Models/ theories of dividend policy

1. FINANCIAL MANAGEMENT
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2. Overview:
 What is Dividend?
 What is dividend policy?
 Theories of Dividend Policy
 Relevant Theory
 Walter’s Model
 Gordon’s Model
 Irrelevant Theory
 M-M’s Approach
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3. Once a company makes a profit, management must decide
on what to do with those profits. They could continue to
retain the profits within the company, or they could pay out
the profits to the owners of the firm in the form of
dividends.
Once the company decides on whether to pay dividends they
may establish a somewhat permanent dividend policy, which
may in turn impact on investors and perceptions of the
company in the financial markets. What they decide depends
on the situation of the company now and in the future. It also
depends on the preferences of investors and potential
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4. Dividend
 Dividends are payments made to stockholders from a
firm's earnings, whether those earnings were generated
in the current period or in previous periods. Dividends
are paid from the company’s earnings taking into
account the Payout Ratio.
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Payout ratio is the proportion of earnings paid out
as dividends to shareholders, typically expressed as
a percentage.

5. Dividend Policy
Dividend policy is the set of guidelines a company
uses to decide how much of its earnings it will pay
out to shareholders.
Some evidence suggests that investors are not
concerned with a company's dividend
policy since they can sell a portion of their portfolio
of equities if they want cash.
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6. Dividend Policies involve the decisions, whether:
 To retain earnings for capital investment and other
purposes; or
 To distribute earnings in the form of dividend
among shareholders; or
 To retain some earning and to distribute remaining
earnings to shareholders.
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7.  There is no obligation for firms to pay dividends to common
shareholders.
 Shareholders cannot force a Board of Directors to declare a
dividend, and courts will not interfere with the BOD’s right to
make the dividend decision because:
 Board members are jointly and severally liable for any damages
they may cause
 Board members are constrained by legal rules affecting
dividends including:
 Not paying dividends out of capital
 Not paying dividends when that decision could cause the
firm to become insolvent
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8. Forms of Dividend
Dividend basically is a distribution of profits earned
by a joint stock company among its shareholders.
Mostly dividends are paid in cash, but there are also
other forms such as script dividends, stock dividends,
and in an unusual circumstances, property dividends.
These are briefly described below:
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9. Scrip Dividend: means of payment when the company
cannot pay in cash. This system simply means
shareholders are paid with commodities, vouchers, tokens
or some other indication of credit instead of cash.
Bond Dividend: Referred to as fixed-income investment
instruments because they promise the holder a fixed
payment as returns on investment.
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Property Dividend: refers to the formal distribution of
an asset other than cash to holders of preferred or
common shares of stock.
Cash Dividend: money paid to stockholders, normally
out of the corporation's current earnings or accumulated
profits.
Bonus share or Stock dividends: do not come with an
explicit payment promise. The amount of dividends paid
to stockholders varies depending on the profits of the
issuing company

11. Factors Affecting Dividend Policy
 Legal Restrictions: Company laws
 Trend of earnings: High profit or low
 Desire and type of Shareholders
 Nature of Industry: capital intensive, asset intensive, share
intensive
 Age of the company: old or new in market
 Taxes on Retained Earnings
 Future Financial Requirements: will a loan be needed, will
there be expansion, will the firm go international
 Stage of Business cycle: Recession, boom, depression, recovery
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13. Dividend Models
Dividend Relevance Model
 Walter Model
 Gordon Model
Dividend Irrelevance Model
 Miller & Modigliani Model
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15. Relevant Theory
If the choice of the dividend policy affects the
value of a firm, it is considered as relevant. In
that case a change in the dividend payout ratio
will be followed by a change in the market value
of the firm.
If the dividend is relevant, there must be an
optimum payout ratio. Optimum payout ratio is
that ratio which gives highest market value per
share.
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16.  The dividend policy given by James Walter
considers that dividends are relevant and they do
affect the share price.
 The model is simple and easy to compute.
 Two factors which influence the market price of the
share are the EPS and DPS.
Walter’s Model
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17. Walter’s Model
 In this model , he studied the relationship
between the internal rate of return (r) and the
cost of capital of the firm(K), to give a dividend
policy that maximizes the shareholders’ wealth.
When r > Ke the firm has to adopt Zero% payout policy.
r < ke the firm has to adopt 100% payout policy.
r = ke any policy between 0 to 100% payout.
 Walter model also look at profitable opportunities
whether to retain their earning instead of getting
dividends. The cost of retention is important here.
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18. Formula of Walter’s Model
Where,
P = Current Market Price of equity share
E= Earnings per share
D = Dividend per share (use payout ratio to calculate)
(E-D)= Retained earnings per share (EPS- DPS)
r = Rate of Return on firm’s investment or % of retained earnings
k = Cost of Equity Capital or Cost of capitalization
P
D + r (E-D)
k
k
=
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19.  Assumptions of Walter’s Model:
 The firm finances all investment through retained earnings.
 The firm’s internal rate of return (r), and its cost of capital
(k) are constant;
 All earnings are either distributed as dividend or reinvested
internally immediately.
 The firm has a very long or infinite life.
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20. Criticisms of Walter’s Model
 The model does not consider all the factors affecting
dividend policy and share prices.
 The model assumes that the investment opportunities
of the firm are financed by retained earnings only and
no external financing.
 Firm’s internal rate of return does not always remain
constant. In fact, r decreases as more and more
investment in made. (income from investment)
 Walter model on dividend policy ignored the business
risk of the firm, which has a direct impact on the value
of the firm. Thus, k cannot be assumed to be constant.
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21. Impact of Dividend Policy on Market
Price
EPS =$ 8
Dividend
Payout
r > ke r < ke r = ke
15% > 12% 10% < 12% 12% = 12%
Market Price (P) Market Price (P) Market Price (P)
0% 83 56 67
25% 79 58 67
50% 75 61 67
75% 71 64 67
100% 67 67 67
Dividend
Policy Zero Payout 100% Payout Payout 0% to 100%
Formula
P = D + r/ke (E-D)
Ke
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22. Illustration Exercise
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23. Solution (i)
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 EPS ( E ) = earnings/ no. of shares= $ 500 000/ 100 000= $5
 DPS (D)= dividend payout ratio * EPS = 60% x $ 5= $3
 E-D = $5 - $3 = $2
 K= 12 %
 R= 15%
 P= 3 + 0.15(2)
0.12
0.12
P = $ 229 .17

24. Solution (ii)
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25. Gordon’s Model
• Gordon uses the dividend capitalization approach
to study the effect of the firms dividend policy on
the stock price.
• According to him, what is presently available is
more preferred that what may be available in the
future.
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26. Gordon’s Model
 Gordon model assumes that the investors are
rational, they want to avoid risk.
 They would prefer to pay a higher price for the
shares now which earn them current dividends
income .
 In the same way, they would retain their earnings
if the company postpones dividends.
 Again, the share price and the dividend depend on
the retention rate.
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27. Formula of Gordon’s Model
 Where,
P = Market Price
E = Earnings per Share
b = Retention Ratio (100 % - % dividend payout
ratio)
K = Rate of return required by shareholders
r = Rate of return on investment
br = g = Growth Rate
P =
E (1 – b)
K - br
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 According to Gordon;
 The firms with rate of return greater than the cost
of capital should have a higher retention ratio.
 Firms which have rate of return less than the cost
of capital, should have a lower retention ratio.
 The firms which have a rate of return equal to the
cost of capital will however not have any impact
on its share value, it can adopt any retention
policy.

29.  Assumptions:
 The firm is an all equity firm
 Only financed by retained earnings
 The internal rate of return (r) and the cost of
capital (k)of the firm is constant.
 Constant Cost of Capital
 The retention ratio (b), once decided upon, is
constant
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30. Criticisms of Gordon’s model
 As the assumptions of Walter’s Model
and Gordon’s Model are same so the
Gordon’s model suffers from the same
limitations as the Walter’s Model.
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31. Illustration 2
The following data are available for Rogers Group.
Earnings per share: $ 40.00
Rate of Return on Investment: 20%
Rate of Return required by shareholders: 30%
If the Gordon valuation model holds, what will be the
price per share when the dividend payout ratio is
25%?
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32. Solution
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P = 40 (1- 0.75)
0.30 – (0.2 x 0.75)
= 10
0.15
= $ 66.67

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34. Irrelevant Theory
 According to this concept, investors do
not pay any importance to the dividend
history of a company and thus, dividends
are irrelevant and have no impact on the
value of a firm.
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35. Modigliani & Miller’s Irrelevance Model
Depends on
Depends on
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36. Modigliani & Miller’s
 According to M & M, the value of the firm
remains the same whether or not the
company pays dividend.
 The value of a firm depends solely on its
earnings power resulting from the investment
policy and not influenced by the manner in
which its earnings are split between
dividends and retained earnings.
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37. Formula of M-M’s Approach
Po =
( D1+P1 )
(1 + p)
Where,
Po = Market price per share at time 0,
D1 = Dividend per share at time 1,
P1 = Market price of share at time 1
p = Capitalization Rate
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38. Modigliani and Miller’s Approach
 Assumption
 Capital markets are perfect:- Investors are
rational, information is freely available,
transaction cost are nil, and no investor can
influence the market price of the share.
 Taxes do not exist
 The firm has a fixed investment policy
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39. Criticism of M-M Model
 No perfect Capital Market
 Lack of Relevant Information
 The assumption that taxes do not exist
is far from reality.
 No fixed investment Policy
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40. Summary
 Dividend is the part of profit paid to
Shareholders.
 Firm decide, depending on the profit, the
percentage of paying dividend.
 Walter and Gordon says that a Dividend
Decision affects the valuation of the firm.
 While the Traditional Approach and MM’s
Approach says that Value of the Firm is
irrelevant to Dividend we pay.
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41. Workshop Questions & Answers
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42. Question 1
 Expanda Ltd. had 50,000 equity shares of $ 10 each
outstanding on January 1. The shares are currently being
quoted at market price. In the wake of the removal of dividend
restraint, the company now intends to pay a dividend of $ 2 per
share for the current calendar year. It belongs to a risk-class
whose appropriate capitalization rate is 15%. Using MM model
and assuming no taxes, ascertain the price of the company's
share as it is likely to prevail at the end of the year (i) when
dividend is declared, and (ii) when no dividend is declared.
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43. Answer to Q1
(i) Price as per share when dividends are paid
P1 = P0 (1+ke) – D1
= 10 (1+.15)-2
= 11.5-2
= Rs. 9.5.
(ii) Price per share when dividends are not paid:
P1 = P0 (1+ke)-D1
= 10 (1+. 15)-0
= Rs. 11.5
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44. Question 2
The following data are available for Phoenix
International.
Earnings per share: $ 10.00
Rate of Return on Investment: 20%
Rate of Return required by shareholders: 16%
If the Gordon valuation model holds, what will be
the price per share when the dividend payout
ratio is (i) 25%? (ii) 50%?
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45. Answer to Q2
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46. Question 3
The following information is available about Benny
Musicals.
Earnings per share: $ 5.00
Rate of return required by shareholders: 16 %
Assuming that the Gordon valuation model holds,
what rate of return should be earned on
investments to ensure that the market price is $ 50
when the dividend payout is 40%?
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47. Answer to Q3
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48. Question 4
 The earnings per share of company are $ 8 and
the rate of capitalization applicable to the company
is 10%. The company has before it an option of
adopting a payout ratio of 25% or 50% or 75%.
Using Walter's formula of dividend payout,
compute the market value of the company's share
if the productivity of retained earnings is (i) 15% (ii)
10% and (iii) 5%
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49. Question 5
The following information is available for Avanti
Corporation.
Earnings per share: $ 4.00
Rate of return on investments: 18%
Rate of return required by shareholders: 15%
What will be the price per share as per the Walter
model if the payout ratio is (i) 40%? (ii) 50%? (iii)
60%?
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50. Question 6
ABC Ltd. had 100,000 equity shares of $ 20 each outstanding on
January 1. The shares are currently being quoted at market price. In
the wake of the removal of dividend restraint, the company now
intends to pay a dividend of $ 5 per share for the current calendar
year. It belongs to a risk-class whose appropriate capitalization rate
is 20%. Using MM model and assuming no taxes, ascertain the price
of the company's share as it is likely to prevail at the end of the year
(i) when dividend is declared, and (ii) when no dividend is declared.
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51. END OF SESSION
It was a pleasure to work with
you all 
ENJOY YOUR TUITION FREE
WEEKS 
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52. Tishta Bachoo
Lecturer in Accounting
Charles Telfair Institute
Tel: 401-6511 | Fax: 433-3005
Email: tishta.bachoo@telfair.ac.mu
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