Dividend Distribution Theories

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Chapter # 3:

Chapter # 3 Dividend Distribution Theories

What is Dividend?:

What is Dividend? Payments made to stockholders from the firm’s earnings, whether those earnings were generated in the current period or in previous periods. Portion of profit ( after tax ) distributed among owners/ shareholders of the firm. May be distributed in form of cash, scrip, property dividend or bonus shares.

Dividend Decision:

Dividend Decision One of the three basic decisions of a financial manager, the other two being investment decision and financing decision Decision as to whether the firm’s profits should be paid as dividend or retained and in what amount. Objective : Maximize wealth of shareholders, Increase the goodwill of the firm, Satisfy the obligations to shareholders.

Types of Dividends:

Types of Dividends Cash Dividend Scrip Dividend Bond Dividend Property Dividend Stock Dividend (Bonus Shares) Buy back of shares Share split

Advantages of Bonus Share:

Advantages of Bonus Share To the Shareholders Tax Benefit Indication of Higher Future Profit Future Dividends may increase Psychological value

Continue…….:

Continue……. To the Company Conservation of cash Only way top pay dividends under the financial difficulty and Contractual restrictions More Attractive Share Price Enhances Prestige Availability of Funds for Expansion Purpose

Disadvantages of Issue of Bonus Share:

Disadvantages of Issue of Bonus Share Shareholders wealth remain unaffected Costly to administrator Problem of adjusting EPS and P/E ratio

Theories of Dividend:

Theories of Dividend DIVIDEND THEORIES RELEVANCE THEORIES IRRELEVANCE THEORIES WALTER’S MODEL GORDON’S MODEL MODIHLIANI AND MILLER MODEL RESIDUAL MODEL

Relevance Theory :

Relevance Theory Dividend policy is very essential for any business firm as it affects the overall value of the firm. Dividend policy is relevant & dividend decision form a very integral part of the investment & financing decision of the firm. Shareholders prefer current dividends & hence there is a direct relationships between the dividend policy & the market value of the firm.

WALTER”S MODEL :

WALTER”S MODEL Dividend policy affects the value of the firm. Together, the cost of capital ( k ) and rate of return ( r) determine the dividend policy that will maximize the shareholders wealth.

WALTER’S MODEL-Assumptions :

WALTER’S MODEL-Assumptions The firm finances all investment through retained earnings while debt and new equity is not used. Business risk remains constant i.e., r & k are also constant. The firm has infinite life. The firm either goes for a 100% pay-out or a 100% retention of the firm.

Walter’s Model Equation:

Walter’s Model Equation P = DPS + ( r/k )( EPS – DPS ) k P = Market price per share DPS = Dividend per share EPS = Earnings per Share r = Firm’s rate of return K = Firm’s cost of capital

WALTER’S MODEL-Decision :

WALTER’S MODEL-Decision Condition Evaluation r>k r<k r=k Type of Firm Growth Firm Declining Firm Normal Firm Pay-out Ratio Zero 100% Indifferent Investment Opportunities Abundant None/ Very Low Optimal Decision Company Should retain all earnings for Investments Company should distribute all earnings in the form of Dividends Dividend does not affect the market price of the share.

WALTER’S MODEL-Criticisms:

WALTER’S MODEL-Criticisms No external financing Constant rate of Return on Investment Constant cost of Capital

GORDON’S MODEL:

GORDON’S MODEL Dividend policy is relevant to the value of the company. Also known as the ‘bird in hand’ argument Dividend policy is relevant as the investors prefer current dividends as against the future uncertain capital gains. Investors discount the firm’s earnings at lower rate when they are certain about returns, placing a higher value for the share and that of the firm.

GORDON’S MODEL-Assumptions :

GORDON’S MODEL-Assumptions No external financing is available. The firm has infinite life. Investors are basically risk-averse. The growth rate of firm ‘g’ is the product of its retention ratio ‘b’ and its rate of return ‘r’, i.e., g = br. The cost of capital is constant and also more than growth rate, i.e., k > g Corporate tax does not exist.

Gordon’s Model Equation:

Gordon’s Model Equation P = EPS ( 1 – b ) k- br P = Market price per share b = Retention Ratio (1-b) = Proportion of earnings of the firm distributed as dividends EPS = Earnings per Share r = Firm’s rate of return k = Firm’s cost of capital g= br = growth rate

GORDON’S MODEL - Decisions:

GORDON’S MODEL - Decisions If r > k >g :- company should distribute less dividend and retain high profit If r < k :- company should distribute more profits as dividend If r = k :- payout ratio is not affected by retention ratio.

Irrelevance Theory :

Irrelevance Theory Dividend policy is irrelevant to maximizing the shareholders wealth. Value of the firm is affected by the earning capacity of the firm i.e., the investment policy and not the dividend policy. Whether the firm retains its earnings or pays dividend, the market price of the share is indifferent towards it.

MOGIGLIANI & MILLER MODEL :

MOGIGLIANI & MILLER MODEL Modigiliani and Miller were two supporters of the irrelevance concept. The value of the firm is not affected by the decision of pay-out or plough-back.. Firms’ dividend policy have no influence on the market price of the shares.

MM’S MODEL-Assumptions :

MM’S MODEL-Assumptions Perfect capital market. There are no taxes. Investment policy is fixed. No flotation cost on issue of shares. Investors behave rationally.

MM’s Model Equation:

MM’s Model Equation P0 = Div1 + P1 k P 0 = Market price per share at time 0 P1 = Market price per share at time 1 Div1 = Expected dividend at time 1 k = Firm’s cost of capital

MM’S MODEL-Concept :

MM’S MODEL-Concept MM model is based on arbitrage argument. Arbitrage is entering simultaneously in two transactions which balance each other. Between dividend and retention of earnings the investors would be indifferent due to balancing nature of internal financing and external financing. So, the firm is indifferent towards the dividend decision.

MM’S MODEL-Criticisms :

MM’S MODEL-Criticisms It is wrong to assume that there are no taxes, flotation costs do not exist and there is absence of transaction costs. There is perfect capital market condition is not always true

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