Walter's Dividend Model Walter's model supports the principle that dividends are relevant.

The investment policy of a firm cannot be separated from its dividend policy and both are inter-related. The choice of an appropriate dividend policy affects the value of an enterprise. Assumptions of this model: 1. 2. 3. Retained earnings are the only source of finance. This means that the company does not rely upon external funds like debt or new equity capital. The firm's business risk does not change with additional investments undertaken. It implies that r(internal rate of return) and k(cost of capital) are constant. There is no change in the key variables, namely, beginning earnings per share(E), and dividends per share(D). The values of D and E may be changed in the model to determine results, but any given value of E and D are assumed to remain constant in determining a given value. The firm has an indefinite life.

4.

Equation showing the value of a share (as present value of all dividends plus the present value of all capital gains) Walter's model: P = D + r/ke (E - D) ke Where: D = Dividend per share and E = Earnings per share

Example: A company has the following facts: Cost of capital (ke) = 0.10 Earnings per share (E) = $10 Rate of return on investments ( r) = 8% Dividend payout ratio: Case A: 50% Case B: 25% Show the effect of the dividend policy on the market price of the shares. Solution: Case A: D/P ratio = 50% When EPS = $10 and D/P ratio is 50%, D = 10 x 50% = $5

5 + [0.08 / 0.10] [10 - 5] P = 0.10 => $90

Case B: D/P ratio = 25% When EPS = $10 and D/P ratio is 25%, D = 10 x 25% = $2.5 2.5 + [0.08 / 0.10] [10 2.5] 0.10

P =

=> $85

Conclusions of Walter's model: 1. When r > ke, the value of shares is inversely related to the D/P ratio. As the D/P ratio increases, the market value of shares decline. Its value is the highest when D/P ratio is 0. So, if the firm retains its earnings entirely, it will maximize the market value of the shares. The optimum payout ratio is zero. When r < ke, the D/P ratio and the value of shares are positively correlated. As the D/P ratio increases, the market price of the shares also increases. The optimum payout ratio is 100%. When r = ke, the market value of shares is constant irrespective of the D/P ratio. In this case, there is no optimum D/P ratio.

2. 3.

Limitations of this model: 1. 2. 3. Walter's model assumes that the firm's investments are purely financed by retained earnings. So this model would be applicable only to all-equity firms. The assumption of r as constant is not realistic. The assumption of a constant ke ignores the effect of risk on the value of the firm. Gordon's Dividend Capitalization Model Gordon's theory contends that dividends are relevant. This model is of the view that dividend policy of a firm affects its value. Assumptions of this model: 1. 2. 3. 4. 5. The firm is an all equity firm. No external financing is used and investment programmes are financed exclusively by retained earnings. Return on investment( r ) and Cost of equity(Ke) are constant. The firm has perpetual life. The retention ratio, once decided upon, is constant. Thus, the growth rate, (g = br) is also constant. Ke > br

Arguments of this model: 1. 2. 3. 4. Dividend policy of the firm is relevant and that investors put a positive premium on current incomes/dividends. This model assumes that investors are risk averse and they put a premium on a certain return and discount uncertain returns. Investors are rational and want to avoid risk. The rational investors can reasonably be expected to prefer current dividend. They would discount future dividends. The retained earnings are evaluated by the investors as a risky promise. In case the earnings are

5. 6.

retained, the market price of the shares would be adversely affected. In case the earnings are retained, the market price of the shares would be adversely affected. Investors would be inclined to pay a higher price for shares on which current dividends are paid and they would discount the value of shares of a firm which postpones dividends. The omission of dividends or payment of low dividends would lower the value of the shares.

Dividend Capitalization model: According to Gordon, the market value of a share is equal to the present value of the future streams of dividends. P = E(1 - b) Ke - br P E b 1-b Ke br - g = = = = = = Price of a share Earnings per share Retention ratio Dividend payout ratio Cost of capital or the capitalization rate Growth rate (rate or return on investment of an all-equity firm)

Where:

Example: Determination of value of shares, given the following data: Case A 40 60 17% 12% $20 => Case B 30 70 18% 12% $20 $81.63 (Case A) $62.50 (Case => B)

D/P Ratio Retention Ratio Cost of capital r EPS P P =

$20 (1 - 0.60) 0.17 (0.60 x 0.12) $20 (1 - 0.70) = 0.18 (0.70 x 0.12)

Gordon's model thus asserts that the dividend decision has a bearing on the market price of the shares and that the market price of the share is favorably affected with more dividends.

Miller and Modigliani Model (MM Model) Miller and Modigliani Model assume that the dividends are irrelevant. Dividend irrelevance implies that the value of a firm is unaffected by the distribution of dividends and is determined solely by the earning power and risk of its assets. Under conditions of perfect capital markets, rational investors, absence of tax discrimination between dividend income and capital appreciation, given the firms investment policy, its dividend policy may have no influence on the market price of the shares, according to this model. Assumptions of MM model 1. Existence of perfect capital markets and all investors in it are rational. Information is available to all free of cost, there are no transactions costs, securities are infinitely divisible, no investor is large enough to influence the market price of securities and there are no floatation costs. There are no taxes. Alternatively, there are no differences in tax rates applicable to capital gains and dividends. A firm has a given investment policy which does not change. It implies that the financing of new investments out of retained earnings will not change the business risk complexion of the firm and thus there would be no change in the required rate of return. Investors know for certain the future investments and profits of the firm (but this assumption has been dropped by MM later).

2. 3.

4.

Argument of this Model 1. By the argument of arbitrage, MM Model asserts the irrelevance of dividends. Arbitrage implies the distribution of earnings to shareholders and raising an equal amount externally. The effect of dividend payment would be offset by the effect of raising additional funds. MM model argues that when dividends are paid to the shareholders, the market price of the shares will decrease and thus whatever is gained by the investors as a result of increased dividends will be neutralized completely by the reduction in the market value of the shares. The cost of capital is independent of leverage and the real cost of debt is the same as the real cost of equity, according to this model. That investors are indifferent between dividend and retained earnings implies that the dividend decision is irrelevant. With dividends being irrelevant, a firms cost of capital would be independent of its dividendpayout ratio. Arbitrage process will ensure that under conditions of uncertainty also the dividend policy would be irrelevant.

2.

3. 4.

5.

MM Model: Market price of the share in the beginning of the period = Present value of dividends paid at the end of the period + Market price of share at the end of the period. P0 = 1/(1 + ke) x (D1 + P1) Where: P0 = Prevailing market price of a share

ke = cost of equity capital D1 = Dividend to be received at the end of period 1 and

P1 = Market price of a share at the end of period 1. (n + n) P1 I + E Value of the firm, nP0 Where: n = = (1 + ke) number of shares outstanding at the beginning of the period change in the number of shares outstanding during the period/ additional shares issued. Total amount required for investment Earnings of the firm during the period.

n = I E = =

Example: A company whose capitalization rate is 10% has outstanding shares of 25,000 selling at $100 each. The firm is expecting to pay a dividend of $5 per share at the end of the current financial year. The company's expected net earnings are $250,000 and the new proposed investment requires $500,000. Prove that using MM model, the payment of dividend does not affect the value of the firm. Solution: 1. Value of the firm when dividends are paid: i. Price per share at the end of year 1: P0 = 1/(1 + ke) x (D1 + P1) $100 = 1/(1 + 0.10) x ($5 + P 1) P1 = $105 Amount required to be raised from the issue of new shares: n P1 = I (E nD1) => $500,000 ($250,000 - $125,000) => $375,000 Number of additional shares to be issued: n = $375,000 / 105 => 3571.42857 shares (unrounded) Value of the firm: => (25,000 + 3571.42857) (105) - $500,000 + $250,000 (1 + 0.10) => $2,500,000 2. Value of the firm when dividends are not paid: i. Price per share at the end of year 1: P0 = 1/(1 + ke) x (D1 + P1) $100 = 1/(1 + 0.10) x ($0 + P1) P1 = $110 Amount required to be raised from the issue of new shares: => $500,000 ($250,000 -0) = $250,000 Number of additional shares to be issued: => $250,000/$110 = 2272.7273 shares (unrounded) Value of the firm:

ii.

iii.

iv.

ii.

iii.

iv.

=> (25,000 + 2272.7273) (110) - $500,000 + $250,000 (1 + 0.10) => $2,500,000 Thus, according to MM model, the value of the firm remains the same whether dividends are paid or not. This example proves that the shareholders are indifferent between the retention of profits and the payment of dividend. Limitations of MM model: 1. 2. The assumption of perfect capital market is unrealistic. Practically, there are taxes, floatation costs and transaction costs. Investors cannot be indifferent between dividend and retained earnings under conditions of uncertainty. This can be proved at least with the aspects of i) near Vs distant dividends, ii) informational content of dividends, iii) preference for current income and iv) sale of stock at uncertain price. LEVERAGE Leverage is generally defined as the ratio of the percentage change in profits to the percentage change in sales. In other words, leverage is the multiplying effect that fixed costs have on profits when there is any change in sales. As sales increases or decreases, it is only the variable costs that change correspondingly, fixed costs remain constant. Profits therefore increase or decrease at a faster rate than the rate of change in sales. This can be better understood with an example. A hypothetical income statement for a firm is as follows:

Sales Less: Variable costs

2000 800 ------

Contribution Less: Fixed costs

1200 500 ------

Profits

700 ------

If the sales of this firm is increased by 20%, the income statement will stand revised as follows:

Sales Less: Variable costs

2500 1000 ------

(increase of 25%) (increase of 25%)

Contribution

1500

(increase of 25%)

Less: Fixed costs

500

(No change) --------

Profits

1000 ---------

With an increase in sales of 25% from Rs. 2,000 to Rs. 2,500, profits have increased from Rs. 700 to Rs. 1000, an increase of 43%. This is the effect of leverage. If the firm had no fixed costs at all but all its costs were variable, there would have been no leverage and the percentage change in sales would have been the same as the percentage change in profits. It is fixed costs that introduce leverage into the firm and higher the fixed cost, higher is the leverage.

Financial management differentiates between two types of leverages Operating leverage and financial leverage. Operating leverage is the leverage effect on account of all fixed costs other than interest and financial leverage is the leverage effect on account of the financial cost, interest. The formulae for calculating the operating leverage and financial leverage are:

Operating leverage % change in PBIT = --------------------% change in sales Financial leverage % change in PBT = --------------------% change in PBIT The leverage therefore gives the sensitivity of profit changes to changes in sales. In the method indicated above for calculating the leverages, two sets of values of the income statement for two levels are needed. However, by using the modified formula given below, the operating and financial leverages can be calculated directly from the data in one income statement. Contribution Operating leverage = ---------------PBIT

PBIT Financial Leverage = ---------PBT Combined leverage factor:

If a firm uses a considerable amount of both operating and financial leverage, even small changes in the level of sales will produce wide fluctuations in PBT. The effect of the superimposition of financial leverage on operating leverage is obtained by multiplying the two leverages. The product is called the combined leverage factor or the leverage multiplier. Combined leverage factor = Operating leverage * Financial leverage Contribution PBIT

= ---------------- * -------PBIT Contribution = ---------------PBT A firm having a high operating leverage at a particular sales level means that its profits (PBIT) will be very sensitive to change in sales. Small changes in sales will bring about a magnified change in PBIT. This is both advantageous as well as disadvantageous. A small increase in sales will bring about a greatly magnified increase in profits but a small decrease in sales might well put the firm into losses. Factors affecting financial leverage: Financial leverage is PBIT/ PBT. Therefore as interest increases, financial leverage will increase. Interest, in turn, being the cost of borrowed funds, will increase with increase in the proportion of debt used for financing assets. That is why, the ratio of borrowings to assets is also called financial leverage. The higher the degree of financial leverage of a firm, the greater is the sensitivity of its profits before tax to changes in PBIT. The combined leverage factor which is the product of operating leverage and financial leverage determines the overall sensitivity of profits before tax to change in sales. As income taxes are calculated as a percentage of profit before tax, the net profit will normally be proportionate to the profit before tax. Therefore, fluctuations in profit before tax will bring about corresponding fluctuations in net profits which in turn will bring about fluctuations in earnings per share (EPS) as EPS equals net profit divided by the number of equity shares. Therefore, the combined leverage factor influences the extent to which net profits and EPS will fluctuate for a given fluctuation in sales. PBT

It is important to remember that additional benefits will accrue only when the return on assets is higher than the cost of borrowings. If however, the cost of borrowings is higher than the return on assets; the return on net worth will be even less than the return on assets.