Dividend Policy

Prof. Harnesh Makhija

 Theories of Dividend Policy

 Relevance of Dividend

 Irrelevance of Dividend
 Dividend Relevance

 It implies that shareholders prefer current dividends

and there is no direct relationship between dividend
policy and market value of a firm.

1. Gordon’s Model
2. Walter’s Model
 Gordon’s Model

 The main preposition of the Model is that the value

of share s reflects the value of future dividend
occurring to that shares. Hence, dividend payment
and its growth are relevant in valuation of shares.
 Po = 𝐾𝑒−𝑔 Po = 𝐸1(1−𝑏)
𝐷𝑜(1+𝑔)
𝐾𝑒 −𝑏𝑟
Where,
Do = Current year dividend
D1 = Expected Dividend
Po = Current market price of share
Ke = Cost of capital
g = Expected future growth rate of dividend
 Gordon’s Model

 Po =
𝐸1(1−𝑏)
𝐾𝑒 −𝑏𝑟
Po = 𝑟𝐴(1−𝑏)
𝐾𝑒 −𝑏𝑟

Where,
E1 = Expected EPS
b = Retention Ratio
(1-b) = Dividend Payout ratio
Ke = Cost of capital
br = g = Growth rate of earnings and dividends
r = Rate of return earn on investment
A = Investment per share
 Example on Gordon Model

 The following information is available in respect of the rate of return

on investment (r), the capitalization rate (Ke), and EPS (E) of XYZ
Ltd. r = 12%, E = Rs.20
 Determine the value of shares assuming the following:
D/P ratio (1-b) Retention Ratio (b) Ke (%)
A 10 90 20
B 20 80 19
C 30 70 18
D 40 60 17
E 50 50 16
F 60 40 15
G 70 30 14
 Solution
D/P ratio Calculations Po
(1-b)

A 10 Rs.21.74
B 20 Rs.42.55
C 30 Rs.62.50

D 40 Rs.81.63

E 50 Rs.100

F 60 Rs.117.65

G 70 Rs.134.62
 Walter’s Model

 Prof. James Walter argued that in the long run the

share price reflects only the present value of
dividend. Retention influence stock price only
through their effect on future dividends.

 Walter relates returns on firms investment or

Internal Rate of return (Ra) and its cost of capital the
required rate of return(Rc)
 Prepositions

 r >k (IRR >Cost of capital)

 r<k (IRR < Cost of capital)

 r=k (IRR = Cost of capital)

 r>k (IRR >Cost of capital)

 If the firm can earn higher IRR then the cost of

capital, the firm can retained earnings.
 Such firms are called “Growth Firm”.
 Their policy would be to plough back the earnings.
 The optimum dividend payout ratio for such firm is
“Zero”
 Having inverse relationship between dividend and
market price.
 Having direct relationship between retention and
market price.
 r<k (IRR <Cost of capital)

 If the firm can earn lower IRR then the cost of

capital, the firm can distribute earnings as dividend.
 Such firms are called “Declining Firm”.
 Their policy would be to back the earnings.
 The optimum dividend payout ratio for such firm is
“100%”
 Having Direct relationship between dividend and
market price.
 Having inverse relationship between retention and
market price.
 r=k (IRR=Cost of capital)

 If the firm IRR is equal to cost of capital, it is matter

of indifference whether earnings are retained or
distributed.
 Such firms are called “Normal Firm”.
 There is no optimum dividend policy for such firm.
Walter’s Model Formulation
 Example

 The EPS of a company is Rs.8 and the rate of capitalization

applicable is 10%. The company has before it, an option of
adopting (i) 50, (ii) 75 and (iii) 100 percent dividend payout
ratio. Compute market price of the company’s quoted shares as
per Walter’s Model if it can earn a return of (a) 15, (b) 10 and
(c) 5% on its retained earnings.
 Irrelevance of Dividend

 It implies that the value of a firm is unaffected by the

distribution of dividends and is determined solely by
the earning power and risk of its assets

 Modigliani and Miller (MM) Hypothesis

 Modigliani and Miller (MM) Hypothesis

 MM maintain that dividend policy has no effect on the

share price of the firm.
 The firm has two alternatives:
(i) It can retain its earnings to finance the investment
programme.
(ii) Distribute the earnings to the shareholders as
dividend and raise an equal amount externally
through the sale of new shares/bonds for the
purpose.
 If the firm select second option the effect of dividend
payment on shareholders wealth will be exactly offset
by the effect of raising additional shares.
 MM Formulation

Po = (1+𝐾𝑒)
𝐷1+𝑃1

Where,
D1 = Dividend to be received at the end of period 1,
P1 = Market price of a share at the end of period 1,
Po = Prevailing market price of share
Ke = Cost of equity capital

Price of shares with new issue of securities

nPo = 𝑛+∆𝑛 𝑃1−𝐼+𝐸

(1+𝐾𝑒)
Where,
n = Number of shares outstanding at the beginning of the period,
△n = Additional shares issued,
P1 = Market price of shares at the end of period 1,
I = Total amount of investment
E = Earnings of the firm during the period,
Ke = Cost of equity capital
 Cont.….

 Number of new shares to be issue:

△n = 𝐼 −(𝐸−𝑛𝐷1)
𝑃1

Where,
n = Number of shares outstanding at the beginning of the period,
△n = Additional shares issued,
P1 = Market price of shares at the end of period 1,
I = Total amount of investment
E = Earnings of the firm during the period,
 Example

 Omega company has a cost of equity capital of 10%,

the current market value of the firm is Rs.2000000
(@ Rs.20 per share). Assume values for investment,
earnings and dividends at the end of the year as
Rs.680000, Rs.150000 and Re.1 per share. Show
that under MM assumption, the payment of dividend
does not affect the value of the firm.