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Relevance and Irrelevance Theories of Dividend - makemynote.weebly.comLINCOLN KUMAR

MBA , Msc IT

makemynote.weebly.com LINCOLN KUMAR MBA , Msc IT

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Relevance and Irrelevance Theories of Dividend

Div idend is that portion of net profits which is distributed among the shareholders. The div idend decision of the firm is of crucial importance for the finance manager since it determines the amount to be distributed among shareholders and the amount of profit to be retained in the business. Retained earnings are v ery important for the growth of the firm. Shareholders may also ex pect the company to pay more div idends. So both the growth of company and higher div idend distribution are in conflict. So the div idend decision has to be taken in the light of wealth max imisation objectiv e. This requires a v ery good balance between div idends and retention of earnings. A financial manager may treat the div idend decision in the following two way s: 1 ) As a long term financing decision:- When div idend is treated as a source of finance, the firm will pay div idend only when it does not hav e profitable inv estment opportunities. But the firm can also pay div idends and raise an equal amount by the issue of shares. But this does not make any sense. 2) As a wealth max imisation decision:- Pay ment of current div idend has a positiv e impact on the share price. So to max imise the price per share, the firm must pay more and more div idends. 4.2 Div idend and Valuation There are conflicting opinions as far as the impact of div idend decision on the v alue of the firm. According to one school of thought, div idends are relev ant to the v aluation of the firm. Others opine that div idends does not affect the v alue of the firm and market price per share of the company . Relev ant T heory If the choice of the div idend policy affects the v alue of a firm, it is considered as relev ant. In that case a change in the div idend pay out ratio will be followed by a change in the market v alue of the firm. If the div idend is relev ant, there must be an optimum pay out ratio. Optimum pay out ratio is that ratio which giv es highest market v alue per share. 4.3 Walters Model (Relev ant T heory ) Prof. James E Walter argues that the choice of div idend pay out ratio almost alway s affects the v alue of the firm. Prof. J. E. Walter has v ery scholarly studied the significance of the relationship between internal rate of return (R) and cost of capital (K) in determining optimum div idend policy which max imises the wealth of shareholders. Walters model is based on the following assumptions: 1 ) The firm finances its entire inv estments by means of retained earnings only . 2) Internal rate of return (R) and cost of capital (K) of the firm remains constant. 3) The firms earnings are either distributed as div idends or reinv ested internally .

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Relevance and Irrelevance Theories of Dividend - makemynote.weebly.comLINCOLN KUMAR

4) The earnings and div idends of the firm will nev er change. 5) The firm has a v ery long or infinite life. Walters formula to determine the price per share is as follows: P= P = market price per share. D = div idend per share. E = earnings per share. R = internal rate of return. K = cost of capital.

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According to the theory , the optimum div idend policy depends on the relationship between the firms internal rate of return and cost of capital. If R>K, the firm should retain the entire earnings, whereas it should distribute the earnings to the shareholders in case the R<K. The rationale of R>K is that the firm is able to produce more return than the shareholders from the retained earnings. Walters v iew on optimum div idend pay out ratio can be summarised as below: a) Growth Firms (R>K):- The firms hav ing R>K may be referred to as growth firms. The growth firms are assumed to hav e ample profitable inv estment opportunities. These firms naturally can earn a return which is more than what shareholders could earn on their own. So optimum pay out ratio for growth firm is 0%. b) Normal Firms (R=K):- If R is equal to K, the firm is known as normal firm. These firms earn a rate of return which is equal to that of shareholders. In this case div idend policy will not hav e any influence on the price per share. So there is nothing like optimum pay out ratio for a normal firm. All the pay out ratios are optimum. c) Declining Firm (R<K):- If the company earns a return which is less than what shareholders can earn on their inv estments, it is known as declining firm. Here it will not make any sense to retain the earnings. So entire earnings should be distributed to the shareholders to max imise price per share. Optimum pay out ratio for a declining firm is 1 00%. So according to Walter, the optimum pay out ratio is either 0% (when R>K) or 1 00% (when R<K). 4.4 Gordons Model Another theory , which contends that div idends are relev ant, is the Gordons model. This model which opines that div idend policy of a firm affects its v alue is based on the following assumptions: a) The firm is an all equity firm (no debt). b) There is no outside financing and all inv estments are financed ex clusiv ely by retained earnings. c) Internal rate of return (R) of the firm remains constant. d) Cost of capital (K) of the firm also remains same regardless of the change in the risk complex ion of the firm. e) The firm deriv es its earnings in perpetuity . f) The retention ratio (b) once decided upon is constant. Thus the growth rate (g) is also constant (g=br).

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g) K>g.

Relevance and Irrelevance Theories of Dividend - makemynote.weebly.comLINCOLN KUMAR

MBA , Msc IT

h) A corporate tax does not ex ist. Gordon used the following formula to find out price per share P= P = price per share K = cost of capital E1 = earnings per share b = retention ratio (1 -b) = pay out ratio g = br growth rate (r = internal rate of return) According to Gordon, when R>K the price per share increases as the div idend pay out ratio decreases. When R<K the price per share increases as the div idend pay out ratio increases. When R=K the price per share remains unchanged in response to the change in the pay out ratio. Thus Gordons v iew on the optimum div idend pay out ratio can be summarised as below: 1 ) The optimum pay out ratio for a growth firm (R>K) is zero. 2) There no optimum ratio for a normal firm (R=K). 3) Optimum pay out ratio for a declining firm R<K is 1 00%. Thus the Gordons Models is conclusions about div idend policy are similar to that of Walter. This similarity is due to the similarities of assumptions of both the models. Bird in Hand Argum ent (Div idends and Uncertainty ) Gordon rev ised this basic model later to consider risk and uncertainty . Gordons model, like Walters model, contends that div idend policy is relev ant. According to Walter, div idend policy will not affect the price of the share when R = K. But Gordon goes one step ahead and argues that div idend policy affects the v alue of shares ev en when R=K. The crux of Gordons argument is based on the following 2 assumptions. 1 . Inv estors are risk av erse and 2. They put a premium on a certain return and discount (penalise) uncertain return. The inv estors are rational. Accordingly they want to av oid risk. The term risk refers to the possibility of not getting the return on inv estment. The pay ment of div idends now completely remov es any chance of risk. But if the firm retains the earnings the inv estors can ex pect to get a div idend in the future. But the future div idend is uncertain both with respect to the amount as well as the timing. The rational inv estors, therefore prefer current div idend to future div idend. Retained earnings are considered as risky by the inv estors. In case earnings are retained, therefore the price per share would be adv ersely affected. This behav iour of inv estor is described as Bird in Hand Argum ent. A bird in hand is worth two in bush. What is av ailable today is more important than what may be av ailable in the future. So the rational inv estors are willing to pay a

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Relevance and Irrelevance Theories of Dividend - makemynote.weebly.comLINCOLN KUMAR

rate. This is shown below. 4.5 Modigliani-Miller Model (Irrelev ance theory )

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higher price for shares on which more current div idends are paid. Therefore the discount rate (K) increases with retention

According to MM, the div idend policy of a firm is irrelev ant, as it does not affect the wealth of shareholders. The model which is based on certain assumptions, sidelined the importance of the div idend policy and its effect thereof on the share price of the firm. According to the theory the v alue of a firm depends solely on its earnings power resulting from the inv estment policy and not influenced by the manner in which its earnings are split between div idends and retained earnings. Assumptions: 1 . Capital markets are perfect:- Inv estors are rational information is freely av ailable, transaction cost are nil, securities are div isible and no inv estor can influence the market price of the share. 2. There are no tax es:- No difference between tax rates on div idends and capital gains. 3. The firm has a fix ed inv estment policy which will not change. So if the retained earnings are reinv ested, there will not be any change in the risk of the firm. So K remains same. 4. Floatation cost does not ex ist. The substance of MM arguments may be stated as below: If the company retains the earnings instead of giv ing it out as div idends, the shareholders enjoy capital appreciation, which is equal to the earnings, retained. If the company distributes the earnings by the way of div idends instead of retention, the shareholders enjoy the div idend, which is equal to the amount by which his capital would hav e been appreciated had the company chosen to retain the earnings. Hence, the div ision of earnings between div idends and retained earnings is irrelev ant from the point of v iew of shareholders.

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