dividend decision & valuation of firm
TRANSCRIPT
Dividend Decision & Valuation of Firm
Dept. of Business and Financial StudiesUniversity of Kashmir
Dividend Decision & Valuation of Firm
Learning Goals:Dividend decision: what it is all about?
Dividend decision & valuation of firm:Walters modelGordon’s modelLinters modelGraham & Dods modelM-M Hypothesis
Dividend Decision & Valuation of Firm
DividendDecision
Amt. distributed among
shareholders
Amount of earnings to be
retained
Impact on Internal source of finance
Increases current wealth
Information value
Dividend Decision & Valuation of Firm
High payout:• Less retained earnings…..slower growth
perhaps lower MPLow payout:• More RE…. Higher growth….higher capital
gain….perhaps higher MP.
Payout Ratio
Low High
Dividend Decision & Valuation of Firm
Q: Does div. decision influence Value of a shares
Dividend Models:Walter’s Model
• Gordon’s Model Relevant• Linter’s Model• Graham & Dodd’s Model• M-M Hypothesis………Irrelevant
Walters Model
Contention:
C1: Div. Decision influences Value of a share……..Optimum P/O Ratio
E1: Relationship between IRR & K Used in determining optimum Decision
E2: Classifies companies into:
Growing, Normal, & Declining
Walters Model
• Less fin. Resources
• Req. more funds
• Difficult to obtain funds
• Suff. Investment opportunities
r > k
• Sufficient resource
• Req. less funds
•Access to funds
•Less feasible Investments opp.
R=k
• Little res.Req
• Little access
• Revamping
R<k
Growth Matured Declining
Walters Model
Assumptions:A1: Only retained earnings used to Finance
investments.
A2: IRR & K remains constant
A3: All earnings are either distributed or reinvested internally immediately
A4: EPS & Dividends never change
A5: Firm has infinite life
Walters Model
Growth Firm………..r > k
C: Optimum payout ratio is zero
E: Able to reinvest at a rate… higher than k
ResultAt zero payout ratio, weighted benefit of RE will be more than the dividends
Walters Model
Normal Firm………..r = k
C: No optimum payout ratio
E: Able to invest at a rate……=k
Result: At any payout ratio, weighted benefit of RE is
equal to that of dividends.
Walters Model
Declining Firm………r < k
C: Optimum payout ratio is 100%
E: No investment opp. or can earn
Less than the rate expected by...
Walters Model
D + (r/k) ( E – D ) P = -------------------------- k
Where: P = Market price of share D = Dividend per share r = IRR k = cost of capital E = EPS
D + (r/k) ( E – D ) P = -------------------------- k
Where: P = Market price of share D = Dividend per share r = IRR k = cost of capital E = EPS
P = Present value of stream of dividends & Capital gain
P = Present value of stream of dividends & Capital gain
Valuation of Shares
Walters Model
Example: The following estimates about three companies viz., A, B, & C are given:
A B C R …………15% 10% 8% K………….10% 10% 10% EPS………Rs 10 Rs 10 Rs 10
Walters ModelPayout Ratio = zero Payout Ratio = zero
Div = 00+(.15/.10) (10-0) .10 = Rs 150
Div = 00+(.10/.10)(10-0) .10 = Rs 100
Div = 00+(.08/.10) (10-0) .10 = Rs 80
Payout ratio = 40%
Div = 44+(.15/.10) (10- 4) .10 = Rs 130
Div = 44+(.10/.10)(10- 4) .10 = Rs 100
Div = 44+(.08/.10) (10- 4) .10 = Rs
Payout ratio = 100% Div =10
10+(.15/.10)(10-10) .10 = Rs 100
Div =100+(.10/.10)(10-10) .10 = Rs 100
Div =100+(.08/.10)(10-10) .10 = Rs 100
Payout Ratio = zero Payout Ratio = zero Div = 0
0+(.15/.10) (10-0) .10 = Rs 150
Div = 00+(.10/.10)(10-0) .10 = Rs 100
Payout Ratio = zero Payout Ratio = zero Div = 0
0+(.15/.10) (10-0) .10 = Rs 150
Div = 00+(.08/.10) (10-0) .10 = Rs 80
Div = 00+(.10/.10)(10-0) .10 = Rs 100
Payout Ratio = zero Payout Ratio = zero Div = 0
0+(.15/.10) (10-0) .10 = Rs 150
Div = 44+(.08/.10) (10- 4) .10 = Rs
Div = 00+(.08/.10) (10-0) .10 = Rs 80
Div = 00+(.10/.10)(10-0) .10 = Rs 100
Payout Ratio = zero Payout Ratio = zero Div = 0
0+(.15/.10) (10-0) .10 = Rs 150
Payout ratio = 40%
Div = 44+(.08/.10) (10- 4) .10 = Rs
Div = 00+(.08/.10) (10-0) .10 = Rs 80
Div = 00+(.10/.10)(10-0) .10 = Rs 100
Payout Ratio = zero Payout Ratio = zero Div = 0
0+(.15/.10) (10-0) .10 = Rs 150
Div = 44+(.10/.10)(10- 4) .10 = Rs 100
Payout ratio = 40%
Div = 44+(.08/.10) (10- 4) .10 = Rs
Div = 00+(.08/.10) (10-0) .10 = Rs 80
Div = 00+(.10/.10)(10-0) .10 = Rs 100
Payout Ratio = zero Payout Ratio = zero Div = 0
0+(.15/.10) (10-0) .10 = Rs 150
Div = 44+(.15/.10) (10- 4) .10 = Rs 130
Div = 44+(.10/.10)(10- 4) .10 = Rs 100
Payout ratio = 40%
Div = 44+(.08/.10) (10- 4) .10 = Rs
Div = 00+(.08/.10) (10-0) .10 = Rs 80
Div = 00+(.10/.10)(10-0) .10 = Rs 100
Payout Ratio = zero Payout Ratio = zero Div = 0
0+(.15/.10) (10-0) .10 = Rs 150
Payout ratio = 100%
Div = 44+(.15/.10) (10- 4) .10 = Rs 130
Div = 44+(.10/.10)(10- 4) .10 = Rs 100
Payout ratio = 40%
Div = 44+(.08/.10) (10- 4) .10 = Rs
Div = 00+(.08/.10) (10-0) .10 = Rs 80
Div = 00+(.10/.10)(10-0) .10 = Rs 100
Payout Ratio = zero Payout Ratio = zero Div = 0
0+(.15/.10) (10-0) .10 = Rs 150
Div =1010+(.15/.10)(10-10) .10 = Rs 100
Payout ratio = 100%
Div = 44+(.15/.10) (10- 4) .10 = Rs 130
Div = 44+(.10/.10)(10- 4) .10 = Rs 100
Payout ratio = 40%
Div = 44+(.08/.10) (10- 4) .10 = Rs
Div = 00+(.08/.10) (10-0) .10 = Rs 80
Div = 00+(.10/.10)(10-0) .10 = Rs 100
Payout Ratio = zero Payout Ratio = zero Div = 0
0+(.15/.10) (10-0) .10 = Rs 150
Div =100+(.10/.10)(10-10) .10 = Rs 100
Div =1010+(.15/.10)(10-10) .10 = Rs 100
Payout ratio = 100%
Div = 44+(.15/.10) (10- 4) .10 = Rs 130
Div = 44+(.10/.10)(10- 4) .10 = Rs 100
Payout ratio = 40%
Div = 44+(.08/.10) (10- 4) .10 = Rs
Div = 00+(.08/.10) (10-0) .10 = Rs 80
Div = 00+(.10/.10)(10-0) .10 = Rs 100
Payout Ratio = zero Payout Ratio = zero Div = 0
0+(.15/.10) (10-0) .10 = Rs 150
Div =1010+(.08/.10)(10-10) .10 = Rs 100
Div =1010+(.10/.10)(10-10) .10 = Rs 100
Div =1010+(.15/.10)(10-10) .10 = Rs 100
Payout ratio = 100%
Div = 44+(.15/.10) (10- 4) .10 = Rs 130
Div = 44+(.10/.10)(10- 4) .10 = Rs 100
Payout ratio = 40%
Div = 44+(.08/.10) (10- 4) .10 = Rs
Div = 00+(.08/.10) (10-0) .10 = Rs 80
Div = 00+(.10/.10)(10-0) .10 = Rs 100
Payout Ratio = zero Payout Ratio = zero Div = 0
0+(.15/.10) (10-0) .10 = Rs 150
Gordon’s Model
Contention:
C1: Div. Decision Influences Value of Firm ………… Optimum P/O Ratio
Determination:D1: Used IRR & K in determining optimum Pay out Ratio
D2: Classifies companies into Growth, Normal, & Declining.
Gordon’s Model
Prepositions of Gordon
r > k Zeror < k 100%r = k….Irrelevant
Gordon’s Model
AssumptionsA1: Firm is all equity
A2: Uses RE to finance investments.
A3: IRR & K remains constant
A4: Retention ratio once decided remains constant
A5: No corporate taxes
A6: Firm derives its earnings perpetually
AssumptionsA1: Firm is all equity
A2: Uses RE to finance investments.
A3: IRR & K remains constant
A4: Retention ratio once decided remains constant
A5: No corporate taxes
A6: Firm derives its earnings perpetually
Gordon’s Model
C2: If risk is considered then, P/ratio would influence Value even when r = k
Assumptions:
A1: Rational investors are risk averse
A2: Prefer nearer Div. than distant Div.
A3: Expect risk premium when retained
Gordon’s Model
Effects of Retention:
E1: Retention means postponement of current Div. in promise of more future
div…………….. RiskE2: More the risk, more the k…..
based on Bird-In-The-Hand argument
Gordon’s Model
Bird-in-the-Hand Argument• One Bird in a hand is better than 2 birds in a
bush• Shareholders Prefer Nearer Div. Over Distant
Dividends
Krishman:Two identical stocks, one paying more dividend will have more MP.. vice versa
Gordon’s ModelRelationship between p/ratio & k
DR(k)
RR(b)
Conclusion•More the retention, more risk, more the k…less MP•Less the retention, less risk, less the k… more MP
K
Gordon’s Model: Valuation of shares
D1 D2 Dn P = ------ +------ …..+----- (1+k) (1+k) (1+k)
Where: P = Market price of share D = Dividend per share r = IRR k = cost of capital E = EPS b = Retention ratio
D1 D2 Dn P = ------ +------ …..+----- (1+k) (1+k) (1+k)
Where: P = Market price of share D = Dividend per share r = IRR k = cost of capital E = EPS b = Retention ratio
P = present value of stream of dividends P = present value of stream of dividends
E1 ( 1 – b ) = --------------------
k - br
Gordon’s Model: Valuation of shares
20 (1- 0.2) .11 – (0.2 x 0.08) = Rs 1,000
20 (1- 0.2) .11 – (0.2 x 0.11) = Rs 100
20 (1- 0.2) .11 – (0.2 x 0.12) = Rs 186
Payout Ratio = 80%
20 (1- 0.6) .11 – (0.6 x 0.12) = Rs 210
20 (1- 0.6) .11 – (0.6 x 0.11) = Rs 100
Payout Ratio = 40%
20 (1- 0.6) .11 – (0.6 x 0.08) = Rs 129
r= 8, k= .11 20 (1- 0.9) .11 – (0.9 x 0.08) = Rs 52.63
r =.11, k=.11 20(1- 0.9) .11 – (0.9 x 0.1I) = Rs 181
Payout Ratio = 10% Payout Ratio = 10% r =.12, k = .11
20 (1- 0.9) .11 – (0.9 x 0.12) = Rs 1,000
M-M Hypothesis
Contention: P/ratio does not influence Value of a Firm
Arguments:A1: Value…….. earning capacity & earnings …….investment decisions.
A2: When company Retains, investor
enjoys C/gain = amount of RE. When company pays investor enjoy Div. in
value = amount of C/gain
M-M Hypothesis
A3: Benefit of Div. is offset by external financing
A4: Shareholders are indifferent to Dividend Decision……..able to Construct Own Div. Policy
M-M Hypothesis
Assumptions:A1: Perfect capital market
• Easy to buy & sell• No buyer/seller large enough to influence MP• Access to information• No transaction costs• Securities are divisible
A2: Rational investors
M-M Hypothesis
A3: No risk of uncertainty (dropped)
A4: No corporate taxes…(no diff.)
A5: k & r is identical for all the shares
A6: IRR = k
M-M Hypothesis
Conclusion:
C1: When r=k, then weighted benefit of RE will be equal to weighted benefit of Div…V constant
C2: When r is same, no shift will take place from low yielding companies to high yielding companies.
M-M Hypothesis
Valuation of shares: P1 = Po ( 1 + k ) – D1
Where:P1 = market price per share at time 1Po = market price per share at time 0K = dr or cost of capital= rD1 = dividend per share at time 1
M-M Hypothesis
Example: ABC Comp. currently has outstanding 1,00,000 shares, selling at Rs 100 each. It is thinking to pay a div. of Rs 5 Ps at t1. K is 10%. What will be the price of the share if:
A div. is not paid.A div. is paid @ Rs 5 per share.How many new shares are to be sold, if
the company requires Rs 20 lakhs & the net profit is Rs 10 lakhs?
M-M Hypothesis
P1 = Po ( 1 + k ) – D1
Po = Rs 100 K = 0.10 D1 = 0.0
P1 = 100(1 + 0.10) –0……= 110
P1 = 100(1 + 0.10) –5……= 105
M-M Hypothesis
No of shares: ∆np1 = I – ( E – D1 )
Where:∆np1 = change in MP of share = 105I = amount to be invested = 20 lacs E = earnings ……………... = 10 lacs D1 = Div. at t = 1………….. = 5 lacs∆n105 = 20,00,000 – ( 10,00,000 -5,00,000)∆n105 = 20,00,000 – 5,00,000∆n = 15,00,000 105 = 14,285
Traditional ApproachAdvocated by Gram & Dodd
Arguments:A1: Div. Dec. is a relevant………Influences value A2: Stock market places considerable Weight age on Div. than RE
Weight assigned to DIV is 3 times the weight assigned to RE
P = m( D + E/3 )
Traditional Approach
Criticism: Based on subjective judgment rather than on empirical evidence
Explanation
E1: Hypothesis Based on empirical evidence…..cite results of cross section regression analysis
E2: DIV. coefficient is much higher than RE.
Traditional Approach
Analysis: Conclusions reached by Gram & Dodd are not justified
R1: Omits risk……….., thus Distorts results
R2: Measurement of earnings Is subject to error… Transmitted to
RE.......Coefficient is biased
Traditional Approach
Traditional Approach
Traditional Approach