The purpose of the present chapter is refer to present a critical analysis of some important theories representing these two schools of thought with a view to illustrating the relationship between dividend policy and the valuation of a firm. Therefore keeping the above in view, subsequent pages are used to show the theory (IES) relating to the theories, which support the relevance hypothesis.
Irrelevance of Dividends
Modigliani and Miller (mm) Hypothesis
Relevance of Dividends
Walter’s Model
Gordon’s Model
Irrelevance of Dividends
The Dividend are irrelevant, or are a passive residual, is based on the assumption that the investors are indifferent between dividends and capital gains.
Modigliani and Miller (mm) Hypothesis
The most comprehensive argument in support of the irrelevance of dividends is provided by the mm hypothesis. Modigliani and miller maintain the dividend policy has no effect on the share price of the firm and is, therefore, of no consequence.
Where
Ke = Cost of equity capital
D, = Dividend to be received at the end of period 1
P, = Market price of a share at the end of period 1
Relevance of dividends
In sharp contrast to the mm position, there are some theories that consider dividend decisions to be an active variable in determining the value of a firm the dividend decision is, therefore, relevant.
Walter’s Model
The investment policy of a firm cannot be separated from its dividend policy and both are, according to walter, inter linked.
Walter has evolved a mathematical formula to arrive at the appropriate dividend decision. His formula is based on a share valuation model which states.
Where
P = Price of equity shares
D = Initial dividend
Ke = Cost of equity capital
G = Expected growth rate of earnings
Where
R = Expected rate of return on firm’s investments
B = Retention rate (E-d) /E
Thus, RB measures growth rate in dividends.
Gordon’s Model
According to Gordon, the market value of a share is equal to the present value of future streams of dividends. A Simplified version of Gordon’s model can be symbolically expressed as
Where
P = Price of a share
E = Earning per share
B = Retention ratio or percentage of earnings retained.
1-b = D/p ratio, i.e., percentage of earning distributed as dividends
Ke = Capitalization rate/cost of capital
Methods of dividend policy
Dividend per share (DPS)
Is the dividend paid to the equity shareholders on a per share basis. In other words, DPS is the net distributed profit belonging to the ordinary shareholders divided by the number of ordinary shares outstanding, that is.
Dividend Pay-out (D/P) Ratio
Is also known as pay out ratio it measures the relationship between the earning belonging to the ordinary shareholders and the dividend paid to them. In other words, the D/P ration shows what percentage share of the net profits after taxes and preference dividend is paid out a dividend to the equity-holders, it can be calculated by dividing the total dividend paid to the owner the DPS by the EPS, thus.
Earning and dividend yield
Is closer related to the EPS and DPS. While the EPS and DPS are based on the book value per share the yield is expressed in terms of the market value per ordinary share.
Similarly the dividend yield is computed by dividing the cash dividend per share by the market value per share that is.
Earning Yield =
Dividend yield =
The earning yield is also called the earning – price ratio.
Alternative practical Dividend policy
Possible alternative dividend policies are almost infinite, A firm’s management unit carefully select one to encompass consideration of both it internal needs and there of its share holders.
These basic types that will be discussed are:
Stable dividends
Target pay out ratio and the
Regular and extra dividends
Stable dividends
Investors may place a premium on the share of a company which pays stable dividends and only increases its dividend payment when it believes that increase can be maintained.
Target pay out ratio
Target pay out ratio (or range) deviating from his target as appropriate to achieve relatively stable dividends or stable and occasionally increasing ones. Companies seek to maintain a target dividend pay out ratio over the long ran bat only with a lag.
Regular and extra dividend
The regular dividend is set at a level that management believes can be maintained regard less of fluctuation in earnings and capital investment requirement.
Determinants of dividends policy
Investment Opportunities:
Basis: Other thing remaining equal, a firm with more investment opportunities will pay a lower fraction of its earrings as dividends than a stable firm.
Proxy for investment opportunities:
A growth rate in firm’s assets, capital investment.
Testable proposition
A firm with higher growth rates in assets or earnings.
Stability in earnings
Basis: A firm were stable earnings will pay out a higher fraction of its earnings as dividends.
Proxy for variability in earnings:
Variance in EPS.
Testable proposition:
A firm with higher variance in EPS will have a lower dividend pay out ratio.
Alternative sources of capital
Basic: A firm which can issue new stock or sounds at low cost.
Proxy For Cost Of Issue:
Size of the firm
Testable Proposition:
A smaller firm will almost invariably have a higher issuance cost than a larger firm in issuing new stock and debt.
Constraints
Basis Firms which have borrowed large amounts of debt usually have several constraints on their dividend policy.
Proxy for leverage Debt ratio
Testable proposition
A firm with a high debt ratio changes in its dividend policy.
Singnalling incentives
Basis Firm which are undervalued may use dividend increases as signals to the market
Proxy for under valuation
Price/value ratios
Testable proposition
As the ratio of price to value decreases dividend increases will become more frequent
Stock holder characteristics
Basis: Firms, which have acquired a reputation as high dividend yield firms also acquire stockholders who desire high dividends.
Testable proposition
The past history of a company’s dividend policy is usually be a good indication of what it will do in the future.
Tax considerations
Dividend can be taxed two ways
Taxing the dividend the share holders receive or.
Taxing the company dividend distribution tax here, a percentage of the total dividend is taken by the government as tax.
Here, for instance, if bonus share is not taxed but dividend is taxed then, it is much better to go for bonus shares issues as tax liability either on the company or on the share holder or both will be less then.
It has to be noted that taxing policy of the government with regard to dividend is not permanent in nature and varies year to year.
Again, in case of euphoria in the market if the government thinks there is too much investment it may have high dividend taxation.
Dividend tax represents less than 2% of the total tax collected. But it is important tool for the government to give direction to the capital market. So it changes the dividend taxation policy per the dictates of the circumstances prevailing in the stock market.
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