1. DIVIDEND THEORY
By Dr. B. Krishna ReddyBy Dr. B. Krishna Reddy
Professor and Head_SKIMProfessor and Head_SKIM

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LEARNING OBJECTIVES
• Highlight the issues of dividend policy
• Critically evaluate why some experts feel that
dividend policy matters
• Discuss the bird-in-the-hand argument for
paying current dividends
• Explain the logic of the dividend irrelevance
• Identify the market imperfections that make
dividend policy relevant
• Understand information content of dividend
policy

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INTRODUCTION
• Dividend policy involves the balancing of
the shareholders’ desire for current
dividends and the firm’s needs for funds
for growth

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Issues in Dividend Policy
• Earnings to be Distributed – High Vs. Low
Payout.
• Objective – Maximize Shareholders
Return.
• Effects – Taxes, Investment and Financing
Decision.

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Relevance Vs. Irrelevance
• Walter's Model
• Gordon's Model
• Modigliani and Miller Hypothesis
• The Bird in the Hand Argument
• Informational Content
• Market Imperfections

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DIVIDEND RELEVANCE:
WALTER’S MODEL
Walter’s model is based on the following
assumptions:
• Internal financing
• Constant return and cost of capital
• 100 per cent payout or retention
• Constant EPS and DIV
• Infinite time

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Walter’s formula to determine
the market price per share:

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Optimum Payout Ratio
• Growth Firms – Retain all earnings
• Normal Firms – Distribute all earnings
• Declining Firms – No effect

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Example: Dividend Policy:
Application of Walter’s Model

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Criticism of Walter’s Model
• No external financing
• Constant return, r
• Constant opportunity cost of capital, k

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DIVIDEND RELEVANCE:
GORDON’S MODEL
Gordon’s model is based on the
following assumptions:
– All-equity firm
– No external financing
– Constant return
– Constant cost of capital
– Perpetual earnings
– No taxes
– Constant retention
– Cost of capital greater than growth rate

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Valuation
• Market value of a share is equal to the present value of
an infinite stream of dividends to be received by
shareholders.

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Example: Application of
Gordon’s Dividend Model

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It is revealed that under
Gordon’s model:

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DIVIDEND AND UNCERTAINTY:
THE BIRD-IN-THE-HAND
ARGUMENT
• Argument put forward, first of all, by
Kirshman
• Investors are risk averters. They consider
distant dividends as less certain than near
dividends. Rate at which an investor
discounts his dividend stream from a
given firm increases with the futurity of
dividend stream and hence lowering share
prices

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DIVIDEND IRRELEVANCE: THE
MILLER–MODIGLIANI (MM)
HYPOTHESIS
• According to M-M, under a perfect market situation, the
dividend policy of a firm is irrelevant as it does not affect
the value of the firm. They argue that the value of the
firm depends on firm earnings which results from its
investment policy. Thus when investment decision of the
firm is given, dividend decision is of no significance.
• It is based on the following assumptions:-
– Perfect capital markets
– No taxes
– Investment policy
– No risk

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Market Imperfections
1. Tax Differential – Low Payout Clientele
2. Flotation Cost
3. Transaction and Agency Cost
4. Information Asymmetry
5. Diversification
6. Uncertainty – High Payout Clientele
7. Desire for Steady Income
8. No or Low Tax on Dividends

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Informational Content of
Dividend
• …. In an uncertain world in which verbal
statements can be ignored or
misinterpreted, dividend action does
provide a clear cut means of ‘making a
statement’ that speaks louder than a
thousand words. — Solomon