Dividend decision
By: Aditi Yadav
DIVIDEND DECISION
The value of the firm can be maximized if the shareholder’s wealth is maximized. There is conflicting view regarding the impact of dividend decision on the valuation of firm. According to one school of thought, dividend decisions does not affect share-holder’s wealth and hence the valuation of firm. On the other hand, according to other school of thought, dividend decision materially affect the shareholder’s wealth and also the valuation of the firm.
Views of two schools of thoughts are discussed below under two groups:-1) Theory of IRRELEVANCE2) Theory of RELEVANCE
1) The irrelevance concept of dividend :
A. Residual Approach: This theory regards dividend decision merely as the part of financial decision because the earning available may be retained in the business for re-investment. But if the funds are not required in the business they may be distributed as dividend. This theory assume that investor do not differentiate between dividend and retention by the firm.
B. Modigliani and Miller approach: They mentioned that dividend policy has no effect on the market price of shares and the value of the firm is determined by the earning capacity of the firm or its investment policy. The splitting of earning between retentions and dividend in any manner the firm’s likes, does not affect the value of firm.
Assumptions of MM hypothesis ☻There are perfect capital market.☻Investors behave rationally.☻Info about the company is available to all without any cost.☻There are no flotation or transaction cost.☻No investor is large enough to effect the market price of share.☻The firm has rigid investment policy.☻There are either no tax or no difference in tax rates applicable to dividend and capital gain.☻There is no risk or uncertainties regard to the future of the firm. (MM dropped this assumption later).
The argument of MMThe argument given by MM in support of their hypothesis is that whatever increase in the value of the firm results from the payment of dividend, will be exactly offset by the decline in market price of shares because of external financing and there will be no change in the total wealth of shareholders.
Po=D1+P1/1+KePo= Market price per share at the beginning of the periodD1= Dividend to be received at the end of the periodP1= market price per share at the end of the period.Ke= Cost of equity capital
The MM hypothesis can be explained in another form also presuming that investment required by the firm on account of payment of dividends is financed out of the new issues of equity share.
m= I(E-nD1)/P1
Further, the value of the firm can be ascertained with the help of the following formula:
nPo= (n+m)P1-(I-E)/1+kewhere,
nPo= value of the firmn= number of shares outstanding at beginning
of period.m= number of shares to be issuedP1= market price per share at the end of the
periodI= investment requiredE= total earning of firm during the periodKe= cost of equity capitalD1= dividend to be paid at the end of the
period
Illustration:ABC ltd. belongs to a risk class for which the appropriate capitalization rate is 10%. It currently has outstanding 5000 shares selling at Rs100 each. The firm is contemplating the declaration of dividend of Rs6 per share at the end of the current financial year. The co. expects the net income of Rs50,000 and has a proposal for marking new investments of Rs1,00,000. Show that under the MM hypothesis, the payment of dividend does not effect the value of the firm.
(A)Value of firm when dividends are paid:
i. Price of share at the end of current financial year
P1=Po (1+Ke)-D=100(1+.10)-6=104
ii. Number of shares to be issuedm={I-(E-nD1)}/P1={1,00,000-(50,000-5000*6)}/104=80,000/104
iii. Value of the firmnPo={(n+m)P1-(1-E)}/1+Ke
={(5000- 80,000/104)*104-(1,00,000-50000)}/1+.10
={6,00,000-50,000}/1.10= 5,00,000
(B) Value of firm when value of dividend are not paid:i. Price of share at the end of the current
financial yearP1=Po (1+Ke)-D1
=100 (1+.10)-0=100*1.10 = 110Rs
ii. Number of shares to be issuedm=I-(E-nD1)/P1
=1,00,000-(50,000-0)/110 = 50,000/110iii. Value of firm
nPo=(n+m)P1-(I-E)/1+Ke
=(5,000+ 50,000/110)*1.10-(1,00,000-50,000)/1+.10=6,00,000-50,000/1.10 = 5,50,000/1.10 =5,00,000
CRITICISM OF MM APROACHMM hypothesis has been criticized on account of various unrealistic assumptions as bellow:1. Perfect capital market does not exist in
reality.2. Information about the company is not
available to all the persons.3. The firm has to incur the flotation cost
while issuing securities.4. Different tax treatment for dividends and
capital gain.
2) Theory of RELEVANCEThe other school of thought on dividend decision holds that the dividend decision considerably affects the value of firm. According to this school dividend communicate the information to the investors about the firm’s profitability and hence dividend decision becomes relevance. Those firms which pay higher dividend, will have grater value as compare to those which do not pay dividends or have lower dividend pay out ratio. Below two theories representing these notions:I. Walter’s approachII. Gordon’s approach
1. Walter’s approach: the relation between internal rate of return earned by the firm and the cost of capital is very significant in determining dividend policy to subserve the ultimate goal of maximizing the wealth of share holder .
Walters approach based on the relationship between the firm’sa. Return on investment i.e. rb. The cost of capital i.e. k
If r>k i.e. if the firm earn the higher rate of return on investment then required , the firm should retain the earning. Such firms are known as growth firms and the optimum pay out would be zero in their case. This would maximize the value of shares.
In case of firms which do not have profitable investment i.e. r<k the shareholder would stand to gain if the firm distribute its earning. For such firms optimum payout would be 100% and the firm should distribute its entire earning on dividend.
In case normal firms where r=k, the dividend policy will not effect the market value of share as the shareholders will get the same return from the firm as expected by them. For such firms, there is no optimum dividend pay out and the value of the firm would not change with the change in dividend rate.
Assumptions of Walter's model☻The investments of the firm are financed through retained earning only and the firm does not use external sources of firms.☻The internal rate of return (r) and the cost of capital (k) of the firm are constant.☻Earnings and dividends do not change while determining the values.☻The firm has a very long life.
Walter’s formula for determining the value of a share
P=D/{Ke-g}P= price of equity shareD= initial dividend per shareKe= cost of equity capitalg= expect growth rate of earningFormula to ascertain the market price of a share
P={D+r (E-D)/Ke}÷KeP= market price of sharesD= dividend per sharer= internal rate of returnE= earning per shareKe=cost of equity capital
Illustration: Following info available in respect of a firm:Capitalization rate=10%Earning per share= rs50Assumed rate of return of investments:I. 12%II. 8%III. 10%Show the effects of dividend policy on market price of share by applying Walter's formula when dividend policy pay out ratio isa) 0%b) 20%c) 40%d) 80% ande) 100%
Solution:P =[D/Ke] + {r[E-D]/Ke}/Ke
Effects of dividend policy on market price of shares:
r=12% r=8% r=10%
p=[0/.10]+{12(50-0)/.10} =600
p=[0/.10]+{.08(50-0)}/.10 =400
p=[0/.10]+{.10(50-0)/.10}/.10
=500
p=[10/.10]+(.12/.10)/.10 (50-10)
=580
p=[10/.10]+{(.80/.10)(50-10)}/.10 =420
p=[10/.10]+{(.10/.10)(50-10)}/.10= 500
p=[20/.10]+(.12/.10)/.10(50-20)=
560
p=[20/.10]+{(.08/.0)(50-20)}/.10 = 440
p=[20/.10]+{(.10/.10)50-20)}/.10 =500
p=[40/.10]+(.12/.10)/.10(50-40) =
520
p=[40/.10]+{(.08/.10)(50-40)}/.10 = 480
p=[40/.10]+{(.10/.10)(50-40)}/.10 = 500
p=[50/.10]+{(.12/.10)(50-50)}/.10 = 500
p=[50/.10]+{(.08/.10)(50-50)}/.10 = 500
p=[50/.10]+{(.10/.10)(50-50)}/.10 = 500
(a)When dividend pay out ratio is 0%
(i)P= 0 +.12(50-0)/.10 (ii) P= 0 +.08(50-0)/.10 .10 .10 .10 .10 = 0+(.12*50)/(.10) = 0+(.08*50)/.10 .10 .10 = Rs 600 = Rs 400
(iii) P = 0 + .10(50-0)/.10 .10 .10 = 0+500
= Rs500
(b) When dividend pay out ratio is 20%
(i)P =10+ .12(50-10)/.10 (ii) P= 10 +.08(50-10)/.10 .10 .10 .10 .10 = 100 + 48/.10 = 100+32/.10 = Rs 580 = Rs420
(iii)P =10 + .10(50-10)/.10 .10 .10 = 100+400 = Rs 500
(c)When dividend pay out ratio is 40%
(i)P =20+.12(50-20)/.10 (ii) P= 20+.08(50-20)/.10 .10 .10 .10 .10 =200+360 =200+240 = Rs 560 = Rs 440
(iii)P = 20 + .10(50-20)/.10 = 200+300 = Rs500
(d). When dividend pay out ratio is 80%
(i)P= 40+.12(50-40)/.10 (ii) P=40+.08(50-40)/.10 .10 .10 .10 .10 400+120=520 400+80=480
(iii) P = 40 + .10(50-40)/.10 .10 .10 = 400+100 =500
(e) When dividend pay out ratio is 100%
(i) P= 50 +.12(50-50)/.10 (ii) P=50 +.08(50-50)/.10 .10 .10 .10 .10 =500+0 = 500+0 = Rs 500 = Rs 500
(iii) P = 50 + .10(50-50)/.10 .10 .10 = 500+0 = Rs 500
CONCLUSION
1. r>k, the company should retain the profits, i.e. when r=12%
2. r<k, then company should pay out high i.e. r is 8%
3. r=k, the dividend does not affect the price of the share i.e. r is 10%
Criticism of Walter’s model:I. Basic assumption that investments are financed
through retained earnings only.II. The internal rate of return , (r) also does not,
remain constant.III. Assumption that cost of capital (k)will remain
constant also does not hold good.