Corporate Finance

Dividend Theories and

Valuation
By
Sumit Gulati
MD & CEO, FinanceKnowledgeHub
Author of the book on Financial Management
Published by Mcgraw Hill

Introduction
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 firms share.

Issues in Dividend Policy

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.

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

Relevance of Dividends
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:

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

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

Assumptions for Walters model are:

Internal financing (No external financing)

Constant cost of capital and rate of return
Fixed EPS and DPS
Infinite life

Walters formula to determine the

market price per share:

Where,
P
DPS
EPS
k
r

=
=
=
=
=

Market price of share

Dividend per share
Earnings per share
Cost of capital
Rate of return

Relevance of Dividends
In the Walters Model, the dividend policy is determined by the

presence of investment options and the relationship between the

firms 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.

Relevance of Dividends
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?

Relevance of Dividends
Solution:
In the given case

EPS = 20, k = 15%, r = 10%

As per Walters Model, the price of a share is:

Relevance of Dividends

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 Walters 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

Relevance of Dividends
Gordons Model
Myron Gordon developed a model to determine market value of

shares in relation to dividend policy.

The main assumptions of Gordons 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 firms share. It indicates the relationship of the

following parameters with the market price of firms share.
Earnings per share (EPS1)
Retention ratio (b)

Rate of return (r)

Cost of capital (k)

Relevance of Dividends
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.

Relevance of Dividends
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 Gordons Model. What will be
the price, if the company has a payout of 70% or 30%?

Relevance of Dividends
Solution:
The Gordons 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

Relevance of Dividends

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

The Bird-in-the-Hand Argument

As per Gordons 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 firms 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.

Irrelevance of Dividend
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 firms 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.

Irrelevance of Dividend
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 firms 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.

Irrelevance of Dividend
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.

Irrelevance of Dividend
Assumptions for MM Hypothesis:
Capital markets are perfect:

No single investor is so large as to affect the market price of the

firms 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.

Irrelevance of Dividend
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

Irrelevance of Dividend

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)

Irrelevance of Dividend
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

Irrelevance of Dividend
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

Irrelevance of Dividend
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

Market Imperfections and Relevance of Dividend

Policy
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

Market Imperfections and Relevance of Dividend

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

Market Imperfections and Relevance of Dividend

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

Dividends

of Tax and Shareholders Preference for

Informational Content of Dividends:

Dividend-Signalling Hypothesis
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 managements 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.

Practical Aspects of Dividend Policy

Dimensions of Dividend Policy
The firms decision to pay dividend may depend upon the
following two approaches.
1. Firms 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, firms life cycle, growth

opportunities, shareholders desires, etc.

Practical Aspects of Dividend Policy

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.

Factors Affecting Dividend Policy

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.

Stability of Dividends
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.

Lintners Model and Dividend Smoothing

by Managers
According to John Lintners 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 Lintners 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

Lintners 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 Lintners model and give your comment.

Lintners Model and Dividend Smoothing

by Managers
Solution:
Using Lintners 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.

Forms of Dividend
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.

Thank You