Chapter21 Dividend Policy and Firm Value

7/27/2019 Chapter21 Dividend Policy and Firm Value

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Chapter 21

DIVIDEND POLICY AND

FIRM VALUE


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OUTLINE

Models in Which Investment and Dividend Decisions are

Related

Traditional Position

Miller and Modigliani Position

Rational Expectations Hypothesis

Radical Position

Overall Picture


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The dividend policy of the firm determines

what proposition of earnings is paid to

shareholders by way of dividends and whatproposition is ploughed back in the firm for

reinvestment purposes.


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MODELS IN WHICH INVESTMENT AND

DIVIDEND DECISIONS ARE RELATED

Walter Model

Gordon Model


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WALTER MODEL

D+ (ED) r/k

P=

k

where: P= price per equity share

E= earnings per shareD= dividend per share

r= rate of return on investmentsk= cost of equity capital

Example

E= Rs.4, D= Rs.2, r= 0.20, k= 0.15

2 + 2 x 0.20/0.15

P=

0.15

= 31.11


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IMPLICATIONS OF THE WALTER MODEL

The optimal payout ratio for a growth firm (r> k) is nil

The optimal payout ratio for a normal firm (r= k) is

irrelevant

The optimal payout ratio for a declining firm (r< k) is

100 percent


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GORDON MODEL

E1 (1b)

P0 =

kbr

where P0 = price per share at the end of year 0

E1 = earnings per share at the end of year 1

(1b) = dividend payout ratio

b= ploughback ratiok = shareholders required rate of return

r= rate of return earned on investments made by the firm

br= growth rate of earnings / dividends

Example

r= 0.20, k= 0.15, E1 = 4.0, b= 0.25

4.0 (10.25)

P0 = = Rs.30

0.15(0.25) (0.20)


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IMPLICATIONS

The optimal payout ratio for a growth firm (r> k) is nil

The payout ratio for a normal firm is irrelevant

The optimal payout ratio for a declining firm (r< k) is

100 percent


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TRADITIONAL POSITION

P= m

where P= market price per share

D= dividend per share

R= retained earnings per share

m= a multiplier

4D

R

+3 3


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MILLER AND MODIGLIANI (MM) POSITION

MM have argued that the value of a firm depends solely on its

earning power and is not influenced by the manner in whichearnings are split between dividends and retained earnings

Earnings

DividendsCurrent

Income

Retained

Earnings

Capital

Apprecn


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MM ASSUMPTIONS

There is no tax advantage or disadvantage associated

with dividends.

Investment and dividend decisions are independent.

Firms can issue stock without incurring any floatation or

transaction costs.


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CRITICISMS OF MM POSITION

Critics of MM agree that, under the assumptions made by

MM, dividends are irrelevant. However, they dispute the

validity of the dividend irrelevance theorem by

challenging the assumptions used by MM.


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CRITICISMS OF MM POSITION

Information about Prospects

Uncertainty and Fluctuations

Offering of Additional Equity at Lower Prices

Issue Cost

Transaction Costs

Differential Rates of Taxes

Rationing

Unwise Investments


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RATIONAL EXPECTATIONS

HYPOTHESIS

What matters in economics is not what actually happens

but the difference between what actually happens and

what was supposed to happen.


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HYPOTHESIS

In a world of rational expectations, unexpected dividendannouncements would transmit messages about changes in

earnings potential which were not incorporated in the

market price earlier.

The reappraisal that occurs as a result of these signals

leads to price movements which look like responses to the

dividends themselves, though they are actually caused byan underlying revision of the estimate of earnings

potential.


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HYPOTHESIS

The above analysis is helpful in reconciling the

practitioners view that dividends matter very much and

the academic view that dividends do not matter. As Merton

Miller said: Both views are correct in their own way. The

academic is thinking of the expected dividend; the

practitioner of the unexpected


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RADICAL POSITION

Directly or indirectly dividends are generally taxed more

heavily than capital gains. So radicalists argue that firms

should pay as little dividends as they can get away with so

that investors earn more by way of capital gains and less

by way of dividends


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EFFECT OF DIVIDEND POLICY

ON REQUIRED RETURN

Firm A

(No Dividend)

Firm B

(High Dividend)

1. Next years price Rs 120 Rs 105

2. Dividend 0 Rs 15

3. Total pre-tax payoff Rs 120 Rs 120

4. Current price Rs 102.86 Rs 101.435. Capital gain Rs 17.14 Rs 3.57

6. Pre-tax rate of return

[(2) + (5)]/ (4)

16.67% 18.31%

7. Tax on dividend at 20 percent Rs 3

8. Tax on capital gains at 10 percent Rs 1.714 Rs 0.357

9. Total post-tax income Rs 15.426 Rs 15.213

10. Post-tax rate of return 15.426

102.86

15.213

101.43= 15% = 15%


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SUMMING UP

There are several views on the relationship between dividend policy and share

valuation.

According to the Walter model and the Gordon model the effect of dividendpolicy depends on the relationship between the rate of return on investments andthe cost of capital.

According to the traditional position the stock market places more weight on

dividends than on retained earnings.

Miller and Modigliani have advanced the view that the value of a firm isindependent of its dividend policy.

According to the critics of Miller and Modigliani, dividends matter because of

uncertainty characterising the future, imperfections in the capital market, andpresence of taxes.

In a world of rational expectations, unexpected dividend announcements would

transmit messages about changes in earnings potential which were notincorporated in the market price earlier.

The radical position argues that a lower dividend payout ratio promotes the

welfare of shareholders.

Chapter21 Dividend Policy and Firm Value

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