Dividend theories and

limitations
Submitted to : Dr. Arifa Bano Talpur
Submitted by: Perah Memon
1918smbanbs12
Walters model
• Walter’s model states that the choice of dividend policy always affects the value of
shareholders.
• Walter’s model clearly describes the relationship between firm’s internal rate of return
(r) and cost of capital (k), which determines the dividend policy to increase the wealth
or shareholders.
assumptions
• The retained earnings are the only source of financing investments in the firm, no debt
or new equity issued.
• The rate of return and cost of capital are always constant.
• The firms life endless or infinite.
• All earnings are again invested internally or distributed.
• The value of earnings and dividends always remain constant in determining a given
value.
problems
• The Walter's model blends dividend policy with investment policy of a firm.
• Walters model assume that r is constant but it decreases when investment increases.
• Walters model assumes that k remains constant but it increases or decreases with the
firm’s risk.
Gordon’s model
• Gordon’s model states that the choice of dividend policy always affects the value of the
firm.
• Gordon’s model shows how dividend policy is used to increase the wealth of
shareholders.
• The main proposition is that the value of a share reflects the value of future dividends
accruing to that share.
• The share market price is equal to the sum of share’s discounted future dividend
payment.
assumption
• The firm is in all equity firm and no external finance is available.
• The discount rate (k) and internal rate of return (r) remains constant.
• There are no corporate taxes.
• The firm has perpetual life.
• The retention ratio (b) once decided remains constant and growth rate g=br always
remains constant.
• If k> g=br, cost of capital is greater than growth rate, then we can get significant value
for the share.
problems
• Gordon model assume that there is no debt and equity finance used by the firm but it is
not applicable to present day business.
• Ke and r cannot remain constant in real time.
• It is not practically applied, there are no corporate tax paid by the firm.
Modigliani and miller’s approach
• The Modigliani-Miller theorem (M&M) states that the 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.
• the split of earnings between dividends and retained earnings is of no significance in
determining the value of the firm.
assumption
• There is always perfect capital market.
• The investors are rational.
• There are no taxes applicable
• The firm has fixed investment policy.
• No risk or uncertainty.
problems
• It is not practically applied, there are no corporate tax paid by the firm.
• There is always a space for risk and uncertainty.
• It assumes that investors behave rationally
THANK YOU