-Dividend-Policies

8/9/2019 -Dividend-Policies

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By Nitin Gogia


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Determinant or Factors affecting Dividend

Policy

Availability ofDivisible Profits

Availability of Profitable Reinvestment Opportunities

Availability of Liquidity Inflation

Effect on Market Prices

Composition of Shareholding

Companys own policy regarding stability of dividend

Attitude and Objectives of Management


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Dividend Theories

Relevance Theories(i.e. which considerdividend decision to berelevant as it affects the

value of the firm)

Irrelevance Theories(i.e. which considerdividend decision to beirrelevant as it does notaffects the value of thefirm)

Walters Model Gordons Model

Modigliani andMillers Model


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GORDONS MODEL OF DIVIDEND

POLICY According to Prof. Gordon, Dividend Policy almost

always affects the value of the firm. He Showed howdividend policy can be used to maximize the wealth ofthe shareholders.

The main proposition of the model is that the value ofa share reflects the value of the future dividendsaccruing to that share. Hence, the dividend payment

and its growth are relevant in valuation of shares. The model holds that the shares market price is equal

to the sum of shares discounted future dividendpayment.


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Assumptions ofGordon Growth

Valuation Model. The firm is an all equity firm and has no debt External financing is not used in the firm. Retained earnings

represent the only source of financing.

The internal rate of return is the firms cost of capital k. Itremains constant and is taken as the appropriate discount rate. Future annual growth rate dividend is expected to be constant. Growth rate of the firm is the product of retention ratio and its

rate of return. Cost of Capital is always greater than the growth rate. The company has perpetual life and the stream of earnings are

perpetual. Corporate taxes does not exist. The retention ratio b once decided upon, remain constant.

Therefore, the growth rate g=br, is also constant forever.


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Walters Valuation Modely Prof. James E Walter argued that in the long-run the

share prices reflect only the present value of expected

dividends. Retentions influence stock price onlythrough their effect on future dividends. Walter hasformulated this and used the dividend to optimize the

wealth of the equity shareholders.


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Formula of Walters ModelD + r (E-D)

k

P = kWhere,

P = Current Market Price of equity share

E = Earning per share

D=D

ividend per share(E-D)= Retained earning per share

r = Rate of Return on firms investment or Internal Rate of Return

k = Cost of Equity Capital


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Assumptions of Walters Modely All financing is done through retained earnings and

external sources of funds like debt or new equity capital arenot used. Retained earnings represents the only source of

funds.y With additional investment undertaken, the firms

business risk does not change. It implies that firms IRRand its cost of capital are constant.

y The return on investment remains constant.y

The firm has an infinite life and is a going concern.y All earnings are either distributed as dividends or invested

internally immediately.y There is no change in the key variables such as EPS or DPS.


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Effect of Dividend Policy on Value of ShareCase If Dividend Payout

ratio IncreasesIf Dividend PayoutRation decreases

1. In case of Growing firm

i.e. where r > k

Market Value of Share

decreases

Market Value of a share

increases2. In case ofDecliningfirm i.e. where r < k

Market Value of Shareincreases

Market Value of sharedecreases

3. In case of normal firmi.e. where r = k

No change in value ofShare

No change in value ofShare


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Criticisms of Walters Modely No External Financing

y Firms internal rate of return does not always remain

constant. In fact, r decreases as more and moreinvestment in made.

y Firms cost of capital does not always remain constant.In fact, k changes directly with the firms risk.


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Modigliani & Millers Irrelevance Model

y According to M-M, under a perfect market situation,the dividend policy of a firm is irrelevant as it does not

affect the value of the firm. They argue that the valueof the firm depends on the firms earnings and firmsearnings are influenced by its investment policy andnot by the dividend policy


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Modigliani & Millers Irrelevance Model

Value of Firm (i.e. Wealth of Shareholders)

Firms Earnings

Firms Investment Policy and not on dividend policy

Depends on

Depends on


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Assumption ofM-MModely Perfect Capital Market: This means that:

y The investors are free to buy and sell securities.

y

The investors behave rationally.y There are no transaction cost/ f lotation cost.

y They are well informed about the risk-return on all types ofsecurities.

y No investor is large enough to affect the market price of a

share.

y No Taxes

y Fixed Investment Policy

y No Risk


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Formulae of M-M Modely According to M-M model the market price of a share,

after dividend declared, is calculated by applying the

following formula:P1 + D1

1 + KeWhere,

P0 = Prevailing market price of a shareP1 = Market Price of a share at the end of the period one

D1 = Dividend to be received at the end of period one

Ke = Cost of equity capital

P0 =


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Formulae of M-M Modely The number of shares to be issued to implement the

new projects is ascertained with the help of the

following:I (E-nD1)

P1Where,

N = Change in the number of shares outstanding during the period.

I = Total Investment amount required for capital budget

E = Earning of net income of the firm during the period

n = Number of shares outstanding at the beginning of the period

D1 = Dividend to be received at the end of period one

P1 = Market price of a share at the end of period one

N =


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Criticism of M-M Modely No perfect Capital Market

y Existence of Transaction Cost

y Existence of Floatation Costy Lack of Relevant Information

y Taxes Exist

y No fixed investment Policy

y Investors desire to obtain current income

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