Dividend Decision & Valuation of Firm Dept. of Business and Financial Studies University of Kashmir

Dividend Decision & Valuation of Firm:

Dividend Decision & Valuation of Firm Learning Goals: D ividend decision: what it is all about? D ividend decision & valuation of firm: Walters model Gordon’s model Linters model Graham & Dods model M-M Hypothesis

Dividend Decision & Valuation of Firm:

Dividend Decision & Valuation of Firm Dividend Decision Amt. distributed among shareholders Amount of earnings to be retained Impact on Internal source of finance Increases current wealth Information value

Dividend Decision & Valuation of Firm:

Dividend Decision & Valuation of Firm High payout: Less retained earnings…..slower growth perhaps lower MP Low payout: More RE…. Higher growth….higher capital gain….perhaps higher MP. Payout Ratio Low High

Dividend Decision & Valuation of Firm:

Dividend Decision & Valuation of Firm Q: Does div. decision influence Value of a shares D ividend Models: Walter’s Model Gordon’s Model Relevant Linter’s Model Graham & Dodd’s Model M-M Hypothesis……… Irrelevant

Walters Model:

Walters Model C ontention: C 1: Div. Decision influences Value of a share……..Optimum P/O Ratio E 1: Relationship between IRR & K Used in determining optimum Decision E 2: Classifies companies into: Growing, Normal, & Declining

Walters Model:

Walters Model Less fin. Resources Req. more funds Difficult to obtain funds Suff. Investment opportunities r > k Sufficient resource Req. less funds Access to funds Less feasible Investments opp. R=k Little res.Req Little access Revamping R<k Growth Matured Declining

Walters Model:

Walters Model A ssumptions: A 1: Only retained earnings used to Finance investments. A 2: IRR & K remains constant A 3: All earnings are either distributed or reinvested internally immediately A 4: EPS & Dividends never change A 5: Firm has infinite life

Walters Model:

Walters Model G rowth Firm………..r > k C: Optimum payout ratio is zero E: Able to reinvest at a rate… higher than k R esult At zero payout ratio, weighted benefit of RE will be more than the dividends

Walters Model:

Walters Model N ormal Firm………..r = k C: No optimum payout ratio E: Able to invest at a rate……=k R esult: At any payout ratio, weighted benefit of RE is equal to that of dividends .

Walters Model:

Walters Model D eclining Firm………r < k C: Optimum payout ratio is 100% E: No investment opp. or can earn Less than the rate expected by...

Walters Model:

Walters Model D + (r/k) ( E – D ) P = -------------------------- k Where: P = Market price of share D = Dividend per share r = IRR k = cost of capital E = EPS P = P resent value of stream of dividends & Capital gain Valuation of Shares

Walters Model:

Walters Model E xample: The following estimates about three companies viz., A, B, & C are given: A B C R …………15% 10% 8% K………….10% 10% 10% EPS………Rs 10 Rs 10 Rs 10

Walters Model:

Walters Model Payout Ratio = zero Div = 0 0+(.15/.10) (10-0) .10 = Rs 150 Div = 0 0+(.10/.10)(10-0) .10 = Rs 100 Div = 0 0+(.08/.10) (10-0) .10 = Rs 80 Payout ratio = 40% Div = 4 4+(.15/.10) (10- 4) .10 = Rs 130 Div = 4 4+(.10/.10)(10- 4) .10 = Rs 100 Div = 4 4+(.08/.10) (10- 4) .10 = Rs Payout ratio = 100% Div =10 10+(.15/.10)(10-10) .10 = Rs 100 Div =10 0+(.10/.10)(10-10) .10 = Rs 100 Div =10 0+(.08/.10)(10-10) .10 = Rs 100 Payout Ratio = zero Div = 0 0+(.15/.10) (10-0) .10 = Rs 150 Div = 0 0+(.10/.10)(10-0) .10 = Rs 100 Payout Ratio = zero Div = 0 0+(.15/.10) (10-0) .10 = Rs 150 Div = 0 0+(.08/.10) (10-0) .10 = Rs 80 Div = 0 0+(.10/.10)(10-0) .10 = Rs 100 Payout Ratio = zero Div = 0 0+(.15/.10) (10-0) .10 = Rs 150 Div = 4 4+(.08/.10) (10- 4) .10 = Rs Div = 0 0+(.08/.10) (10-0) .10 = Rs 80 Div = 0 0+(.10/.10)(10-0) .10 = Rs 100 Payout Ratio = zero Div = 0 0+(.15/.10) (10-0) .10 = Rs 150 Payout ratio = 40% Div = 4 4+(.08/.10) (10- 4) .10 = Rs Div = 0 0+(.08/.10) (10-0) .10 = Rs 80 Div = 0 0+(.10/.10)(10-0) .10 = Rs 100 Payout Ratio = zero Div = 0 0+(.15/.10) (10-0) .10 = Rs 150 Div = 4 4+(.10/.10)(10- 4) .10 = Rs 100 Payout ratio = 40% Div = 4 4+(.08/.10) (10- 4) .10 = Rs Div = 0 0+(.08/.10) (10-0) .10 = Rs 80 Div = 0 0+(.10/.10)(10-0) .10 = Rs 100 Payout Ratio = zero Div = 0 0+(.15/.10) (10-0) .10 = Rs 150 Div = 4 4+(.15/.10) (10- 4) .10 = Rs 130 Div = 4 4+(.10/.10)(10- 4) .10 = Rs 100 Payout ratio = 40% Div = 4 4+(.08/.10) (10- 4) .10 = Rs Div = 0 0+(.08/.10) (10-0) .10 = Rs 80 Div = 0 0+(.10/.10)(10-0) .10 = Rs 100 Payout Ratio = zero Div = 0 0+(.15/.10) (10-0) .10 = Rs 150 Payout ratio = 100% Div = 4 4+(.15/.10) (10- 4) .10 = Rs 130 Div = 4 4+(.10/.10)(10- 4) .10 = Rs 100 Payout ratio = 40% Div = 4 4+(.08/.10) (10- 4) .10 = Rs Div = 0 0+(.08/.10) (10-0) .10 = Rs 80 Div = 0 0+(.10/.10)(10-0) .10 = Rs 100 Payout Ratio = zero Div = 0 0+(.15/.10) (10-0) .10 = Rs 150 Div =10 10+(.15/.10)(10-10) .10 = Rs 100 Payout ratio = 100% Div = 4 4+(.15/.10) (10- 4) .10 = Rs 130 Div = 4 4+(.10/.10)(10- 4) .10 = Rs 100 Payout ratio = 40% Div = 4 4+(.08/.10) (10- 4) .10 = Rs Div = 0 0+(.08/.10) (10-0) .10 = Rs 80 Div = 0 0+(.10/.10)(10-0) .10 = Rs 100 Payout Ratio = zero Div = 0 0+(.15/.10) (10-0) .10 = Rs 150 Div =10 0+(.10/.10)(10-10) .10 = Rs 100 Div =10 10+(.15/.10)(10-10) .10 = Rs 100 Payout ratio = 100% Div = 4 4+(.15/.10) (10- 4) .10 = Rs 130 Div = 4 4+(.10/.10)(10- 4) .10 = Rs 100 Payout ratio = 40% Div = 4 4+(.08/.10) (10- 4) .10 = Rs Div = 0 0+(.08/.10) (10-0) .10 = Rs 80 Div = 0 0+(.10/.10)(10-0) .10 = Rs 100 Payout Ratio = zero Div = 0 0+(.15/.10) (10-0) .10 = Rs 150 Div =10 10+(.08/.10)(10-10) .10 = Rs 100 Div =10 10+(.10/.10)(10-10) .10 = Rs 100 Div =10 10+(.15/.10)(10-10) .10 = Rs 100 Payout ratio = 100% Div = 4 4+(.15/.10) (10- 4) .10 = Rs 130 Div = 4 4+(.10/.10)(10- 4) .10 = Rs 100 Payout ratio = 40% Div = 4 4+(.08/.10) (10- 4) .10 = Rs Div = 0 0+(.08/.10) (10-0) .10 = Rs 80 Div = 0 0+(.10/.10)(10-0) .10 = Rs 100 Payout Ratio = zero Div = 0 0+(.15/.10) (10-0) .10 = Rs 150

Gordon’s Model:

Gordon’s Model C ontention: C 1: Div. Decision Influences Value of Firm ………… Optimum P/O Ratio D etermination: D 1: Used IRR & K in determining optimum Pay out Ratio D 2: Classifies companies into Growth, Normal, & Declining.

Gordon’s Model:

Gordon’s Model P repositions of Gordon r > k Zero r < k 100% r = k….Irrelevant

Gordon’s Model:

Gordon’s Model Assumptions A 1: Firm is all equity A 2: Uses RE to finance investments. A 3: IRR & K remains constant A 4: Retention ratio once decided remains constant A 5: No corporate taxes A 6: Firm derives its earnings perpetually

Gordon’s Model:

Gordon’s Model C 2: If risk is considered then, P/ratio would influence Value even when r = k A ssumptions: A 1: Rational investors are risk averse A 2: Prefer nearer Div. than distant Div. A 3: Expect risk premium when retained

Gordon’s Model:

Gordon’s Model E ffects of Retention: E 1: Retention means postponement of current Div. in promise of more future div…………….. Risk E 2: More the risk, more the k….. based on Bird-In-The-Hand argument

Gordon’s Model:

Gordon’s Model B ird-in-the-Hand Argument One Bird in a hand is better than 2 birds in a bush Shareholders Prefer Nearer Div. Over Distant Dividends K rishman: Two identical stocks, one paying more dividend will have more MP.. vice versa

Gordon’s Model:

Gordon’s Model Relationship between p/ratio & k DR(k) RR(b ) Conclusion More the retention, more risk, more the k…less MP Less the retention, less risk, less the k… more MP K

Gordon’s Model: Valuation of shares:

Gordon’s Model: Valuation of shares D1 D2 Dn P = ------ +------ …..+----- (1+k) (1+k) (1+k ) W here: P = Market price of share D = Dividend per share r = IRR k = cost of capital E = EPS b = Retention ratio P = present value of stream of dividends E1 ( 1 – b ) = -------------------- k - br

Gordon’s Model: Valuation of shares:

Gordon’s Model: Valuation of shares 20 (1- 0.2) .11 – (0.2 x 0.08) = Rs 1,000 20 (1- 0.2) .11 – (0.2 x 0.11) = Rs 100 20 (1- 0.2) .11 – (0.2 x 0.12) = Rs 186 Payout Ratio = 80% 20 (1- 0.6) .11 – (0.6 x 0.12) = Rs 210 20 (1- 0.6) .11 – (0.6 x 0.11) = Rs 100 Payout Ratio = 40% 20 (1- 0.6) .11 – (0.6 x 0.08) = Rs 129 r = 8, k= .11 20 (1- 0.9) .11 – (0.9 x 0.08) = Rs 52.63 r =. 11, k=.11 20(1- 0.9) .11 – (0.9 x 0.1I) = Rs 181 Payout Ratio = 10% r =.12, k = .11 20 (1- 0.9) .11 – (0.9 x 0.12) = Rs 1,000

M-M Hypothesis :

M-M Hypothesis C ontention: P/ratio does not influence Value of a Firm Arguments: A1: Value…….. earning capacity & earnings …….investment decisions. A2: When company Retains, investor enjoys C/gain = amount of RE. When company pays investor enjoy Div. in value = amount of C/gain

M-M Hypothesis :

M-M Hypothesis A 3: Benefit of Div. is offset by external financing A 4: Shareholders are indifferent to Dividend Decision……..able to Construct Own Div. Policy

M-M Hypothesis :

M-M Hypothesis A ssumptions: A 1: Perfect capital market Easy to buy & sell No buyer/seller large enough to influence MP Access to information No transaction costs Securities are divisible A 2: Rational investors

M-M Hypothesis :

M-M Hypothesis A 3: No risk of uncertainty (dropped ) A 4: No corporate taxes …(no diff.) A 5: k & r is identical for all the shares A 6: IRR = k

M-M Hypothesis :

M-M Hypothesis C onclusion: C 1 : When r=k, then weighted benefit of RE will be equal to weighted benefit of Div…V constant C 2 : When r is same, no shift will take place from low yielding companies to high yielding companies.

M-M Hypothesis :

M-M Hypothesis V aluation of shares: P1 = Po ( 1 + k ) – D1 W here: P1 = market price per share at time 1 Po = market price per share at time 0 K = dr or cost of capital= r D1 = dividend per share at time 1

M-M Hypothesis :

M-M Hypothesis Example: ABC Comp. currently has outstanding 1,00,000 shares, selling at Rs 100 each. It is thinking to pay a div. of Rs 5 Ps at t1. K is 10%. What will be the price of the share if: A div. is not paid. A div. is paid @ Rs 5 per share. How many new shares are to be sold, if the company requires Rs 20 lakhs & the net profit is Rs 10 lakhs?

M-M Hypothesis:

M-M Hypothesis P 1 = Po ( 1 + k ) – D1 Po = Rs 100 K = 0.10 D1 = 0.0 P 1 = 100(1 + 0.10) –0……= 110 P 1 = 100(1 + 0.10) –5……= 105

M-M Hypothesis:

M-M Hypothesis No of shares: ∆np1 = I – ( E – D1 ) Where: ∆np1 = change in MP of share = 105 I = amount to be invested = 20 lacs E = earnings ……………... = 10 lacs D1 = Div. at t = 1………….. = 5 lacs ∆n105 = 20,00,000 – ( 10,00,000 -5,00,000) ∆n105 = 20,00,000 – 5,00,000 ∆n = 15,00,000 105 = 14,285

Traditional Approach:

Traditional Approach Advocated by Gram & Dodd A rguments: A1: Div. Dec. is a relevant………Influences value A2: Stock market places considerable Weight age on Div. than RE Weight assigned to DIV is 3 times the weight assigned to RE P = m( D + E/3 )

Traditional Approach:

Traditional Approach C riticism: Based on subjective judgment rather than on empirical evidence E xplanation E 1: Hypothesis Based on empirical evidence…..cite results of cross section regression analysis E 2: DIV. coefficient is much higher than RE .

Traditional Approach:

Traditional Approach Analysis: Conclusions reached by Gram & Dodd are not justified R 1: Omits risk……….., thus Distorts results R 2: Measurement of earnings Is subject to error… Transmitted to RE....... Coefficient is biased

Traditional Approach:

Traditional Approach

Traditional Approach:

Traditional Approach

Traditional Approach:

Traditional Approach

You do not have the permission to view this presentation. In order to view it, please
contact the author of the presentation.

Send to Blogs and Networks

Processing ....

Premium member

Use HTTPs

HTTPS (Hypertext Transfer Protocol Secure) is a protocol used by Web servers to transfer and display Web content securely. Most web browsers block content or generate a “mixed content” warning when users access web pages via HTTPS that contain embedded content loaded via HTTP. To prevent users from facing this, Use HTTPS option.

By: mohan.chandra (119 month(s) ago)

this is useful to my ppt presentation