Relevance and Irrelevance Theories of Dividend

April 3, 2018 | Author: ptselvakumar | Category: Cost Of Capital, Dividend, Financial Economics, Business Economics, Economies


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5/6/13Relevance and Irrelevance Theories of Dividend - makemynote.weebly.comLINCOLN KUMAR MBA , Msc IT makemynote.weebly.com LINCOLN KUMAR MBA , Msc IT HOME MBA SEMESTER-I MBA SEMESTER-II INFORMATION TECHNOLOGY MORE... Relevance and Irrelevance Theories of Dividend Div idend is that portion of net profits which is distributed among the shareholders. The div idend decision of the firm is of crucial importance for the finance manager since it determines the amount to be distributed among shareholders and the amount of profit to be retained in the business. Retained earnings are v ery important for the growth of the firm. Shareholders may also ex pect the company to pay more div idends. So both the growth of company and higher div idend distribution are in conflict. So the div idend decision has to be taken in the light of wealth max imisation objectiv e. This requires a v ery good balance between div idends and retention of earnings. A financial manager may treat the div idend decision in the following two way s: 1 ) As a long term financing decision:- When div idend is treated as a source of finance, the firm will pay div idend only when it does not hav e profitable inv estment opportunities. But the firm can also pay div idends and raise an equal amount by the issue of shares. But this does not make any sense. 2) As a wealth max imisation decision:- Pay ment of current div idend has a positiv e impact on the share price. So to max imise the price per share, the firm must pay more and more div idends. 4.2 Div idend and Valuation There are conflicting opinions as far as the impact of div idend decision on the v alue of the firm. According to one school of thought, div idends are relev ant to the v aluation of the firm. Others opine that div idends does not affect the v alue of the firm and market price per share of the company . Relev ant T heory If the choice of the div idend policy affects the v alue of a firm, it is considered as relev ant. In that case a change in the div idend pay out ratio will be followed by a change in the market v alue of the firm. If the div idend is relev ant, there must be an optimum pay out ratio. Optimum pay out ratio is that ratio which giv es highest market v alue per share. 4.3 Walter’s Model (Relev ant T heory ) Prof. James E Walter argues that the choice of div idend pay out ratio almost alway s affects the v alue of the firm. Prof. J. E. Walter has v ery scholarly studied the significance of the relationship between internal rate of return (R) and cost of capital (K) in determining optimum div idend policy which max imises the wealth of shareholders. Walter’s model is based on the following assumptions: 1 ) The firm finances its entire inv estments by means of retained earnings only . 2) Internal rate of return (R) and cost of capital (K) of the firm remains constant. 3) The firms’ earnings are either distributed as div idends or reinv ested internally . makemynote.weebly.com/relevance-and-irrelevance-theories-of-dividend.html 1/4 com/relevance-and-irrelevance-theories-of-dividend. Thus the growth rate (g) is also constant (g=br). D = div idend per share. So entire earnings should be distributed to the shareholders to max imise price per share. If R>K.weebly. E = earnings per share. All the pay out ratios are optimum. These firms naturally can earn a return which is more than what shareholders could earn on their own. So according to Walter.weebly. is the Gordon’s model.html 2/4 . the optimum pay out ratio is either 0% (when R>K) or 1 00% (when R<K). In this case div idend policy will not hav e any influence on the price per share. The rationale of R>K is that the firm is able to produce more return than the shareholders from the retained earnings. the optimum div idend policy depends on the relationship between the firm’s internal rate of return and cost of capital. makemynote. These firms earn a rate of return which is equal to that of shareholders. d) Cost of capital (K) of the firm also remains same regardless of the change in the risk complex ion of the firm. e) The firm deriv es its earnings in perpetuity . So there is nothing like optimum pay out ratio for a normal firm. Here it will not make any sense to retain the earnings. Optimum pay out ratio for a declining firm is 1 00%.If R is equal to K.5/6/13 Relevance and Irrelevance Theories of Dividend . This model which opines that div idend policy of a firm affects its v alue is based on the following assumptions: a) The firm is an all equity firm (no debt). K = cost of capital. R = internal rate of return.The firms hav ing R>K may be referred to as growth firms. Walter’s v iew on optimum div idend pay out ratio can be summarised as below: a) Growth Firms (R>K):. it is known as declining firm.If the company earns a return which is less than what shareholders can earn on their inv estments. whereas it should distribute the earnings to the shareholders in case the R<K. MBA . b) Normal Firms (R=K):. Walter’s formula to determine the price per share is as follows: P= P = market price per share. Msc IT According to the theory . the firm is known as normal firm.makemynote. c) Declining Firm (R<K):. 4. the firm should retain the entire earnings.4 Gordon’s Model Another theory . c) Internal rate of return (R) of the firm remains constant. f) The retention ratio (b) once decided upon is constant. b) There is no outside financing and all inv estments are financed ex clusiv ely by retained earnings.comLINCOLN KUMAR 4) The earnings and div idends of the firm will nev er change. 5) The firm has a v ery long or infinite life. The growth firms are assumed to hav e ample profitable inv estment opportunities. So optimum pay out ratio for growth firm is 0%. which contends that div idends are relev ant. 5/6/13 g) K>g. Gordon’s model. But the future div idend is uncertain both with respect to the amount as well as the timing. The term risk refers to the possibility of not getting the return on inv estment. Thus Gordon’s v iew on the optimum div idend pay out ratio can be summarised as below: 1 ) The optimum pay out ratio for a growth firm (R>K) is zero. Msc IT h) A corporate tax does not ex ist. So the rational inv estors are willing to pay a makemynote. This behav iour of inv estor is described as “Bird in Hand Argum ent”. Accordingly they want to av oid risk. What is av ailable today is more important than what may be av ailable in the future. They put a premium on a certain return and discount (penalise) uncertain return. when R>K the price per share increases as the div idend pay out ratio decreases. like Walter’s model. The pay ment of div idends now completely remov es any chance of risk. Thus the Gordon’s Model’s is conclusions about div idend policy are similar to that of Walter.com/relevance-and-irrelevance-theories-of-dividend. But if the firm retains the earnings the inv estors can ex pect to get a div idend in the future. 1 . The inv estors are rational. therefore the price per share would be adv ersely affected. Bird in Hand Argum ent (Div idends and Uncertainty ) Gordon rev ised this basic model later to consider risk and uncertainty .comLINCOLN KUMAR MBA . In case earnings are retained. The crux of Gordon’s argument is based on the following 2 assumptions.html 3/4 . Gordon used the following formula to find out price per share P= P = price per share K = cost of capital E1 = earnings per share b = retention ratio (1 -b) = pay out ratio g = br growth rate (r = internal rate of return) According to Gordon. This similarity is due to the similarities of assumptions of both the models. The rational inv estors.weebly. 2) There no optimum ratio for a normal firm (R=K). Inv estors are risk av erse and 2. div idend policy will not affect the price of the share when R = K. Relevance and Irrelevance Theories of Dividend . But Gordon goes one step ahead and argues that div idend policy affects the v alue of shares ev en when R=K.makemynote. Retained earnings are considered as risky by the inv estors. When R=K the price per share remains unchanged in response to the change in the pay out ratio. When R<K the price per share increases as the div idend pay out ratio increases. contends that div idend policy is relev ant. According to Walter. therefore prefer current div idend to future div idend. A bird in hand is worth two in bush. 3) Optimum pay out ratio for a declining firm R<K is 1 00%.weebly. Therefore the discount rate (K) increases with retention According to MM. the shareholders enjoy the div idend. Hence.html 4/4 . Assumptions: 1 . which is equal to the earnings. sidelined the importance of the div idend policy and its effect thereof on the share price of the firm. the div idend policy of a firm is irrelev ant.com/relevance-and-irrelevance-theories-of-dividend. the div ision of earnings between div idends and retained earnings is irrelev ant from the point of v iew of shareholders. The firm has a fix ed inv estment policy which will not change. So K remains same. The model which is based on certain assumptions. There are no tax es:. So if the retained earnings are reinv ested. there will not be any change in the risk of the firm. According to the theory the v alue of a firm depends solely on its earnings power resulting from the inv estment policy and not influenced by the manner in which its earnings are split between div idends and retained earnings. the shareholders enjoy capital appreciation. securities are div isible and no inv estor can influence the market price of the share. 4. Create a free website with makemynote.weebly. 3. Capital markets are perfect:. Msc IT higher price for shares on which more current div idends are paid. 4.makemynote. as it does not affect the wealth of shareholders.weebly.No difference between tax rates on div idends and capital gains. If the company distributes the earnings by the way of div idends instead of retention. which is equal to the amount by which his capital would hav e been appreciated had the company chosen to retain the earnings. The substance of MM arguments may be stated as below: If the company retains the earnings instead of giv ing it out as div idends.comLINCOLN KUMAR rate. Floatation cost does not ex ist. This is shown below. 2. retained.5 Modigliani-Miller Model (Irrelev ance theory ) MBA .Inv estors are rational information is freely av ailable. transaction cost are nil.5/6/13 Relevance and Irrelevance Theories of Dividend .
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