Dividend Decision and Theories

Introduction

  · Dividend refers to the portion of profit after tax which is distributed among the shareholders of the firm. It is returned that shareholders get on their investment.

   · According to the Institute of Chartered Accountant of India, dividend is defined as “a distribution to shareholders out of profit or reserves available for this purpose”.

Dividend Decision:

The Dividend Decision is one of the crucial decisions made by the finance manager relating to the pay-outs to the shareholders. The pay-out is the portion of Earning Per Share given to the shareholders in the form of dividends.

Pay-out of dividend is two opposing effects:

·        It increases dividend thereby stock price rise.

·        It reduces the fund available for investment.

Walter’s Model:

Assumptions:

·        Retained earnings are the only source of financing investments in the firm, there is no external finance involved.

·        The cost of capital (ke) and the rate of return on investment (r) are constant i.e., even if new investment decisions are taken, the risk of the business remains same.

·        The firm has an infinite life.

Valuation Formula:

Professor James E. Walter argues 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 firm’s internal rate of return (r) and it’s cost of capital (k) in determining the dividend policy that will maximize the wealth of shareholders.

As per the equation (I), the price per share is two components:

  Ø The first component is the present value of an infinite stream of dividends.

  Ø The second component is the present value of an infinite stream of returns from retained earnings.

Three cases of model:

  v Growth firm:

The price per share increases as the dividend pay-out ratio decreases.

  v Normal firm:

The price per share does not vary with changes in dividend pay-out ratio.

  v Declining firm:

The price per share increases as the dividend per share increases.

Gordon Model

Proposed or model of stock valuation using the dividend capitalization approach.

Assumptions:

·        Retained earnings are the only source of financing for the firm.

·        The rate of return on the firm’s investment is constant.

·        The product of retention ratio b and the rate of return r gives us the growth rate of the firm g.

·        The cost of capital ke, is not only constant but greater than the growth rate i.e., ke > g.

·        The firm has a perpetual life.

·        Text does not exist.

Valuation Formula: 

P = Price per share

E = Earnings per share

b = Retention Ratio (1 – pay-out ratio)

r = Rate of return on the firm’s investments

ke = Cost of equity

br =Growth rate of the firm (g)

Miller-Modigliani Theorem

Modigliani and Miller argued that the value of firm is solely determined by the earning capacity of a firm's assets and split of earnings between dividend and retained earnings does not affect the shareholders wealth.

Assumptions:

    ·        Information is freely available.

    ·        No taxes.

    ·        Floatation and transaction cost do not exist.

    ·        Rational behaviour by investors.

    ·        Securities are divisible (split into any part).

    ·        Capital markets are perfectly exist.

    ·     Perfect certainty of future profit of firm.

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 firm's 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-M’s hypothesis of irrelevance is based on the following assumptions.

Risk of uncertainty does not exist. That is, investors can 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.

Valuation model:

Step 1- Market price of the share in the beginning of the period = Present value of dividends paid at the end of the period + Market price of shares at the end of the period.

Step 2- If the firm’s internal source of financing its investment opportunities fall short of the funds required, and n is the number of new shares issued at the end of the year 1 at price of P1 then equation:

The above equation of M-M valuation allows for the issuance of new shares, unlike Walter’s and Gordon’s model. 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 Walter’s and Gordon’s models.