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FINANCIAL MANAGEMENT & CORPORATE FINANCE-KMB204

UNIT IV - SET 2

DIVIDEND DECISIONS AND VALUATION OF FIRMS

The value of the firm can be maximized if the shareholders’ wealth is maximized. There are
conflicting views regarding the impact of dividend decisions on the valuation of firms.
According to one school of thought dividend decisions does not affect the share holders’ wealth
and hence the valuation of the firm. On the other hand , according to other school of thought ,
dividend decisions materially affects the shareholders and wealth and also the valuation of the
firm. These two schools of thoughts can be discussed under following classifications.

1. The irrelevance Concept of Dividend or the Theory of irrelevance and

2. The relevance Concept of Dividend or the Theory of relevance

1.The irrelevance Concept of Dividend or the Theory of irrelevance

 Residual Approach
According to this theory, dividend decisions have no affect on the wealth of the
shareholders or the prices of the shares, and hence it is irrelevant so far as the valuation of
the firm is concerned. This theory regards dividend decisions merely as a part of
financing decisions because the earnings available may be distributed as dividends.
Thus the decision to pay dividends or retain the earnings may be taken as a residual
decision. This theory assumes that the investors do not differentiate between dividends
and retentions by the firm. Their basic desire is to earn higher return on their investment.
In case the firm has profitable investment opportunities giving higher rate of return the t
cost of retained earnings, the investors would be content with the firm retaining the
earnings to finance the same.
However if the firm is not in a position to find profitable investment opportunities the
investors would prefer to receive the earnings in the form of dividends.

 Modigliani and Miller’s hypothesis:

According to Modigliani and Miller (M-M), dividend policy of a firm is irrelevant as it does not
affect the wealth of the shareholders. They argue that the value of the firm depends on the firm’s
earnings which result from its investment policy.
Thus, when investment decision of the firm is given, dividend decision the split of earnings
between dividends and retained earnings is of no significance in determining the value of the
firm.
M – M’s hypothesis of irrelevance is based on the following assumptions.
 The firm operates in perfect capital market
 Taxes do not exist
 The firm has a fixed investment policy
 Information about the company is available to all without any cost.
 There are no floatation and transaction costs
 No investor is large enough to affect the market price of shares.
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 Risk of uncertainty does not exist. That is, investors are able to forecast future prices and
dividends with certainty and one discount rate is appropriate for all securities and all time
periods. Thus, r = K = Kt for all t.

The argument of MM
The argument given by MM in support of their hypothesis is that whatever increase in the value
of the firm results from the payment of dividend, will be exactly off set by the decline in the
market price of the share because of external financing and there will be no change in the total
wealth of the shareholders. For example if a company having investment opportunities,
distributes all its earnings among the shareholders it will have to raise additional funds from
external sources. This will result in the increase in number of shares or payment of interest
charges resulting in fall in the earnings per share in the future. Thus whatever a shareholder gains
on account of dividend payment is neutralized completely by the fall in the market price of
shares due to decline in the expected futures earnings per share.
To be more specific the market price of the share in the beginning of a period is equal to the
present value of dividends paid at the end of the period plus the market price of the shares at the
end of the period. This can be put in the form of following formula:

P0 = (D1 + P1 ) / ( 1+ Ke )

Where P0 = Market price per share at the beginning of the period or prevailing market price of
a share.
D1 = Dividend to be received at the end of the period.
P1 = Market price per share at the end of the period.
Ke = Cost of equity Capital or rate of Capitalization

The value of P1 can be derived by the above equation as under:

P1 = P0 ( 1+ Ke ) - D1

The MM hypothesis can be explained in another form also presuming that investment required
by the firm on account of payment of dividends is financed out of the new issue of equity shares.

In such a case, the number of shares to be issued can be computed with the help of the following
equation

m= I- (E-Nd1) / P1

Further the value of the firm can be ascertained with the help of the following formula.
nP0= ( n+ m)P1- ( I-E) / 1 + Ke
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Where ,
nP0= Value of the firm
m= numbers of shares to be issued.
I = Investment required
E = Total earnings of the firm during the period.
P1= Market price of the share at the end of the period.
Ke = Cost of equity capital
n= numbers of shares outstanding at the beginning of the period.
D1 = Dividend to be paid at the end of the period.

Because of the unrealistic nature of the assumption, M-M’s hypothesis lacks practical relevance
in the real world situation.

Thus, it is being criticized on the following grounds.

 The assumption that taxes do not exist is far from reality.
 M-M argue that the internal and external financing are equivalent. This cannot be true if
the costs of floating new issues exist.
 According to M-M’s hypothesis the wealth of a shareholder will be same whether the
firm pays dividends or not. But, because of the transactions costs and inconvenience
associated with the sale of shares to realise capital gains, shareholders prefer dividends to
capital gains.
 Even under the condition of certainty it is not correct to assume that the discount rate (k)
should be same whether firm uses the external or internal financing.
 If investors have desire to diversify their port folios, the discount rate for external and
internal financing will be different.
 M-M argues that, even if the assumption of perfect certainty is dropped and uncertainty is
considered, dividend policy continues to be irrelevant. But according to number of
writers, dividends are relevant under conditions of uncertainty.

2.The relevance Concept of Dividend or the Theory of relevance

 Walter’s model: Professor James E. Walterargues that the choice of dividend policies
almost always affects the value of the enterprise. His model shows clearly the importance
of the relationship between the firm’s internal rate of return (r) and its cost of capital (k)
in determining the dividend policy that will maximise the wealth of shareholders.

According to Prof Walter if,

 r > k , if the firm earns a higher rate of return on its investment than the required
rate of return , the firm should retain the earnings. Such firms are termed as
growth firm’s and the optimum pay out would be zero in their case. This would
maximise the value of shares.
 r < k , if the firm earns a lesser rate of return on its investment than the required
rate of return , the firm should distributes all its earnings. Such firms are termed
as decline firm’s and the optimum pay-out would be 100 % in their case. This
would maximise the value of shares.
 r = k, if the firm earns a rate of return on its investment equal to the required rate of
return, such firms are termed as normal firm’s and there is no optimum pay-out ratio for
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such firms. The dividend policy will not affect the market value of shares as the
shareholders will get the same return from the firm as expected by them.

Walter’s model is based on the following assumptions:

 The firm finances all investment through retained earnings; that is debt or new equity is
not issued;
 The firm’s internal rate of return (r), and its cost of capital (k) are constant;
 All earnings are either distributed as dividend or reinvested internally immediately.
 Beginning earnings and dividends never change. The values of the earnings pershare (E),
and the divided per share (D) may be changed in the model to determine results, but any
given values of E and D are assumed to remain constant forever in determining a given
value.
 The firm has a very long or infinite life.
Walter’s formula to determine the market price per share (P) is as follows:
P = D/K +(r(E-D)/K)/K
Where P = Market price per share
D = Dividend per share
r= Internal rate of Retrun
E = Earnings per Share
Ke = Cost of equity capital

The above equation clearly reveals that the market price per share is the sum of the present value
of two sources of income:
o The present value of an infinite stream of constant dividends, (D/K) and
o The present value of the infinite stream of stream gains, [r (E-D)/K/K]

Criticism:
Walter’s model is quite useful to show the effects of dividend policy on an all equity firm under
different assumptions about the rate of return. However, the simplified nature of the model can
lead to conclusions which are net true in general, though true for Walter’s model.
The criticisms on the model are as follows:
 Walter’s model of share valuation mixes dividend policy with investment policy of the
firm. The model assumes that the investment opportunities of the firm are financed by
retained earnings only and no external financing debt or equity is used for the purpose
when such a situation exists either the firm’s investment or its dividend policy or both
will be sub-optimum. The wealth of the owners will maximise only when this optimum
investment in made.
 Walter’s model is based on the assumption that r is constant. In fact it decreases as more
investment occurs. This reflects the assumption that the most profitable investments are
made first and then the poorer investments are made.
 The firm should step at a point where r = k. This is clearly an erroneous policy and fall to
optimise the wealth of the owners.
 A firm’s cost of capital or discount rate, K, does not remain constant; it changes directly
with the firm’s risk. Thus, the present value of the firm’s income moves inversely with
the cost of capital. By assuming that the discount rate, K is constant, Walter’s model
abstracts from the effect of risk on the value of the firm.
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 Gordon’s Model: One very popular model explicitly relating the market value of the
firm to dividend policy is developed by Myron Gordon. Gordon has developed a model
on the lines of Prof. Walter suggesting that dividends are relevant and the dividend
decision of the firm affects its value. His basic valuation model assumptions are as
follows.
Assumptions:
 The firm is an all Equity firm
 No external financing is available
 The internal rate of return (r) of the firm is constant.
 The appropriate discount rate (K) of the firm remains constant.
 The firm and its stream of earnings are perpetual
 The corporate taxes do not exist.
 The retention ratio (b), once decided upon, is constant. Thus, the growth rate (g) = br is
constant forever.
 K > br = g if this condition is not fulfilled, we cannot get a meaningful value for the
share.
 According to Gordon’s dividend capitalisation model, the market value of a share (Pq) is
equal to the present value of an infinite stream of dividends to be received by the share.
Thus:

The above equation explicitly shows the relationship of current earnings (E,), dividend policy,
(b), internal profitability (r) and the all-equity firm’s cost of capital (k), in the determination of
the value of the share (P0).

The implications of Gordon’s basic valuation model may be summarized as below.

 When r > k , when the rate of return of the firm on its investment is greater than required
rate of return, the price of the share increases as the dividend pay -out ratio decreases.
Thus growth firms should distribute lesser dividends and should retain maximum
earnings.
 When r < k , when the rate of return of the firm on its investment is lesser than required
rate of return, the price of the share increases as the dividend pay -out ratio increases. For
such firms i.e. decline firms optimum payout ratio would be 100%.
 When r =k , when the rate of return of the firm on its investment is equal to the required
rate of return, the price of the shares are not unaffected by the firms dividend policy.
Thus for a normal firm there is no optimum dividend payout.