Description about the Dividend Decision and theories of relevance and irrelevance

1. Dividend Decision & Theories
Presented by:
Jitendra Kumar Sharma
Arvind Kumar Arya
Prashant Singh Solanki

2. Introduction:
Dividend refer to the portion of profit after tax which is
distributed among the shareholders of the firm. It is return
that shareholders get on their investment.
According to the Institute of Chartered Accountant of India,
dividend is defined as “a distribution to shareholders out of
profits or reserves available for this purpose”.

3. Dividend Decision:
The Dividend Decision is one of the crucial decisions made by
the finance manager relating to the payouts to the
shareholders. The payout is the proportion of Earning Per
Share given to the shareholders in the form of dividends.
Payment of dividend is two opposing effects:
It increases dividend thereby stock price rise.
It reduces the fund available for investment.

4. Theories of Dividend
Dividend Theories
Relevance Theory Irrelevance Theory
Walter’s Model
Gordon’s Model
Residual Theory
MM Approach

5. Walter’s Model:
Assumptions:
 Retained earnings are the only source of financing investments in the firm, there is
no external finance involved.
 The cost of capital (ke) 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.
 The firm has an infinite life
Valuation formula:
P = Price per equity share
D = Dividend per share
E = Earning per share
E-D = Retained earning per share
r = Rate of return
k = Cost of equity
D+(E-D)r/k
k
P =

6. (Contd.)
As per the equation (I), the price per share is two components:
 The first component is the present value of an infinite stream of dividends.
 The second component is the present value of an infinite stream of returns from
retained earnings.
Three cases of model:
Growth Firm : r > k
The price per share increases as the dividend payout ratio decreases.
Normal Firm: r = k
The price per share does not vary with changes in dividend payout ration.
Declining Firm: r < k
The price per share increases as the dividend per share increases.
D (E-d)r/k
k k

7. Gordon Model
Proposed a model of stock valuation using the dividend capitalization approach.
Assumptions:
 Retained earnings are the only source of financing for the firm
 The rate of return on the firms investment is constant.
 The product of retention ratio b and the rate of return r gives us the growth rate of the firm g.
 The cost of capital ke, is not only constant but greater than the growth rate i.e. ke>g.
 The firm has a perpetual life.
 Tax does not exist.
Valuation formula :
P = price per share
E = Earnings per share
b = Retention ratio (1 - payout ratio)
r = Rate of return on the firm's investments
ke = Cost of equity
br = Growth rate of the firm (g)
E(1-b)
K-br
P=

8. Miller- Modigliani theorem
Modigliani and Miller argued that the value of firm is solely determined by the earning
capacity of a firm’s assets and split of earnings between dividend and retained earnings
does not affect the shareholders’ wealth.
Assumptions:
 Information is freely available.
 No taxes.
 Flotation and transaction cost do not exist.
 Rational behavior by investors.
 Securities are divisible (split into any part).
 Capital markets are perfectly exist.
 Perfect certainty of future profit of firm.

9. (Contd.)
Valuation Model:
Step 1- Market price of the share in the beginning of the period = Present value of
dividends paid at the end of the period + Market price of share at the end of the
period.
PO = Market price per share at beginning of period 0.
D1 = Dividend to be received at end of period 1.
P1 = Market price per share at end of period 1.
Ke = Cost of equity capital.
P₀ = (D₁+P₁)1
1+Kₑ

10. (Contd.)
Step 2- If the firm’s internal source of financing its investment opportunities fall short of
the funds required, and n is the number of new shares issued at the end of the year 1 at
price of P1 then equation:
Where,
n = Number of outstanding shares
nP₀ = Total market value of outstanding shares at time 0
nD₁ = Total dividends in year 1 payable on equity share outstanding at time 0
m = Number of equity shares
P₁ = the prevailing market share at time 1
(n+m) P₁ = total market value of outstanding shares at time 1
mP₁ = Market value of shares issued at time 1
1 1+KₑnP₀ = {nD₁ + (n+m) P₁ - mP₁}
1
1+Kₑ