Dividend Theories

WALTER’S MODEL

• Walter’s model is based on the following premises:

• (1) The firm finance its entire investments by means of retained earnings. New equity

• stock or debenture is not issued to raise funds.

• (2) Internal rate of return (r) and cost of capital (Ke) of the firm remain constant.

• (3) The firm’s earnings are either distributed as dividends or reinvested internally.

• (4) Earnings and dividends of the firm never change.

• (5) The firm has long or infinite life.

Cont---

• P= D+ r/k(E-D)/K

• Where,

• P = Market price per share

• D = Dividend per share

• E = Earnings per share

• r = Internal rate of return (Actual capitalization rate)

• K = Cost capital (External capitalization rate)

Numerical Walter Model

• The earnings per share of a company is Rs. 8 and the rate of capitalisation

• applicable is 10%. The company has before it an option of adopting (i) 50%, (ii)75%and(iii)100% dividend payout ratio. Compute the market price of the company’s quoted

• shares as per Walter’s model if it can earn a return of (i) 15%, (ii) 10% and (iii) 5% on its

• retained earnings.

GORDON’S MODEL

• 1. The firm is an all equity firm.

• 2. No external financing is available or used. Retained earnings represent the only source

• of financing investment programmes.

• 3. The rate of return on the firm’s investment r, is constant

Cont---

• 4. The retention ratio, b, once decided upon is constant. Thus, the growth rate of the

• firm g = br, is also constant.

• 5. The cost of capital for the firm remains constant and it is greater than the growth

• rate, i.e. k > br.

• 6. The firm has prepetual life.

• 7. Corporate taxes do not exist.

• P=E (1-b)/Ke-br • Or • P=D/Ke-g

• Where, • P = Price of shares • E = Earnings per share • b = Retention Ratio • ke = Cost of equity capital • br = g = growth rate in r, i.e., rate of return on investment of

an all-equity firm • D = Dividend per share

Gordon Model

• ABCLtd registered earnings of Rs. 800,000 for the year ended 31st March. They finance

• all investments out of retained earnings. The opportunities for investments are many. If such opportunities are not availed their earnings will stay perpetually at Rs. 800,000. Following figures are relevant

Policy Retention (% Growth (%) Cost of equity on all investments

A 0 0 14

B 25 5 15

C 40 7 16

• The returns to shareholders are expected to rise if the earnings are retained because of the

• risk attached to new investments. As for the current year, dividend payments will be made

• with or without retained earnings. What according to you, should be retained

MM Model

• Texa Ltd. belongs to a risk class of which the appropriate capitalisation rate is 10%. It currently has 1,00,000 shares selling at Rs. 100 each. The firm is contemplating declaration of a dividend of Rs.6 per share at the end of the current fiscal year which has just

• begun. Answer the following questions based on Modigliani and Miller Model and assumption of no taxes:

• (i) What will be the price of the shares at the end of the year if a diviend is not declared?

• (ii) What will be the price if dividend is declared? • (iii) Assuming that the firm pays dividend, has net income

of Rs. 10 lakh and new investments of Rs. 20 lakhs during the period, how many new shares must be issued?

• Modigliani and Miller suggested that in a perfect world with no taxes or bankruptcy cost, the dividend policy is irrelevant. They proposed that the dividend policy of a company has no effect on the stock price of a company or the company’s capital structure.

• MM say that if an investor gets a dividend that’s more than he expected then he can re-invest in the company’s stock with the surplus cash flow. If the expected dividend is too small, then he can sell a part of his shares and replicate the same cash flow he would get if the dividend was what he expected. In both cases, investors are irrelevant to what the company’s dividend policy is because they can create their own cash flows.

Assumption

• Taxes do not exist: Personal income taxes or corporate income taxes

• When a company issues a stock, there are no flotation costs or transaction costs

• When a firm decides its capital budgeting, dividend policy has no impact on it

• Information is readily and freely available to all investors. Information about the firm’s future prospects is available to the company’s manager as well as investors

• Leverage has zero impact on the cost of capital of the company

The Theory in Real Life

• In reality, none of these assumptions stand true. Taxes are a certainty for all of us. Companies have to deal with flotation costs while dealing with issuances. Information is readily available to everyone, but the tools and sophistication with which institutional investors analyze securities is far better than what a retail investor might use. The information that a company’s manager might have is still superior than what an institutional investor might have in spite of the sophisticated tools that they possess.

• MM believe that it’s only the company’s ability to earn money—and how risky that activity is—that has an impact on the value of the company. MM’s conclusions might stand true theoretically but they do not stand true in the practical world.