dividend policy and valuation

By

Sumit Gulati

MD & CEO, FinanceKnowledgeHub

Author of the book on ‘Financial Management’

Published by Mcgraw Hill

Dividend Theories and

Valuation

Corporate Finance

Dividend refers to the payout in full or part of net earnings of the

firm to the shareholders in proportion to the number of shares

held by them.

The proportion of dividend payout from net earnings is called the

dividend payout ratio.

Proportion of retained earnings out of net earnings in called

retention ratio.

Shareholders’ wealth depends on the present payout of dividend

and the market price of firm’s share.

Introduction

The primary objective of the dividend policy is to maximise

shareholders’ wealth.

Shareholders get their return in two forms, i.e. dividend and

capital gains.

The main objective of the dividend policy is to bifurcate the

earnings into two parts.

The issue of dividend policy and value of the firm have been

studied by many researchers who have proposed various

theories.

Issues in Dividend Policy

Relevance Vs. Irrelevance

Walter's Model

Gordon's Model

The Bird in the Hand Argument

Residual Theory of Dividends

Modigliani and Miller Hypothesis

Informational Content

Market Imperfections

4

The relevance theory says that the dividend policy decision of the firm is important and relevant to the total wealth of shareholders and the value of the firm.

The two models under relevance theory are:

Walter’s Model: Professor James E. Walter states that the decision regarding the

dividend payout, almost always influences the value of the firm.

Assumptions for Walter’s model are: Internal financing (No external financing) Constant cost of capital and rate of return Fixed EPS and DPS Infinite life

Relevance of Dividends

Walter’s formula to determine the

market price per share:

Where,

P = Market price of share

DPS = Dividend per share

EPS = Earnings per share

k = Cost of capital

r = Rate of return

In the Walter’s Model, the dividend policy is determined by the

presence of investment options and the relationship between the

firm’s internal rate of return (r) and cost of capital (k).

The decision would be:

Where r > k, retain all earnings (0 per cent payout ratio)

Where r < k, distribute all earnings (100 per cent payout ratio)

Where r = k, dividend policy does not affect the share price. Hence,

any payout ratio can be chosen.


Example:

The earnings per share of a company is Rs 20. The market rate of

discount applicable to the company is 15%. Retained earnings can

be employed to yield a return of 10%. The company is considering

a pay-out of 30%, 60% and 80%. Which of these would maximize

the wealth of shareholders?


Solution:

In the given case EPS = 20, k = 15%, r = 10%

As per Walter’s Model, the price of a share is:



As can be seen from the above calculations the wealth of the

shareholders will be maximum when the company follows a

payout ratio of 80%. It is also evident from the fact that the rate

of return of the firm, r, is 10% whereas the required rate of

return of the investors is 15% i.e. r < k.

Criticism of Walter’s Model

Zero external financing: In real life a firm would like to optimize

both investment decision and dividend decision including the use of

external financing, if required.

Constant return, r: ‘r’ is based on the type of investment

opportunities a firm is able attract. If a firm is getting very profitable

opportunities the value of ‘r’ may go up.

Constant opportunity cost of capital, k: The cost of capital of a

firm depends upon the risk level of operations of the firm. With the

induction of more new projects the risk profile of the firm may

undergo change.

11

Gordon’s Model

Myron Gordon developed a model to determine market value of

shares in relation to dividend policy.

The main assumptions of Gordon’s Model are:

The firm is an all equity firm

All investments are financed by retained earnings

The internal rate of return (r) and cost of capital (k) of the firm is constant.

The firm and its earnings are perpetual

There are no corporate taxes

The retention ratio is constant and therefore growth rate is also constant

The cost of capital is greater than growth rate


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

infinite stream of dividends to be received by shareholders.

The above equation shows the effect of dividend policy on the market price of firm’s share. It indicates the relationship of the following parameters with the market price of firm’s share.

Earnings per share (EPS1)

Retention ratio (b)

Rate of return (r)

Cost of capital (k)

Decision with Gordon model would be : Growth firm, where r > k

In this case as the retention ratio is increased, the market price

of share will increase and the value of the firm will go up.

Declining firm, where r < k

In such a situation, it is better to adopt the policy of disinvestment. The shareholders would avoid any investment in the firm out of earnings.

Normal firm, where r = k When r = k, the dividend policy is irrelevant.


Example:

A firm has total investment in assets of Rs 7,00,000 and 70,000

outstanding equity shares of Rs 10 each. It earns a rate of 20%

on its investments, and follows a policy of paying 60% of the

earnings as dividends. If the discount rate for the firm is 10%,

find out the price of its share using Gordon’s Model. What will be

the price, if the company has a payout of 70% or 30%?


Solution:

The Gordon’s share valuation model is as under:

Where,

b = Retention ratio = 0.40 or 0.30 or 0.70

k = discount rate = 0.10

r = rate of return = 0.20

EPS1 = Rs 2.0


In the last case, the share price is negative which is unrealistic. In such case where cost of capital is less than the growth rate, Gordon share valuation is not applicable


As per Gordon’s Model, the dividend policy is irrelevant for

normal firm where r = k.

Under more realistic assumptions; Gordon states that the

dividend policy does affect value of the firm’s share even when r

= k.

The shareholders many a times act on the principle of ‘a bird in

the hand is better than two in the bush’.

Shareholders are willing to pay higher share price for the share

with higher current dividend.

The Bird-in-the-Hand Argument

Gordon emphasizes that the rate at which an investor discounts

the future dividends increases with futurity of the dividends.

Increasing the retention ratio would lead to raising the discount

rate k’ and correspondingly reducing the share price.

The Bird-in-the-Hand Argument

As per the irrelevance theory shareholders’ are indifferent

whether they are paid dividend in the present or capital gain in

the future.

The two theories under irrelevance theory are:

Residual Theory of Dividends:

The theory of paying dividends out of the residual funds after meeting

the requirement of the firm’s investment opportunities is called

residual theory of dividend policy.

The residual theory treats the dividend as a passive decision based

on the availability of profitable projects.

Irrelevance of Dividend

The Miller-Modigliani (MM) Hypothesis

As per MM, under perfect market situation, the dividend policy of a

firm does not affect the value of the firm.

The main argument of MM is that the value of a firm depends upon its

earnings which are the result of its investment policy.

The key concept of the MM hypothesis is that the shareholders do

not necessarily depend on the dividends to get cash.


The Miller-Modigliani (MM) Hypothesis

A firm operating under perfect market conditions can find three

possible situations:

The firm possesses enough cash in order to pay dividends: While the shareholders get cash on account of payment of dividends, the firm’s assets (cash balance) reduce accordingly. Hence total wealth of shareholders remains unchanged.

The firm does not have enough cash and therefore it issues

new shares to generate cash to be able to pay dividends: The existing shareholders transfer a portion of their claim on the assets of the firm to new shareholders in exchange for the cash received. Thus, the value of the firm remains unchanged.


The firm does not pay dividends, but shareholders require

cash: The shareholders can sell a part of their holding and

generate cash. This cash is generally referred to as home-made

dividend.

The shareholders will now have less claim on the assets of the

firm .

The value of the firm will remain unchanged.


Assumptions for MM Hypothesis: Capital markets are perfect:

No single investor is so large as to affect the market price of the firm’s share.

The investors behave rationally Total information is freely available to all investors There are no transaction costs

Floatation costs do not exist

Zero taxes: The money in the form of dividends and capital gains has same value.

Fixed investment policy

No risk of uncertainly: A single discount rate is applicable for all time periods.


In the MM hypothesis, rate of return for shares held for one year

will be,

Where,

P0 = Market price of share at time 0

P1 = Market price of share at time 1

So,

Under the assumptions of certainty and perfect markets, r = k


MM hypothesis permits issue of new shares and raise funds to undertake optimum investment.

The value of new shares to be issued will be:

mP1 = I1 – (X1 – nDPS1)

Where,

I1 = Total amount of investment in period 1

X1 = Net profit of investment in period 1

n= number of shares outstanding

The firm sells m new shares at time 1 at price P1

The value of the firm:

Where,

V = the total value of the firm (V)


Example:

A company has 20,000 outstanding shares selling at Rs 120 each. It has a cost of capital as 5%. The firm intends to declare Rs 12 dividend at the end of the current fiscal year. Given the assumption of MM, calculate;

The price of the shares at the end of the year:

If a dividend is not declared

If dividend is declared

Assuming that the firm pays the dividend and has a net income of Rs

6,00,000 and makes new investments of Rs 9,00,000 during the period, how many new shares must be issued?

What would be the current value of the firm:

If a dividend is not declared

If dividend is declared


Solution:

P1 = Po * (1 + k) – DPS

= 120 (1 + 0.05) – 12

= Rs 114

However, if the dividend of Rs 12 is not paid, the price of the share would be:

P1 = Po * (1 + k)

= 120 * (1 + 0.05) – 0

= Rs 126

Issue of new shares if dividend is paid:

m * P1 = I1 – (X1 – n * DPS1)

m * 114 = 9,00,000 – [6,00,000 – 2,40,000] m * 114 = 9,00,000 – 3,60,000 m * 114 = 5,40,000

m = 4,737 Shares


Current value of the firm:

If the dividend of Rs 12 is paid, P1 is Rs 114 and the current value is:

nPo = Rs 24,00,017

If the dividend of Rs 12 is not paid, the value of the firm would be:

New shares to be issued, m = 2,381 Shares

The current value of the firm, nPo = Rs 24,00,006


Because of unrealistic nature of the assumptions, the MM

hypothesis lacks practical relevance.

For Example,

Perfect capital market conditions may not exist

Floatation cost for new issues may exist

Dividends and capital gains may be taxed differently

Investors may encounter transaction costs

Future prices and dividends may not be forecast with certainty

Market Imperfections and Relevance of Dividend

Policy

The situations under which the MM hypothesis may go wrong are:

Shareholders’ Preference for Current Income:

MM refutes the Bird in hand argument

MM argues that market price of two identical firms with same

capital structure and risk level cannot be different.

For some firms, high payout clientele may exist not due to the

consideration of current dividend as safer, but for three

different reasons :

o Doubt due to lack of proper communication by firm

o Some shareholders require steady income

o Some shareholders want do diversify their portfolio


Policy

Internal and External Financing and Shareholders’ Preference

for Dividends:

External Financing has the presence of the following due to which in

internal and external financing the wealth of the shareholders vary or

change:

Floatation costs

Transaction costs

Under pricing

Legal considerations


Policy

Information Asymmetry, Agency Costs and Shareholders’

Preference for dividends:

Information with managers and shareholders is not the same.

The gap mainly is due to the managers desire to act in their own

interest.

If high dividend are paid agency cost is reduced, since more

external financing so banks and other lenders would closely

monitor the performance of the firm

Also if in future firm becomes insolvent, the shareholders by virtue

of dividends has made the first claim instead of lenders.

Existence of Tax and Shareholders’ Preference for

Dividends


Policy

When a firm announces an increase in current dividend, the

market price of its share generally goes up.

A dividend reduction is generally a signal that the firm is in

trouble.

An increase in the dividend payment is the management’s signal

to the market that the firm is likely to perform better.

The reaction of the market share price to any change in

dividends is called the ‘informational content effect of dividend’.

Informational Content of Dividends:

Dividend-Signalling Hypothesis

Dimensions of Dividend Policy

The firm’s decision to pay dividend may depend upon the

following two approaches.

1. Firm’s Requirement of Funds

2. Shareholders’ Preference for Current Income

The decision of dividend policy must be arrived at keeping the

above two approaches in view.

An optimum dividend policy would split the net earnings between

dividends and retained earnings so as to achieve the objective of

maximisation of shareholders’ wealth.

Practical Aspects of Dividend Policy

The firm can follow either a low payout policy or a high payout one.

A low payout policy would generally lead to high growth rate resulting in increase of the share prices.

A high payout policy would lead to higher current income and slower growth leading to lower expected share price in the future.

Paying dividends improves the image of the firm

A firm decides its dividend policy based on its actual situation regarding its nature of business, firm’s life cycle, growth opportunities, shareholders desires, etc.


Some important aspects that go into the final decision making

regarding a dividend policy are:

Investment Opportunities for Firms

Management of a firm has to continuously strike a balance between

the investment opportunities, other financial needs and disbursement

of dividends.

Expectations of Shareholders

Shareholders are the owners of the firm. Therefore, the managers

must give due consideration to their expectation for dividends.


The ultimate decision regarding the dividend policy depends

upon a large number of factors. Some of the key factors are:

Nature of business: Good consistent earning firm can formulate a

stable and steady high dividend policy.

Age of a firm: Recent firms may pay less dividends.

Liquidity position of a firm

Equity shareholders preference for current income

Tax rules

Institutional investors’ requirements

Factors Affecting Dividend Policy

The ultimate decision regarding the dividend policy depends upon a large number of factors. Some of the key factors are: Legal rules: The dividend policy has to be decided within the

prevailing rules and regulations.

Contractual requirements

Financial requirement of the firm: One of the main requirements.

Access to external sources of funds

Control of the firm: High Payout may lead to issue of new shares

when requirement arises. Hence dilution of control

Inflation: Depreciation fund is not adequate

Dividend policy of competition

Past dividend rate of the firm

Other factors: Eg:, Anticipated change in technology, political and

economic changes etc.

Factors Affecting Dividend Policy

The term ‘stability of dividends’ refers to payment of dividend

every year and at an almost uniform rate.

Stability of dividends is considered desirable by investors.

There are three types of stability:

Constant Dividend Per Share

The principle in this case is to maintain a uniform amount as dividend

per share regularly and increase the amount when the firm is

reasonably confident of sustaining increased earnings.

Stability of Dividends

Constant Dividend Payout

Some firms follow the policy of constant payout ratio. It means that

the proportion of earnings which would be distributed as dividend is

fixed.

Stable Dividend Per Share Plus Extra Dividend

If a firm has a particularly good year and earnings are high it may like

to distribute a portion of extra earnings to shareholders.

The concept of extra dividend is particularly suitable for firms with

highly fluctuating earnings.

Stability of Dividends

According to John Lintner’s study, dividends are sticky, in the

sense these are slow to change and lag behind the shifts in

earnings.

According to him, a firm strives to achieve stable dividend policy

without occasional reduction of dividends.

The Lintner’s formula for the calculation of dividend is:

D1 = EPS1 * SA * DPR + (1 – SA) * D0

Where,

D1 = Dividend for the current year, D0 = Dividend for the last

year, EPS1 = EPS for the current year, SA = Speed of

Adjustment, DPR = Target Dividend Payout Ratio

Lintner’s Model and Dividend Smoothing

by Managers

Example:

For a firm EPS for the current is Rs 15. The firm has target payout

ratio is 50%. Dividend of last year was Rs 5 per share. The speed

of adjustment for the firm is 40%. Determine dividend for the

current year as per Lintner’s model and give your comment.


by Managers

Solution:

Using Lintner’s Model:

D1 = EPS * SA * DPR + (1 – SA) D0

= Rs (15 * 0.4 * 0.5 + (1 – 0.4) * 5)

= Rs (3 + 3)

= Rs 6

So dividend for the current year is Rs 6 per share. It can be see

that as per dividend payout ratio of 50% and EPS o f Rs 15, the

firm should have paid Rs 7.5 (15 * 0.5) as dividend per share.


by Managers

The forms in which dividends can be paid are:

Cash Dividend

When a firm pays dividend in cash, it must have necessary cash

availability at the time when dividend is announced.

When dividends are paid in cash, the total assets and net worth of

the firm are reduced.

Bonus Shares

Issue of bonus shares is another form of paying dividends, though

strictly speaking, it does not amount to payout by the firm.

Issue of bonus shares does not alter the shareholders’ wealth.

Forms of Dividend

Buy-back of Shares Another way to distribute cash is to repurchase or buy back its own

shares.

Share repurchase can be done in three ways: The firm buys its own shares from the open market.

The firm makes an open offer to all existing shareholders.

The firm approaches some major shareholders and buys the required

number of shares.

The repurchase of shares is equivalent to payout of dividend.

The most important reason for share buy-back is to pay the extra

cash after exhausting the profitable investment opportunities to shareholders.

Forms of Dividend

In case the firm distributes dividends, dividend disbursement tax

is payable by the firm.

In order to save on the tax element, the firms follow the policy of

share buy-back.

The main reasons leading the firms to resort to share buy-back

are:

Savings on tax

Enhancing share value

Target capital structure

Control

Hostile Takeover

Forms of Dividend

Share Split

Share split is a process in which the existing shares of the firm are

split into more number of shares of smaller face value.

The basic purpose of share split is to bring the share price to a

popular trading range.

Bonus shares and share split have almost identical effect on the firm

except for a small accounting difference.

Some firms do the opposite of share split i.e. combine a number of

existing shares into a single share.

The purpose of reverse split is to raise the value of low value shares

to give a feel of respectability to the firm.

Forms of Dividend

Thank You

dividend policy and valuation

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