Chapter 10

FINANCIAL
MANAGEMENT

DIVIDEND THEORIES
Learning Objectives

Afer studying this chapter, you should be able to understand:

The impact of dividend decision on valuation offirms

Dividend theories
Relevance theories-Walter's model and Gordon's model

I Irrelevance theory-Millerand Modiglianitheory

DIVIDEND DECISION AND VALUATION OF FIRMs (THEORIES OF DIVIDEND)

is maximised. There are
if the shareholders'wealth
The value of the firm can be maximised
on the valuation of the firm. Acording
conflicting views regarding
the impact of dividernd decision
wealth and hence the
school of thought, dividend decision does not affect the share-holders
to one
schoolof thought, dividend decision
valuation of the firm.On the
other hand, according to the other
and also the valuation of the firm.
materially affects the shareholders' wealth
under two groups :
We have discussed below the views of thetwo schoolsof thought
Relevance, and
Concept of Dividend or the Theory
of
1. The Relevance

of Dividend or the Theory of Irrelevance.

2. The Irrelevance Concept

OF RELEVANCE
DIVIDEND OR THE
THEORIES
I 1. THE I RELEVANCE CONCEPT OF

dividend decisions considerably

holds that the Gordon, Jone
decision Myron
The other school thought on dividend
of
thought include to the
affect the
school of
of this information
value of the firm. The advocates communicate frms
Linter, James
to them dividends relevant.
Those
Walter and Richardson. According becomes
decision
investorsabout the firms' hence dividend
and
profitability
 Dividend Theories,
Dividend Thec
10.2
which do not pay
to those
which pay higher dividends, value as compared
will have greater

dividends or have a lower dividend pay out ratio.

notion:
this
We have examined belowtwo theories representing Prof

(i) Walters Aproach, and (i) Gordon'sApproach

the
O ()WALTER'S APPROACH
are relevant
and affect
decisions
that dividend cost
firm and its
earned by
the
Prof. supports the doctrine
Walter's approach
return or
rate of
the ultimate goal
of
value of the firm. The relationship between the internal
policy to subserve
the relationship
of capital is very significant in determining
the dividend
mnodel
is based on whe
Walter's rate of
or the required
Prof.
maximising the wealth of the share holders.
the cost of capital
and (ii)
betweenthe firm's (i) return on investment, i.e. r,

return, ie.k. on its investment

rate of return
a higher
the firm earns as growth
Such firmsare termed
If r i.e., if
According to Prof. Walter,
> k

retainthe earnings.
thanthe required rate of return, thefirm should the value of
This would maximise
would be zero in their case.
s and the optimum pay-out
m
Let
shares.
i.e, where< k, the
r IL
profitable investments,
firms which do not have
In case of declining its earnings. For such firms, the optimum
to gain if the firm distributes
shareholderswould stand the entire earnings as
dividends.
be 100% and the firms should distribute
pay-out would
will not affect the market
value of shares
r = k, the dividend policy
In case of normal firms where by them. For such firms,there
A
return from the firm as expected
as the shareholders will get the same
would not change with the change in
is no optimum dividend pay out and the value of the firm
dividend rate.

O Assumption of Walter's Model

(i) The investments of the firm are financed through retained earnings only and the firm does
divic
not use external sources of funds.

(ii) The internal rate of return (r) and the cost of capital (k) of the firmare constant. S

(iii) Earnings and dividends do not change while determining the value.

(iv) The firm has a very long life.

O Walter'sFormula for Determining the Value of a Share

Walterhas developed a mathematical equation to ascertain the market price of
enables a
firm to arrive at the
a share which
appropriate dividend decision. His equation
share valuation model : is based on the following

D
P=
ke-8
Where, P =Priceof
equity share

F20
 10.3

dividend per share

Dividend
Theories, D =Initial

ke =Cost of equity capital

g =Expected growth rate of earnings/dividend
share:
formula to ascertain the market price of a

has given the following

Walter
Prof. D)
D+r (E-
ke
P= ke

r(E-D)/Ke
P=keD ke
or
P =Market price per share
where,
D =Dividend per share
=Internal rate of return
r

E =Earnings per share

ke =Cost of equity capital
equation.
to understand the above
following illustration
Let us take the
in respect of a firm:
is available
following information
ILLUSTRATION 1.The
Capitalisation
rate =10%
=750
Earningsper share

rate of return
on investments:
Assumed

(i) 12%
(ii) 8%
(iii) 10%
formula when
policy on market price of shares applying Walter's
Show the effect of dividend
80%,and (e) 100%
dividend pay out ratio is (a) 0% (b) 20%, (c) 40%, (d)

SOLUTION :

P= D
ke
r(E-D)/Ke
ke

Effect of dividend policy on market price of shares

r=8% (iii) r=10%
(i) r= 12% (ii)

(a) When dividend pay-out ratio is 0%

0
P= 0 .12 (50 –0) /.10
P= 10 .08(50 - 0)/.10 P= 10 .10(50 –0)/.10
10
.10
.10 10
.12,
(50) 50)

= 0+-10
.10
1260)
= 0+l0 .10
=0+1010
=600 =400 =500
 Dividend Theories,
10.4

(b) When dividend pay-out is 20% 10

(50–10)
12 .08 10 10
10 -(50 -10) P
10 J0 .10
P= 10(50–10) P= .10
.10
.10 10 .10

48
=100+ 400
= 100+ 10 =100 + 320
=7500
=580 =420
When dividend pay out 40%
(c) is
10(50–20)
.12
.08 20 .10
(50- 20) P =
20 -+0 20+10 .10 .10
P= )-20) P= .10 .10
10 10(50-
= 200 + 300
36 = 200 +240
=200+ 10 =7500
=440
=7560
When dividendpay-out is 80%
(d) 10(50–40)
.08 40 10
.12 (50-40) P=
40 10
P=
40
+10(50–40) P=.10 .10
10

10 10 400+100

=400 + 120 =400+80 7500

=480
=520
pay-out is 100%
(e) When dividend
.08
10 (50 -–50)
(50–50) 50.10
12(50–50) 50 .10 P= .10
50 10 P= 10
P = 10 10
10 .10
=500+0
=500+0
=500+0 =7500
=7500
=7500
the conclusion that when,
draw
above analysis we
can
the
Conclusion :From
i.e., when r=12%. Ke =10%;
retain the profits,
(i) »k, the company should
be high; and
ris 8%, i.e., r<k, the pay-out should
(íi)
the price of the share.
pay-out does not affect
(iii) ris 10%; i.e., r=k;the dividend

O Criticism of Walter'sModel
assumptions made by Prof. Walter in
on account of various
Walter's model has been criticised
his hypothesis :
formulating
through retained earnings only is
()The basic assumption that investments are financed

seldom true in real world. Firms do raise fundsby external financing.

(ii) The internal rate of return, ie., r,also does not , remain constant. As a matter of fact, with

increased investment the rate of return also changes.

(i) The assumption that cost of capital (k) will remain constant also does not hold good. As a

firm's risk pattern does not remain constant, it is not proper to assume that k will always
remain constant.
Dividend Theories,

o (ii) GORDON'S APPROACH 10.5

Myron Gordon has also developed a model on the lines

dividends are relevant and the dividend of
Prof.
decision of the

:
firm affects Walter
ie hasic valuation its value. suggesting that
model is based on the following
assumptions
(i) The firm is an all equity firm.

(ii) No external financing is available or used. Retained

financing investmentprogrammes. earnings
represent the only source
(ii) The rate of return on th firm's of

investmentr, is constant.
(iv) The retention ratio, b, once decided
upon is constant.
br, is also constant. Thus,the growth rate of the firm g
(n) The cost of =
capital for the firm
> br. remains constant and it is greater
than the growth rate.ie k
(vi) The firm has perpetuallife.
(vii) Corporate taxes do not exist.

According to Gordon, the

market value of a
dividends.Thus, shareis equal to the
present value of future
stream of

P = D, D2
(1+k) (1+k'
Dt
f=1 (1+k'
Gordon's basic valuation
formula can be simplifiedas
under:
P= E(1-b)
ke-br

Po
D Do(1+g)
ke-g ke-&
or,

where, P = Price of shares

E =Earnings per share
b =Retentionratio
ke =Cost of equity capital
br =g=Growth rate in rate of
r,i.e., return on investment of an all-equity firm

D, =Dividend per share

D, =Expected dividend at the end of year 1.

The implications of Gordon's basic valuation model may be summarised asbelow:

1. When the rate of return of firm on its investment is greater than the required rate of return,
1.e; when r> k, the price per share increases as the dividend payout ratio decreases. Thus,
growth firm should distribute smaller dividends and should retain maximum earnings.
 Dividend Theories.

10.6
when r=k,the price per
of return, ie.,
rate a normal firm
2. When therate of return equal to therequired policy. Thus, for

is
by dividend
share remains unchanged and is not affected
there is no optimum dividend payout. i.e., when r< k, the price per
rate of return, of
less than the required shareholders declining
When the rate Thus, the
3. of return is

ratio increases. firms, the optimum

pay out
share increases as the dividend payout For such
earnings.
firm stand to gain if the firm distributes its

would be 100%. of the rate of return on

in respect
is available
The information
ILLUSTRATION 2.
(E) of ABC
following Ltd.

investmnent (r), the cost

and earning per share
of capital (k)
and (i1) 107%
on investment (r)= ()15%: (ii) 12%;
Rate of return

Cost of capital = (k) 12%

Earning per share (E) =
10
assuming the following
:
using Gordon'sModel
the value of its shares (b)
Determine Retention ratio
Dlp ratio (1-b) 0
100 20
(a) 80
(b) 60
40
(c)

SOLUTION:
E(1-b)
P= ke -br
and the Value of Shares
Dividend Policy
(iii) r= 10% (r < k)
(ü) r=12% (r = k)
(i)r 15% (r>)

(a) When D/p ratio is 100% or b= 0

10 (1-0)
P=
10 (1-0) P =
P= 0.12- (0) 10 (1-0)
0.12 -(0) (0.12) 0.12 -(0) (0.10)
(0.15)

10 10
10
0.12 0.12
0.12
=83.33 =783.33
=783.33

(b) When Dp ratio is 80% or b= .20

10 (1–0.20) 10 (1-0.20)
P= 10 (1-0.20)
P= P=
0.12 -(0.20)(0.15) 0.12 -(0.20) (0.12) 0.12-(0.20) (0.10)

8 8
0.09 0.096 0.10
=88.89 =83.33 =80
(c) When D/p ratio ís 40% or b= .60
10(1–0.60)
P= P= 10 (1-0.60)
P= 10 (1-0.60)
0.12 - (0.60) (0.15)
0.12-(0.60) (0.12) 0.12-(0.60)(0.10)
4
4
4
0.03
0.048
0.06
=7133.33
=83.33
=66.67
 Dividend Theories,

o Gordon's Revised Model

10.7

The basic assumptionin Gordon's Basic Valuation

Modelthat cost of
for firm is not true in Thus, Gordon revised capital(k)
a practice.
his basic model remains consant
revised model, he suggested to consider
uncertainty. In the that even when risk and
value shares on account of uncertainty of
of
r=k,
dividend policy
future, shareholders affects the

higher rate than they discount near dividends. discount future

That is there is a dividends at a
are risk averse, and (ii) they put a
two fold assumption,viz.
premium on a certain (i)investors
wohurns. Because the return and
investors are rational discount/penalise
and they want to avoid risk, uncertain
than future dividends. This argument is they prefer near
described as dividends
of dividend bird-in-the hand
income is more than the argument, i.e. the value
LE "of two stocks with
value of rupee of capital
identical earnings,
gain. In the words of
of a

Krishnan.,
record, prospects, but the one
dividend than the other, the former paying a larger
will
undoubtedly command a
shareholders prefer present to higher price merely
future values. Mypoic because
Gtockholders vision plays part in the
often act on the principle price-making process.
that a bird in harnd is
this reason are worth than two in the bushes
willing to pay a and for
premium for the stock with the
discount the one wih the higher dividend rate, just as
lower rate." Thus, if they
dividend policy is considered in
uncertainty, the cost of capital the context of
cannot be assumed to be
dividend payout ratio and offer a constant and so firm
should set a high
high dividend yield in order to
minimise its cost of capital.
ILLUSTRATION3.The following information is available in
the cost of capital (ke) respect of return on
(r),
and earning per share (E)of XYZ Ltd. investment

r = 10 percent
E =40
Determine the value of its shares
using Gordon's Model, assuming

Dlp
the following :
ratio (1-b) Retention raito (b)
Cost of equity (ke)%
a) 20 80
(b) 40 20
60 18
(c) 60 40
16
(d) 80 20
14
SOLUTION :

P= E(1-b)
ke -br

where, P = Price of shares

E =Earnings per share
=Retention Ratio
ke =Cost of equity capital
br
=g-growth rate in r, ie., rate of return on investment of an all-equity firm
Dividend Policy and Value of Sharesof XYZ Ltd.
(a) D/p ratio =20 (b) D/p ratio =40 (c) D/p ratio =60 (d) D/p ratio = 80
Retention ratio =80 Retention ratio =60 Retention ratio =40 Retention ratio = 20
br =0.8x0.10=0.08 br = 0.6 >x 0.10=0.06 br = 0.4 x 0.10=0.04 br =
0.2 x0.10=0.02
10.8 Dividend
Theories,

40 (1-0.2)
40 (1-0.4) P=
P= 40 (1-0.8) P= 40 (1-0.6) P= 0.16-0.04
0.14-0.02
0.20 -0.08 0.18-0.06
40 (0.8)
40 (0.6)
40 (0.2) 40 (0.4) 0.12
0.12
0.12 0.12
32
24
8 16 0.12
0.12
0.12 0.12 =7266.67
=7200
=66.67 =133.33

OF IRRELEVANCE
CONCEPT OF DIVIDEND OR THE THEORY
Z. THE IRRELEVANCE

O A. RESIDUAL APPROACH
shareholders or tho
decision has no effect
on the wealth of the
dividend
According to this theory, the firm is concerned. Thie
so far as the valuation of
it is irrelevant
prices of the shares,and hence decision because
the earninge
financing
as a part of
regards dividend decision merely But, if the funds
are not required in the
theory for re-investmernt. the
in the business dividends or retain
availablemay be retained decision to pay
as dividends. Thus, the
business they may be
distributed
assumes that investors
do not differentiate
decision. This theory
earnings may be taken
as a residual
desire is to earn
higher return on their
by the firm. Their basic
and retentions of return
between dividends giving a higher rate
firm has profitable investmentopportunities the earnings
investment.In case the would be content with the firm
retaining
earnings, the investors investment
than the cost of retained is not in a position
to find profitable
However, if the firm Thus, a
to finance the
same. in the form of dividends.
prefer to receive the earnings
investors would otherwise it should pay
opportunities, the opportunities
if it has profitable investment
earnings
firm should retain the
them as dividends.

AND MILLER APPROACH (MM

MODEL)
O B. MODIGLIANI
in support of the
have expressed in the most comprehensive manner
Modigliani and Miller the market price of the
dividend policy has no effect on
theory of irrelevance.
They maintain that
of the firm or its investment
capacity
by the earning
and the value of the firm is determined
shares
retentions and dividends,
may be in any manner the firm
of earnings between
policy. The splitting
"Under conditions of perfect capital
value of the firm. As observed by M.M.
likes,does not affect the
of tax discrimination between dividend income and capital
markets, rational investors, absence
may have no influence on the
investmentpolicy, its dividend policy
appreciation, given the firm's

market price of the shares."!

•Assumptions of MM Hypothesis
The MM hypothesis of irrelevance of dividends is based on the following assumptions :

(i) There are perfect capital markets.

(ii) Investors behave rationally.

(iti) Information about the company is available to all without any cost.

(iv) There are no floatation and transaction costs.

Dividend Theories,

(v) No investor is large enough to effect the market price of 10.9

There are either no taxes shares.
(vi) or there are no differences
in thetax
and capital gains. rates
applicable to
(vii) The firm has a rigid investmentpolicy. dividends

(viii) There is no risk or uncertainty in regard to the future

assumption later). of the firm.
(MM dropped this
•The Argument of MM
The argument given by MM in
support of their
ofthe firm results from the payment of hypothesis is that
whatever
dividend, will be increase in the
exactly off set by value
price of shares because of external the decline in the
financing andthere will
shareholders. For examnple, if be no change in market
a company, the total
the having investment wealth of the
among shareholders,it will have to raise opportunities, distributes
additional funds all its
intheincrease in number of shares or from external earnings
payment of interest sources. This will
charges, result
share in the future. Thus whatever a resulting in fall in the
neutralised shareholder gains on account earnings per
completely by the fall in of
dividend
the market price payment is
earmings per share.To be of shares due to
more specific, the market decline in expected
future
equal to the present price of a share
value of dividends paid in the beginning
of a period is
at the end of the
sharesat the end of the period. period plus the market
price of the

This can be put in the

formn of the following formula :

P, D +P
1+Ke
Where
P, = Market price per share at the beginning of the period,
or prevailing market price ofa share
D, =Dividend to be received atthe end of the
period.
P, = Market price per shareat the end of the period.
Ke =Cost of equitycapital or rate of capitalisation.
The value of P,can be derived by the
above equationas under :
P, =P, (1+ke) -D,
The MM hypothesis can be explained in another form also
presuming that investment
by the firm on account of payment of dividends is financedout of the new issue of equity
required
shares.
In such a case,the number of shares to be issued carn be computed with the help of the following
equation:

1M= I(EnD,)
P
Further,the value of the firm can beascertained with the help of the following formula:

(n+m)P -(|-E)
1+ke
 10.10
Dividend
Theories,

Where, m = number of shares to be issued.

I = Investmentrequired.
E = Total earnings of the firm during the period.

P, = Market price per share at the end of the period.

Ke = Cost of equity capital.

n = number of shares outstanding the beginning at of the period.

D, = Dividend to be paid the end of the period.

at

nP = Value of the firm

Let us take the following illustration to MM hypothesis of irrelevance
illustrate of dividend to the
valuationof firm.

ILLUSTRATION4. ABC Ltd. belongs to a risk class for which the appropriate
capitalisation
rate is 10%. It currently has outstanding 5,000 shares selling at 100 each. The
firm is contemplating
the declaration of dividend of 6 per share at the end of the current financial
year. The company
expects to have a
net income of 50,000 and has a proposal for
making new investmentsof ?1,00,000.
Show that under the MM
hypothesis, the payment of dividend does not effect the
value of the firm.
SOLUTION:
(A) Value of th firm when dividends arepaid:
(i) Price of the share at the end of the
current financial year

P =Po (1+ke) - D1

= 100 (1 +.10) –6

= 100 x 1.10 -6
= 110 -6=104
(i1) Number of shares to be issued

M = -(E-nD,)

1,00,000-(50,000-5,000 x6)
104

80,000
104

(iii) Value of the firm

nP = (n+m)P -(1-E)
1+ke

(5,000 00) x104-(1,00,

80,
104 000 –50,000)

1+.10
 Theories,
Dividend 5,20,000+80,000 104
-(50,000)
104
1.10

6,00,000 -50,000
1.10

5,50,000
=75,00,000.
1.10

when dividends are not paid:

of the firm
(B) Value
end the current financial year
share atthe
of

() Price
per

P -Po (1 + ke) - D
=100 (1 +.10)-0

=100 x 1.10 =110

to be issued
(ii) Number of shares
–(E-nD)

1,00,000 –(50,000 –0)

110

50,000
110

(iii) Value
of the firm

(n+m)P -(1-E)
nP = 1+ke

|5,000+-
50,000
x1.10 -(1,00,000-50,000)
110
1+.10

110
5,50,000 +50,000 50,000
110
1.10

6,00,000 –50,000
1.10

5,50,000
=5,00, 000.
1.10

the same 5,00,000.

value of the firm remains
whether dividends are paid or not, the
Hence,
on
shares of 10 each outstanding
Expandent Ltd. had 50,000 equity
ILLUSTRATION 5.
wake of the removal of
being quoted at par in the market.In the
are currently
January 1. The shares
company now intends to pay a dividend of
per share for the current 2
the
dividend restraint,
capitalisation rate is
15%. Usng M
belongs to a risk-class whose appropriate prevail at
calendar year. It
it is likely to
the price of the company's share as
model and assuming no taxes,
ascertain
 10.12 Dividend
Theories,

the end declared, and (ii) when no dividend is

declared. Also
of the year (i) when dividend is find
company must issue to meet its investment needs of 3
Out the number of new equity shares that the

lakhs, assuming a net income of 1.1 lakhs and also assuming that the dividend is paid.

SOLUTION:

(i) Price per share when dividends are paid

P = Po (1+ke) - D

10 (1+.15)-2

11.5-2 =9.5
(i) Price per share when dividends are not paid :

Po (1+ke) -D
10 (1+.15)-0

711.5

of new equity shares be issued if dividend is paid

(ii) Number to

I-(E-nD)
11 =
2,00,000-(1,10,000 – 50,000 ×2)
9.5

1,90,000
20,000 shares
9.5

o Criticism of MM Approach

MM hypothesis has been criticised on account of various unrealistic assumptions as given below.

1. Prefect capital market does not exist in reality

2. Informationabout the company is not available to all the persons.

3. The firms have toincur flotation costs while issuing securities.

4. Taxes do exit and there is normally different tax treatment for dividends and capital gains.

5. The firmsdo not follow a rigid investmentpolicy.

6. The investors have to pay brokerage, fees, etc. while doing any transaction.
7. Shareholdersmay prefer current income as compared to further gains.

ILLUSTRATION 6.The current price ofa company's share is75 and dividend per share 1s*

5.Calculate the dividendgrowth rate, if its capitalisation rate is 12 percent.

SOLUTION:

P, = D Do(1+g)
K-8 K-8

75 = 5(1+g)
0-12-8
 10.13

Theories,
Dividend
9.0-75g =5+5g
-80 g =4
or,
=0.05 or 5%
or,

7.| The current price of a company's share is 200. The company is expected
ILLUSTRATION
of? 5 per share next year with an annual growth rate of 10 per cent. If an investor' s

a dividend
to pay buy theshare?
he
of return is 12%, should
rate
required

SOLUTION:
share,
Value of the

Pó D1
Ke-8
5
0.12-0.10

=7250
current price of 200, the investor should buy
Ae the value of the share (?250) is more than its

the share.
company is and its rate of return on
145.50
The book value per shareof a
uLUSTRATION 60% pay out. What is the price of its
8.
of
dividend policy
company follows
a
The
equity is
10 percent.
?
rate is 12 percent
share if the capitalisation

SOLUTION:
10

Earning per share

(EPS) =145.50 x

100
-=Rs. 14.55

60
Dividend per share (D1) = 14.55x 100
Rs. 8.73

Growth in dividend (g) = 0.10 x=100

40
Rs. 0.04

D
Price of the Share Po Ke-8
8.73

0.12-0.04

8.73

0.08

=7109.13

it will not pay any dividends for 20 years. After

LLUSTRATION 9.Acompany decides that
However,
15 per share indefinitely.
company could pay dividend
of

at tme t is expected that the

rate of this company's
shareholdersiS
Opany at present could pay 3 per share.The
required
10 of the policy of the company ? Calculate
Percent. What is the loss
to each shareholder as a result

the value of the

equity share.
 Dividend Theories,
10.14

SOLUTION:
The value of the share at theend of 20years shall be :

D 15
=150
P20
K, 0.10

The current value of the share is.

150
Po = =22.29
(1.1)20

shareif the company at present could pay dividend of 3per share forever
The value of

3
Po =30
0.10

Thus, the loss per share to each shareholder is :30-22.29 -7.71