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DIVIDEND THEORIES
1) Relevance Theory :
> Walters Model
> Gordons Model
2) Irrelevance Theory :
> Miller & Modigliani Hypothesis ( MM
Approach)
Walters Model
Shows relationship b/w a firms rate of return r and its cost
of capital k. it is based on the following assumptions:
1.Internal financing The firm finances all its investments
through retained earnings. (debt or new equity is not
issued).
2.Constant return and cost of capital The firms rate of
return r, and its cost of capital k are constant
3.100% payout or retention all earnings are either
distributed
as
dividends
or
reinvested
internally
immediately.
4.Constant EPS and DPS beginning earnings and dividends
never change. The values of the EPS and DPS may be
changed in the model to determine results but are assumed
to remain unchanged in determining a given value.
5.Infinite time the firm has a very long or infinite life
In a nutshell:
If r>ke, the firm should have
zero payout and make
investments.
If r<ke, the firm should have
100% payouts and no investment
of retained earnings.
If r=ke, the firm is indifferent
between dividends and
investments.
Walter concludes:
The optimum payout ratio is nil in
case of growth firm, the payout ratio
of a constant firm is irrelevant, the
optimum payout ratio for a declining
firm is 100 per cent.
Mathematical representation
Walter has given a mathematical
model for the above made
statements:
Where,
P = Market price of the share
D = Dividend per share
r = Rate of return on the firm's
investments
ke= Cost of equity
Gordons Model :
Con..
1. No external financing is available;
consequently retained earnings would be used
to finance any expansion of the firm. Similar
argument as Walters for the dividend and
investment policies.
2. Constant return which ignores diminishing
marginal efficiency of investment as
represented in the diagram on Walters model.
3. Constant cost of capital; model also ignores
the risk-effect as did Walters
Con..
5. Constant retention ratio b, i.e. once
decided upon stays as such forever.
The growth rate g = br stays
constant in that case.
6. Cost of capital greater than the
growth rate (k > br = g); otherwise
it is not possible to obtain a
meaningful value for the share.
Where:
(1 b) = dividend payout ratio where
retention ratio of the firm is b
g = the growth rate determined as br
g is always less than k
Dividends Irrelevance
The propagators of this school of thought
were France Modigliani and Merton Miller
(1961).
They state that the dividend policy employed
by a firm does not affect the value of the
firm. They argue that the value of the firm
is dependent on the firms earnings
which result from its investment policy,
so that when the investment policy is given
the dividend policy is of no use.
Assumptions of M-M
hypothesis
Perfect capital markets, i.e. investors behave
rationally, information is freely available to all
investors, transaction and floatation costs do not
exist, no investor is large enough to influence the
price of a share.
Taxes do not exist; or there is no difference in the tax
rates applicable to both dividends and capital gains.
The firm has a fixed investment policy
The risk of uncertainty does not exist, i.e. all
investors are able to forecast future prices and
dividends with certainty and one discount rate is
appropriate for all securities over all time periods.
Con..
This discount rate will also be equal
for all firms under the M-M
assumption since there are no risk
differences.
From the above M-M fundamental
principle we can derive their
valuation model as follows:
{I-(E_nD1)}/P1
Criticisms?
THANK YOU