Dividend Decision & Valuation of Firm

Dept. of Business and Financial Studies University of Kashmir

Learning Goals: Dividend decision: what it is all

about? firm:

Dividend Decision & Valuation of Firm

Dividend decision & valuation of

Walters model Gordons model Linters model Graham & Dods model

Dividend Decision & Valuation of Firm

Dividend Decision
Amt. distributed among shareholders Amount of earnings to be retained

Impact on Internal source of finance

Increases current wealth Information value

Dividend Decision & Valuation of Firm

Payout Ratio

Low High payout:

High

Less retained earnings..slower growth perhaps lower MP

Low payout:
More RE. Higher growth.higher

Q:

Dividend Decision & Valuation of Firm

Does div. decision influence Value of a shares Walters Model Gordons Model Relevant Linters Model Graham & Dodds Model M-M HypothesisIrrelevant

Dividend Models:

Walters Model

Contention:
C1: Div. Decision influences
Value of a share..Optimum P/O Ratio

E1: Relationship between IRR &

K Used in determining optimum Decision

E2: Classifies companies into:

Walters Model
Growth
Req. more funds Difficult to obtain funds Suff. Investment opportunities

Matured
Req. less funds Access to funds Less feasible Investments opp.

Declining
Little res.Req Little access Revamping

Less fin. Resources Sufficient resource

R<k

r>k

R=k

Walters Model

Assumptions:
A1:
Only retained earnings used to Finance investments. IRR & K remains constant All earnings are either distributed or reinvested internally immediately EPS & Dividends never change Firm has infinite life

A2: A3: A4:

A5:

Walters Model

Growth Firm..r > k C: Optimum payout ratio is

zero

E:

Able to reinvest at a rate higher than k

Result
At zero payout ratio, weighted benefit of RE will be more than

Walters Model

Normal Firm..r = k
C: No optimum payout ratio

E: Able to invest at a rate=k Result:

At any payout ratio, weighted benefit of RE is equal to that of dividends.

Walters Model

Declining Firmr < k

C:
100% Optimum payout ratio is No investment opp. or can

E:
earn

Less than the rate expected by...

Walters Model
Valuation of Shares

P = Present value of stream of dividends &

Capital gain
D + (r/k) ( E D )

P =

-------------------------k

Where:
P = Market price of share D = Dividend per share r = IRR k = cost of capital E = EPS

Walters Model

Example: The following

estimates about three companies viz., A, B, & C are given: A B C R 15% 10% 8% K.10% 10%

Walters Model
Div Div = =0 0 0+(.15/.10) 0+(.15/.10) (10-0) (10-0) .10 .10 = = Rs Rs 150 150 Div Div = =4 4 4+(.15/.10) 4+(.15/.10) (10(10- 4) 4) .10 .10 = = Rs Rs 130 130 Div =10 10+(.15/.10)(10-10) .10 = Rs 100

Payout Payout Ratio Ratio = = zero zero

Div Div = =0 0 0+(.10/.10)(10-0) 0+(.10/.10)(10-0) .10 .10 = = Rs Rs 100 100

Payout Payout ratio ratio = = 40% 40%

Div Div = =4 4 4+(.10/.10)(104) 4+(.10/.10)(10- 4) .10 .10 = = Rs Rs 100 100

Div Div = =0 0 0+(.08/.10) 0+(.08/.10) (10-0) (10-0) .10 .10 = = Rs Rs 80 80 Div Div = =4 4 4+(.08/.10) (10- 4) 4) 4+(.08/.10) (10.10 .10 = = Rs Rs

Payout ratio = 100%

Div =10 Div =10 10+(.10/.10)(10-10) 0+(.10/.10)(10-10) 0+(.08/.10)(10-10) 10+(.08/.10)(10-10) .10 .10 = Rs 100 = Rs 100

Gordons Model

Contention:
C1:
Div. Decision Influences Value of Firm Optimum P/O Ratio

Determination:
D1: Used IRR & K in determining
optimum Pay out Ratio

D2:

Classifies companies into Growth, Normal, & Declining.

Gordons Model

Prepositions of Gordon
r > k Zero r < k 100% r = k.Irrelevant

Gordons Model

Assumptions
A1: Firm is all equity A2: Uses RE to finance
investments.

A3: A4:
A5:

IRR & K remains constant

Retention ratio once decided remains constant No corporate taxes Firm derives its earnings

A6:

Gordons Model

C2:

If risk is considered then, P/ratio would influence Value even when r = k

Assumptions:
A1: Rational investors are risk
averse

A2: Prefer nearer Div. than

distant Div.

Gordons Model

Effects of Retention:
E1: Retention means
postponement of current Div. in promise of more future div..

Risk

E2: More the risk, more the

k.. based on Bird-In-The-

Gordons Model

Bird-in-the-Hand Argument
One Bird in a hand is better than 2 birds in a bush Shareholders Prefer Nearer Div. Over Distant Dividends

Krishman:
Two identical stocks, one paying more dividend will have more MP.. vice versa

Gordons Model
Relationship between p/ratio & k DR(k)
K

RR(b)

Conclusion
More the retention, more risk, more the kless MP Less the retention, less risk, less the k more MP

P = present value of stream of dividends

Gordons Model: Valuation of shares

P = D1 D2 Dn ------ +------ ..+----(1+k) (1+k) (1+k )
E1 ( 1 b ) = -------------------k - br

Where:
P = Market price of share D = Dividend per share r = IRR k = cost of capital E = EPS b = Retention ratio

Gordons Model: Valuation of shares Payout Ratio = 10%

r =.12, k = .11
20 (1- 0.9) .11 (0.9 x 0.12) = Rs 1,000

r =.11, k=.11
20(1- 0.9) .11 (0.9 x 0.1I) = Rs 181

r= 8, k= .11
20 (1- 0.9) .11 (0.9 x 0.08) = Rs 52.63

Payout Ratio = 40%

20 (1- 0.6) .11 (0.6 x 0.12) = Rs 210 20 (1- 0.6) .11 (0.6 x 0.11) = Rs 100 20 (1- 0.6) .11 (0.6 x 0.08) = Rs 129

Payout Ratio = 80%

20 (1- 0.2) .11 (0.2 x 0.12) = Rs 186 20 (1- 0.2) .11 (0.2 x 0.11) = Rs 100 20 (1- 0.2) .11 (0.2 x 0.08) = Rs 1,000

M-M Hypothesis

Contention:
a Firm

P/ratio does not influence Value of

Arguments:
A1: Value.. earning capacity & earnings .investment decisions.

A2:

When company Retains, investor

M-M Hypothesis

A3: Benefit of Div. is offset

by external financing

A4:

Shareholders are indifferent to Dividend Decision..able to Construct Own Div. Policy

Assumptions:
A1:

M-M Hypothesis

Perfect capital market

Easy to buy & sell No buyer/seller large enough to influence MP Access to information No transaction costs Securities are divisible

A2: Rational investors

M-M Hypothesis

A3: A4: A5: A6:

No risk of uncertainty (dropped) No corporate taxes(no diff.) k & r is identical for all the shares IRR = k

M-M Hypothesis

Conclusion:

C1 :
C2 :

When r=k, then weighted benefit of RE will be equal to weighted benefit of DivV constant When r is same, no shift will take place from low

M-M Hypothesis

Valuation of shares:
P1 D1 = Po ( 1 + k )

Where:
P1 = market price per share at time 1 Po = market price per share at time 0

M-M Hypothesis

Example: ABC Comp. currently

has outstanding 1,00,000 shares, selling at Rs 100 each. It is thinking to pay a div. of Rs 5 Ps at t1. K is 10%. What will be the price of the share if: A div. is not paid. A div. is paid @ Rs 5 per share. How many new shares are to be sold, if the company requires Rs 20 lakhs & the net profit is Rs 10

M-M Hypothesis

P1

Po ( 1 + k ) D1 Po = Rs 100 K = 0.10 D1 = 0.0

P1
= 110

= 100(1 + 0.10) 0 = 100(1 + 0.10) 5

P1

M-M Hypothesis

No of shares:
D1 )

np1 = I ( E

Where:
np1 = change in MP of share = 105 I = amount to be invested = 20 lacs E = earnings ... = 10 lacs D1 = Div. at t = 1.. =

Traditional Approach
Advocated by Gram & Dodd

Arguments:
A1: Div. Dec. is a relevant Influences value A2: Stock market places considerable Weight age on Div. than RE Weight assigned to DIV is 3 times the weight assigned to RE

m( D + E/3 )

Traditional Approach

Criticism: Based on subjective

judgment rather than on empirical evidence

Explanation
E1: Hypothesis Based on
empirical evidence..cite results of cross section regression analysis

Traditional Approach

Analysis: Conclusions
reached by Gram & Dodd are not justified

R1: Omits risk.., thus

Distorts results

R2:

Measurement of earnings Is subject to error Transmitted to

Traditional Approach

Traditional Approach

Traditional Approach