CHAPTE R 17
DIVIDEND THEORY
LEARNING OBJECTIVES
2
? Highlight
the issues of dividend policy ? Critically evaluate why some experts feel that dividend policy matters ? Discuss the bird-in-the-hand argument for paying current dividends ? Explain the logic of the dividend irrelevance ? Identify the market imperfections that make dividend policy relevant ? Understand information content of dividend policy
INTRODUCTION
3
? Dividend
policy involves the balancing of the shareholders’ desire for current dividends and the firm’s needs for funds for growth.
Issues in Dividend Policy
4
? Earnings
to be Distributed – High Vs. Low
Payout. ? Objective – Maximize Shareholders Return. ? Effects – Taxes, Investment and Financing Decision.
Relevance Vs. Irrelevance
5
? Walter's
Model ? Gordon's Model ? Modigliani and Miller Hypothesis ? The Bird in the Hand Argument ? Informational Content ? Market Imperfections
6
DIVIDEND RELEVANCE: WALTER’S MODEL
Walter’s model is based on the following assumptions: ? Internal financing ? Constant return and cost of capital ? 100 per cent payout or retention ? Constant EPS and DIV ? Infinite time
7
Walter’s formula to determine the market price per share:
Optimum Payout Ratio
8
Firms – Retain all earnings ? Normal Firms – Distribute all earnings ? Declining Firms – No effect
? Growth
Example: Dividend Policy: Application of Walter’s Model
9
Criticism of Walter’s Model
10
? No
external financing ? Constant return, r ? Constant opportunity cost of capital, k
11
DIVIDEND RELEVANCE: GORDON’S MODEL
Gordon’s model is based on the following assumptions:
?
? ?
?
? ? ? ?
All-equity firm No external financing Constant return Constant cost of capital Perpetual earnings No taxes Constant retention Cost of capital greater than growth rate
Valuation
? Market
value of a share is equal to the present value of an infinite stream of dividends to be received by shareholders.
Example: Application Gordon’s Dividend Model
13
of
It is revealed that under Gordon’s model:
14
DIVIDEND AND UNCERTAINTY: THE BIRD-IN-THE-HAND ARGUMENT
? Argument ? Investors
put forward, first of all, by Kirshman
are risk averters. They consider distant dividends as less certain than near dividends. Rate at which an investor discounts his dividend stream from a given firm increases with the futurity of dividend stream and hence lowering share prices.
DIVIDEND IRRELEVANCE: THE MILLER–MODIGLIANI (MM) HYPOTHESIS
? According
to M-M, under a perfect market situation, the dividend policy of a firm is irrelevant as it does not affect the value of the firm. They argue that the value of the firm depends on firm earnings which results from its investment policy. Thus when investment decision of the firm is given, dividend decision is of no significance. is based on the following assumptions
erfect capital markets No taxes Investment policy No risk
? It
? ? ? ?
Market Imperfections
17
1.
2.
3. 4.
5.
6. 7. 8.
Tax Differential – Low Payout Clientele Flotation Cost Transaction and Agency Cost Information Asymmetry Diversification Uncertainty – High Payout Clientele Desire for Steady Income No or Low Tax on Dividends
Informational Content of Dividend
? ….
In an uncertain world in which verbal statements can be ignored or misinterpreted, dividend action does provide a clear cut means of ‘making a statement’ that speaks louder than a thousand words. — Solomon
doc_910988679.ppt
DIVIDEND THEORY
LEARNING OBJECTIVES
2
? Highlight
the issues of dividend policy ? Critically evaluate why some experts feel that dividend policy matters ? Discuss the bird-in-the-hand argument for paying current dividends ? Explain the logic of the dividend irrelevance ? Identify the market imperfections that make dividend policy relevant ? Understand information content of dividend policy
INTRODUCTION
3
? Dividend
policy involves the balancing of the shareholders’ desire for current dividends and the firm’s needs for funds for growth.
Issues in Dividend Policy
4
? Earnings
to be Distributed – High Vs. Low
Payout. ? Objective – Maximize Shareholders Return. ? Effects – Taxes, Investment and Financing Decision.
Relevance Vs. Irrelevance
5
? Walter's
Model ? Gordon's Model ? Modigliani and Miller Hypothesis ? The Bird in the Hand Argument ? Informational Content ? Market Imperfections
6
DIVIDEND RELEVANCE: WALTER’S MODEL
Walter’s model is based on the following assumptions: ? Internal financing ? Constant return and cost of capital ? 100 per cent payout or retention ? Constant EPS and DIV ? Infinite time
7
Walter’s formula to determine the market price per share:
Optimum Payout Ratio
8
Firms – Retain all earnings ? Normal Firms – Distribute all earnings ? Declining Firms – No effect
? Growth
Example: Dividend Policy: Application of Walter’s Model
9
Criticism of Walter’s Model
10
? No
external financing ? Constant return, r ? Constant opportunity cost of capital, k
11
DIVIDEND RELEVANCE: GORDON’S MODEL
Gordon’s model is based on the following assumptions:
?
? ?
?
? ? ? ?
All-equity firm No external financing Constant return Constant cost of capital Perpetual earnings No taxes Constant retention Cost of capital greater than growth rate
Valuation
? Market
value of a share is equal to the present value of an infinite stream of dividends to be received by shareholders.
Example: Application Gordon’s Dividend Model
13
of
It is revealed that under Gordon’s model:
14
DIVIDEND AND UNCERTAINTY: THE BIRD-IN-THE-HAND ARGUMENT
? Argument ? Investors
put forward, first of all, by Kirshman
are risk averters. They consider distant dividends as less certain than near dividends. Rate at which an investor discounts his dividend stream from a given firm increases with the futurity of dividend stream and hence lowering share prices.
DIVIDEND IRRELEVANCE: THE MILLER–MODIGLIANI (MM) HYPOTHESIS
? According
to M-M, under a perfect market situation, the dividend policy of a firm is irrelevant as it does not affect the value of the firm. They argue that the value of the firm depends on firm earnings which results from its investment policy. Thus when investment decision of the firm is given, dividend decision is of no significance. is based on the following assumptions
erfect capital markets No taxes Investment policy No risk? It
? ? ? ?
Market Imperfections
17
1.
2.
3. 4.
5.
6. 7. 8.
Tax Differential – Low Payout Clientele Flotation Cost Transaction and Agency Cost Information Asymmetry Diversification Uncertainty – High Payout Clientele Desire for Steady Income No or Low Tax on Dividends
Informational Content of Dividend
? ….
In an uncertain world in which verbal statements can be ignored or misinterpreted, dividend action does provide a clear cut means of ‘making a statement’ that speaks louder than a thousand words. — Solomon
doc_910988679.ppt