Chapter 21

DIVIDEND POLICY AND FIRM VALUE

OUTLINE Models in Which Investment and Dividend Decisions are Related

Traditional Position
Miller and Modigliani Position Rational Expectations Hypothesis Radical Position Overall Picture

The dividend policy of the firm determines what proposition of earnings is paid to shareholders by way of dividends and what proposition is ploughed back in the firm for reinvestment purposes.

MODELS IN WHICH INVESTMENT AND DIVIDEND DECISIONS ARE RELATED

Walter Model

Gordon Model

WALTER MODEL
D + (E D) r/k P= k where: P = price per equity share E = earnings per share D = dividend per share r = rate of return on investments k = 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

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

GORDON MODEL
E1 (1 b)
P0 = where k br P0 = price per share at the end of year 0 E1 = earnings per share at the end of year 1 (1 b) = dividend payout ratio b = ploughback ratio k = 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 (1 0.25) P0 = = Rs.30 0.15 (0.25) (0.20)

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

TRADITIONAL POSITION 4D P=m + R

where P = market price per share

D = dividend per share

R = retained earnings per share

m = a multiplier

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 which earnings are split between dividends and retained earnings
Current Income

Dividends

Earnings

Retained Earnings

Capital Apprecn

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.

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.

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

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.

RATIONAL EXPECTATIONS

HYPOTHESIS
In a world of rational expectations, unexpected dividend announcements 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 by an underlying revision of the estimate of earnings potential.

RATIONAL EXPECTATIONS

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

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

EFFECT OF DIVIDEND POLICY ON REQUIRED RETURN

Firm A (No Dividend) 1. Next years price 2. Dividend 3. Total pre-tax payoff 4. Current price 5. Capital gain 6. Pre-tax rate of return [(2) + (5)]/ (4) 7. Tax on dividend at 20 percent 8. Tax on capital gains at 10 percent 9. Total post-tax income Rs 120 0 Rs 120 Rs 102.86 Rs 17.14 16.67% Rs 1.714 Rs 15.426 Firm B (High Dividend) Rs 105 Rs 15 Rs 120 Rs 101.43 Rs 3.57 18.31% Rs 3 Rs 0.357 Rs 15.213

10. Post-tax rate of return

15.426 = 15% 102.86

15.213 = 15% 101.43

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 dividend policy depends on the relationship between the rate of return on investments and the 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 is independent 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, and presence of taxes. In a world of rational expectations, unexpected dividend announcements would transmit messages about changes in earnings potential which were not incorporated in the market price earlier. The radical position argues that a lower dividend payout ratio promotes the welfare of shareholders.