DIVIDEND DECISION

WALTER AND GORDON MODEL

OF DIVIDEND

PRESENTED BY
MAYANK ANAND
MBA (FINANCE)
FLOW OF PRESENTATION
 INTRODUCTION
 DIVIDEND DECISION

 FACTORS AFFECTING DIVIDEND DECISION

 DIVIDEND THEORIES

 WALTER MODEL OF DIVIDEND DECISION AND

VALUATION OF FIRM
 GORDON MODEL OF DIVIDEND DECISION

AND VALUATION OF FIRM

INTRODUCTION
 Theterm dividend refers to a part of profit of a
company which is distributed by the company
among its stakeholder.

 Itis a reward for the shareholder for the

investment made by them in the share of the
company.
DIVIDEND DECISION

 Aninvestor is generally interested in earning the

maximum return on his investment and to maximize his
wealth.

A company on the other hands needs to provide funds for

financing its long term growth.

 Ifa company pays out most of the earning as a dividend,

so for the further expansion it has to depend on the other
sources such as debt or issue of new shares.

A firm has basically two option, i.e. either firm can retain
the earning or can distribute the same as a dividend.

 The first option suited to those firms which want to

finance their long term project.
CONT…
 While the second option of declaring the dividend
will lead to maximization of shareholder wealth.

 So the return to the share holder either by the

way of dividend or the capital gains are affected
by the dividend decision policy of the firm.

 Itis the dividend decision policy of the firm which

decide the retention ratio and the pay out ratio.
(dividend as a % of profit).

 There are basically two school of thought

regarding the dividend decision.
FACTORS AFFECTING DIVIDEND
PAYOUT RATIO
 Funds Requirement
 Liquidity

 Access to external source of financing

 Shareholders Preference

 Difference in the cost of External Equity and retained

earning
 Control

 Taxes

 Inflation
DIVIDEND THEORIES

 The Theory Of Irrelevance

 MM Model

o The Theory Of Relevance

 Walter’s Approach
 Gordon’s Approach
THEORY OF RELEVANCE

• This school of thought on dividend decision

says that dividend decision considerably
affect the value of the firm.

• Dividend communicate the information

about the firm’s profitability to the investor
so it become relevant.

 There is basically two theories

representing this assumption.

1. Walter’s Approach
2. Gordon’s Approach
WALTER’S APPROACH
• According to this concept the relationship between the internal
rate of return earned by the firm and its cost of capital is very
significant in determining the dividend decision policy.

• It is based on the relationship between the return on

investment r, and cost of capital or required rate of return, k.

• According to Prof. Walter, if r>k i.e. the firm should retain the
earning.

• If r<k, the shareholder would stand to gain if the firm

distribute its earnings.
•

• If r=k, the dividend policy will not affect the market value of
the firm.
ASSUMPTION OF WALTER’S MODEL

• The investment of the firm are financed

through retained earning only.

• The internal rate of return and cost of capital

is constant.

• Earning per share and the dividend do not

change while determining the value.

• The firm has a very long life.

FORMULA FOR CALCULATION

 P= D + r/Ke (E – D)
Ke Ke
 Where , P= market price per shares

 D= dividend per shares

 r= internal rate of return

 E= earning per share

 Ke= cost of capital

which can be written as follows :

P = D + r/Ke (E- D)
Ke
EXAMPLE:
 The following information is available in
respect of the firm:
 Cost of Capital 10%
 Earning per share 50 Rs.
 Assumed rate of return on investment:
1- 12%
2- 8%
3- 10%
Show the effect of dividend policy on market
price of the share when dividend pay-out
ratio is 0%, 20%, 40%, 80%, and 100%.
S0LUTION :

r=12% r=8% r=10%

r> k
r<k r=k
D/P is 0% 600 400 500

D/P is 20% 580 420 500

D/P is 40% 560 440 500

D/P is 80% 520 480 500

D/P is 100% 500 500 500

CRITICISM OF WALTER’S MODEL

 Investment are financed through external

burrowing.
 The Internal rate of Return also does not
remains constant.
 The cost of capital also does not remains
constant.
GORDON’S MODEL
 Assumptions:
1. The firm is an all equity firm.
2. No external financing is available or
used.
3. The rate of return is constant.
4. The retention ratio, b, once decided is
constant.
5. The growth rate of the firm g=br, is also
constant.
6. The cost of capital is also constant and
is greater than the g.
7. Corporate tax does not exist.
CRUX OF THE MODEL
 When r>k, the price per share increases as
the dividend pay-out ratio decreases. So the
firm should retain maximum earning.

 If r=k, price remain unchanged. dividend

decision does not affect it.

 If r<k, the price increases as the pay out

ratio increases. So the dividend would be
100%.
FORMULA FOR CALCULATION :

 According to Gordon model ,the market value of a share is

equal to the present value of a share is equal to infinite
stream of dividends received by the shareholders .
 The formula is as following :

P= E (1-b)
k- br
P= market price per share
E= EPS
b= Fraction of earning that firm retain
k= rate of return expected by shareholders
r= rate of return earned on investment by firm
br= Growth rate of earning and dividends
EXAMPLE:
The following information is available in respect of the
rate of return on investment (r), the cost of capital (k),
and earning per share of ABC Ltd.
Rate of return= 15%, 12%, 10%
Cost of capital= 12%
Earning per share=10 Rs.
Determine the value of the shares if dividend payout
ratio is 100%,80%,40% by using the Gordon’ Model.
SOLUTION :

r=15% r=12% r=10%

r>k r=k r<k
k= 12% k= 12% k= 12%

D/P is 83.33 83.33 83.33

100%
Or b=0
D/P is 80% 88.89 83.33 80
Or b=20%
D/P is 40% 133.33 83.33 66.67
Or b=60%
.

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