dividend policy & valuation of enterprise

8/8/2019 dividend policy & valuation of enterprise

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DIVIDEND POLICY &

VALUATION OF ENTERPRISE


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Problem of management of businessProblem of management of businessincomeincome

o Disposition of income left after meeting all businessexpenses is the finance managers exclusiveresponsibility.

o A portion of the business profits is retained for reinvestment in the firm & reminder is paid out tostockholders as dividends.

o A major problem facing a finance manager in

managing income is to decide what portion of the profit to pay out to stockholders & what portionto retain in the firm so as to maximize the marketvalue of the firm & consequently maximize the

wealth of stockholders.


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o If the management decide of retain the predominant portion of profits, the firm will get a

substantially large amount of funds as cheaper rate& with out any obligation to refund the same tosatisfy major portion of its expansion &modernization schemes.

A strong & stable firm will obviously enlist thesupport of investor as well as creditor that willhelp the firm to procure funds from externalsources at a reasonable rate conveniently.


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o Against the security of such shares, stock holder encounter no problem borrowing funds on

reasonable terms because of increased value of share as collateral security .o Shock holders have strong preference dividend

income because of uncertainty in future return. To

them dividend is the tangible evidence of profitability of the firm .

o A Finance manager is, therefore, in dilemma tostrike a satisfactory compromise between dividend

payments & retention.o A skilful finances manager has to formulate

dividend policy in such way has to maximizeshare price.


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WALTERS MOD ELWALTERS MOD EL

I ntroductionI ntroductionP rof Walter explains the relationship between

internal rate of return (r) & cost of capital (k)& its influence on the dividend decisions toachieve wealth maximisation .


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AA SSU MP TI ON SSSU MP TI ON S

U se of only retained earnings for financinginvestment opportunities.

IRR (r) & cost of capital (k) remainsconstant.Earnings & dividend remains constant.

Firm has a long life.


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FF O R M ULAEO R M ULAE

P= D+ (E-D) r/k

Where, p = mkt price per shareD= dividend per shareR = internal rate of return

E= earnings per shareK = cost of capital


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CC ON C LUSI ONON C LUSI ON

C ost of funds < IRR = Retain profit for further investment.

IRR < cost of funds= H

igh dividend.IRR = C ost of funds than, no effect inrespect of mkt value of shares.


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G rowth Firms

IRR > Normal earnings rate (r/k)r/k factor >1

Normal Firms IRR = Normal capitalisation rate (r = k)

Declining Firms IRR < Normal earnings rate


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EE VALUATI ONVALUATI ON

P rof Walter focused on effects of dividend policy on value of equity shares.

Theory laid down is unrealistic.C onclusions drawn are hardly true in reallife situations.

Assumption of r remains constant is nottrue under all situations.


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G O R DON S MOD ELG O R DON S MOD EL

I ntroduction

G ordons model is also known as G ordon'sgrowth model. This model stress thatdividend policy of the company has a direct

bearing on the market value of shares


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AA SSU MP TI ON SSSU MP TI ON S

The rate of return is constant.Operates its investment activities only

through equity.It ignores risk involved in investment &

assumes the discount rate of firm remainconstant.The corporate taxes does not exist.Retention ratio is constant.The firm has perpetual life.


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FF O R M ULAEO R M ULAE

P = Y (1-b ) / ke br or P = D / ke gWhere ,

P = M arket price per shareY = Earnings per share b = Retained earnings

Ke = C ost of equity capitalG = G rowth rateR = Internal rate of return


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EE XA MP LEXA MP LE

A B C

r 0.30 0.20 0.15

Ke 0.20 0.20 0.20

E (E P S) 5 5 5

Effect of dividend policy on market value of

shares according toG

ordons model whenretention ratio is 40% & 60%.


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CC ON C LUSI ONON C LUSI ON

G rowth firm :-IRR is greater than

the cost of capital. r > k Normal firm :-

IRR is equal to costof capital. r = k.decline firm :-

IRR is less than costof capital. r < k.


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MOD I G LIA NIMOD I G LIA NI-- M ILLERS M ILLERS MOD ELMOD EL

I ntroduction

The M odigliani M illers M odel is acornerstone of modern corporate Finance.

TheM

-M

sM

odel provides conditionsunder which the firms financial decisiondo not affect the value of the Firm.


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Assumption

Existence of P erfect C apital M arketThere is no Taxes

Firms investment policy is well planned.There is no uncertainty as to futureinvestments & profit of the firm.

M -M s irrelevance approach is based onarbitrage argument.


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M athematical formulation to prove irrelevance of dividend policy

P o = d1+ p1(1 + k)

Where,

P o = Existing price of a share.

K = C ost of C apitalD1 = Dividend to be received at the year endP 1 = M arket value of a share at the year end


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Ev aluation of MEv aluation of M -- M s ModelM s Model

o M -M s M odel of dividend irrelevance islaid down on a number of simplifying &

potentially restrictive assumptions.o In a world where taxes, transaction costs

& a host of other complexities do exist,its should come as no surprise that theirrelevance proposition is only a starting

point for our discussion.


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The following paragraphs are devoted to review &critically examine the more important argumentagainst irrelevance.

Risk AversionDesire for current income

Information content of dividendsSales of additional stock of lower pricesDifferential tax treatment of dividends & capitalgainsTransaction C ostsErratic behaviours of investors


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T T HANK HANK YOU YOU ....

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dividend policy & valuation of enterprise

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