1. 1.

CORPORATE FINANCE13TH JULY 2011DIVIDEND THEORIES

2. 2. There are three main categories advanced:1. Dividend relevance theories2. Dividend
irrelevance theories3. Dividend DIVIDEND THEORIES & uncertainty
3. 3. Myron Gordon (Gordons model) James E. Walter (Walters model) These are
theories whose propagators argue that the dividend policy of a firm affects the value of
the firm. There are two main theorists: DIVIDEND RELEVANCE THEORIES
4. 4. Shows relationship btwn a firms 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 firms rate of return, r, and its cost of capital k are constant3. 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 WALTERS MODEL
5. 5. k = firms cost of capital r = firms average rate of return EPS = earnings per
share DPS = dividend per share P = market price per share Walters formula for
determining MPS is as follows:P = (DPS/k) + [r (EPS DPS)/k]/kWhere:
6. 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(EPSDPS)/kHence the formula can be rewritten as P = DPS + (r/k) (EPS DPS) k
7. 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
arent 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. 8. 3. Declining firm: there arent 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. 9. constant cost of capital, i.e. disregards the firms risk which changes over time hence
the discount rate will change over time in proportion. Model assumes a constant rate of
return and; Model assumes investment decisions of the firm are financed by retained
earnings alone CRITICISMS OF WALTERS MODEL
10. 10. Assumptions:1. The firm is an all equity firm, i.e. no debt2. No external financing is
available; consequently retained earnings would be used to finance any expansion of the
firm. Similar argument as Walters for the dividend and investment policies.3. Constant
return which ignores diminishing marginal efficiency of investment as represented in the
diagram on Walters model.4. Constant cost of capital; model also ignores the risk-effect
as did Walters GORDONS MODEL
11. 11. 5. Perpetual stream of earnings for the firm6. Corporate taxes do not exist7. 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. 12. P0 = EPS (1 b) kg According to Gordons 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:
13. 13. g is always less than k g = the growth rate determined as br (1 b) = the
retention ratio of the firm given b as the payout ratio. Where:
14. 14. The conclusions of Gordons model are similar to Walters 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<k3. The market
value is not affected by the dividend policy where r = k
15. 15. 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 firms earnings which
result from its investment policy, such that when the policy is given the dividend policy is
of no consequence. The propagators of this school of thought were France Modigliani
and Merton Miller (1961). DIVIDENDS IRRELEVANCE
16. 16. Conditions that face a firm operating in a perfect capital market, either;1. The firm
has sufficient funds to pay dividend2. The firm does not have sufficient funds to pay
dividend therefore it issues stocks in order to finance payment of dividends3. The firm
does not pay dividends but the shareholders need cash.
17. 17. 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. The firm has a fixed investment policy Taxes do not exist; or
there is no difference in the tax rates applicable to both dividends and capital gains.
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. ASSUMPTIONS OF M-M HYPOTHESIS
18. 18. The return is computed as follows: r = Dividends + Capital gains (loss) Share price r
= DIV1 + (P1 P0) P0 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.
19. 19. This arbitraging or switching continues until the differentials in rates of return are
eliminated. 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.
20. 20. Consequently the present value per share after dividends and external fin 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. 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. CONCLUSIONS OF THE MODEL Thus the shareholders are
indifferent between the payment of dividends and retention of earnings. ancing is equal
to the present value per share before the payment of dividends.
21. 21. No or low taxes on dividends Desire for steady income Uncertainty (high-payout
clientele) Diversification Information asymmetry Transaction and agency costs

Floatation costs
Tax differentials (low-payout clientele)
Presence of Market
Imperfections: CRITICISMS?
22. 22. Investors behave rationally, are risk-averse and therefore have a preference for near
dividends to future dividends. Relaxing of Gordons 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. THE BIRD-IN-THE-HAND THEORY
23. 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. 24. The appropriate discount rate would thus increase with the retention ratio. 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. When dividend is considered
with respect to uncertainty the discount rate cannot be held constant, it increase with
uncertainty. Uncertainty of dividends increases with futurity, i.e. the further one looks
the more uncertain dividends become

Some of the major different theories of dividend in financial management

are as follows: 1. Walters model 2. Gordons model 3. Modigliani and
Millers hypothesis.
On the relationship between dividend and the value of the firm different
theories have been advanced.
They are as follows:
1. Walters model
2. Gordons model
3. Modigliani and Millers hypothesis

1. Walters model:
Professor James E. Walterargues that the choice of dividend policies
almost always affects the value of the enterprise. His model shows clearly

the importance of the relationship between the firms internal rate of return
(r) and its cost of capital (k) in determining the dividend policy that will
maximise the wealth of shareholders.
Walters model is based on the following assumptions:
1. The firm finances all investment through retained earnings; that is debt
or new equity is not issued;
2. The firms internal rate of return (r), and its cost of capital (k) are
constant;
3. All earnings are either distributed as dividend or reinvested internally
immediately.
4. Beginning earnings and dividends never change. The values of the
earnings pershare (E), and the divided per share (D) may be changed in
the model to determine results, but any given values of E and D are
assumed to remain constant forever in determining a given value.
5. The firm has a very long or infinite life.
Walters formula to determine the market price per share (P) is as
follows:
P = D/K +r(E-D)/K/K
The above equation clearly reveals that the market price per share is
the sum of the present value of two sources of income:
i) The present value of an infinite stream of constant dividends, (D/K) and
ii) The present value of the infinite stream of stream gains.
[r (E-D)/K/K]

Criticism:
Walters model is quite useful to show the effects of dividend policy on an
all equity firm under different assumptions about the rate of return.
However, the simplified nature of the model can lead to conclusions which
are net true in general, though true for Walters model.
The criticisms on the model are as follows:
1. Walters model of share valuation mixes dividend policy with investment
policy of the firm. The model assumes that the investment opportunities of
the firm are financed by retained earnings only and no external financing
debt or equity is used for the purpose when such a situation exists either
the firms investment or its dividend policy or both will be sub-optimum. The
wealth of the owners will maximise only when this optimum investment in
made.
2. Walters model is based on the assumption that r is constant. In fact
decreases as more investment occurs. This reflects the assumption that
the most profitable investments are made first and then the poorer
investments are made.
The firm should step at a point where r = k. This is clearly an erroneous
policy and fall to optimise the wealth of the owners.
3. A firms cost of capital or discount rate, K, does not remain constant; it
changes directly with the firms risk. Thus, the present value of the firms
income moves inversely with the cost of capital. By assuming that the
discount rate, K is constant, Walters model abstracts from the effect of risk
on the value of the firm.

2. Gordons Model:

One very popular model explicitly relating the market value of the firm to
dividend policy is developed by Myron Gordon.

Assumptions:
Gordons model is based on the following assumptions.
1. The firm is an all Equity firm
2. No external financing is available
3. The internal rate of return (r) of the firm is constant.
4. The appropriate discount rate (K) of the firm remains constant.
5. The firm and its stream of earnings are perpetual
6. The corporate taxes do not exist.
7. The retention ratio (b), once decided upon, is constant. Thus, the growth
rate (g) = br is constant forever.
8. K > br = g if this condition is not fulfilled, we cannot get a meaningful
value for the share.
According to Gordons dividend capitalisation model, the market value of a
share (Pq) is equal to the present value of an infinite stream of dividends to
be received by the share. Thus:

The above equation explicitly shows the relationship of current earnings

(E,), dividend policy, (b), internal profitability (r) and the all-equity firms cost
of capital (k), in the determination of the value of the share (P0).

3. Modigliani and Millers hypothesis:

According to Modigliani and Miller (M-M), dividend policy of a firm is

irrelevant as it does not affect the wealth of the shareholders. They argue
that the value of the firm depends on the firms earnings which result from
its investment policy.
Thus, when investment decision of the firm is given, dividend decision the
split of earnings between dividends and retained earnings is of no
significance in determining the value of the firm. M Ms hypothesis of
irrelevance is based on the following assumptions.
1. The firm operates in perfect capital market
2. Taxes do not exist
3. The firm has a fixed investment policy
4. Risk of uncertainty does not exist. That is, investors are able to forecast
future prices and dividends with certainty and one discount rate is
appropriate for all securities and all time periods. Thus, r = K = Kt for all t.
Under M M assumptions, r will be equal to the discount rate and identical
for all shares. 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.
Thus, the rate of return for a share held for one year may be
calculated as follows:

Where P^ is the market or purchase price per share at time 0, P, is the

market price per share at time 1 and D is dividend per share at time 1. As
hypothesised by M M, r should be equal for all shares. If it is not so, the

low-return yielding shares will be sold by investors who will purchase the
high-return yielding shares.
This process will tend to reduce the price of the low-return shares and to
increase the prices of the high-return shares. This switching will continue
until the differentials in rates of return are eliminated. This discount rate will
also be equal for all firms under the M-M assumption since there are no risk
differences.
From the above M-M fundamental principle we can derive their valuation
model as follows:

Multiplying both sides of equation by the number of shares outstanding (n),

we obtain the value of the firm if no new financing exists.

If the firm sells m number of new shares at time 1 at a price of P^, the value
of the firm at time 0 will be

The above equation of M M valuation allows for the issuance of new

shares, unlike Walters and Gordons models. Consequently, a firm can pay
dividends and raise funds to undertake the optimum investment policy.
Thus, dividend and investment policies are not confounded in M M
model, like waiters and Gordons models.

Criticism:

Because of the unrealistic nature of the assumption, M-Ms hypothesis

lacks practical relevance in the real world situation. Thus, it is being
criticised on the following grounds.
1. The assumption that taxes do not exist is far from reality.
2. M-M argue that the internal and external financing are equivalent. This
cannot be true if the costs of floating new issues exist.
3. According to M-Ms hypothesis the wealth of a shareholder will be same
whether the firm pays dividends or not. But, because of the transactions
costs and inconvenience associated with the sale of shares to realise
capital gains, shareholders prefer dividends to capital gains.
4. Even under the condition of certainty it is not correct to assume that the
discount rate (k) should be same whether firm uses the external or internal
financing.
If investors have desire to diversify their port folios, the discount rate for
external and internal financing will be different.
5. M-M argues that, even if the assumption of perfect certainty is dropped
and uncertainty is considered, dividend policy continues to be irrelevant.
But according to number of writers, dividends are relevant under conditions
of uncertainty.