Decisions > Miller & Modigliani Model Miller and Modigliani Model Assignment Help, Tutor Help: Miller and Modigliani Model (MM Model)Miller and Modigliani Model assume that the dividends are irrelevant.Dividend irrelevance implies that the value of a firm is unaffected bythe distribution of dividends and is determined solely by the earningpower and risk of its assets. Under conditions of perfect capital markets,rational investors, absence of tax discrimination between dividend income and capital
  19. 19. appreciation, given the firm‟s investment policy, its dividend policy may have no influence onthe market price of the shares, according to this model.Assumptions of MM model 1. Existence of perfect capital markets and all investors in it are rational. Information is available to all free of cost, there are no transactions costs, securities are infinitely divisible, no investor is large enough to influence the market price of securities and there are no floatation costs. 2. There are no taxes. Alternatively, there are no differences in tax rates applicable to capital gains and dividends. 3. A firm has a given investment policy which does not change. It implies that the financing of new investments out of retained earnings will not change the business risk complexion of the firm and thus there would be no change in the required rate of return. 4. Investors know for certain the future investments and profits of the firm (but this assumption has been dropped by MM later).Argument of this Model 1. By the argument of arbitrage, MM Model asserts the irrelevance of dividends. Arbitrage implies the distribution of earnings to shareholders and raising an equal amount externally. The effect of dividend payment would be offset by the effect of raising additional funds. 2. MM model argues that when dividends are paid to the shareholders, the market price of the shares will decrease and thus whatever is gained by the investors as a result of increased dividends will be neutralized completely by the reduction in the market value of the shares. 3. The cost of capital is independent of leverage and the real cost of debt is the same as the real cost of equity, according to this model. 4. That investors are indifferent between dividend and retained earnings implies that the dividend decision is irrelevant. With dividends being irrelevant, a firm‟s cost of capital would be independent of its dividend-payout ratio. 5. Arbitrage process will ensure that under conditions of uncertainty also the dividend policy would be irrelevant.MM Model:Market price of the share in the beginning of the period = Present value of dividends paid at theend of the period + Market price of share at the end of the period.P0 = 1/(1 + ke) x (D1 + P1)Where:P0 = Prevailing market price of a share ke = cost of equity capital Dividend to be received at the end D1 = of period 1 and
  20. 20. Market price of a share at the end of P1 = period 1. (n + ∆ n) P1 – IValue of the +E =firm, nP0 (1 + ke)Where: n = number of shares outstanding at the beginning of the period change in the number of shares outstanding during the period/ ∆n= additional shares issued. I = Total amount required for investment E = Earnings of the firm during the period.Example:A company whose capitalization rate is 10% has outstanding shares of 25,000 selling at $100each. The firm is expecting to pay a dividend of $5 per share at the end of the current financialyear. The companys expected net earnings are $250,000 and the new proposed investmentrequires $500,000. Prove that using MM model, the payment of dividend does not affect thevalue of the firm.Solution: 1. Value of the firm when dividends are paid: i. Price per share at the end of year 1: P0 = 1/(1 + ke) x (D1 + P1) $100 = 1/(1 + 0.10) x ($5 + P1) P1 = $105 ii. Amount required to be raised from the issue of new shares: ∆ n P1 = I – (E – nD1) => $500,000 – ($250,000 - $125,000) => $375,000 iii. Number of additional shares to be issued: ∆n = $375,000 / 105 => 3571.42857 shares (unrounded) iv. Value of the firm: => (25,000 + 3571.42857) (105) - $500,000 + $250,000 (1 + 0.10) => $2,500,000 2. Value of the firm when dividends are not paid:
  21. 21. i. Price per share at the end of year 1: P0 = 1/(1 + ke) x (D1 + P1) $100 = 1/(1 + 0.10) x ($0 + P1) P1 = $110 ii. Amount required to be raised from the issue of new shares: => $500,000 – ($250,000 -0) = $250,000 iii. Number of additional shares to be issued: => $250,000/$110 = 2272.7273 shares (unrounded) iv. Value of the firm: => (25,000 + 2272.7273) (110) - $500,000 + $250,000 (1 + 0.10) => $2,500,000Thus, according to MM model, the value of the firm remains the same whether dividends arepaid or not. This example proves that the shareholders are indifferent between the retention ofprofits and the payment of dividend.Limitations of MM model: 1. The assumption of perfect capital market is unrealistic. Practically, there are taxes, floatation costs and transaction costs. 2. Investors cannot be indifferent between dividend and retained earnings under conditions of uncertainty. This can be proved at least with the aspects of i) near Vs distant dividends, ii) informational content of dividends, iii) preference for current income and iv) sale of stock at uncertain price.Online Live Tutor Miller and Modigliani Model:We have the best tutors in accounts in the industry. Our tutors can break down a complex Millerand Modigliani Model problem into its sub parts and explain to you in detail how each step isperformed. This approach of breaking down a problem has been appreciated by majority of ourstudents for learning Miller and Modigliani Model concepts. You will get one-to-onepersonalized attention through our online tutoring which will make learning fun and easy. Ourtutors are highly qualified and hold advanced degrees. Please do send us a request for Miller andModigliani Model tutoring and experience the quality yourself.Online Miller and Modigliani Model Help:If you are stuck with a Miller and Modigliani Model Homework problem and need help, we haveexcellent tutors who can provide you with Homework Help. Our tutors who provide Miller andModigliani Model help are highly qualified. Our tutors have many years of industry experienceand have had years of experience providing Miller and Modigliani Model Homework Help.
  22. 22. Please do send us the Miller and Modigliani Model problems on which you need Help and wewill forward then to our tutors for review.Topics under Dividend Decisions: Dividend & Determinants of Dividend Policy Gordons Dividend Capitalization Model Walters Dividend Model.2.2. Gordon’s ModelMyron Gordon has also proposed a model suggesting that the dividend is relevant and can affectthe value of the share and that of the firm. This model is also based on the assumptions similar tothat Walter‟s model. However, two additional assumptions made by this model are as follows: The growth rate of firm „g‟ is the product of retention ratio, b, and its rate of return, r, i.e., r= br, and The cost of capital besides being constant is more than the growth rate i.e., ke>gGordon argues that the investors do have a preference for current dividends and this is a directrelationship between the dividend policy and the market value of the share. The basic premise ofthe model is that the investors are basically risk averse and they evaluate the future dividends/capital gains as a risky and uncertain proposition. Dividends are more predictable than capitalgains; management can control dividends but it cannot dictate the market price of the share.Investors are certain of receiving incomes than from future capital gains. The incremental riskassociated with capital gains implies a higher required rate of return for discounting the capitalgains than for discounting the current dividends. In other words, an investor values, currentdividend more highly than an expected future capital gain.
  23. 23. So, the “bird in the hand” argument of this model suggests that the dividend policy is relevant asthe investors prefer current dividends as against the future uncertain capital gains. When theinvestors are certain about their returns, they discount the firms earning at a lower rate andtherefore, placing a higher value for the share and that of the firm. So, the investors require ahigher rate of return as retention rate increases and this would adversely affect the share price.Thus, Gordon‟s Model is a share valuation model. Under this model, the market price of a sharecan be calculated as follows: P = E (1-b) ke- brWhere,P= Market price of equity shareE= Earnings per share of the firmB= Retention ratio (1- payout ratio)R= Rate of return on investment of the firmKe = Cost of Equity share capital, andBr = g i.e., Growth rate of the firmThis model shows that there is a relationship between payout ratio (i.e., 1-b), cost of capital ke,rate of return, r, and the market value of the share. This can be explained with the help of thefollowing example:The following information is available in respect of Axis Ltd.Earning per share (EPS or E) $ 10Cost of Capital, ke, 10%Find out the market price of the share under different rate of return, r, of 8%, 10%, and 15% fordifferent payouts of 0%, 40%, 80% and 100%.ANSWER:The market price of the share as per Gorden‟s model may be calculated as follows:If r=15% and payout ratio is 40%, then the retention ratio, b, is .6 (i.e. 1-.4) and the growth rate,g= br= .09 (i.e., .6*.15) and the market price of the share is
  24. 24. P = E (1-b) ke- brP = 10(1-.6)/.10-.09 P = $ 400If r= 8% and payout ratio is 80%, then the retention ratio, b, .2 (i.e., 1-.8) and the growth rate,g=br=.016 (i.e., .2*.08) and the market price of the share is P = 10(1-.2)//10-.016 P = $ 95Similarly the expected market price under different combinations of „r‟ and dividend payout ratiohave been calculated and shown below: r= 15% 10% 8%D/P Ratio 0% 0 0 0 40% $400 $100 $77 80% 114.3 100 95 100% 100 100 100On the basis of figures given in the table above, it can be seen that if the firm adopts a zeropayout then the investor may not be willing to offer any price. For a growth firm (i.e., r>ke>br),the market price decreases when the payout is increased. For a firm having r<ke, the market priceincreases when the payout is increased.If r=ke, the dividend policy is irrelevant and the market price remains constant at $100 only.Gordon had also argued that even if r=ke, the dividend payout ratio matters and the investorsbeing risk averse prefer current dividends which are certain to future capital gains which areuncertain. The investors will apply a higher capitalization rate i.e., ke to discount the futurecapital gains. This will compensate them for the future uncertain capital gain and thus, themarket price of the share of a firm which retains profit will be adversely affected.
  25. 25. 9.2.1. Walter’s ModelWalter J.E. supports the view that the dividend policy has a bearing on the market price of theshare and has presented a model to explain the relevance of dividend policy for valuation of thefirm based on the following assumptions: All investment proposals of the firm are to be financed through retained earnings only and no external finance is available to the firm. The business risk complexion of the firm remains same even after fresh investment decisions are taken. In other words, the rate of return on investment i.e. ‘r’ and the cost of capital of the firm i.e. ke, are constant. The firm has an infinite life.This model considers that the investment decisions and dividend of a firm are interrelated. Afirm should or should not pay dividends upon whether it has got the suitable investmentopportunities to invest the retained or not.The model is presented below:If a firm pays dividend to shareholders, they in turn, will invest this income to get further returns.This expected return to shareholder is the opportunity cost of the firm and hence the cost ofcapital, ke, to the firm. On the other hand, if the firm does not pay dividends, and instead retains,then these retained earnings will be reinvested by the firm to get return on these retained earningswill be reinvested by the firm to get return on these investment. This rate of return on theinvestment, r. Of the firm must be at least equal to the cost of capital, ke. If r= ke, the firm isearning a return just equal to what the shareholders could have earned had the dividends beenpaid to them.However, what happen if the rate of return, r, is more than the cost of capital, ke? In such case,the firm can earn more by retaining the profits, than the shareholders can earn by investing theirdividend income. The Walter‟s model, thus says that if r>ke, the firm should refrain from shouldreinvest the retained earnings and thereby increase the wealth of the shareholders. However, ifthe investment opportunities before the firm to reinvest the retained earnings are expected to givea rate of return which is less than the opportunity cost of the shareholders of the firm, then thefirm should better distribute the entire profits. This will give opportunity to the shareholders toreinvest this dividend income and get higher returns.
  26. 26. In a nutshell, therefore, the dividend policy of a firm depends upon the relationship between r &k. If r>ke (a case of a growth firm), the firm should have zero payout and reinvest the entireprofits to earn more than the investors. If however, r<ke, then the firm should have 100% payoutratio and let the shareholders reinvest their dividend income to earn higher returns, if „r‟ happensto be just equal to ke, the shareholders will be indifferent whether the firm pays dividends orretain the profits. In such a case, the returns of the firm from reinvesting the retained earningswill be just equal to the earnings available to the shareholders on their investment of dividendincome.Thus, a firm can maximise the market value of its share and the value of the firm by adopting adividend policy as follows: If r>ke, the payout ratio should be zero If r<ke, the payout ratio should be 100% and the firm should not retain any profit, and If r=ke, the dividend is irrelevant and the dividend policy is not expected to affect the market value of the share.In order to testify the above, Walter has suggested a mathematical valuation model i.e., P = D + (r/ke) (E-D) Ke keWhere,P = Market price of equity shareD = Dividend per share paid by the firm.R = Rate of return on investment of the FirmKe = Cost of Equity share capital, andE = Earnings per share of the firm.As per the above formula, the market price of a share is the sum of two components i.e., The present value of an infinite stream of dividends, and The present value of an infinite stream of return from retained earnings.Thus, the Walter‟s formula shows that the market value of a share is the present value of theexpected stream of dividends and capital gains. The effect of varying payout ratio on the marketprice of the share under different rate of returns, r, have been shown below:The following information is available in respect of Axis Ltd.
  27. 27. Earning per share (EPS or E) $ 10Cost of Capital, ke, 10%Find out the market price of the share under different rate of return, r, of 8%, 10%, and 15% fordifferent payouts of 0%, 40%, 80% and 100%.Answer:The market price of the share as per Walter‟s Model may be calculated for differentcombinations of rates and dividend payout ratios (the earnings per share, E, and the cost ofcapital, ke, taken as constant) as follows:If the rate of return, r= 15% and the dividend payout ratio is 40%, thenP = D + (r/ke) (E-D) Ke ke = 40 + 90 = 130Similarly, if r= 8% and dividend Payout ratio = 80%, thenP= 80+ 16 = 96The expected market price of the share under different combinations of „r‟ and ke have beencalculated and presented in the table below: r= 15% 10% 8%D/P Ratio 0% $150 $100 $80 40% 130 100 88 80% 110 100 96 100% 100 100 100It may be seen from the table that for a growth firm (r= 15% and r>ke), the market price ishighest at $ 150 when the firm adopts a zero payout and retains the entire earnings. As the
  28. 28. payout increases gradually from 0% to 100%, the market price tends to decrease from $ 150 to $100 and the firm retains no profit. However if r=ke= 10%, then the price is constant at $ 100 fordifferent payouts ratios. Such a firm does not have any optimum ratio and every payout ratio isgood as any other.Critical AppraisalThe Walter‟s model provides a theoretical and simple frame work to explain the relationshipbetween policy and value of the firm. As far as the assumptions underlying the model hold well,the behaviour of the market price of the share in response to the dividend policy of the firm canbe explained with the help of this model.However, the limitation of this model is that these underlying assumptions are too unrealistic.The financing of investments proposals only by retaining earnings and no external financing isseldom found in real life. The assumption of constant „r‟ and constant „ke‟ is also unrealistic anddoes not hold good. As more and more investment is made, the risk complexion of the firm willchange and consequently the ke may not remain constant.Relevance of Dividend PolicyGenerally, the firms pay dividend and view such dividend payments positively. The investorsalso expect and like to receive dividend income on their investments. The firm not payingdividends may be adversely rated by the investors thereby affecting the market value of theshare. The basic argument of those supporting the dividend relevance is that because current cashdividends reduce investor‟s uncertainty, the investors will discount the firm‟s earnings at a lowerrate. Ke, thereby placing a higher value on the shares. If the dividends are not paid then theuncertainty of shareholders/investors will increase, raising the required rate, ke, resulting inrelatively lower market value of the share and the value of the firm. The market price of theshare will increase if the firm pays dividends, otherwise it may decrease. A firm must thereforepay dividend to shareholders to fulfil the expectations of the shareholders in order to maintain orincrease the market price of the share.
  29. 29. Two models representing this argument are discussed below:ividend Decision And Valuation Of The Firm9.1 IntroductionTwo basic schools of thoughts on dividend policy have been expressed in the theoreticalliterature of finance. One school, associated with Myron Gordon and John Lintner, holds that thecapital gains expected from earnings retention are more risky than dividend expectations.Accordingly, this school suggested that the earnings of a firm with a low payout ratio willtypically be capitalized at higher rates than the earnings of a high payout firm. The other schoolassociated with Merton Miller & Franco Modigliani, holds that investors are basically indifferentto returns in the form of dividends or capital gains. Empirically, when firms raise or lower theirdividend, their stock prices tend to rise or fall in like manner; does this not prove that investorsprefer dividends?The term dividend refers to that portion of profit (after tax) which is distributed among theowners/shareholders of the firm and the profit which is not distributed is known as retainedearnings. A company may have preference share capital as well as equity share capital anddividends may be paid on both types of capital. However there is no decision involved as far asthe dividend payable to preference shareholders is concerned. The reason being is that thepreference dividend is more or less, a contractual liability and is payable at a fixed rate. On theother hand a firm has to consider a lot of factors before deciding about the equity dividend. Thedividend decision may seem simple enough, but it evokes a surprising amount of controversy,which we will deal with later.
  30. 30. The dividend decision is one of the three basic decisions which a financial manager may berequired to take, the other two being the investment and financing decisions.In dividend decision the financial manager is required to decide one or more of the following: Should the profits be ploughed back to finance the investments decisions? Whether any dividend should be paid? If yes, how much dividends be paid? When these dividend should be paid? Interim or Final? In what form should the dividends be paid? Cash Dividend or Bonus Share?All these decisions are inter related and have bearing on the future growth plans of the firm. If afirm pays dividend, it affects the cash flow position of the firm but earns goodwill among theinvestors who therefore, may be willing to provide additional funds for the financing ofinvestment plans of the firm. On the other hand, the profits which are not distributed as dividendsbecome an easily available source of funds at no explicit cost. Every aspect of the decision has tobe critically evaluated. The most important of these considerations is to decide as to what portionof profit should be distributed. This is also known as the dividend payout ratio.While deciding the dividend payout ratio the firm should consider the effect of such policy onthe objective of maximization of shareholders wealth. If the dividend is expected to increase themarket value of the share the dividend must be paid, otherwise, the profits may be retained andused as an internal source of finance. So, the firm must find out and establish a relationshipbetween the dividend policy and the market value of the share. There are conflicting views onthe relationship between the dividend policy and value of the firm.Dividend policy and Value of the FirmDividend policy is basically concerned with deciding whether to pay dividend in cash now, or topay increased dividends at a later stage or distribute profits in the form of bonus shares. Thecurrent dividend provides liquidity to the investors but the bonus share will bring capital gains tothe shareholders. The investor‟s preference between the current cash dividend and the futurecapital gain has been viewed differently. Some are of the opinion that the future gains are morerisky than the current dividends while others argue that the investors are indifferent between thecurrent dividend and the future capital gains.Various models have been proposed to evaluate the dividend policy decision in relation to valueof the firm. While agreement is not found among the models as to what is the preciserelationship, it is still worthwhile to examine some of these models to gain insight into the effectwhich the dividend policy might have on the market price of the shares and hence on the wealthof the shareholders. Two schools of thoughts have emerged on the relationship between thedividend policy and value of the firm.One school associated with Walter, Gordon, etc holds that the future capital gains are more riskyand the investors have preference for current dividends. The investors do have a tilt towardsthose firms which pay regular dividend. So, the dividend affects the market value of the shareand as a result the dividend policy is relevant for the overall value of the firm. On the other hand,
  31. 31. the other school of thought associated with Modigliani and Miller holds that the investors arebasically indifferent between current cash dividends and capital gains. Both these schools ofthought on the relationship between dividend policy and value of the firm have been discussed asfollows:Irrelevance Of Dividend PolicyThe other school of thought on dividend policy and valuation argues that what a firm pays asdividend to shareholders is irrelevant and the shareholders are indifferent about receiving currentdividends receiving capital in future. The advocates of this school of thought argue that thedividend policy has no effect on the market price of a share. The shareholders do notdifferentiate between the present dividend or future capital gains. They are basically interested inhigher returns earned either by the firm by investing profits in profitable investment opportunityor earned by them by making investment of dividend income.The conclusion that dividends are not relevant is based on two pre conditions: That investment and financing decisions are already being made and that these decisions will not be altered by the amount of dividend payments. That the perfect capital market is there in which an investor can buy and sell the shares without any transaction cost and that the companies can issue shares without any flotation cost.Two theories have been discussed below to focus the irrelevance of dividend policy for valuationof the firm though it is well accepted that like the capital structure irrelevance proposition, thedividend irrelevance argument has its roots in the Modigliani-Miller Analysis.Email Based Assignment Help in Irrelevance Of Dividend Policy
  32. 32. Residuals Theory Of DividendsThis theory is based on the assumption that either he eternal financing is not available to the firmor if available, cannot be used due to its excessive costs of financing the profitable investmentopportunities of the firm. Therefore, the firm finances its investments decisions by retainingprofits. The quantum of profits to be distributed is a balancing figure and thus depends uponwhat portions of profits to be retained. If a firm has sufficient profitable investmentopportunities, then the wealth of the shareholders will be maximised by retaining profits andreinvesting them in the financing of investment opportunities either by reducing dividend or evenby paying no dividend to the shareholder. If a firm has no such investment opportunity, then theprofits may be distributes among the shareholders.Thus firm does not decide how much dividends to be paid rather it decide as to how much profitsshould be retained. The dividends are a distribution of residual profits after retaining sufficientprofit for financing the available opportunities. This is referred to as Residuals Theory ofDividends.

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