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DIVIDEND THEORIES

INTRODUCTION
. Dividend decision is the one of the decisions of Financial Management. . A dividend decision is the third major financial decision. . It decides the proportion of equity earnings to be paid to equity share holders & the remaining proportion of net earning are retained in the firm.

The proportion of profits distributed as dividends is called dividend payout ratio. The retained portion of profits is known as the retention ratio. Dividends are generally paid in cash A firm may also issue bonus shares

Companies mostly pay dividends in cash. Bonus shares are the shares issued to the existing shareholders without any charge. In India, bonus shares are issued in addition to the cash dividend and not in lieu of cash dividend.

Advantages of Bonus shares


Shareholders 1. Tax benefit 2. Future dividends may increase

. Company
1. Only means to pay dividend under financial difficulty. 2. More attractive share price.

Payment of dividend has two opposing effects: 1) It increases dividend there by stock price rise 2) It reduce the funds available for investment Various models have been developed to help firms analyses and evaluate the perfect dividend policy. There is no agreement between these schools of thought over the relationship between dividends and the value of the share or the wealth of the shareholders in other words.

One school comprises of people like James E. Walter and Myron J. Gordon, who believe that current cash dividends are less risky than future capital gains. Thus, they say that investors prefer those firms which pay regular dividends and such dividends affect the market price of the share. Another school linked to Modigliani and Miller holds that investors don't really choose between future gains and cash dividends.

DIVIDEND THEORIES
1) Relevance Theory : > Walters Model > Gordons Model

2)

Irrelevance Theory :
> Miller & Modigliani Hypothesis ( MM Approach)

DIVIDEND RELEVANCE THEORIES


Dividends paid by the firms are viewed positively both by the investors and the firms. The firms which do not pay dividends are rated in oppositely by investors thus affecting the share price. There are two main theorists:
James E. Walter (Walters model) Myron Gordon (Gordons model) its exactly opposite in the case of increased uncertainty due to non-payment of dividends.

Relevance Theory
According to relevance theory dividend decisions affects value of firm thus it is called relevance theory. Walters Models theory : This model is based on 1) Return on investment OR Internal rate of return (r). 2) Cost of capital OR Required rate of return. Here, the model divides the firm into three groups 1) Growth firms 2) Normal firms 3) Declining firms

Walters Model
Shows relationship b/w 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 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

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 will 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.

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.

In a nutshell: If r>ke, the firm should have zero payout and make investments. If r<ke, the firm should have 100% payouts and no investment of retained earnings. If r=ke, the firm is indifferent between dividends and investments.

Walter concludes: The optimum payout ratio is nil in case of growth firm, the payout ratio of a constant firm is irrelevant, the optimum payout ratio for a declining firm is 100 per cent.

Mathematical representation Walter has given a mathematical model for the above made statements:

Where, P = Market price of the share D = Dividend per share r = Rate of return on the firm's investments ke = Cost of equity E = Earnings per share'

Criticisms of Walters 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 firms risk which changes over time hence the discount rate will change over time in proportion. The constant r and ke are seldom found in real life, because as and when a firm invests more the business risks change

Gordons Model : According to this model a firm share price is dependent on dividend pay out ratio. > Assumptions :

1)
2) 3) 4) 5) 6)

The firm is all equity firm.


All investment projects are financed by exclusively retained earnings. The rate of return firms is constant. The cost of capital remains constant. The firm has perpetual life. There are no corporate taxes.

Gordons 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 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 riskeffect as did Walters

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.

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: P0 = EPS (1 b) kg

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

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 < k 3. The market value is not affected by the dividend policy where r = k

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 firms earnings which result from its investment policy, such that when the policy is given the dividend policy is of no consequence.

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.

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.

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

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.

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.

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

Dividend Irrelevance Theory


Miller and Modigliani showed algebraically that dividend policy didnt matter:
They showed that as long as the firm was realizing the returns expected by the market, it didnt matter whether that return came back to the shareholder as dividends now, or reinvested.
They would see it in dividend or price appreciation.

The shareholder can create their own dividend by selling the stock when cash is needed.

Dividend Policy and Stock Price


Dividend Irrelevance Theory:
Miller/Modigliani argued that dividend policy should be irrelevant to stock price. If dividends dont matter, this chapter is irrelevant as well (which is what most of you are thinking anyway).

Dividend Irrelevance Theory


1 Vt Dt Vt 1 mt 1 Pt 1 1 rt where rt Discount rate Dt Total Dividends Paid Vt 1 Firm Value @ t +1 = nt Pt 1 mt 1 Pt 1 Amount raised in equity = I t X t Dt X t Income @ t

I t Capital Investments

Dividend Irrelevance Theory


1 Vt Dt Vt 1 I t X t Dt 1 rt 1 Vt 1 I t X t 1 rt

Dividends are not in the final equation!

Therefore, dividends are irrelevant to value!

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