CHAPTER 17

DIVIDEND THEORY
Q.1.
A.1.

What are the essentials of Walters dividend model? Explain its shortcomings.
Prof. J E Walter argues that the choice of dividend policies almost always affects
the value of the firm. Walters model is based on the following assumptions:
1. The firm finances all its investment through retained earnings;
2. The firms rate of return r, and its cost of capital, k, are constant;
3. The firm have 100% dividend payment or retention ratio;
4. The firms EPS and DPS are constant forever in determining a given value
of firm.
The market price of share is the sum total of present value of infinite stream of
constant dividend, DIV/k; and infinite stream of capital gains, [r(EPS-DPS)/k]/k].
DIV + r / k (EPS DPS)
P=
k
According to the Walters model, the optimum dividend policy depends
on the relationship between r and k. If r>k, the share value will increase as the
firm retains more earnings; the price will be maximum when the firm retains
100%. If r<k, the price will be maximum if the firm distributes 100% dividend.
The Walters model assumes that the firms investment opportunities are
financed by retained earnings only. In the long-term, r does not remain constant; it
decreases as more and more investment is made. The firms cost of capital also
does not remain constant; it changes directly with firms risk.

Q.2.
A.2.

What are the assumptions which underlie Gordons model of dividend effect?
Does dividend policy affect the value of the firm under Gordons model?
Gordons model is based on the following assumptions.
1. The firm is an all-equity firm.
2. No external financing is available for expansion.
3. Constant internal rate of return, r3 and constant cost of capital, k.
4. The firm and its stream of earnings are perpetual.
5. Corporate taxes do not exist.
6. The retention ratio, b, once decided upon, is constant.
7. The firms cost of capital is greater than growth rates where growth rate is
retention ration multiplied by internal rate of return, i.e., g = br.
Gordons model is expressed as follows:
EPS1 (1 b)
Po =
k g
where b is retention ratio; EPS is earnings per share; g is growth rate and it
is equal to br (retention ration multiplied by rate of return).
The Gordon model suffers from the same limitations as the Walter model.

Q.3.

A.3.

Q.4.
A.4.

Walters and Gordons models are essentially based on the same assumptions.
Thus, there is no basic difference between the two models. Do you agree or not?
Why?
Yes, because both models, in short, conclude that,
1. The market value of the share increases with increase in retention ratio
when r>k.
2. The market value per share is not affected by the dividend policy when
r=k.
3. The market value per share decrease with retention if r<k.
According to Walters model the optimum payout ratio can be either zero or 100
per cent. Explain the circumstances, when this is true.
In the case of growth firm (r>k), the market value per share, P, increases as
payout ratio declines (optimum payout ratio is zero).
In the case of declining firm (r<k), the market value per share, P, increases
as payout ratio increases (optimum payout ratio is 100%).
In the case of normal firm (r=k), the payout ratio has no effect on the
market value per share.
Growth firm Normal firm Declining firm
Example:
r>k
r=k
r<k
Basic data

r = 0.15
k = 0.10

r = 0.10
k = 0.10

r = 0.08
k = 0.10

EPS

Rs 10

Rs 10

Rs 10

P=

DIV + r / k (EPS DPS)

k

Payout ratio = 0%
P = Rs 150

P = Rs 100

P = Rs 80

P = Rs 100

P = Rs 100

P = Rs 100

Payout ratio = 100%

Q.5.

A.5.

The contention that dividends have an impact on the share price has been
characterized as the bird-in-the-hand argument. Explain the essential of this
argument. Why this argument is considered fallacious?
According to the bird-in-the-hand argument, investors tend to behave rationally,
are risk averse and, therefore, have a preference for near dividends to future
dividends. They most certainly prefer to have their dividend today and let
tomorrow take care of itself. Further, given two companies with identical earnings
record, and prospects but one paying a larger dividend will always command
higher share price because investors prefer present to future values.
This argument is fallacious, on the contention that, if the firm does not pay
any dividend, a shareholder can create a home-made dividend by selling a part
of his/her shares at the fair market price in the capital market for obtaining cash.
This will not make any dilution in the wealth.

Q.6.
A.6.

What is Modigliani-Millers dividend irrelevance hypothesis? Critically evaluate

its assumptions.
MM hypothesis of irrelevance is based on the assumptions like perfect capital
market existence, no transaction and flotation costs, no corporate taxes, no
difference in the tax rates applicable to capital gains and dividends, and risk of
uncertainty does not exist.
As per MM, in the equilibrium, r (rate of return) will be equal to k (cost of
capital), 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, for every share will be equal to the discount rate. Hence, todays
market price per share is as follows:
DIV1 + P1
Po =
(1 + k )
MM argument implies that when the firm pays dividends, its advantage is
offset by external financing. This means that terminal value (Pl) of the share
declines when dividends are paid.
Above assumptions may not always be found valid because capital
markets are not perfect, existence of flotation and transaction costs, dividend may
be taxed differently than capital gains, etc.

Q.7.
A.7.

Q.8.
A.8.

The assumptions underlying the irrelevance hypothesis of Modigliani and Miller

are unrealistic. Explain and illustrate.
The MM assumptions on dividend irrelevance are considered unrealistic on
account of the following reasons.
1. Investors have to pay different taxes on dividend income and capital gains.
2. The firms internal and external financing are not equivalent, because
flotation costs (e.g., underwriting and brokers commission, etc.) are
involved if new shares are issued.
3. The home-made dividend benefit cannot be fully realized by investors on
account of transaction costs (such as brokerage fee). Further, it is
inconvenient to sell the shares by investors.
4. Investors may have a desire to diversify the portfolios from the dividend
income. If firm does not distribute the dividends, then investors will be
inclined to use a higher value of k if they expect the firm to use retained
earnings for internal financing.
5. The current receipt of money in the form of dividends is considered safer
than the uncertain potential gain in future by investors, etc.
Give arguments to support the view that dividends are relevant.
Market imperfections may make dividends relevant. Dividends are relevant
because some shareholders need a steady source of income. Some shareholders
are better off receiving dividends now rather than in the future on account of risk
of uncertainty. A tax system that treats dividends favourably than capital gains
can also result in high expectation by shareholders for dividend income. In India,

as per the existing law, the dividend income is non taxable, capital gains arising
within a year are taxable.
Q.9.
A.9.

Explain the effect of following on the dividend policy: (i) transaction costs; (ii)
agency costs.
The presence of transaction costs makes the external financing costlier than the
internal financing via retained earnings. Thus, for example, if flotation costs are
considered, the equivalence between retained earnings and new share capital is
disturbed and the retention of earnings would be favoured over the payment of
dividends. In practice, dividend decisions seem to be sticky for whatever reasons.
Companies continue paying same dividends, rather increasing it, unless earnings
decline, in spite of need for funds.
Agency problems arise because of the conflicts between managers and
shareholders. Managers may not have enough incentive to disclose full
information to shareholders. They may act in their own self-interest and take
away the firms wealth in the form of non-pecuniary benefits. Shareholders incur
agency costs to obtain full information about a companys investment plans,
future earnings, expected dividend payments, etc. The shareholders-managers
conflict can be reduced through monitoring which includes bonding contracts and
limiting the power of managers vis--vis allocation of wealth and managerial
compensation. However, monitoring involves costs that are referred to as agency
costs. Payment of dividend allocates resources to shareholders, and thus,
alleviates the need for monitoring and incurring agency costs.

Q.10. What is the informational content of dividend payments? How does it affect the
share value?
A.10. It is contended that dividends are relevant because they have informational value.
The payment of dividends conveys that the company is profitable and financially
strong. It is also contended that dividends may offer tangible evidence of the
firms ability to generate cash, and, as a result, the dividend policy of the firm
affects the share price.
If a company follows a dividend policy of changing dividends with every
cyclical change in earnings, the market price of share may be affected little
because shareholders knew the information. A greater increase in the dividends
than the earnings may convey to the shareholders that profitable investment
opportunities of the firm are diminishing. This may depress the market price of
share in spite of an increase in dividend payments.
Q.11. What is the relationship between taxes and dividend policy? Explain by citing the
impact of different tax systems.
A.11. From the tax point of view, a shareholder should prefer dividend over capital
gains on account of dividend income tax exempted, while capital gain is taxable
in India.
In most countries, different tax rates are applicable to dividends and
capital gains. On account of tax differential, some investors prefer lesser dividend
income while others prefer larger dividend income. Generally, following

differential tax systems are implemented in different countries regarding taxation

of shareholders earnings.
1. Double taxation: The shareholders earnings are taxed twice; first the
corporate tax is levied on profit of companies, and then dividends are
taxed as ordinary income in the hands of shareholders.
2. Single taxation: The shareholders are exempt from tax on dividend
income; while earnings are taxed at the corporate level.
3. Split-rate taxation: Corporate profits are divided into retained earnings and
dividends for tax purpose. Different tax rates are applied to retained
earnings and amount distributed by way of dividend.
4. Imputation taxation: The shareholders earnings are not subjected to
double taxation. A company pays corporate tax on its earnings;
shareholders pay personal taxes on dividend but get full or partial tax
relief for the tax paid by the company.
Q.12. What is the argument about the tax neutrality of dividend? Illustrate your answer.
A.12. The cost of dividends is the higher tax on dividend. Shareholders trade off the
benefits of dividends against the tax loss. Based on the trade-offs that
shareholders make, there are three clienteles: (i) a clientele that considers
dividends are always good; (ii) a clientele that considers dividends are always
bad; and (iii) a clientele that is indifferent to dividends. Shareholders in high tax
brackets may belong to high-payout clientele since in their case the tax
disadvantage may outweigh the benefits of dividends. On the other hand,
shareholders in low tax brackets may fit in to low-payout clientele as they may
suffer marginal tax disadvantage of dividends. Tax-exempt investors are
indifferent between dividends and capital gains, as they pay no taxes on their
income.