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Copyright © 2015 by McGraw Hill Education (India) Private Limited Chapter 21 DIVIDEND POLICY AND FIRM VALUE  Centre for Financial Management , Bangalore  OUTLINE Models in Which Investment and Dividend Decisions are Related Tra...

Copyright © 2015 by McGraw Hill Education (India) Private Limited Chapter 21 DIVIDEND POLICY AND FIRM VALUE  Centre for Financial Management , Bangalore  OUTLINE Models in Which Investment and Dividend Decisions are Related Traditional Position Miller and Modigliani Position Rational Expectations Hypothesis Radical Position Overall Picture  Centre for Financial Management , Bangalore  MODELS IN WHICH INVESTMENT AND DIVIDEND DECISIONS ARE RELATED Walter Model Gordon Model  Centre for Financial Management , Bangalore  WALTER MODEL D + (E – D) r/k P= k where: P = price per equity share E = earnings per share D = dividend per share r = rate of return on investments k = cost of equity capital Example E = Rs.4, D = Rs.2, r = 0.20, k = 0.15 2 + 2 x 0.20/0.15 P= 0.15 = 31.11  Centre for Financial Management , Bangalore  IMPLICATIONS OF THE WALTER MODEL The optimal payout ratio for a growth firm (r > k) is nil The optimal payout ratio for a normal firm (r = k) is irrelevant The optimal payout ratio for a declining firm (r < k) is 100 percent  Centre for Financial Management , Bangalore  GORDON MODEL E1 (1 – b) P0 = k – br where P0 = price per share at the end of year 0 E1 = earnings per share at the end of year 1 (1 – b) = dividend payout ratio b = ploughback ratio k = shareholders’ required rate of return r = rate of return earned on investments made by the firm br = growth rate of earnings / dividends Example r = 0.20, k = 0.15, E1 = 4.0, b = 0.25 4.0 (1 – 0.25) P0 = = Rs.30 0.15 – (0.25) (0.20)  Centre for Financial Management , Bangalore  IMPLICATIONS The optimal payout ratio for a growth firm (r > k) is nil The payout ratio for a normal firm is irrelevant The optimal payout ratio for a declining firm (r < k) is 100 percent  Centre for Financial Management , Bangalore  TRADITIONAL POSITION 4D R P=m + 3 3 where P = market price per share D = dividend per share R = retained earnings per share m = a multiplier  Centre for Financial Management , Bangalore  MILLER AND MODIGLIANI (MM) POSITION MM have argued that the value of a firm depends solely on its earning power and is not influenced by the manner in which earnings are split between dividends and retained earnings Current Dividends Income Earnings Retained Capital Earnings Apprec’n  Centre for Financial Management , Bangalore  MM ASSUMPTIONS There is no tax advantage or disadvantage associated with dividends. Investment and dividend decisions are independent. Firms can issue stock without incurring any floatation or transaction costs.  Centre for Financial Management , Bangalore  CRITICISMS OF MM POSITION Critics of MM agree that, under the assumptions made by MM, dividends are irrelevant. However, they dispute the validity of the ‘dividend irrelevance’ theorem by challenging the assumptions used by MM.  Centre for Financial Management , Bangalore  CRITICISMS OF MM POSITION Information about Prospects Uncertainty and Fluctuations Offering of Additional Equity at Lower Prices Issue Cost Transaction Costs Differential Rates of Taxes Rationing Unwise Investments  Centre for Financial Management , Bangalore RATIONAL EXPECTATIONS HYPOTHESIS What matters in economics is not what actually happens but the difference between what actually happens and what was supposed to happen.  Centre for Financial Management , Bangalore  RATIONAL EXPECTATIONS HYPOTHESIS In a world of rational expectations, unexpected dividend announcements would transmit messages about changes in earnings potential which were not incorporated in the market price earlier. The reappraisal that occurs as a result of these signals leads to price movements which look like responses to the dividends themselves, though they are actually caused by an underlying revision of the estimate of earnings potential.  Centre for Financial Management , Bangalore  RATIONAL EXPECTATIONS HYPOTHESIS The above analysis is helpful in reconciling the practitioner’s view that dividends matter very much and the academic view that dividends do not matter. As Merton Miller said: “Both views are correct in their own way. The academic is thinking of the expected dividend; the practitioner of the unexpected”  Centre for Financial Management , Bangalore  RADICAL POSITION Directly or indirectly dividends are generally taxed more heavily than capital gains. So radicalists argue that firms should pay as little dividends as they can get away with so that investors earn more by way of capital gains and less by way of dividends  Centre for Financial Management , Bangalore EFFECT OF DIVIDEND POLICY ON REQUIRED RETURN Firm A Firm B (No Dividend) (High Dividend) 1. Next year’s price Rs 120 Rs 105 2. Dividend 0 Rs 15 3. Total pre-tax payoff Rs 120 Rs 120 4. Current price Rs 102.86 Rs 101.43 5. Capital gain Rs 17.14 Rs 3.57 6. Pre-tax rate of return 16.67% 18.31% [(2) + (5)]/ (4) 7. Tax on dividend at 20 percent – Rs 3 8. Tax on capital gains at 10 percent Rs 1.714 Rs 0.357 9. Total post-tax income Rs 15.426 Rs 15.213 10. Post-tax rate of return 15.426 15.213 102.86 = 15% 101.43 = 15%  Centre for Financial Management , Bangalore  SUMMING UP There are several views on the relationship between dividend policy and share valuation. According to the Walter model and the Gordon model the effect of dividend policy depends on the relationship between the rate of return on investments and the cost of capital. According to the traditional position the stock market places more weight on dividends than on retained earnings. Miller and Modigliani have advanced the view that the value of a firm is independent of its dividend policy. According to the critics of Miller and Modigliani, dividends matter because of uncertainty characterising the future, imperfections in the capital market, and presence of taxes. In a world of rational expectations, unexpected dividend announcements would transmit messages about changes in earnings potential which were not incorporated in the market price earlier. The radical position argues that a lower dividend payout ratio promotes the welfare of shareholders.  Centre for Financial Management , Bangalore