THEORIES OF DIVIDEND POLICY

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ii)

Dividend Relevance Theories

Dividend Irrelevance Theories

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Dividend Relevance Theory

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ii)
iii)
iv)
v)
vi)

The dividend is a relevant variable in determining the value

of the firm, it implies that there exists
an optimal dividend policy, which the managers should seek
to determine, that maximises the
value of the firm. There are three models, which have been
developed under this approach. These are:
Traditional Model
Walters Model
Gordons Dividend Capitalisation Model
Bird-in-hand Theory
Dividend Signalling Theory
Agency Cost Theory
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TRADITIONAL MODEL

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MP is positively related to higher dividends. Thus MP would

increase if dividends are higher and decline if dividends are
lower.
P = m (D + E/3)

where,

P = Market price
m = Multiplier
D = Dividend per share
E = Earnings per share

WALTERS MODEL

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Based on the assumptions that all investments are financed

through RE, rate of return and cost of capital are constant,
the firm either distributes dividends or reinvested
internally; Walter put forth the following model for
valuation of shares
P0 = D + (E D) rlk
k
P0 = market price per share
D = Dividend per share
E = Earnings per share
E D = Retained earnings per share
r = Firms average rate of return
k = firms cost o capital
From the model it is clear that the market price per share is the
sum
of two consumptions:
i.
The first component Dlk is the present value of an infinite
stream of cash flows in the form of dividends.
ii.
The second component (E D)rlk is the present value of
an infinite stream of returns
k
retained earnings.

GORDONS DIVIDEND
CAPITALISATION MODEL

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Assumptions : Firm is all-equity, RE are used to finance

projects, r and k are constant, there are no taxes, b
once decided is constant.
Gordon put forward the following valuation model:

P0 = E1 + (1 b)
k - br
where,
P0 = Price per share at the end of the year 0
E1 = Earnings per share at the end of year 1
(1 b) = Fraction of earnings the firm distributes by way of
earnings
b = Fraction of earnings the firms ploughs back
k = Rate of return required by the shareholders
r = Rate of return earned on investments made by the firm
br = Growth rate of earnings and dividends
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BIRD-IN-HAND THEORY

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John Lintner propounded this theory in 1962 and Myron

Gordon in
1963. The shareholders are not entitled to any fixed return.
The return
to the shareholders is in the form of dividends and capital
gains.
Current dividends are relatively certain compared to future
capital
gains.
According to this theory shareholders are risk averse and
prefer to
receive dividends in the present time period to future
capital gains.
Modigliani and Miller termed this argument as bird-in-hand
fallacy.

DIVIDEND SIGNALLING THEORY

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Managers have greater access to inside information about the

company. They may share this information with the shareholders
through an appropriate dividend policy. Constant or increasing
dividends convey positive signals about the future prospects of the
company resulting in an increase in share price. Similarly, absence of
dividends or decreasing dividends convey negative signal resulting
in
decline in share price.
A liberal dividend policy by reducing the agency costs may lead to
enhancement of the shareholder value.

DIVIDEND IRRELEVANCE THEORY

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These theories contend that there are two components of

shareholderreturns.
a)
Dividend Yield (D / P0)
b)
Capital Yield (P1 / P0) / P0)
Suppose a firm issues a Rs.10 par value share at a
premium of Rs.90.
In other words, the issue price is Rs.100. If the firm
declares a dividend of Rs.3 (the dividend yield is 3%)
price at the end of next year
is Rs.115, the capital yield is (115 100) / 100 = 15 per
cent. The total
return to the shareholders is 18 per cent.
These theories, which argue that dividends are not relevant
in
determining the value of the firm, are:
i.
Residual Theory
ii.
Modigliani and Miller (M&M) Model
iii.
Dividend Clientele Effect
iv.
Rational Expectations Model

DIVIDEND IRRELEVANCE THEORY

Residual Theory

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According to this theory a firm will only pay dividends from

residual
earnings, that is, from earnings left over after all the
suitable
investment opportunities have been financed.

Modigliani and Miller (M&M) Model

According to the model, it is only the firms investment
policy that will have an impact on the share value of
the firm and hence should be given more importance.

DIVIDEND IRRELEVANCE THEORY

Modigliani and Miller (M&M) Model
The current market price of the share is equal to the discounted
value of the dividend paid and the market price at the end of the
period.

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P0 = _1___ (D1 + P1 )
(1 + ke)
where,
P0 = Current market price of the share (t = 0)
P1 = Market price of the share at the end of the period (t = 1)
D1 = Dividends to be paid at the end of the period (t = 1)
ke = Cost of equity capital
With no external financing the total value of the firm will be as
follows:
nP0 = _1___ (nD1 + nP1 )
(1 + ke)
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DIVIDEND IRRELEVANCE THEORY

Modigliani and Miller (M&M) Model

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Simplifying the above equation, we get

n1P1 = I E + nD1
where,
I = Total investment required
nD1 = Total dividends paid
E = Earnings during the period
(E - nD1 ) = Retained earnings

Substituting this value of the new shares in the above equation, we

get
nP0 = _1___ [nD1 + (n + n1)P1 - I + E - nD1 ]
(1 + ke)
= nD1 + (n + n1)P1 - I + E - nD1
(1 + ke)
nP0 = (n + n1)P1 - I + E
(1 + ke)
Thus, according to the M&M model, the market value of the share is
not
affected by the dividend policy and this is clear from the last equation

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:According to this theory, dividend

policy is irrelevant in determining the firms value.
Different firms may follow different dividend policies
depending upon their own needs and circumstances.
One firm may decide on a higher payout ratio whereas
others may decide on lower dividend payout.
Similarly,different shareholders may have different
needs some may prefer current dividends whereas
others may be more interested in capital gains. Those
investors who prefer current dividends would like to
become shareholders in companies which declare
generous dividends whereas those investors who are
more interested in capital gains would folk to
companies having relatively lower payout ratios.
RATIONAL EXPECTATIONS MODEL: According to this model there
would be no effect of dividend declaration on the
market price as long as the dividend declared is in line
with the expected dividends. If dividend <expected
dividend MP will decline and vice versa. Thus, so far
as dividend declared ratifies the market expectation
the dividend policy is not relevant in determining the
MP.

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DIVIDEND CLIENTELE EFFECT

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PRACTICAL CONSIDERATIONS IN THE

FORMULATION OF DIVIDEND POLICY
Profitability and Liquidity

Legal Constraints

Contractual Constraints

Growth Prospects

Owner Considerations

Market Considerations

Industry Practice

Shareholders Expectations

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