Dividend Decision

Prepare by
Priyanka Gohil
 There are two options which a firm has while
utilizing its profits.
1. Retain profit
2. Distribute profit to the shareholders.
o The returns to the shareholders either by way of the
dividend receipts or capital gains are affected by the
dividend policies of the firm.
o There exist a relationship between return on
investments r and the cost of capital k.
Theories of Dividend policy
o Traditional Approach
o Dividend Relevance Model
1.Walter Model
2. Godon’s Dividend capitalization Model
o Miller and Modigliani Model
Traditional Approach
 Traditional approach to the dividend policy was
given by B Graham and D L Dodd lays a clear
emphasis on the relationship between the
dividends and the stock market.
 According to this approach, the stock value
responds positively to higher dividends and
negatively when there are low dividends.
The following expression given by traditional approach,
establishes the relationship between market price and dividends

 P= m(D+E/3)

Where,
P= Market Price
m=Multipler
D=Dividend per share
E=Earning per share
 Under Dividend relevance model two theories,
1. Walter Model
2. Gordon’s Dividend capitalization Model
Walter Model

 Dividend policy given by James E Walter also considers

that dividends are relevant and they do affect the share
price.
 In this model he studied the relationship between the
internal rate of return (r) and the cost of capital of the firm
(k), to give a dividend policy that maximizes the
shareholder’s wealth.
 The model studies the relevance of the dividend
policy in three situations:
1. r>Ke
2. r<Ke
3. r=ke
Assumptions:

The relevance of the dividend policy as explained by the

walter’s Model is based on a few assumptions, which are
as follows:
1. Retained earnings is the only source of finance available to
the firm, with no outside debt or additional equity used.
2. r and k are assumed to be constant and thus additional
investments made by the firm will not change its risk and
return profiles.
3. Firm has an infinite life
4. For a given value of the firm, the dividend per share and
the earnings per share remain constant
P= D + [r/ke (E-D)]
Ke Ke
P= Market price per share
D= Dividend per share
E= Earning per share
R= Internal rate of return
Ke= Cost of equity capital
 Given the following information about ZED Ltd. Show the
effect of the dividend policy on the market price of its
shares, using the Walter’s model:
Equity capitalization rate (ke) = 12%
Earning per share (E) = Rs. 8
Assumed return on investments (r) are as follows:
i. r= 15%
ii. r=10%
iii. r=12%
Show the effect of the dividend policies on the share value
of the firm for three different levels of r, taking the DP
ratio as zero, 25%,50%,75%, and 100%
Gordon’s Dividend capitalization Model

Myron Gordon used the dividend capitalization

approach to study the effect of the firm’s dividend
policy on the stock price.
Gordon’s Model assumes that the investors are
rational and risk-averse.
Thus, investors would prefer to pay a higher price
for the stocks which earn them current dividend
income.
Assumptions
 The following are the assumptions based on which Gordon based
the dividend policy model for firms.
 The firm will be an all equity firm with the new investment
proposals being financed solely by the retained earnings.
 Return on investment (r) and the cost of equity capital (ke) remain
constant.
 Firm has an infinite life
 The retention ration remains constant and hence the growth rate also
is constant.
 K>br i.e. cost of equity capital is greater than the growth rate.
 P= E(1-b)
ke-br
Where,
P= share price
E= earning per share
b=retention ratio
(1-b)=Dividend pay-out ratio
Ke=Cost of equity capital
Br=Growth rate (g) in the rate of return on investment
If ke = 11% and E= Rs. 15 calculate the stock value of Swan Ltd.
For (i) r=12%
(ii) r=11%
(iii) r=10% for the various levels of the D/P ratios.

D/P ratio Retention Ratio

(1-b)
A 10% 90%
B 20% 80%
C 30% 70%
D 40% 60%
e 50% 50%
Miller and Modigliani Model
 Miller and Modigliani have propounded the MM
hypothesis to explain the irrelevance of a firm’s dividend
policy.
 According to the model, it is only the firm’s investment
policy that will have an impact on the share value of the
firm and hence should be given more importance.
 Step 1 Price per share at the end of year 1
Po = 1 (D1+P1)
(1+Ke)
where, Ke= cost of equity capital
D1=Dividends to be paid at the end of the period
P1= Market price of the share at the end of the period
Po=Current market price of the share
Step 2 Amount to be raised by the issue of new shares
n1p1=I-(E-nD1)
Where,
I= Total investment required
E= Earnings during the period
n =No. of share outstanding
D1=Dividends to be paid at the end of the period
N1=Number of additional shares to be issued
Step 3 Number of additional shares to be issued
n1= n1p1
P1
n1= number of additional shares to be issued
P1=Price per share at the end of year
Step 4 Value of the firm
nPo= (n+n1)P1-I+E
(1+Ke)
n= No. of share outstanding
n1= number of additional shares to be issued
P1= Price per share at the end of year
I= Total investment required
E= Earnings during the year
Ke= cost of capital
The capitalization rate of A1 Ltd.is 12 %. This company
has outstanding shares to the extent of 25,000 shares selling
at the rate of Rs. 100 each. Anticipating a net income of Rs.
3,50,000 for the current financial year, A1 Ltd. Plans to
declare a dividend of Rs. 3 per share. The company also has
a new project the investment requirement for which is Rs.
5,00,000. Show that under the MM model, the dividend
payment does not affect the value of the firm.