Dividend decision theories

The presentation takes the viewer through the following dividend decision theories:
1. Walter's Model
2. Gordon's Model
3. Miller Modigliani Theory

1. Dividend Decision Theories Ayush Jain

2. Contents Factors affecting dividend decision Walter’s Model Gordon’s Model Miller Modigliani Hypothesis

3. Factors Affecting Dividend Decision Nature of Entity’s Business Future investment prospects Legal Regulations Cash Flow Position Availability of Finance Expectations of Shareholders Past Dividends distributed Corporate Tax Policy General Economic Environment (Dividend of other firms)

4. Types of Dividend Theories

5. Walter’s Model

6. Assumptions to Walter’s Model Market Value of share is affected by present values of future expected dividends. Retained earnings of business affect the expectations from future dividends and consequently the market price of shares. The firm’s business risk does not change with increase in investment. This implies that the IRR (R a ) of project and Cost of Capital ( R c ) are constant. All future projects to be financed with retained earnings. The firm has an infinitely long life

7. Walter’s Formula Where, P = Market Price per share D = Dividend per share r = Rate of return on investment of the firm K e = Cost of Equity E = Earnings per share P = D + (r/ K e )(E-D) K e K e

8. Walter’s Model – Explanation As per this formula, if r> K e , the company should retain all earnings and invest in available projects; If r> K e , the company should distribute all the earnings as the shareholders can earn more than what the company can with retained amount; i f r= K e , the dividend is irrelevant and the dividend policy would not affect market value of the firm.

9. Walter’s Model – Explanation (contd.) Walter’s model states that the market price of shares is the sum of the capitalized value of the true value of the retained earnings (arrived at as a relation between the company’s return and the shareholder’s return) and the capitalized value of dividends P = D + (r/ K e )(E-D) K e K e

10. Gordon’s Model

11. Assumptions to Gordon’s Model Market Value of share is affected by present values of future expected dividends. Retained earnings of business affect the expectations from future dividends and consequently the market price of shares. The firm’s business risk does not change with increase in investment. This implies that the IRR (R a ) of project and Cost of Capital ( K e ) are constant. Also, K e >r All future projects to be financed with retained earnings. The growth rate of the firm is given by ‘g = br ’ where b is the retention ration The firm has an infinitely long life

12. Gordon’s Formula Where, P = Market Price per share E = Earning per share b = Retention ration r = rate of return on investment of the firm K e = Cost of equity br = growth rate of the firm P= E*(1-b) K e – br

13. Gordon’s Model – Explanation Gordon argues that the investors do have a preference for current dividends and a direct relationship between the dividend policy and the market price per share. Investors are risk averse and consider only the future dividends better than capital gains, and thus value it based on the expected returns in the future. Investors have a bird-in-the-hand preference.

14. Miller Modigliani Hypothesis

15. Assumptions to MM Approach Capital Markets are perfect, i.e. Information is freely available to all No transaction/floatation costs No investor large enough to affect the market price of the shares Investors behave rationally There are no taxes or there is no difference between the Corporate Taxes and the CDT. The firm has a fixed investment policy Infinitely divisible securities

16. MM Formula Where, P = Market price per share at the beginning of the year D 1 = Expected dividend at the end of the period P 1 = Market price per share at the end of the year K e = Cost of Equity capital P = D 1 + P 1 1+K e P 1 =P (1+K e )-D 1

17. MM Approach Explanation MM approach treats dividend as the irrelevant to the market price of the shares. The price at the end of the year will be offset by the dividend distributed by the company and in turn shall not affect the market price, so lower the dividend, higher the market price at the end of the period (as clearly visible in the second formula). Value of firm remains constant even on external finance since the EPS decreases with increase in share capital and thus causing the value of shares to go down.