Download - Chapter21 Dividend Policy and Firm Value
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Chapter 21
DIVIDEND POLICY AND
FIRM VALUE
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OUTLINE
Models in Which Investment and Dividend Decisions are
Related
Traditional Position
Miller and Modigliani Position
Rational Expectations Hypothesis
Radical Position
Overall Picture
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The dividend policy of the firm determines
what proposition of earnings is paid to
shareholders by way of dividends and whatproposition is ploughed back in the firm for
reinvestment purposes.
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MODELS IN WHICH INVESTMENT AND
DIVIDEND DECISIONS ARE RELATED
Walter Model
Gordon Model
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WALTER MODEL
D+ (ED) r/k
P=
k
where: P= price per equity share
E= earnings per shareD= dividend per share
r= rate of return on investmentsk= 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
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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
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GORDON MODEL
E1 (1b)
P0 =
kbr
where P0 = price per share at the end of year 0
E1 = earnings per share at the end of year 1
(1b) = dividend payout ratio
b= ploughback ratiok = 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 (10.25)
P0 = = Rs.30
0.15(0.25) (0.20)
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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
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TRADITIONAL POSITION
P= m
where P= market price per share
D= dividend per share
R= retained earnings per share
m= a multiplier
4D
R
+3 3
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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 whichearnings are split between dividends and retained earnings
Earnings
DividendsCurrent
Income
Retained
Earnings
Capital
Apprecn
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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.
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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.
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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
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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.
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RATIONAL EXPECTATIONS
HYPOTHESIS
In a world of rational expectations, unexpected dividendannouncements 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 byan underlying revision of the estimate of earnings
potential.
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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
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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
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EFFECT OF DIVIDEND POLICY
ON REQUIRED RETURN
Firm A
(No Dividend)
Firm B
(High Dividend)
1. Next years price Rs 120 Rs 105
2. Dividend 0 Rs 15
3. Total pre-tax payoff Rs 120 Rs 120
4. Current price Rs 102.86 Rs 101.435. Capital gain Rs 17.14 Rs 3.57
6. Pre-tax rate of return
[(2) + (5)]/ (4)
16.67% 18.31%
7. Tax on dividend at 20 percent Rs 3
8. Tax on capital gains at 10 percent Rs 1.714 Rs 0.357
9. Total post-tax income Rs 15.426 Rs 15.213
10. Post-tax rate of return 15.426
102.86
15.213
101.43= 15% = 15%
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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 dividendpolicy depends on the relationship between the rate of return on investments andthe 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 isindependent 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, andpresence of taxes.
In a world of rational expectations, unexpected dividend announcements would
transmit messages about changes in earnings potential which were notincorporated in the market price earlier.
The radical position argues that a lower dividend payout ratio promotes the
welfare of shareholders.