Learning Outcome

• Concepts of Dividends and Retained earnings

• To understand what is dividend policy
• Relationship between Dividend policy and
value of the firm
• Factors responsible for Dividend policy
• Relevance theories like Walter and Gordon
models
• Irrelevance theory like Modigliani and Miller
model
 Concepts
• Making decision on dividend is very crucial area in Corporate
Finance
• Dividends : It refers part of profits , which distributed by the
company among shareholders
• Ploughed Back Profits : Part of Profits which are not
distributed by the company to their shareholders
• Dividend payout Ratio : DPS/EPS
• Retention Ratio : (1-DPR)
• Dividend Policy means:
To determine the amount of earning to be distributed to the
shareholders and the amount to be retained in the firm
 Dividend policies
1. Low payout policy :
It implies more retention of profits
Less payout dividends
Impact :
Growth companies will realize their return mostly in the form of capital gain
Dividend yield will be low
Ex: New age corporations like Flipkart (walmart) fund panda(ola)
2. High payout policy :
It implies Less retention of profits
High dividend payout
Impact :
Slow Growth companies will realize their return on capital gain is low
Dividend yield will be high
Ex: Coal India Ltd, TCS, ONGC, Infosys, IOCL , HUL , NTPC Ltd, NMDC
 Factors influence on dividend policy of the firm
• Liquidity
• The Growth
• Profitability
• Cost and availability of alternative form of financing
• Preference of the shareholders
• Contractual restrictions
• Access to the capital markets
• Inflation.
• Leverage
• Age of company
• Taxation policy
• Control objectives
 Relationship between
Dividend policy and value of the firm
• Different opinions have come up
• These can be grouped into two categories
I. Relevance Theories : Dividend policy
influence on value of the firm
II. Irrelevance theories : Dividend policy does
not influence on value of the firm
 Dividend Theories
• Relevance theories
Walter's Model
Gordon's Model
Irrelevance theories :
• Modigliani and Miller Hypothesis
 Walter model
• According to Prof.James E.Walter says that
• The dividend policies affect the value of the firm
• The investment policy cannot be separated from
the dividend policy since both are interlinked
• Walter’s Model shows the clear relationship
between the return on investments (r) and the
cost of capital (K).
• The choice of appropriate dividend policy affects
the value of the firm
 Assumptions of Walter’s Model

• All the financing is done through the retained

earnings; no external financing is used.
• Required rate of return (r) and the cost of capital (K)
remain constant
• The earnings per share (EPS) and Dividend per share
(DPS) remains constant.
• The firm has a perpetual life
• Capital Markets are perfect
• No flotation, transaction costs
• No Corporate Dividend tax
9
 Optimum Payout Ratio
Growth Firms – Retain all earnings
• If r>K Zero Payout Ratio 100% Retention Ratio
• the firm should retain the earnings because it possesses better investment
opportunities and can gain more than what the shareholder can by re-investing.
• The firms with more returns than a cost are called the “Growth firms” and have a
zero payout ratio.
Declining Firms – Distribute all earnings
• If r<K 100% Payout Ratio 0% Retention Ratio,
• the firm should pay all its earnings to the shareholders in the form of dividends,
because they have better investment opportunities than a firm. Here the payout
ratio is 100%.
Normal Firms – No significance
• If r=K, the firm’s dividend policy has no effect on the firm’s value.
• Here the firm is indifferent towards how much is to be retained and how much is
to be distributed among the shareholders.
• The payout ratio can vary from zero to 100%.
 Example

• The details of the firm as follows

• EPS =Rs.4/- and K=15% - if Dividend payout Ratio is 100%
Growth Firm Normal firm Declining firm
r>k r=k r<k
r=20%, k=15% EPS = Rs.4 , DPS =4 r=15%, k=15% EPS = Rs.4 , DPS =4 r=10%, k=15% EPS = Rs.4 , DPS =4
P= D+(EPS-DPS) r/K P= D+(EPS-DPS) r/K P= D+(EPS-DPS) r/K
K K k
P= 4+ (4-4) 0.20/0.15 P= 4+ (4-4) 0.15/0.15 P= 4+ (4-4) 0.10/0.15
0.15 0.15 0.15
P= 4+0 =26.67 4+0 = 26.67 4+0 =26.67
0.15 0.15 0.15
If Dividend Payout Raito is 50% it means EPS=4 and DPS = 50% of 4 = Rs.2/-
r>k r=k r<k
r=20%, k=15% EPS = Rs.4 , DPS =2 r=15%, k=15% EPS = Rs.4 , DPS =2 r=10%, k=15% EPS = Rs.4 , DPS =2
P= D+(EPS-DPS) r/K P= D+(EPS-DPS) r/K P= D+(EPS-DPS) r/K
K K k
P= 2+ (4-2) 0.20/0.15 P= 2+ (4-2) 0.15/0.15 P= 2+ (4-2) 0.10/0.15
0.15 0.15 0.15
P= 2 + 2*0.20/0.15 2+ 2*0.15/0.15 2+ 2*0.10/0.15
0.15 0.15 0.15
p= 2+2.67/0.15 P= 2+2 /0.15 p = 2+1.33/0.15
P = 4.67/0.15 = 31.11 P= 4/0.15 =26.67 p= 3.33/0.15 = 22.21
 Implications

• r >k : The price per share increases when Dividend

payout ratio decreases
• r =k : The per share does not vary with changes in
Dividend payout Ratio
• r < k : The price per share increases when the
Dividend payout ratio increases
Thus walter model implies that
Optimum payout ratio for growth firm is NIL
for Normal firm is irrelevant
for Declining firm is 100%
 Case study
• The following information is available for
Avanti Corporation
• EPS= Rs.4/- ; r= 18%; k=15%
• What will be the price per share as per the
walter model
• If i) Dividend payout ratio at 40%
• ii) Dividend payout ratio at 50%
• iii) Dividend payout ratio at 60%
 Criticism of walter model
• Single source of capital is practically non viable
• Stable rate of return on investment is possible
• Stable cost of capital is not practically possible
• No transaction and flotation costs
• No Dividend tax is practically not possible
Example: Dividend Policy: Application of Walter’s Model

15
 DIVIDEND RELEVANCE: GORDON’S MODEL

• It is proposed by Myron Gordon

• It is another dividend relevance theory
• It relates the value of share depends on
dividend policy of the firm
• It States that
• “The company dividend payout policy and
relationship between its rates of return and
cost of capital influence the price per share of
the company.”
 Assumptions of Gordon model
– All-equity firm
– No external financing
– Constant return
– Constant cost of capital
– Perpetual earnings
– No corporate taxes
– Constant retention ratio
– Cost of capital greater than growth rate

17
 Valuation
• Market value of a share is equal to the present
value of an infinite stream of dividends to be
received by shareholders.
 Relationship between Dividend payout ratio
and the value of the share
Relationship between r and K Increase D/P Ratio Decrease D/P Ratio
Growth firm:
• If r>K) price per share decreases price per share increases

Declining Firms:
• If r<K price per share increases price per share decreases
Normal Firms:
• If r=K, the firm’s dividend policy has no effect on the firm’s value.
 Example

• The details of the firm as follows

• EPS =Rs.4/- and K=15%; - if Dividend payout Ratio is 100%
• Note : b= retention ratio ; (1-b) = Dividend Pay out ratio; Growth rate = b*r
• Note : cost of capital is nothing but cost of equity because no debt capital
• Note : cost of equity (ke) is greater than growth rate (g)
Growth Firm Normal firm Declining firm
r>k r=k r<k
r=20%, k=15% EPS = Rs.4 , DPS =4 r=15%, k=15% EPS = Rs.4 , DPS =4 r=10%, k=15% EPS = Rs.4 , DPS =4
If Retention Ratio is 25% ie b=25%;( IT MEANS DIVIDEND PAYOUT RATIO WILL BE 75%)
P= E(1-b) = D/k-g P= E(1-b) =D/k-g P= E(1-b) = D/k-g
K-b*r K-b*r k-b*r
P= 4(1- 0.25) P= 4 (1-0.25) p = 4 (1-0.25)
0.15-0.25*0.20 0.15- 0.25*0.15 0.15-0.25*0.10
P= 3 = Rs.30 3 = Rs.26.67 3 = Rs.24
0.10 0.1125 0.125
If Retention Raito is 50% it means EPS=4 and DPS = 50% of 4 = Rs.2/- ( It means D/P Ratio is 50%)
r>k r=k r<k
r=20%, k=15% EPS = Rs.4 , DPS =2 r=15%, k=15% EPS = Rs.4 , DPS =2 r=10%, k=15% EPS = Rs.4 , DPS =2
P= E(1-b) = D/k-g P= E(1-b) =D/k-g P= E(1-b) = D/k-g
K-b*r K-b*r k-b*r
P= 4(1- 0.50) P= 4 (1-0.50) p = 4 (1-0.50)
0.15-0.50*0.20 0.15- 0.50*0.15 0.15-0.50*0.10
P= 2 = Rs.40 2 =Rs.26.67 2 = Rs.20
0.05 0.075 0.10
 Implications of Gordon model
• If r>k ; the price per share is increases if the retention ratio
increases
If r=K ; the price per share is remain unchange irrespective of
Retention raio
• If r<k; the price per share is decrease if the retention ratio
increases
Optimal payout ratio :
if r>k : Nil
If r=k : irrelevant
If r<k : 100%
Example: Application of Gordon’s Dividend Model

22
 Case study

• TCS reveled the following information

• EPS=Rs.3/- ; cost of capital =12% , rate of
return 15%
• If Gordon dividend model holds good
• What will be the price per share when
• i) Dividend payout ratio will be 25%
• Ii) Dividend payout ratio will be 50%
• Iii) Dividend payout ratio is 75%
 Modigliani and Miller Approach /Hypothesis
• According to MM approach dividend policy has no effect on
the price of shares of the firm
• It believes that it is investment policy that increases the firm’s
share value
• MM approach stated that
• “The value of the firm depends solely on its earnings power
and is not influenced by the manner in which its earnings are
split between dividends and retained earnings.”
 Assumptions of MM theory

• Capital markets are perfect

• Investors are rational
• Information is freely available
• There is no transaction costs
• Securities are divisible
• No investor influence market price
• No flotation costs
• There are no taxes
• Investment opportunities and future profits are known with
certainty
• Investment and dividend decisions are independent
 MM Argument

If a company retains earnings instead of giving it out as a

dividend
• The shareholders enjoys capital appreciation equal to the
amount of retained earnings
If a company distribute earnings by way of Dividends instead of
retaining it ,
• The shareholder enjoys dividends equal value to the amount
which his capital would have appreciated had company
chosen retain its earnings .
Hence :
The division of earnings between dividend and retained
earnings is irrelevant from the point of view of the
shareholders.
 MM-Irrelevance theory : Proof
Step 1:
• Po = D1 + P1
• (1+Ke) (1+Ke)
Where Po = Current Market Price of a share
D1 = Dividend paid end of the period
P1 = Market price per share end of the period
Ke = cost of equity
Price per share = PV of dividend + PV of market price of end of the year
Step 2: Assuming no external financing the total capitalized value of the
firm
nPo = nD1 + nP1 where n = No.of outstanding shares
(1+Ke) (1+Ke)
Step 3: if the firm internal source of financing its investment opportunities fall
short of funds required and
m is the number of new shares issued at the end of year 1 , at the price P1
npo = n * D1 + (n + m )P1 - m * P1
(1+Ke) (1+Ke)
PV value of the firm = PV of Dividend paid end of the year + Pv of
market price before issue of new stocks
Where :
n = No.of outstanding shares at time 0
Npo = the total market value of outstanding shares at time 0
nD1 = the total dividends in year1 payable on equity shares outstanding at
time 0
m = no.of equity shares issued at time 1 at a price p1
P1 = Prevailing market price at time 1
(n+m) P1 = Total market value of all outstanding shares at time 1
mP1= the market value of shares issued at time 1
ke = Cost of equity
• Step 4:
• If the firm were to finance all investment proposals, the total amount of raised through
new shares issued would be given equation
• mP1 = I – (E-nD1) or I-E+nD1
• Where mp1 = Amount obtained from sale of new shares
I = Total amount of investment
E= Earning of the firm during the year
nD1 = Total Dividends paid for outstanding shares at time 0
(E-nD1) = Retained earnings
Step 5: if we substitute Equation in Step 4 into Equation in step 3
npo = n D1 + (n + m )P1 - m P1 step 3 Equation
(1+Ke) (1+Ke)
npo = n D1 + (n + m )P1 - (I – E-nD1)
(1+Ke)
or
npo = n D1 + (n + m )P1 - I+E-nD1
(1+Ke)

There is a positive nD1 and negative nD1 so nD1 cancels

we then have
nP0= (n + m )P1 - I + E
(1+Ke)
Step 6: since dividends are not in the final
equation MM concludes that dividend
and dividend policy has no effect on the
value of the firm / share price
Hence it is prove that dividend is
irrelevant value of the firm
• (n+m)P1 , the value of equity of the firm end of year
1, is no way affected by dividend paid end of the year.
• Why ?
• If the firm pays more D1 ,
• P1 Decreases but m increases
• On the other hand if firm pays less D1
• P1 increases but m decreases .
• Hence there is no relevance of dividend to change the
price of share and value of the firm The reason is
simple
Note : D1 influences P1 and m in mutually offsetting
manner
 Case study ( Khan & Jain)
• Risk class of a company and its capitalization rate (ke) is 10%
• Outstanding shares (n) =25,000
• Price per share at current market (Po)= 100
• Dividends to be declared during the year(D1) =Rs.5/-
• Expected Earnings during the year (E) = Rs.2,50,000/-
• New investment capital required (I) = Rs.5,00.000/-
Show under MM model , The payment of Dividends not affect the value of the firm
Solution :
A: value of the firm when dividends are paid:
• P0 = D1 + P1
• (1+Ke)
• 100 = 5+P1
• 1.10
• 110=5+P1
• 110-5 = P1
• P1= 110-5 =105
ii) Amount to be raised through issue of new shares
m * P1 = I-( E- n D1)
= 5,00,000 - ( 2,50,000- 25,000*5)
= 5,00,000- (2,50,000-1,25,000)
= 5,00,000-1,25,000 = 3,75,000
iii) no.of additional shares to be issued
m= Amount to be raised
price per share end of the year 1
= 3,75,000/105 = 3571.42857 shares
iv) Value of the firm
nPo= (n+m) P1 – I+E
(1+ke)
= [(25,000+ 3571.42857)105 – 5,00,000+2,50,000]
(1+.10)
= 30,00,000- 5,00,000 +2,50,000
1.10
= 27,50,000/1.10 = 25,00,000
B: value of the firm when dividends are not paid:
i) Price per share end of the year
• P0 = D1 + P1
• (1+Ke) (1+Ke)
• 100 = 0 +P1
• 1.10
• 110-0 = P1
• P1= 110-0 =110
ii) Amount to be raised through issue of new shares
m * P1 = I-( E- n D1)
= 5,00,000 - ( 2,50,000- 0)
= 5,00,000-2,50,000 = 2,50,000
iii) no.of additional shares to be issued
m = Amount to be raised / price per share end of the year 1
= 2,50,000/110 = 2272.72727 shares
iv) Value of the firm
npo= (n+m) P1 – I+E
(1+ke)
= [(25,000+ 2,272.72727)110 – 5,00,000+2,50,000]
(1+.10)
= 30,00,000- 5,00,000 +2,50,000
1.10
= 27,50,000/1.10 = 25,00,000

• Hence no relevance of dividend policy on value of the firm

• The theorem was proved