Different models of dividend policy

Some of the major different theories of dividend in financial management are as follows: 1. Walter’s model 2. Gordon’s model 3. Modigliani and Miller’s hypothesis.

On the relationship between dividend and the value of the firm different theories have been advanced.

1. Presented By:- Anju Pal Ashish Kanyal Gaurav Verma Sunny Mervyne Baa Different Models Of Dividend Policy

2. Walter’s Theory on Dividend Policy

3. Relation of Dividend Decision and Value of a Firm

4. Gordon’s Theory on Dividend Policy

5. Assumptions of the Model Gordon’s model is based on the following assumptions:

6. Gordon’s formula to calculate the market price per share (P) is P = {EPS * (1-b)} / (k-g) Where, P = market price per share EPS = earnings per share b= retention ratio of the firm (1-b) = payout ratio of the firm k = cost of capital of the firm g = growth rate of the firm = b*r Valuation Formula and its Denotations

7. The above model indicates that the market value of the company’s share is the sum total of the present values of infinite future dividends to be declared. The Gordon’s model can also be used to calculate the cost of equity, if the market value is known and the future dividends can be forecasted. Explanation

8. Gordon’s theory on dividend policy is criticised mainly for the unrealistic assumptions made in the model. ◾Constant Internal Rate of Return and Cost of Capital: The model is inaccurate in assuming that r and k always remain constant. A constant r means that the wealth of the shareholders is not optimized. A constant k means the business risks are not accounted for while valuing the firm . ◾No External Financing: Gordon’s belief of all investments being financed by retained earnings is faulty. This reflects sub-optimum investment and dividend policies. Criticism of Gordon’s Model

9. Gordon’s theory of dividend policy is one of the prominent theories in the valuation of the company. Though it comes with its own limitations, it is a widely accepted model to determine the market price of the share using the forecasted dividends. Summary

10. Modigliani- Miller Theory on Dividend Policy

11. Modigliani – Miller theory is a major proponent of ‘Dividend Irrelevance’ notion. According to this concept, investors do not pay any importance to the dividend history of a company and thus, dividends are irrelevant in calculating the valuation of a company. This theory is in direct contrast to the ‘Dividend Relevance’ theory which deems dividends to be important in the valuation of a company. Modigliani – Miller theory

12. Modigliani – Miller theory was proposed by Franco Modigliani and Merton Miller in 1961. They were the pioneers in suggesting that dividends and capital gains are equivalent when an investor considers returns on investment. The only thing that impacts the valuation of a company is its earnings, which is a direct result of the company’s investment policy and the future prospects. So, according to this theory, once the investment policy is known to the investor, he will not need any additional input on the dividend history of the company. The investment decision is, thus, dependent on the investment policy of the company and not on the dividend policy.  Modigliani – Miller theory goes a step further and illustrates the practical situations where dividends are not relevant to investors. Irrespective of whether a company pays a dividend or not, the investors are capable enough to make their own cash flows from the stocks depending on their need for the cash. If the investor needs more money than the dividend he received, he can always sell a part of his investments to make up for the difference. Likewise, if an investor has no present cash requirement, he can always reinvest the received dividend in the stock. Thus, the Modigliani – Miller theory firmly states that the dividend policy of a company has no influence on the investment decisions of the investors . This theory also believes that dividends are irrelevant by the arbitrage argument. By this logic, the dividends distribution to shareholders is offset by the external financing . Due to the distribution of dividends, the price of the stock decreases and will nullify the gain made by the investors because of the dividends. This theory also implies that the cost of debt is equal to the cost of equity as the cost of capital is not affected by the leverage. Crux of Modigliani-Miller Model

13. Assumptions of the Model

14. Modigliani – Miller’s valuation model is based on the assumption of same discount rate / rate of return applicable to all the stocks. P1 = P0 * (1 + k) – D Where, P1 = market price of the share at the end of a period P0 = market price of the share at the beginning of a period k = cost of capital D = dividends received at the end of a period Valuation Formula and its Denotations

15. Criticism of Modigliani Miller’s Model

16. Modigliani – Miller theory of dividend policy is an interesting and a different approach to the valuation of shares. It is a popular model which believes in the irrelevance of the dividends. However, the policy suffers from various important limitations and thus, is critiqued regarding its assumptions. Summary