DIVIDEND THEORIES

DIVIDEND THEORIES
 There are three main categories
advanced:
1. Dividend relevance theories

2. Dividend irrelevance theories

3. Dividend & uncertainty

DIVIDEND RELEVANCE THEORIES
 These are theories whose propagators
argue that the dividend policy of a firm
affects the value of the firm. There are
two main theorists:
 James E. Walter (Walter’s model)
 Myron Gordon (Gordon’s model)
WALTER’S MODEL
 Shows relationship btwn a firm’s 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 firm’s 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
 Walter’s formula for determining MPS is
as follows:
P = (DPS/k) + [r (EPS – DPS)/k]/k 
Where:
 P = market price per share
 DPS = dividend per share
 EPS = earnings per share
 r = firm’s average rate of return
 k = firm’s cost of capital
 the market value is determined as the
present value of two sources of income:
1. PV of constant stream of dividend (DPS/k)

2. PV of infinite stream of capital gains:

r(EPS-DPS)/k
Hence the formula can be rewritten as
P = DPS + (r/k) (EPS – DPS)
k
 Given three types of firms or scenarios of firms the
model can be summarized as follows:
1. Growth firm: there are several investment
opportunities (r > k) and the firm can reinvest
earnings at a higher rate r than that which is
expected by shareholders k. thus they wil maximize
value per share if they reinvest all earnings.
2. Normal firm: there aren’t any investments
available for the firm that are yielding higher rates
of return (r = k) thus the dividend policy has no
effect on market price.
3. Declining firm: there aren’t any
profitable investments for the firm to
reinvest its earnings, i.e. any
investments would earn the firm a rate
less than its cost of capital (r < k). The
firm will therefore maximize its value
per share if it pays out all its earnings
as dividend.
CRITICISMS OF WALTER’S MODEL
 Model assumes investment decisions of
the firm are financed by retained
earnings alone
 Model assumes a constant rate of
return and;
 constant cost of capital, i.e. disregards
the firm’s risk which changes over time
hence the discount rate will change
over time in proportion.
GORDON’S MODEL
 Assumptions:
1. The firm is an all equity firm, i.e. no debt

2. No external financing is available; consequently

retained earnings would be used to finance any
expansion of the firm. Similar argument as Walter’s
for the dividend and investment policies.
3. Constant return which ignores diminishing
marginal efficiency of investment as represented
in the diagram on Walter’s model.
4. Constant cost of capital; model also ignores the
risk-effect as did Walter’s
5. Perpetual stream of earnings for the
firm
6. Corporate taxes do not exist
7. Constant retention ratio b, i.e. once
decided upon stays as such forever.
The growth rate g = br stays constant
in that case.
8. Cost of capital greater than the growth
rate (k > br = g); otherwise it is not
possible to obtain a meaningful value
 According to Gordon’s model dividend per
share is expected to grow when earnings are
retained. The dividend per share is equal to
the payout ratio multiplied by earnings [EPS
X (1-b)]. To determine the value of the firm
therefore based on the dividend growth
model the value of the firm will be:
 P0 = EPS (1 – b)
k–g
 Where:
 (1 – b) = the retention ratio of the firm given
b as the payout ratio.
 g = the growth rate determined as br
 g is always less than k
 The conclusions of Gordon’s model are similar to
Walter’s model due to the fact that their sets of
assumptions are similar.
1. The market value of P0 increases with retention
ratio b, for firms with growth opportunities, i.e.
when r > k.
2. The market value of the share P0 increases with
payout ratio (1 – b), for declining firms with r < k
3. The market value is not affected by the dividend
policy where r = 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 firm’s earnings
which result from its investment policy, such
that when the policy is given the dividend
policy is of no consequence.
 Conditions that face a firm operating in
a perfect capital market, either;
1. The firm has sufficient funds to pay
dividend
2. The firm does not have sufficient funds
to pay dividend therefore it issues
stocks in order to finance payment of
dividends
3. The firm does not pay dividends but
the shareholders need cash.
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.
 Under the assumptions the rate of return, r, will
be equal to the discount rate, k. As a result the
price of each share must adjust so that the rate
of return, which is composed of the rate of
dividends and capital gains on every share, will
be equal to the discount rate and be identical for
all shares.
 The return is computed as follows:
r = Dividends + Capital gains (loss)
Share price
r = DIV1 + (P1 – P0)
P0
 As hypothesised, r should be equal for all
the shares otherwise the lower yielding
securities will be traded for the higher
yielding ones thus reducing the price of
the low yielding ones and increasing the
price of the high yielding ones.
 This arbitraging or switching continues
until the differentials in rates of return
are eliminated.
CONCLUSIONS OF THE MODEL
 A firm which pays dividends will have to raise funds
externally in order to finance its investment plans. When a
firm pays dividend therefore, its advantage is offset by
external financing.
 This means that the terminal value of the share declines
when dividends are paid. Thus the wealth of the
shareholders – dividends plus the terminal share price –
remains unchanged.
 Consequently the present value per share after dividends
and external financing is equal to the present value per
share before the payment of dividends.
 Thus the shareholders are indifferent between the payment
of dividends and retention of earnings.
CRITICISMS?
 Presence of Market Imperfections:
 Tax differentials (low-payout clientele)
 Floatation costs
 Transaction and agency costs
 Information asymmetry
 Diversification
 Uncertainty (high-payout clientele)
 Desire for steady income
 No or low taxes on dividends
THE BIRD-IN-THE-HAND THEORY
 Relaxing of Gordon’s simplifying assumptions
to conform slightly to reality, he concludes
that even when r = k, the dividend policy does
affect the value of the share based on the
view that: under conditions of uncertainty,
investors tend to discount distant
dividends (capital gains) at a higher rate
than they discount near dividends.
 Investors behave rationally, are risk-averse
and therefore have a preference for near
dividends to future dividends.
Put forth by Kirshman (1969) in the following terms:
“Of two stocks with identical earnings record and
prospects but the one paying higher dividend than the
other, the former will undoubtedly command higher
dividend than the latter merely because stockholders
prefer present to future values….stockholders
normally act on the premise that a bird in the
hand is worth two in the bush and for this reason
are willing to pay a premium price for the stock with
the higher dividend rate just as they discount the one
with the lower rate”.
 Uncertainty of dividends increases with
futurity, i.e. the further one looks the more
uncertain dividends become
 When dividend is considered with respect to
uncertainty the discount rate cannot be held
constant, it increase with uncertainty.
 Investors prefer to avoid uncertainty and
would be willing to pay a higher price for the
share that pays the higher current dividend, all
things held constant.
 The appropriate discount rate would thus
increase with the retention ratio.
QUESTIONS?