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THEORIES OF DIVIDEND POLICYTHEORIES OF DIVIDEND POLICY

i)i) Dividend Relevance TheoriesDividend Relevance Theoriesii)ii) Dividend Irrelevance TheoriesDividend Irrelevance Theories

Dividend Relevance TheoryDividend Relevance Theory

The dividend is a relevant variable in determining the value The dividend is a relevant variable in determining the value of the firm, it implies that there exists of the firm, it implies that there exists

an optimal dividend policy, which the managers should seek an optimal dividend policy, which the managers should seek to determine, that maximises the to determine, that maximises the

value of the firm. There are three models, which have been value of the firm. There are three models, which have been developed under this approach. These are:developed under this approach. These are:

i)i) Traditional ModelTraditional Modelii)ii) Walter’s ModelWalter’s Modeliii)iii) Gordon’s Dividend Capitalisation ModelGordon’s Dividend Capitalisation Modeliv)iv) Bird-in-hand TheoryBird-in-hand Theoryv)v) Dividend Signalling TheoryDividend Signalling Theoryvi)vi) Agency Cost TheoryAgency Cost Theory

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TRADITIONAL MODELTRADITIONAL MODELMP is positively related to higher dividends. Thus MP would increase MP is positively related to higher dividends. Thus MP would increase

if dividends are higher and decline if dividends are lower.if dividends are higher and decline if dividends are lower.

P = m (D + E/3)P = m (D + E/3)

where, where,

P = Market priceP = Market pricem = Multiplierm = MultiplierD = Dividend per shareD = Dividend per shareE = Earnings per shareE = Earnings per share

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WALTER’S MODELWALTER’S MODELBased on the assumptions that all investments are financed Based on the assumptions that all investments are financed

through RE, rate of return and cost of capital are constant, through RE, rate of return and cost of capital are constant, the firm either distributes dividends or reinvested the firm either distributes dividends or reinvested internally; internally; Walter Walter put forth the following model for put forth the following model for valuation of sharesvaluation of shares

PP00 = = D + (E – D) rlkD + (E – D) rlk kkPP00 = market price per share = market price per shareD = Dividend per shareD = Dividend per shareE = Earnings per shareE = Earnings per shareE – D = Retained earnings per shareE – D = Retained earnings per sharer = Firm’s average rate of return r = Firm’s average rate of return k = firm’s cost o capitalk = firm’s cost o capital

From the model it is clear that the market price per share is the From the model it is clear that the market price per share is the sumsum

of two consumptions:of two consumptions:i.i. The first component Dlk is the present value of an infinite The first component Dlk is the present value of an infinite

stream of cash flows in the form of dividends.stream of cash flows in the form of dividends.ii.ii. The second component The second component (E – D)rlk(E – D)rlk is the present value of is the present value of

an infinite stream of returns kan infinite stream of returns k retained earnings.retained earnings.

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GORDON’S DIVIDEND GORDON’S DIVIDEND CAPITALISATION MODELCAPITALISATION MODEL

Assumptions : Firm is all-equity, RE are used to finance Assumptions : Firm is all-equity, RE are used to finance projects, r and k are constant, there are no taxes, b projects, r and k are constant, there are no taxes, b once decided is constant. once decided is constant.

Gordon put forward the following valuation model:Gordon put forward the following valuation model:

PP00 = E = E11 + (1 – b) + (1 – b) k - br k - br where, where, PP00 = Price per share at the end of the year 0 = Price per share at the end of the year 0EE11 = Earnings per share at the end of year 1 = Earnings per share at the end of year 1(1 – b) = Fraction of earnings the firm distributes by way of (1 – b) = Fraction of earnings the firm distributes by way of

earningsearningsb = Fraction of earnings the firms ploughs backb = Fraction of earnings the firms ploughs backk = Rate of return required by the shareholdersk = Rate of return required by the shareholdersr = Rate of return earned on investments made by the firmr = Rate of return earned on investments made by the firmbr = Growth rate of earnings and dividendsbr = Growth rate of earnings and dividends

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BIRD-IN-HAND THEORYBIRD-IN-HAND THEORYJohn Lintner propounded this theory in 1962 and Myron John Lintner propounded this theory in 1962 and Myron

Gordon inGordon in1963. The shareholders are not entitled to any fixed return. 1963. The shareholders are not entitled to any fixed return.

The returnThe returnto the shareholders is in the form of dividends and capital to the shareholders is in the form of dividends and capital

gains.gains.Current dividends are relatively certain compared to future Current dividends are relatively certain compared to future

capitalcapitalgains.gains.

According to this theory shareholders are risk averse and According to this theory shareholders are risk averse and prefer toprefer to

receive dividends in the present time period to future receive dividends in the present time period to future capital gains.capital gains.

Modigliani and Miller termed this argument as bird-in-hand Modigliani and Miller termed this argument as bird-in-hand fallacy.fallacy.

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DIVIDEND SIGNALLING THEORYDIVIDEND SIGNALLING THEORY

Managers have greater access to inside information about the Managers have greater access to inside information about the company. They may share this information with the shareholders company. They may share this information with the shareholders through an appropriate dividend policy. Constant or increasing through an appropriate dividend policy. Constant or increasing dividends convey positive signals about the future prospects of the dividends convey positive signals about the future prospects of the company resulting in an increase in share price. Similarly, absence of company resulting in an increase in share price. Similarly, absence of dividends or decreasing dividends convey negative signal resulting dividends or decreasing dividends convey negative signal resulting

in in decline in share price.decline in share price.

A liberal dividend policy by reducing the agency costs may lead toA liberal dividend policy by reducing the agency costs may lead toenhancement of the shareholder value.enhancement of the shareholder value.

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DIVIDEND IRRELEVANCE THEORYDIVIDEND IRRELEVANCE THEORYThese theories contend that there are two components of These theories contend that there are two components of

shareholder’returns.shareholder’returns.a)a) Dividend Yield (D / PDividend Yield (D / P00))b)b) Capital Yield (PCapital Yield (P11 / P / P00) / P) / P00))Suppose a firm issues a Rs.10 par value share at a Suppose a firm issues a Rs.10 par value share at a

premium of Rs.90.premium of Rs.90.In other words, the issue price is Rs.100. If the firm In other words, the issue price is Rs.100. If the firm

declares a dividend of Rs.3 (the dividend yield is 3%) declares a dividend of Rs.3 (the dividend yield is 3%) price at the end of next year price at the end of next year

is Rs.115, the capital yield is (115 – 100) / 100 = 15 per is Rs.115, the capital yield is (115 – 100) / 100 = 15 per cent. The total cent. The total

return to the shareholders is 18 per cent.return to the shareholders is 18 per cent.

These theories, which argue that dividends are not relevant These theories, which argue that dividends are not relevant inin

determining the value of the firm, are:determining the value of the firm, are:i.i. Residual TheoryResidual Theoryii.ii. Modigliani and Miller (M&M) ModelModigliani and Miller (M&M) Modeliii.iii. Dividend Clientele EffectDividend Clientele Effectiv.iv. Rational Expectations ModelRational Expectations Model

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DIVIDEND IRRELEVANCE THEORYDIVIDEND IRRELEVANCE THEORY

Residual TheoryResidual Theory

According to this theory a firm will only pay dividends from According to this theory a firm will only pay dividends from residualresidual

earnings, that is, from earnings left over after all the earnings, that is, from earnings left over after all the suitablesuitable

investment opportunities have been financed.investment opportunities have been financed.

Modigliani and Miller (M&M) ModelModigliani and Miller (M&M) Model

According to the model, it is only the firms’ investment According to the model, it is only the firms’ investment policy that will have an impact on the share value of policy that will have an impact on the share value of the firm and hence should be given more importance.the firm and hence should be given more importance.

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DIVIDEND IRRELEVANCE THEORYDIVIDEND IRRELEVANCE THEORY

Modigliani and Miller (M&M) ModelModigliani and Miller (M&M) Model

The current market price of the share is equal to the discounted The current market price of the share is equal to the discounted value of the dividend paid and the market price at the end of thevalue of the dividend paid and the market price at the end of theperiod.period.

PP00 = _ = _1___ 1___ (D(D11 + P + P11 ) ) (1 + k(1 + kee) ) where, where, PP00 = Current market price of the share (t = 0) = Current market price of the share (t = 0)PP11 = Market price of the share at the end of the period (t = 1) = Market price of the share at the end of the period (t = 1)DD11 = Dividends to be paid at the end of the period (t = 1) = Dividends to be paid at the end of the period (t = 1)kkee = Cost of equity capital = Cost of equity capital

With no external financing the total value of the firm will be asWith no external financing the total value of the firm will be asfollows:follows:nPnP00 = _ = _1___ 1___ (nD(nD11 + nP + nP11 ) ) (1 + k(1 + kee) )

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DIVIDEND IRRELEVANCE THEORYDIVIDEND IRRELEVANCE THEORYModigliani and Miller (M&M) ModelModigliani and Miller (M&M) Model

Simplifying the above equation, we getSimplifying the above equation, we getnn11PP1 1 = I – E + nD= I – E + nD11 where,where,I = Total investment requiredI = Total investment requirednDnD1 1 = Total dividends paid= Total dividends paidE = Earnings during the periodE = Earnings during the period(E - nD(E - nD1 1 ) = Retained earnings) = Retained earnings

Substituting this value of the new shares in the above equation, we Substituting this value of the new shares in the above equation, we getget

nPnP00 = _ = _11___ [nD___ [nD11 + (n + n + (n + n11)P)P1 1 - I + E - nD- I + E - nD11 ] ] (1 + k(1 + kee) )

= = nDnD11 + (n + n + (n + n11)P)P1 1 - I + E - nD- I + E - nD11 (1 + k(1 + kee) )

nPnP00 = = (n + n(n + n11)P)P1 1 - I + E- I + E (1 + k(1 + kee) )

Thus, according to the M&M model, the market value of the share is Thus, according to the M&M model, the market value of the share is notnot

affected by the dividend policy and this is clear from the last equation affected by the dividend policy and this is clear from the last equation above.above.

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DIVIDEND CLIENTELE EFFECTDIVIDEND CLIENTELE EFFECT :According to this theory, dividend :According to this theory, dividend policy is irrelevant in determining the firm’s value. policy is irrelevant in determining the firm’s value. Different firms may follow different dividend policies Different firms may follow different dividend policies depending upon their own needs and circumstances. depending upon their own needs and circumstances. One firm may decide on a higher payout ratio whereas One firm may decide on a higher payout ratio whereas others may decide on lower dividend payout. others may decide on lower dividend payout. Similarly,different shareholders may have different Similarly,different shareholders may have different needs – some may preferneeds – some may prefer current dividends whereas current dividends whereas others may be more interested in capital gains. Those others may be more interested in capital gains. Those investors who prefer current dividends would like to investors who prefer current dividends would like to become shareholders in companies which declare become shareholders in companies which declare

generous dividends whereas those investors who are generous dividends whereas those investors who are more interested in capital gains would folk to more interested in capital gains would folk to companies having relatively lower payout ratios.companies having relatively lower payout ratios.

RATIONAL EXPECTATIONS MODELRATIONAL EXPECTATIONS MODEL: According to this model there : According to this model there would be no effect of dividend declaration on the would be no effect of dividend declaration on the market price as long as the dividend declared is in line market price as long as the dividend declared is in line with the expected dividends. If dividend <expected with the expected dividends. If dividend <expected dividend – MP will decline and vice versa. Thus, so far dividend – MP will decline and vice versa. Thus, so far as dividend declared ratifies the market expectation as dividend declared ratifies the market expectation the dividend policy is not relevant in determining the the dividend policy is not relevant in determining the MP.MP.

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PRACTICAL CONSIDERATIONS IN THE PRACTICAL CONSIDERATIONS IN THE FORMULATION OF DIVIDEND POLICYFORMULATION OF DIVIDEND POLICY

► Profitability and LiquidityProfitability and Liquidity

► Legal ConstraintsLegal Constraints

► Contractual ConstraintsContractual Constraints

► Growth ProspectsGrowth Prospects

► Owner ConsiderationsOwner Considerations

► Market ConsiderationsMarket Considerations

► Industry PracticeIndustry Practice

► Shareholders ExpectationsShareholders Expectations