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12. 12. P0 = EPS (1 b) kg According to Gordons model dividend per share is expected
to grow when earnings are retained. The dividend per share is equal to the payout ratio
multiplied by earnings [EPS X (1-b)]. To determine the value of the firm therefore based
on the dividend growth model the value of the firm will be:
13. 13. g is always less than k g = the growth rate determined as br (1 b) = the
retention ratio of the firm given b as the payout ratio. Where:
14. 14. The conclusions of Gordons model are similar to Walters model due to the fact that
their sets of assumptions are similar.1. The market value of P0 increases with retention
ratio b, for firms with growth opportunities, i.e. when r > k.2. The market value of the
share P0 increases with payout ratio (1 b), for declining firms with r<k3. The market
value is not affected by the dividend policy where r = k
15. 15. They state that the dividend policy employed by a firm does not affect the value of
the firm. They argue that the value of the firm is dependent on the firms earnings which
result from its investment policy, such that when the policy is given the dividend policy is
of no consequence. The propagators of this school of thought were France Modigliani
and Merton Miller (1961). DIVIDENDS IRRELEVANCE
16. 16. Conditions that face a firm operating in a perfect capital market, either;1. The firm
has sufficient funds to pay dividend2. The firm does not have sufficient funds to pay
dividend therefore it issues stocks in order to finance payment of dividends3. The firm
does not pay dividends but the shareholders need cash.
17. 17. The risk of uncertainty does not exist, i.e. all investors are able to forecast future
prices and dividends with certainty and one discount rate is appropriate for all securities
over all time periods. The firm has a fixed investment policy Taxes do not exist; or
there is no difference in the tax rates applicable to both dividends and capital gains.
Perfect capital markets, i.e. investors behave rationally, information is freely available to
all investors, transaction and floatation costs do not exist, no investor is large enough to
influence the price of a share. ASSUMPTIONS OF M-M HYPOTHESIS
18. 18. The return is computed as follows: r = Dividends + Capital gains (loss) Share price r
= DIV1 + (P1 P0) P0 Under the assumptions the rate of return, r, will be equal to the
discount rate, k. As a result the price of each share must adjust so that the rate of return,
which is composed of the rate of dividends and capital gains on every share, will be equal
to the discount rate and be identical for all shares.
19. 19. This arbitraging or switching continues until the differentials in rates of return are
eliminated. As hypothesised, r should be equal for all the shares otherwise the lower
yielding securities will be traded for the higher yielding ones thus reducing the price of the
low yielding ones and increasing the price of the high yielding ones.
20. 20. Consequently the present value per share after dividends and external fin This
means that the terminal value of the share declines when dividends are paid. Thus the
wealth of the shareholders dividends plus the terminal share price remains
unchanged. A firm which pays dividends will have to raise funds externally in order to
finance its investment plans. When a firm pays dividend therefore, its advantage is offset
by external financing. CONCLUSIONS OF THE MODEL Thus the shareholders are
indifferent between the payment of dividends and retention of earnings. ancing is equal
to the present value per share before the payment of dividends.
21. 21. No or low taxes on dividends Desire for steady income Uncertainty (high-payout
clientele) Diversification Information asymmetry Transaction and agency costs
Floatation costs
Tax differentials (low-payout clientele)
Presence of Market
Imperfections: CRITICISMS?
22. 22. Investors behave rationally, are risk-averse and therefore have a preference for near
dividends to future dividends. Relaxing of Gordons simplifying assumptions to conform
slightly to reality, he concludes that even when r = k, the dividend policy does affect the
value of the share based on the view that: under conditions of uncertainty, investors tend
to discount distant dividends (capital gains) at a higher rate than they discount near
dividends. THE BIRD-IN-THE-HAND THEORY
23. 23. Put forth by Kirshman (1969) in the following terms:Of two stocks with identical
earnings record and prospects but the one paying higher dividend than the other, the
former will undoubtedly command higher dividend than the latter merely because
stockholders prefer present to future values.stockholders normally act on the premise
that a bird in the hand is worth two in the bush and for this reason are willing to pay a
premium price for the stock with the higher dividend rate just as they discount the one
with the lower rate.
24. 24. The appropriate discount rate would thus increase with the retention ratio. Investors
prefer to avoid uncertainty and would be willing to pay a higher price for the share that
pays the higher current dividend, all things held constant. When dividend is considered
with respect to uncertainty the discount rate cannot be held constant, it increase with
uncertainty. Uncertainty of dividends increases with futurity, i.e. the further one looks
the more uncertain dividends become
1. Walters 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 firms internal rate of return
(r) and its cost of capital (k) in determining the dividend policy that will
maximise the wealth of shareholders.
Walters model is based on the following assumptions:
1. The firm finances all investment through retained earnings; that is debt
or new equity is not issued;
2. The firms internal rate of return (r), and its cost of capital (k) are
constant;
3. All earnings are either distributed as dividend or reinvested internally
immediately.
4. 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.
5. The firm has a very long or infinite life.
Walters formula to determine the market price per share (P) is as
follows:
P = D/K +r(E-D)/K/K
The above equation clearly reveals that the market price per share is
the sum of the present value of two sources of income:
i) The present value of an infinite stream of constant dividends, (D/K) and
ii) The present value of the infinite stream of stream gains.
[r (E-D)/K/K]
Criticism:
Walters 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 Walters model.
The criticisms on the model are as follows:
1. Walters 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 firms 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.
2. Walters model is based on the assumption that r is constant. In fact
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.
3. A firms cost of capital or discount rate, K, does not remain constant; it
changes directly with the firms risk. Thus, the present value of the firms
income moves inversely with the cost of capital. By assuming that the
discount rate, K is constant, Walters model abstracts from the effect of risk
on the value of the firm.
2. Gordons Model:
One very popular model explicitly relating the market value of the firm to
dividend policy is developed by Myron Gordon.
Assumptions:
Gordons model is based on the following assumptions.
1. The firm is an all Equity firm
2. No external financing is available
3. The internal rate of return (r) of the firm is constant.
4. The appropriate discount rate (K) of the firm remains constant.
5. The firm and its stream of earnings are perpetual
6. The corporate taxes do not exist.
7. The retention ratio (b), once decided upon, is constant. Thus, the growth
rate (g) = br is constant forever.
8. K > br = g if this condition is not fulfilled, we cannot get a meaningful
value for the share.
According to Gordons 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:
low-return yielding shares will be sold by investors who will purchase the
high-return yielding shares.
This process will tend to reduce the price of the low-return shares and to
increase the prices of the high-return shares. This switching will continue
until the differentials in rates of return are eliminated. This discount rate will
also be equal for all firms under the M-M assumption since there are no risk
differences.
From the above M-M fundamental principle we can derive their valuation
model as follows:
If the firm sells m number of new shares at time 1 at a price of P^, the value
of the firm at time 0 will be
Criticism: