Inventory Management

1. Chapter 23
Dividend Policy and
Firm Valuation

2. LEARNING OBJECTIVES
• List out Dividend Theories
• Explain Walter’s model – determination of stock price
• Discuss Gordon’s model – determination of stock price
• Critically evaluate the MM Hypothesis

3. Dividend Theories
• Relevant theories
• Irrelevant theories

4. Walter’s Model
• Walter’s Model supports the view of dividend policy of an
enterprise has bearing on value of firm. The Model is based on r and
K o.
• Model divides firms into:
Growth firms: r>K o
Normal firms: r=K o
Declining firms: r<K o
• Assumptions:
• Only internal source of funds used
• r and K o constant
• All earnings are paid as dividends or completely reinvested
• EPS; and DPS never change
• Perpetual life

5. Water’s Model [contd.]
Where: P = Price per equity share;
D = Dividends per share;
E = Earnings per share;
(E–D)= Retained earnings per share;
r = Rate of return on investment;
K0 = Cost of capital.
P
D r K E D
K
or
D
K
E D r K
K

  

 
( )( ) ( )
0
0 0 0

6. Walter’s Model [contd.]
• Interpretation
r>K o=optimum DP Ratio is zero
r=K o=No optimum DP Ratio
r<K o=Optimum DP Ratio 100%
• Criticism
* No external financing
* Constant rate of return as investment
* Constant cost of capital

7. Gordon’s Model
• Gordon Model says that firm’s share price is dependent on
dividend payout ratio.
• Assumptions
– All equity firm;
– Properties financed by retained earnings;
– ‘r’ is constant;
– K o remains constant;
– K o>b. r;
– Perpetual stream of earnings;
– Perpetual life;
– Retention ratio constant;
– No corporate taxes

8. Gordon’s Model [contd.]
Where: P = Price per share
E = Earnings per share
b = Retention ratio
(1- b) = Proportion of earnings of the firm distributed as dividends;
K o = Capitalization rate or cash of capital or required return by
equity shareholders
r = Rate of returns earned an investment made by the firm
g = b. r = growth rate
Gordon’s argument: Investors are risk averse, need premium on
uncertain return
P
E b
K b r
o



( )
.
1

9. MM Theory
• MM Theory: Value of Firm is determined by its basic earning
power and its business risk.
• Assumptions
– Existence of perfect capital markets
– No taxes
– Firm has fixed investment policy
– There is no risk

10. MM Theory [Argument]
• Arbitrage involving simultaneously into two transactions
which exactly balance each other.
• Here two transactions are:
(i) Payment of dividends
(ii) Raising funds externally

11. MM Theory [Proof of MM Theory]
1. Market Price of Share at the end of Period 1: The market price
per share (Po) in the beginning of the period is equal to the
present value of dividends paid at the end of the period plus
market price of share at the end of the period.
Po =
Where: Po = Market price per share at period ‘o’
D1 = Dividends per share at end of period ‘1’
P1 = Market price per share at the end of period 1
k = Discount rate applicable to the risk less to
which the firm belongs to (cost of equity capital)
P1 = Po (1 + Ke) – D1
1
1
1 1
( )
( )


k
D P

12. MM Theory
[Proof of MM Theory] [contd.]
2. The total capitalization value of outstanding equity shares of
the firm at period ‘0’ is obtained by the use of following
formula.
nPo =
1
1
1 1
( )
( )


k
nD nP

13. 3. Amount needed to be raised by the Issue of New Shares
ΔnP1 = I – (E – nD1)
Where: ΔnP1 = Amount raised by sale of new shares
I = Total funds required for investment
E = Total earnings of the firm during the period
nD1 = Total dividends period
(E – nD1)= Retained earnings.
4. No. of additional Shares to be Issued;
Δn = ΔnP1 ÷ P1
5. Value of the Firm:
nP
n n P I E
K
o
e

  

( )
( )
 1
1

14. Criticisms on MM Theory
• Tax deferential
• Existence of flotation cash
• Existence of transaction costs
• Information asymmetry
• Institutional restrictions
• Resolution of uncertainty
• Near vs. Distant dividend
• Desire for current income
• Under pricing