CHAPTER

19 DIVIDEND DECISION
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CONTENTS

 Introduction
Relevance of Dividend
 Walter’s Model
 Gordon’s Model
Irrelevance of Dividend
 Miller & Modigliani’s Theory of Irrelevance
 Home-made Dividend
 Assumptions of Irrelevance of Dividend
 Gordon’s Model vs. Irrelevance
 Bird-in the-Hand vs. Irrelevance
 Limitations of Theory of Irrelevance
DIVIDEND DECISION CHAPTER 19
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CONTENTS
 Passive Residual Dividend Policy
 Information Content of Dividend
 Investors’ Preference for Current Income
 Clientele Effect
 Factors Affecting Dividend Policy
 Alternative Forms of Dividend
 Bonus Shares
 Stock Splits
 Share Buyback
 Advantages of Share Buyback
 Disadvantages of Share Buyback
DIVIDEND DECISION CHAPTER 19
4
DIVIDEND & DIVIDEND
POLICY
 A firm earns for its shareholders.
 The income generated after meeting all
obligations by the firm belongs to the
shareholders.
 The part of earning that is distributed is called
dividend.
 The optimum dividend policy would be one that
maximizes the value of the firm.
 The question of in what ratio to retain or
distribute the earned income, is referred as
dividend decision or policy.
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RELEVANCE AND
IRRELEVENCE

 There are two schools of thought regarding dividend

policy.
IRRELEVANCE OF DIVIDEND
 One set of people believes that dividend policy
affects the value of the firm.
Walter’s Model and Gordon’s Model:
 These models of valuation of the firm link the
dividend policy to the
 investment opportunities available.
 rate of return on investment opportunities as compared
with expectations of the shareholders
DIVIDEND DECISION CHAPTER 19
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WALTER’S MODEL

 Walter’s model considers the value of the firm as sum

of two components;
1. an infinite stream of dividend, D and
2. an infinite stream of retained earning, E – D reinvested at
constant rate of k, which are generated each year for infinite
length of time.

 Walter’s Model links the value of the firm to

 the earning level,
 dividend level,
 reinvestment rate, and
 the shareholders’ expectations
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ASSUMPTIONS AND
LIMITATIONS
 Funding of new projects is done through the
earnings alone.
 The growth opportunities do not alter the risk
profile of the firm as a whole, and therefore the
market capitalisation rate remains constant.
 The firm is a going concern and the pricing model
assumes perpetual earnings.
 there is an implied assumption that the
reinvestment rate ‘k’ remains constant.
 Walter’s model assumes inter-dependence of the
investment and dividend decisions.
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WALTER’S MODEL

The optimum dividend policy is determined on

the basis of reinvestment rate, k.
 If firm’s reinvestment rate, k exceeds shareholders
expectations, r then optimum dividend policy is
100% retention,
 if k < r then optimum is 100% pay out, and
 when k = r the dividend policy is immaterial.
D k(E - D)/r
P0 = +
r r

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WALTER’S MODEL
VALUE OF THE FIRM

Reinvestment Reinvestment Reinvestment

Rate k > r Rate k < r Rate k = r
E = Rs. 20 E = Rs. 20 E = Rs. 20
D = Rs. 10 D = Rs. 10 D = Rs. 10
k = 20% k = 12% k = 16%
r = 16% r = 16% r = 16%
k k k
D+ (E - D) D+ (E - D) D+ (E - D)
r r P0 = r
P0 = P0 =
r r r
0.20 0.12 0.16
10 + (20 - 10) 10 + (20 - 10) 10 + (20 - 10)
0.16 0.16 0.16
= = =
.16 .16 .16
= 140.63 = 109 .37 = 125 .00

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WALTER’S MODEL
DIVIDEND DECISION

Reinvestment Reinvestment Reinvestment

Rate k > r Rate k < r Rate k = r

Dividend increased to 75% (Rs. 15 per share)

0.20 0.12 0.16

15 + (20 - 15) 15 + (20 - 15) 15 + (20 - 15)
0.16 0.16 0.16
P0 = P0 = P0 =
.16 .16 .16
= 132.81 = 117.19 = 125.00

Dividend decreased to 25% (Rs. 5 per share)

0.20 0.12 0.16

5+ (20 - 5) 5+ (20 - 5) 5+ (20 - 5)
0.16 0.16 0.16
P0 = P0 = P0 =
.16 .16 .16
= 148.44 = 101.62 = 125.00

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WALTER’S MODEL-
OUTCOME

 The optimum dividend policy is determined on the basis of

reinvestment rate, k. If firm’s reinvestment rate, k exceeds
shareholders expectations, r then optimum dividend
policy is 100% retention, if k < r then optimum is 100% pay
out and when k = r the dividend policy is immaterial.

Reinvestment Reinvestment Reinvestment

Rate k > r Rate k < r Rate k = r
If dividend pay If dividend pay Price remains
out increases out increases same
the price the price irrespective of
decreases increases dividend pay
out

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GORDON’S MODEL

 Another model that supports the view that

dividend policy is relevant is Gordon’s
Model.
 Its assumptions and conclusions are similar
to Walter’s model.
D1
P0 
r-g
E1x(1 - b )
P0 
r - bk
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13
GORDON’S MODEL
VALUE OF THE FIRM

Reinvestment Reinvestment Reinvestment

Rate k > r Rate k < r Rate k = r
E = Rs. 20 E = Rs. 20 E = Rs. 20
D = Rs. 10 D = Rs. 10 D = Rs. 10
k = 20% k = 12% k = 16%
r = 16% r = 16% r = 16%

E(1 - b) E(1 - b) E(1 - b)

P0 = P0 = P0 =
r - bk r - bk r - bk
10 10 10
= = =
0.16 - 0.10 0.16 - 0.06 0.16 - 0.08
= 166.67 = 100.00 = 125.00

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14
GORDON’S MODEL
DIVIDEND POLICY

Reinvestment Reinvestment Reinvestment

Rate k > r Rate k < r Rate k = r

Dividend increased to 75% (Rs. 15 per share)

15 15 15
P0 = P0 = P0 =
0.16 - 0.05 0.16 - 0.04 0.16 - 0.03
= 136.36 = 115.38 = 125.00

Dividend decreased to 25% (Rs. 5 per share)

5 5 5
P0 = P0 = P0 =
0.16 - 0.15 0.16 - 0.09 0.16 - 0.12
= 500.00 = 71.43 = 125.00

DIVIDEND DECISION CHAPTER 19

15
GORDON’S MODEL
THE OUTCOME
 Like Walter’s model the value of the firm under Gordon’s
model is also dependent upon the reinvestment rate and
shareholders’ expectations.
 Walter’s model keeps the dividend amount constant in each
period while Gordon’s model assumes growing dividend in
each period.
Reinvestment Reinvestment Reinvestment
Rate k > r Rate k < r Rate k = r
If dividend pay If dividend pay Price remains
out increases out increases same
the price the price irrespective of
decreases increases dividend pay
out

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BIRD- IN-THE-HAND
THEORY

 Bird-in-the-hand argument suggests that

increased dividend means increased
certainty of the cash flows.
 Since this helps in reducing the discount
rate the value of the firm must increase
with increased dividend.
D1
r g
P0
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BIRD- IN-THE-HAND
THEORY
Dividend Policy and Price
Bird-in-the-Hand Argument (Gordon Model)

Earning 25 25 25 25
(Rs./share)

Reinvestment 20% 20% 20% 20%

Rate ‘k’(%)

Dividend Payout 5 10 15 20
(Rs.)

Retention Ratio 20% 40% 60% 80%

‘b’ %

Capitalisation 20% 18% 16% 14%

Rate ‘r’ (%)
15
5 10 P0  20
Price of the D1
P0  P0  .16  .08 P0 
.20  .16 .18  .12 .14  .04
share P0   Rs.125.00  Rs.166.67
 Rs.187.50
 Rs.200.00
r g

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IRRELEVANCE OF
DIVIDEND
Miller & Modigliani Theory of Irrelevance
 MM argument of irrelevance of dividend rests on
the assumption that
 earnings and the investment policy determine the
value of the firm, and
 not how the earnings are distributed.
 Increased dividends today are compensated by
reduced dividends tomorrow and vice-versa.

 To keep the investment policy same the firm

would have to issue larger number of new shares
in case they increase the dividend.
DIVIDEND DECISION CHAPTER 19
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MILLER & MODIGLIANI (MM)
THEORY OF IRRELEVANCE

Existing Shares (Nos.) 1,000 1,000 1,000 1,000 1,000

Current Price (Rs.) 500 500 500 500 500

Returns Required (%) 20% 20% 20% 20% 20%

Dividend per Share - 25 30 35 40

Projected Price (Ex
Dividend) 600 575 570 565 560

Investment Required 600,000 600,000 600,000 600,000 600,000

Earnings Available 400,000 400,000 400,000 400,000 400,000

Dividend - 25,000 30,000 35,000 40,000

New Capital Required 200,000 225,000 230,000 235,000 240,000

Nos of New Shares
Issued 333.33 391.30 403.51 415.93 428.57
Total Market Value
(Rs.) 800,000 800,000 800,000 800,000 800,000

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MM’S THEORY OF
IRRELEVANCE

 The value of the firm would remain same but

there would be transfer of wealth from old
shareholders to new shareholders
Total Market Value
Allocated to
Old Shareholders

Market Value 600,000 575,000 570,000 565,000 560,000

Add: Dividend
Received - 25,000 30,000 35,000 40,000

Total 600,000 600,000 600,000 600,000 600,000

New Shareholders

Market Value 200,000 225,000 230,000 235,000 240,000

Less: Dividend not
received - 25,000 30,000 35,000 40,000

Total 200,000 200,000 200,000 200,000 200,000

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MM’S THEORY OF
IRRELEVANCE

Value of the Firm Old Shareholders New Shareholders

900
800 -
700 200
Value (Rs. 000s)

600
500
400 800
300 600
200
100
-
No Dividend
1 2
With Dividend

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MM’S THEORY OF
IRRELEVANCE

Dividend Irrelevance: Earnings and Investment Determine Value

Shareholders

Adjustable Pipe

Dividend New Shares

Constant Constant
Earnings
Value Investment
of the
Firm

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HOME - MADE
DIVIDEND
 Homemade dividend enables individual
investors to make their own dividend
policy by buying and selling shares to
adjust current income.
 They can undo the corporate action in
their individual capacities.

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HOME - MADE
DIVIDEND
Cash realised by selling 5 shares
= 5 x 600 = Rs. 3,000
Value of the remaining 95 shares
= 95 x 600 = Rs. 57,000
Total wealth = Rs. 60,000
Investment made
= 500 x 100 = Rs. 50,000
Returns obtained =10,000/50,000 = 20%
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HOME - MADE
DIVIDEND
Amount of dividend received = 50 x 95 = Rs.
4,750
Current income desired = Rs. 3,000
Surplus available that can be invested = Rs. 1,750
Stock Price = Rs.
670
Nos. of additional shares bought = 1,750/670 = 2.6119

Wealth at the end of Period ‘1’.

Total number of shares at the end of the period ‘1’ =
97.6119
Market Value of shares = 97.6119 x 670 = Rs. 65,400
Dividend retained = Rs. 3,000
Total wealth at the end of Period ‘1’ = Rs. 68,400

Value of investment at the beginning

= 95 shares x Rs. 600
DIVIDEND DECISION
= Rs.
CHAPTER 19
57,000
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MM AND TAXES

 Under perfect market conditions the

theory of irrelevance holds good.
 But several real world factors make the
dividend policy relevant.
 Prominent among these factors are
 presence of taxes, and
 frictions in the markets.

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ASSUMPTIONS
IRRELEVANCE OF DIVIDEND
 Given investment policy
 Indifference to dividend and capital gains
 No/uniform taxes
 Absence of flotation costs
 Uniform/homogeneous expectations
 Perfect capital markets
 there were no transaction (brokerage) costs involved
 the shares were infinitesimally divisible
 buying/selling actions does not influence the price
 investors are equally well informed
 they incur no cost of information, and
 interpret the information in homogeneous way.
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MM AND BIRD-IN-HAND

MM vs. Gordon MM vs. Gordon

Discount Rate Value of the Firm

Discount Rate Value

Gordon’s Bird-in-Hand

MM’s Irrelevance MM’s Irrelevance

Gordon’s Bird-in-Hand

Dividend Dividend

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TAXES AND MM

 Preferential tax treatment of capital gains

favours retention of earnings for
increasing the value of the firm.
 Presence of transaction cost makes
dividend more valuable, while flotation
cost, phenomena of under pricing, and
legal hassles favour retention of earnings.

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PASSIVE RESIDUAL
DIVIDEND POLICY

 Passive residual dividend policy suggests

acceptance of all positive NPV projects and
distribution of only left over earnings as
dividend.
 Key considerations in passive residual
dividend policy are
 identification of investment opportunities,
 fixing the target capital structure to find residual, and
then
 smoothing them to reserve the information content,
investors’ preferences and clienteles.
DIVIDEND DECISION CHAPTER 19
 INFORMATION CONTENT OF
31 DIVIDEND
(SIGNALLING THEORY)

 Signaling hypothesis emphasizes that

dividends convey plenty of information
that is tangible besides providing returns.
 Therefore change in dividend policy is
important for revaluation of the firm.

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CLIENTELE EFFECT

 Investors can be grouped according to

their preference of dividend and capital
gains.
 These groups are referred as clienteles.
 Change in dividend policy would cause
the clienteles to shift investment.

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TAX AND SHAREHOLDERS’
WEALTH

Firm with No Firm with

Dividend Dividend
A. Earnings Available 100 100
B. Dividend Proposed Nil 100
C. Dividend distribution Tax - 15
(15%)
D. Post Tax Cash Flow to - 85
Shareholders
E. Rise in The value of the 100 -
firm
F. Capital Gains 100 -
G. Tax on capital Gains (10%) 10 -
H. Post Tax Capital Gains
I. Post Tax Cash Flow to 90 85
Shareholders (D+H)
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ALTERNATIVE FORMS OF
DIVIDEND
 Besides cash dividend the firms can also reward its
shareholders with non-cash tools of bonus shares
and split shares.
 The rationale for such measures is to bring the
price to more trading friendly zone and increase
investors’ participation.
 Bonus shares and stock splits increase the number
of shares yet keep the same shareholding pattern.
 They increase proportionately the number of
shares and liquidity but keeps the total wealth of
the shareholders same.
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SHARE BUYBACK

 Share buyback is a substitute for dividend

payment when it is large.
 It provides an option to shareholders to
continue or exit the investment in the
desired ratio.

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ADVANTAGES OF SHARE
BUYBACK

 Indicative of worth of the firm.

 Reduce information asymmetry.
 Control shareholding pattern and threat of take-
over.
 Control the capital structure .
 Provide a choice to shareholders.
 Preserve the information content of the dividend.

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DISADVANTAGES OF
BUYBACK

 It can’t be recurring
 Excessive pricing

DIVIDEND DECISION CHAPTER 19