This document discusses dividend policy and its impact on firm value. It covers 5 sections: 1) Models relating investment and dividend decisions, including the Walter and Gordon models. 2) The traditional view that the market values dividends more than retained earnings. 3) The Miller-Modigliani position that dividend policy does not impact value under certain assumptions. 4) The radical view that dividends should be minimized due to tax advantages of capital gains. 5) An overall picture of two broad schools of thought on the relationship between dividends and share value.

1. CHAPTER: DIVIDEND POLICY AND
FIRM VALUE
PRESENTED BY:
VIKRAM RAJAI
RAJKUMAR PRAJAPATI
DIVYAKANT CHOPADA

2. CONTENTS
 DIVIDEND POLICY
 FIVE SECTIONS OF DIVIDEND
POLICY

3. DIVIDEND POLICY
WHY DIVIDEND POLICY ?
Dividend policy of a firm determines what
proportion of earnings is paid to
shareholders by way of dividends and
what proportion is ploughed back in the
firm for investment purposes.

4. FIVE SECTIONS OF DIVIDEND
POLICY
1. Models in which investment and
dividend decisions are related.
2. Traditional positions.
3. Miller and Modigliani position.
4. Radical position.
5. Overall picture.

5. 1. Models in which investment and dividend
decisions are related.
 WALTER MODEL
James Walter has proposed a model of share
valuation which supports the view that the
dividend policy of the firm has the bearing on
share valuation. His model is based on the
following assumptions:
1. The firm is an all-equity financed entity. It will rely
only on retained earnings to finance its future
investments. This means that the investment
decision is depend on the dividend decisions.
2. The rate of return on investments is constant.
3. The firm has an infinite life.

6. Equation:
P = D + (E - D)r/K
k
P = price per equity share
D = dividend per share
E = earnings per share
(E - D) = retained earnings per share
r = rate of return on investments
k = cost of capital

7. Numerical example for Walter Model
Growth firm: r>k Normal firm: r=k Declining firm: r<k
r = 20% r = 15% r = 10%
k = 15% k = 15% k = 15%
E = rs. 4 E = rs. 4 E = rs. 4
If D= 4 If D= 4 If D= 4
P0= 4+(0).20/.15 P0= 4+(0).15/.15 P0= 4+(0).10/.15
0.15 0.15 0.15
= Rs. 26.67 = Rs, 26.67 = Rs. 26.67
If D= 2 If D= 2 If D= 2
P0= 2+(0).20/.15 P0=2+(0).15/.15 P0= 2+(0).10/.15
0.15 0.15 0.15
= Rs. 31.11 = Rs, 26.67 = Rs. 22.22

8. 1. Models in which investment and
dividend decisions are related. (cont.)
 GORDON MODEL
Myron Gordon proposed a model of stock
valuation by using the dividend capitalization
approach. His model is based on following
assumptions:
1. Retained earnings represent the only source of
financing the firm.
2. The rate of return on the firm’s investment is
constant.
3. The growth rate of the firm is the product of its
retention ratio and its rate of return.
4. The cost of capital for the firm remains constant
and it is greater than the growth rate.
5. The firm has perpetual life.
6. Tax does not exist.

9. Equation:
P0 = E1 (1 - b)
k – br
P0 =price at the end of the year 0
E1 = earning per share at the end of the year 1
(1 - b) = fraction of earnings the firm distributes by
way of dividends
b = fraction of earnings the firm retains
k = rate of return required by the shareholders
r = rate of return earned on investments
br = growth rate of earnings and dividends

10. Numerical example for Gordon Model
Growth firm: r>k Normal firm: r=k Declining firm: r<k
r = 20% r = 15% r = 10%
k = 15% k = 15% k = 15%
E = rs. 4 E = rs. 4 E = rs. 4
If b=0.25 If b=0.25 If b=0.25
P0= (0.75)4 P0= (0.75)4 P0= (0.75)4
0.15-(0.25)(0.20) 0.15-(0.25)(0.15) 0.15-(0.25)(0.10)
= Rs. 30 = Rs, 26.67 = Rs. 24.00
If b=Rs. 0.5 If b=Rs. 0.5 If b=Rs. 0.5
P0= (0.50)4 P0= (0.50)4 P0= (0.50)4
0.15-(0.5)(0.20) 0.15-(0.5)(0.15) 0.15-(0.5)(0.10)
= Rs. 40 = Rs, 26.67 = Rs. 20.00

11. 2. Traditional positions.
 The traditional position expounded
by Graham and Dodd holds that the
stock market places considerably
more weight on dividends than on
retained earnings.

12. Equation:
P = m (D + E/3)
P = market price per share
D = dividend per share
E = earnings per share
m = multiplier
Here, E = (D + R)
P = m (D + D + R)
3

13. Empirical Evidence
Advocates of the traditional position
cite the results of cross-section
regression analysis like the
following:
Price = a + b Dividend + c Retained
earnings
Price = a + b Dividend + c Retained
earnings + d Risk

14. 3. Miller and Modigliani position.
 Miller and Modigliani have advanced the view
that the value of a firm depends solely on its
earning power and it is not influenced by the
manner in which its earnings are split between
dividends and retained earnings. The following
are the assumptions:
1. Capital markets are perfect and investors are
rational: information is freely available,
transactions are instantaneous and costless,
securities are divisible, and no investor can
influence market prices.
2. Floatation costs are nil.
3. There are no taxes.
4. Investment opportunities and future profits of
firms are known with certainty.
5. Investment and dividend decisions are
independent.

15. Equation:
P0 = 1 ( D1 + P1)
(1 + p)
P0 = market price per share at time 0
D1 = dividend per share at time 1
P1 = market price per share at time 1

16. Criticisms of MM Position
 Information About Prospects
 Uncertainty and Fluctuations
 Offering of Additional Equity at Lower
Prices
 Issue Cost
 Transaction Cost
 Differential Rates of Taxes
 Rationing: Self-imposed or Market-
imposed
 Unwise Investments

17. 4. Radical position.
Dividends are taxed more heavily
than capital gains, directly or
indirectly. Hence, the radicalists
argue that firms should pay as little
dividend as they can get away with
so that investors earn more by way
of capital gains and less by way of
dividends.
Return = a + b BETA + c EXPECTED
DIVIDEND YIELD

18. 5. Overall picture.
 Dividend policy and share value are
two broad schools of thoughts
 Perfect market
 Imperfect market