business environment

1. DIVIDEND THEORIES

2. DIVIDEND THEORIES
 There are three main categories advanced:
1. Dividend relevance theories
2. Dividend irrelevance theories
3. Dividend & uncertainty

3. DIVIDEND RELEVANCE
THEORIES
 These are theories whose propagators argue that
the dividend policy of a firm affects the value of
the firm. There are two main theorists:
 James E. Walter (Walter’s model)
 Myron Gordon (Gordon’s model)

4. Walter’s Model
 Shows relationship btwn a firm’s rate of return r and
its cost of capital k. it is based on the following
assumptions:
1. Internal financing – the firm finances all its
investments through retained earnings; debt or new
equity is not issued.
2. Constant return and cost of capital – the firm’s rate
of return, r, and its cost of capital k are constant
3. 100% payout or retention – all earnings are either
distributed as dividends or reinvested internally
immediately.
4. Constant EPS and DPS – beginning earnings and
dividends never change. The values of the EPS and
DPS may be changed in the model to determine
results but are assumed to remain unchanged in
determining a given value.
5. Infinite time – the firm has a very long or infinite life

5.  Walter’s formula for determining MPS is as
follows:
P = (DPS/k) + [r (EPS – DPS)/k]/k
Where:
 P = market price per share
 DPS = dividend per share
 EPS = earnings per share
 r = firm’s average rate of return
 k = firm’s cost of capital

6.  the market value is determined as the present
value of two sources of income:
1. PV of constant stream of dividend (DPS/k)
2. PV of infinite stream of capital gains:
r(EPS-DPS)/k
Hence the formula can be rewritten as
P = DPS + (r/k) (EPS – DPS)
k

7.  Given three types of firms or scenarios of firms
the model can be summarized as follows:
1. Growth firm: there are several investment
opportunities (r > k) and the firm can reinvest
earnings at a higher rate r than that which is
expected by shareholders k. thus they wil
maximize value per share if they reinvest all
earnings.
2. Normal firm: there aren’t any investments
available for the firm that are yielding higher
rates of return (r = k) thus the dividend policy
has no effect on market price.

8. 3. Declining firm: there aren’t any profitable
investments for the firm to reinvest its earnings,
i.e. any investments would earn the firm a rate
less than its cost of capital (r < k). The firm will
therefore maximize its value per share if it pays
out all its earnings as dividend.

9. Criticisms of Walter’s model
 Model assumes investment decisions of the firm
are financed by retained earnings alone
 Model assumes a constant rate of return and;
 constant cost of capital, i.e. disregards the firm’s
risk which changes over time hence the discount
rate will change over time in proportion.

10. Gordon’s Model
 Assumptions:
1. The firm is an all equity firm, i.e. no debt
2. No external financing is available; consequently
retained earnings would be used to finance any
expansion of the firm. Similar argument as
Walter’s for the dividend and investment
policies.
3. Constant return which ignores diminishing
marginal efficiency of investment as
represented in the diagram on Walter’s model.
4. Constant cost of capital; model also ignores the
risk-effect as did Walter’s

11. 5. Perpetual stream of earnings for the firm
6. Corporate taxes do not exist
7. Constant retention ratio b, i.e. once decided
upon stays as such forever. The growth rate g =
br stays constant in that case.
8. Cost of capital greater than the growth rate (k >
br = g); otherwise it is not possible to obtain a
meaningful value for the share.

12.  According to Gordon’s model dividend per share
is expected to grow when earnings are retained.
The dividend per share is equal to the payout
ratio multiplied by earnings [EPS X (1-b)]. To
determine the value of the firm therefore based
on the dividend growth model the value of the
firm will be:
 P0 = EPS (1 – b)
k – g

13.  Where:
 (1 – b) = the retention ratio of the firm given b
as the payout ratio.
 g = the growth rate determined as br
 g is always less than k

14.  The conclusions of Gordon’s model are similar to
Walter’s model due to the fact that their sets of
assumptions are similar.
1. The market value of P0 increases with retention
ratio b, for firms with growth opportunities, i.e.
when r > k.
2. The market value of the share P0 increases with
payout ratio (1 – b), for declining firms with r < k
3. The market value is not affected by the dividend
policy where r = k

15. Dividends Irrelevance
 The propagators of this school of thought were
France Modigliani and Merton Miller (1961).
 They state that the dividend policy employed by a
firm does not affect the value of the firm. They
argue that the value of the firm is dependent on
the firm’s earnings which result from its
investment policy, such that when the policy is
given the dividend policy is of no consequence.

16.  Conditions that face a firm operating in a perfect
capital market, either;
1. The firm has sufficient funds to pay dividend
2. The firm does not have sufficient funds to pay
dividend therefore it issues stocks in order to
finance payment of dividends
3. The firm does not pay dividends but the
shareholders need cash.

17. Assumptions of M-M hypothesis
 Perfect capital markets, i.e. investors behave
rationally, information is freely available to all
investors, transaction and floatation costs do not
exist, no investor is large enough to influence the
price of a share.
 Taxes do not exist; or there is no difference in the
tax rates applicable to both dividends and capital
gains.
 The firm has a fixed investment policy
 The risk of uncertainty does not exist, i.e. all
investors are able to forecast future prices and
dividends with certainty and one discount rate is
appropriate for all securities over all time periods.

18.  Under the assumptions the rate of return, r, will be
equal to the discount rate, k. As a result the price of
each share must adjust so that the rate of return,
which is composed of the rate of dividends and
capital gains on every share, will be equal to the
discount rate and be identical for all shares.
 The return is computed as follows:
r = Dividends + Capital gains (loss)
Share price
r = DIV1 + (P1 – P0)
P0

19.  As hypothesised, r should be equal for all the
shares otherwise the lower yielding securities will
be traded for the higher yielding ones thus
reducing the price of the low yielding ones and
increasing the price of the high yielding ones.
 This arbitraging or switching continues until the
differentials in rates of return are eliminated.

20. Conclusions of the model
 A firm which pays dividends will have to raise funds
externally in order to finance its investment plans.
When a firm pays dividend therefore, its advantage is
offset by external financing.
 This means that the terminal value of the share
declines when dividends are paid. Thus the wealth of
the shareholders – dividends plus the terminal share
price – remains unchanged.
 Consequently the present value per share after
dividends and external financing is equal to the
present value per share before the payment of
dividends.
 Thus the shareholders are indifferent between the
payment of dividends and retention of earnings.

21. Criticisms?
 Presence of Market Imperfections:
 Tax differentials (low-payout clientele)
 Floatation costs
 Transaction and agency costs
 Information asymmetry
 Diversification
 Uncertainty (high-payout clientele)
 Desire for steady income
 No or low taxes on dividends

22. The Bird-in-the-hand theory
 Relaxing of Gordon’s simplifying assumptions to
conform slightly to reality, he concludes that even
when r = k, the dividend policy does affect the value
of the share based on the view that: under
conditions of uncertainty, investors tend to
discount distant dividends (capital gains) at a
higher rate than they discount near dividends.
 Investors behave rationally, are risk-averse and
therefore have a preference for near dividends to
future dividends.

23.  Put forth by Kirshman (1969) in the following
terms:
“Of two stocks with identical earnings record and
prospects but the one paying higher dividend
than the other, the former will undoubtedly
command higher dividend than the latter merely
because stockholders prefer present to future
values….stockholders normally act on the
premise that a bird in the hand is worth two in
the bush and for this reason are willing to pay a
premium price for the stock with the higher
dividend rate just as they discount the one with
the lower rate”.

24.  Uncertainty of dividends increases with futurity, i.e.
the further one looks the more uncertain dividends
become
 When dividend is considered with respect to
uncertainty the discount rate cannot be held
constant, it increase with uncertainty.
 Investors prefer to avoid uncertainty and would be
willing to pay a higher price for the share that pays
the higher current dividend, all things held constant.
 The appropriate discount rate would thus increase
with the retention ratio.

25. TYPES OF DIVIDENDS
 CASH DIVIDEND
1. NORMAL DIVIDEND
2. INTERIM DIVIDEND
 STOCK DIVIDEND
 SCRIP DIVIDEND
 BOND DIVIDEND
 PROPERTY DIVIDEND

26. DETERMINANTS OF DIVIDEND
POLICY
 LEGAL CONSIDERATION
 INFLATION IN ECONOMY
 DIVIDEND POLICIES
 COST OF CAPITAL
 NATURE OF BUSINESS
 FUND REQUIREMENT
 LIQUIDITY OF FUNDS
 ACCESSIBILITY OF EXTERNAL SOURCES
 TRADE CYCLES
 SHAREHOLDER PREFERENCE
 CONTROL
 PAST DIVIDEND RATE
 GOVERNMENT POLICIES

27. TYPES OF DIVIDEND POLICY
 CONSERVATIVE DIVIDEND POLICY
 LIBERAL POLICY
 STABLE POLICY
1. STABLE DIVIDEND PER SHARE
2. STABLE PAYOUT RATE
3. STABLE DIVIDEND RATE
4. STABLE DIVIDEND PER SHARE PLUS
EXTRA DIVIDEND

28. MERITS OF STABLE DIVIDEND
POLICY
 STABILITY IN MARKET PRICE OF SHARE
 INSTITUTIONAL INVESTOR’S REQUIREMENT
 CONFIDENCE AMONG INVESTORS
 SHAREHOLDERS DESIRE FOR CURRENT
INCOME
 HELPFUL IN PLANNING

29. DANGERS OF STABILITY OF
DIVIDENDS

30. Questions?