1

Issues in Dividend Policy

Earnings to be Distributed High Vs. Low

Payout.
Objective Maximize Shareholders Return.
Effects Taxes, Investment and Financing

Decision.

Relevance Vs. Irrelevance

Walter's Model Gordon's Model Modigliani and Miller Hypothesis The Bird in the Hand Argument

Informational Content
Market Imperfections
3

Walters Model
Assumptions
Valuation Optimum Payout Ratio

Criticism

Assumptions
Internal Financing
Constant Return and Cost of Capital 100% Payout or Retention

Constant EPS and DIV

Infinite Time
5

Valuation
Market price per share is the sum of the

present value of the infinite stream of constant dividends and present value of the infinite stream of capital gains.
P (DIV / k ) (r / k ) (EPS DIV) k

Example
r 0.15, 0.10, 0.08 k 0.10 EPS Rs 10 DPS 40% (0.15 / 0.1) P (4 / 0.1) (10 4) Rs 130 0.1 (0.10 / 0.1) P (4 / 0.1) (10 4) Rs 100 0.1 (0.08 / 0.1) P (4 / 0.1) (10 4) Rs 88 0.1

Optimum Payout Ratio

Growth Firms Retain all earnings Normal Firms Distribute all earnings

Declining Firms No effect

Criticism
No external Financing

Constant Rate of Return

Constant opportunity cost of capital

Gordon's Model
Assumptions

Valuation
Optimum Payout Ratio Criticism

10

Assumptions
All Equity Firm No External Financing Constant Return and Cost of Capital

Perpetual Earnings
No Taxes Constant Retention Cost of Capital greater than Growth Rate

11

Valuation
Market value of a share is equal to the

present value of an infinite stream of dividends to be received by shareholders

P EPS(1 b) /(k br )

12

Example
r = 0.15, 0.10, 0.08 k = 0.10 EPS = Rs 10 b = 60% P = (1 0.6) / 0.10 (0.15 * 0.6) = Rs 400 P = 10(1 0.6) / 0.10 (0.10 * 0.6) = Rs 100 P = 10(1 0.6) / 0.10 (0.08 * 0.6) = Rs 77

13

Optimum Payout Ratio

Growth Firms Retain all earnings

Normal Firms Distribute all earnings

Declining Firms No effect

14

The Bird in the Hand

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.

15

Modigliani and Miller

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.

16

Market Imperfections
Tax Differential Low Payout Clientele

Flotation Cost
Transaction and Agency Cost Institutional Restrictions

Information Asymmetry
Diversification Uncertainty High Payout Clientele

Desire for Steady Income

No or Low Tax on Dividends
17

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. Ezra Solomon

18