Dividend Policy & theory

LEARNING OBJECTIVES

• Highlight the issues of dividend policy

• Critically evaluate why some experts feel that dividend policy

matters.

• Discuss the bird-in-the-hand argument for paying current

dividends.

• Explain the logic of the dividend irrelevance.

• Identify the market imperfections that make dividend policy

relevant.

• Understand information content of dividend policy.

2/11/2011 Prof. Anuj Verma 2

INTRODUCTION

Dividend policy involves the balancing of the

shareholders’ desire for current dividends and the firm’s

needs for funds for growth.

2/11/2011 Prof. Anuj Verma 3

Issues in Dividend Policy

• Earnings to be Distributed –High Vs. Low Payout.

• Objective –Maximize Shareholders Return.

• Effects –Taxes, Investment and Financing Decision.

2/11/2011 Prof. Anuj Verma 4

Relevance Vs. Irrelevance

• Walter's Model

• Gordon's Model

• Modigliani and Miller Hypothesis

• The Bird in the Hand Argument

• Informational Content

• Market Imperfections

2/11/2011 Prof. Anuj Verma 5

DIVIDEND RELEVANCE: WALTER’S MODEL

Walter’s model is based on the following assumptions:

• Internal financing

• Constant return and cost of capital

• 100 per cent payout or retention

• Constant EPS and DIV

• Infinite time

2/11/2011 Prof. Anuj Verma 6

Walter’s formula to determine the market price per share:

2/11/2011 Prof. Anuj Verma 7

Optimum Payout Ratio

• Growth Firms –Retain all earnings

• Normal Firms –Distribute all earnings

• Declining Firms –No effect

2/11/2011 Prof. Anuj Verma 8

Example: Dividend Policy: Application of Walter’s Model

2/11/2011 Prof. Anuj Verma 9

Criticism of Walter’s Model

• No external financing

• Constant return, r

• Constant opportunity cost of capital, k

2/11/2011 Prof. Anuj Verma 10

DIVIDEND RELEVANCE: GORDON’S MODEL

Gordon’s model is based on the following assumptions:

• All-equity firm

• No external financing

• Constant return

• Constant cost of capital

• Perpetual earnings

• No taxes

• Constant retention

• Cost of capital greater than growth rate 2/11/2011 Prof. Anuj Verma 11

Valuation

Market value of a share is equal to the present value of an

infinite stream of dividends to be received by shareholders.

2/11/2011 Prof. Anuj Verma 12

Example: Application of Gordon’s Dividend Model

2/11/2011 Prof. Anuj Verma 13

It is revealed that under Gordon’s model:

2/11/2011 Prof. Anuj Verma 14

DIVIDEND AND UNCERTAINTY: THE BIRD-IN-THE-HAND ARGUMENT

Argument was put forward by Kirshman.

Investors are risk averters. They consider distant

dividends as less certain than near dividends. Rate at

which an investor discounts his dividend stream from

a given firm increases with the futurity of dividend

stream and hence lowering share price

2/11/2011 Prof. Anuj Verma 15

DIVIDEND IRRELEVANCE: THE MILLER–MODIGLIANI (MM)

HYPOTHESIS

According to M-M, under a perfect market situation, the

dividend policy of a firm is irrelevant as it does not affect the

value of the firm. They argue that the value of the firm depends

on firm earnings which results from its investment policy. Thus,

when investment decision of the firm is given, dividend decision

is of no significance.

It is based on the following assumptions:-

• Perfect capital markets

• No taxes

• No risk

2/11/2011 Prof. Anuj Verma 16

2/11/2011 Prof. Anuj Verma 17

M M Hypothesis - An illustration

Po = 1/(1+Ke)*(D1+P1) ______________1 mP1= I-(E-nD1)_____________________2 nPo= 1/(1+Ke)*[(n+m)P1-I+E]_________3

Market Imperfections • Tax Differential –Low Payout Clientele

• Flotation Cost

• Transaction and Agency Cost

• Information Asymmetry

• Diversification

• Uncertainty –High Payout Clientele

• Desire for Steady Income

• No or Low Tax on Dividends

2/11/2011 Prof. Anuj Verma 18

Informational Content of Dividend

…. In an uncertain world in which verbal statements can be

ignored or misinterpreted, dividend action does provide a

clear cut means of ‘making a statement’ that speaks louder

than a thousand words.

—Solomon

2/11/2011 Prof. Anuj Verma 19