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2. 2. There are three main categories advanced:1. Dividend relevance theories2. Dividend

irrelevance theories3. Dividend DIVIDEND THEORIES & uncertainty

3. 3. Myron Gordon (Gordons model) James E. Walter (Walters model) These are

theories whose propagators argue that the dividend policy of a firm affects the value of

the firm. There are two main theorists: DIVIDEND RELEVANCE THEORIES

4. 4. Shows relationship btwn a firms rate of return r and its cost of capital k. it is based on

the following assumptions:1. Internal financing the firm finances all its investments

through retained earnings; debt or new equity is not issued.2. Constant return and cost of

capital the firms rate of return, r, and its cost of capital k are constant3. 100% payout or

retention all earnings are either distributed as dividends or reinvested internally

immediately.4. Constant EPS and DPS beginning earnings and dividends never

change. The values of the EPS and DPS may be changed in the model to determine

results but are assumed to remain unchanged in determining a given value.5. Infinite time

the firm has a very long or infinite life WALTERS MODEL

5. 5. k = firms cost of capital r = firms average rate of return EPS = earnings per

share DPS = dividend per share P = market price per share Walters formula for

determining MPS is as follows:P = (DPS/k) + [r (EPS DPS)/k]/kWhere:

6. 6. the market value is determined as the present value of two sources of income:1. PV of

constant stream of dividend (DPS/k)2. PV of infinite stream of capital gains: r(EPSDPS)/kHence the formula can be rewritten as P = DPS + (r/k) (EPS DPS) k

7. 7. Given three types of firms or scenarios of firms the model can be summarized as

follows:1. Growth firm: there are several investment opportunities (r > k) and the firm

can reinvest earnings at a higher rate r than that which is expected by shareholders k.

thus they wil maximize value per share if they reinvest all earnings.2. Normal firm: there

arent any investments available for the firm that are yielding higher rates of return (r = k)

thus the dividend policy has no effect on market price.

8. 8. 3. Declining firm: there arent any profitable investments for the firm to reinvest its

earnings, i.e. any investments would earn the firm a rate less than its cost of capital (r <

k). The firm will therefore maximize its value per share if it pays out all its earnings as

dividend.

9. 9. constant cost of capital, i.e. disregards the firms risk which changes over time hence

the discount rate will change over time in proportion. Model assumes a constant rate of

return and; Model assumes investment decisions of the firm are financed by retained

earnings alone CRITICISMS OF WALTERS MODEL

10. 10. Assumptions:1. The firm is an all equity firm, i.e. no debt2. No external financing is

available; consequently retained earnings would be used to finance any expansion of the

firm. Similar argument as Walters for the dividend and investment policies.3. Constant

return which ignores diminishing marginal efficiency of investment as represented in the

diagram on Walters model.4. Constant cost of capital; model also ignores the risk-effect

as did Walters GORDONS MODEL

11. 11. 5. Perpetual stream of earnings for the firm6. Corporate taxes do not exist7. Constant

retention ratio b, i.e. once decided upon stays as such forever. The growth rate g = br

stays constant in that case.8. Cost of capital greater than the growth rate (k > br = g);

otherwise it is not possible to obtain a meaningful value for the share.

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

are as follows: 1. Walters model 2. Gordons model 3. Modigliani and

Millers hypothesis.

On the relationship between dividend and the value of the firm different

theories have been advanced.

They are as follows:

1. Walters model

2. Gordons model

3. Modigliani and Millers hypothesis

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:

(E,), dividend policy, (b), internal profitability (r) and the all-equity firms cost

of capital (k), in the determination of the value of the share (P0).

irrelevant as it does not affect the wealth of the shareholders. They argue

that the value of the firm depends on the firms 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 Ms hypothesis of

irrelevance is based on the following assumptions.

1. The firm operates in perfect capital market

2. Taxes do not exist

3. The firm has a fixed investment policy

4. 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.

Under M M assumptions, r will be equal to the discount rate and identical

for all shares. 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.

Thus, the rate of return for a share held for one year may be

calculated as follows:

market price per share at time 1 and D is dividend per share at time 1. As

hypothesised by M M, r should be equal for all shares. If it is not so, the

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:

we obtain the value of the firm if no new financing exists.

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

shares, unlike Walters and Gordons models. Consequently, a firm can pay

dividends and raise funds to undertake the optimum investment policy.

Thus, dividend and investment policies are not confounded in M M

model, like waiters and Gordons models.

Criticism:

lacks practical relevance in the real world situation. Thus, it is being

criticised on the following grounds.

1. The assumption that taxes do not exist is far from reality.

2. M-M argue that the internal and external financing are equivalent. This

cannot be true if the costs of floating new issues exist.

3. According to M-Ms 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.

4. 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.

5. 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.

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