Dividend theory

By Avilash Michel
 What is dividend?

• Portion of the profit is distributed among

the shareholders of the firm
• May be distributed in the form of
cash, ,property dividend and bonus
shares.
 TYPES OF DIVIDEND THEORY
1. Relevance theory
• Walter’s model
• Gordon's model
2.Irrelevence theory
• Modigliani and miller’s model
• Residual model
 Relevance theory
• Dividend policy is very essential
for any business firm as it affects
the overall value of the firm.
• It is an integral part of the
investment and financing
decision of the firm.
 Walter model
• Dividend policy affect the value of
the firm.
• Cost of capital and rate of return
determine the dividend policy
that maximizes the shareholders
wealth
 Assumption
The firm finances all investment
through retained earnings while
debt and equity is not used.
Business risk remain constant
and “r” and “K”.
Firm has infinite life.
 Criticism
• It ignores the benefit of optimal
capital structure.
• It ignores that market price is
affected by many factors.
• assumption that ‘k’ remain
constant.
 Gordon’s model
• Dividend policy is relevant to company’s value.
• Also known as ‘bird in hand ‘ argument.
• Investors are concerned about current dividend
as against future uncertain capital gain.
• Investors discount the firm’s earning at lower
rate when they are certain about returns,
placing a higher value for the shares that of
firm.
 Assumption
• No external financing is available.
• Corporate tax does not exist.
• The firm has infinite life.
• Investors are basically risk averse.
• Growth rate of the firm ‘g’ is the product of its
retention ratio ‘b’ and its rate of return r i.e., g=br.
• Cost of capital is constant and more than growth
rate .
 Irrelevance theory
• dividend policy is irrelevant to maximizing the
shareholders wealth.
• Value of the firm is affected by the earning
capacity of the firm i.e., investment policy not
the dividend policy.
• Whether company retained its earning or pays
dividend ,the market price of the share is
indifferent towards it.
 Modigliani and miller model
• Value of the firm is not affected
by pay out ratio.
• Dividend policy has no relevance
in determining market price of
the share.
 Assumptions
Perfect capital market .
Investors behave rationally.
There are no taxes.
Investment policy is fixed.
No flotation cost on issue of
shares.
 Criticism
• It is wrong to assume that there
are no taxes , floating charges
,transaction cost.
• There is no perfect capital market
condition.
THANKS