dividend valuation

8/8/2019 Dividend Valuation

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Dividend Valuation

Relevant or Irrelevant ????


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Wh at are Dividends?

Dividends are payments made to stock h oldersfrom a firm's earnings.

Such dividends are paid out of profits.Th e alternate to t h e payment of dividends isth e retention of profits/earnings.

Th

e retained earnings constitute an easilyaccessible important source of financing t h einvestment requirements.


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Inverse R sh ipTh ere is an inverse relations h ip betweenretained earnings and cas h dividends:Larger t h e retentions, lesser dividends and

vice versa.

Alternative Useof Net Earnings

Dividends RetainedEarnings


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Effect of t h e Decision

Given t h e objective of W ealt h-M aximisation,th e firm s h ould be guided by t h econsideration as to w h ich alternative use isconsistent wit h th e goal of wealt h-maximisation.


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Relevance and Irrelevance M odels

Two Th oug h ts

DividendDecision isRelevant

W alter s M odel

Gordan s M odel

DividendDecision isIrrelevant

M . M .Hypot h esis


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Relevance M odel

Th ese t h eories consider dividend decisions tobe an active variable in determining t h e valueof a firm.i.e. It effects t h e market price of t h e s h are of th e company w h o is distributing t h e dividendor retaining it.


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W alter s M odel

Dividends are relevant.Investment policy of a firm cannot be separated fromits dividends policy. Bot h are interlinked.M

ajor determinant is th

e relationsh

ip b/w Rate of Return (r) and its cost of capital ( k ).M odel relates t h e distribution of dividends to availableinvestment opportunities.

If r > k, t h e firm is able to earn more t h an w h at t h esh are h olders could, h ence t h e firm s h ould retain t h eearnings.


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Th ree Situations

r > k r = k r


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Assumptions

All financing is done t h roug h retainedearnings.

Business risk does not ch

ange. i.e. r and k areconstant.Firm h as perpetual life


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Basic formula

P = { D + r/ke (E D) } / keWh ere:

P = M arket Price per s h areD = Dividend per s h areE = Earnings per s h are

r = rate of return on firm s investmentke = cost of equity


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Illustration

Capitalisation rate (ke) = 0.10Earnings per s h are (E) = Rs. 10

Assume rate of return on investments asi. 15%ii. 10%iii. 8%Sh ow t h e effect of dividend policy on t h emarket price of s h ares using W alter s M odel.


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D/ P ratio D (DividendPer share)

r > k r = k r < k

0 0

25 2.5

50 5

75 7.5

100 10


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D/ P ratio D(Dividend

Per share)

r > k r = k r < k

0 0 150 100 80

25 2.5 137.50 100 85

50 5 125 100 90

75 7.5 112.50 100 95

100 10 100 100 100


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Per share)

r > k r = k r < k

0 0 150 100 80

25 2.5 137.50 100 85

50 5 125 100 90

75 7.5 112.50 100 95

100 10 100 100 100


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Per share)

r > k r = k r < k

0 0 150 100 80

25 2.5 137.50 100 85

50 5 125 100 90

75 7.5 112.50 100 95

100 10 100 100 100


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Limitations

M odel only applicable to an all -equity firms;all financing is done t h roug h retainedearnings.Unrealistic assumptions regarding constant rand k.W alter s model ignores t h e effect of risk onth e value of t h e firm.


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Gordon s M odel

Dividends are relevant.Investors put a positive premium on current

income or dividends.Also, investors put a premium on a certain(fixed) return and penalise or discountuncertain returns.Investors are risk -averse.


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Dividend Capitalisation M odel

P = {E ( 1-b )} / ke brWh ere:

P = Price per sh

areE = Earnings per s h areb = retention ratio, part of profits retained

1-b = D/ P ratiobr = g = growt h rateKe = equity capitalisation rate


19/27

Bird in the hand argument A bird in h and is better t h an two in t h e bus h .Wh at is available at present is preferable towh at may be available in t h e future.Investors would be inclined to pay a h igh erprice for s h ares on w h ich current dividends

are paid.Conversely, t h ey would discount t h e value of sh ares of a firm w h ich postpones dividends.


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Illustration

D/ P ratio (1-b ) Retention Ratio Ke

10 90 20

20 80 19

30 70 18

40 60 17

50 50 16

60 40 15

70 30 14

r = 12%E = Rs. 20Determine t h e value of s h ares.


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D/ P ratio br Price per share

10

20

30

40

50

60

70


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Increase in D/P increases market priceper s h are

D/ P ratio br Price per share

10 0.9* 0.12 = .108 21.74

20 0.8 * 0.12 = 0.096 42.55

30 0.7 * 0.12 = 0.084 62.50

40 0.6 * 0.12 = 0.72 81.63

50 0.5 * 0.12 = 0.60 100

60 0.4 * 0.12 = 0.048 117.65

70 0.3 * 0.12 = 0.036 134.62


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M M HYPOTHESIS


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Irrelevance of Dividends

Investors are indifferent between dividendsand capital gains.

Value of th

e firm is unaffected by th

edistribution of dividends and is determinedsolely by t h e earning power and risk of itsassets.


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Assumptions of MM Hypot h eses

Perfect capital marketNo taxes

No ch ange in cost of capital; required rate of returnInvestors are able to forecast future prices and

dividends with

certainity


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Arbitrage Process

Arbitrage h ere implies t h e distribution of earnings to s h are h olders and raising an equalamount externally .Hence t h e effect of dividend on value of t h efirm would be offset by t h e effect of raisingadditional funds from outside (it wouldincrease t h e cost of capital and h encedecrease t h e value of t h e firm).


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How Arbitrage Process W orks?

If a firm h as an investment opportunity, it h as twoalternatives:

1. It can retain its earnings (not pay dividend) to finance

th

e investment programme.O r 2. Distribute t h e earnings (pay dividend) and raise an

equal amount externally t h roug h th e sale of newsh ares or bonds. In t h is case arbitrage process sets inand t h e effect of dividend payment on s h are h older swealt h will be exactly offset by t h e effect of raisingadditional s h are capital.

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