THEORIES OF DIVIDEND POLICY

i) Dividend Relevance Theories

ii) Dividend Irrelevance Theories

Dividend Relevance Theory

The dividend is a relevant variable in determining the value

of the firm, it implies that there exists
an optimal dividend policy, which the managers should seek
to determine, that maximises the
value of the firm. There are three models, which have been
developed under this approach. These are:

i) Traditional Model
ii) Walter’s Model
iii) Gordon’s Dividend Capitalisation Model
iv) Bird-in-hand Theory
v) Dividend Signalling Theory
vi) Agency Cost Theory

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 TRADITIONAL MODEL
MP is positively related to higher dividends. Thus MP would
increase if dividends are higher and decline if dividends are
lower.

P = m (D + E/3)

where,

P = Market price
m = Multiplier
D = Dividend per share
E = Earnings per share

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 WALTER’S MODEL
Based on the assumptions that all investments are financed
through RE, rate of return and cost of capital are constant,
the firm either distributes dividends or reinvested
internally; Walter put forth the following model for
valuation of shares
P0 = D + (E – D) rlk
k
P0 = market price per share
D = Dividend per share
E = Earnings per share
E – D = Retained earnings per share
r = Firm’s average rate of return
k = firm’s cost o capital

From the model it is clear that the market price per share is the
sum
of two consumptions:
i. The first component Dlk is the present value of an infinite
stream of cash flows in the form of dividends.
ii. The second component (E – D)rlk is the present value of
an infinite stream of returns k
retained earnings. 3
 GORDON’S DIVIDEND
CAPITALISATION MODEL
Assumptions : Firm is all-equity, RE are used to finance
projects, r and k are constant, there are no taxes, b
once decided is constant.
Gordon put forward the following valuation model:

P0 = E1 + (1 – b)
k - br
where,
P0 = Price per share at the end of the year 0
E1 = Earnings per share at the end of year 1
(1 – b) = Fraction of earnings the firm distributes by way of
earnings
b = Fraction of earnings the firms ploughs back
k = Rate of return required by the shareholders
r = Rate of return earned on investments made by the firm
br = Growth rate of earnings and dividends

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 BIRD-IN-HAND THEORY
John Lintner propounded this theory in 1962 and Myron
Gordon in
1963. The shareholders are not entitled to any fixed return.
The return
to the shareholders is in the form of dividends and capital
gains.
Current dividends are relatively certain compared to future
capital
gains.

According to this theory shareholders are risk averse and

prefer to
receive dividends in the present time period to future
capital gains.
Modigliani and Miller termed this argument as bird-in-hand
fallacy.
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 DIVIDEND SIGNALLING THEORY

Managers have greater access to inside information about the

company. They may share this information with the shareholders
through an appropriate dividend policy. Constant or increasing
dividends convey positive signals about the future prospects of the
company resulting in an increase in share price. Similarly, absence of
dividends or decreasing dividends convey negative signal resulting
in
decline in share price.

A liberal dividend policy by reducing the agency costs may lead to

enhancement of the shareholder value.

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 DIVIDEND IRRELEVANCE THEORY
These theories contend that there are two components of
shareholder’returns.
a) Dividend Yield (D / P0)
b) Capital Yield (P1 / P0) / P0)
Suppose a firm issues a Rs.10 par value share at a
premium of Rs.90.
In other words, the issue price is Rs.100. If the firm
declares a dividend of Rs.3 (the dividend yield is 3%)
price at the end of next year
is Rs.115, the capital yield is (115 – 100) / 100 = 15 per
cent. The total
return to the shareholders is 18 per cent.

These theories, which argue that dividends are not relevant

in
determining the value of the firm, are:
i. Residual Theory
ii. Modigliani and Miller (M&M) Model
iii. Dividend Clientele Effect 7
iv. Rational Expectations Model
 DIVIDEND IRRELEVANCE THEORY
Residual Theory

According to this theory a firm will only pay dividends from

residual
earnings, that is, from earnings left over after all the
suitable
investment opportunities have been financed.

Modigliani and Miller (M&M) Model

According to the model, it is only the firms’ investment

policy that will have an impact on the share value of
the firm and hence should be given more importance.

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DIVIDEND IRRELEVANCE THEORY
Modigliani and Miller (M&M) Model
The current market price of the share is equal to the discounted
value of the dividend paid and the market price at the end of the
period.

P0 = _1___ (D1 + P1 )
(1 + ke)
where,
P0 = Current market price of the share (t = 0)
P1 = Market price of the share at the end of the period (t = 1)
D1 = Dividends to be paid at the end of the period (t = 1)
ke = Cost of equity capital

With no external financing the total value of the firm will be as

follows:
nP0 = _1___ (nD1 + nP1 )
(1 + ke)

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DIVIDEND IRRELEVANCE THEORY
Modigliani and Miller (M&M) Model

Simplifying the above equation, we get

n1P1 = I – E + nD1
where,
I = Total investment required
nD1 = Total dividends paid
E = Earnings during the period
(E - nD1 ) = Retained earnings

Substituting this value of the new shares in the above equation, we

get
nP0 = _1___ [nD1 + (n + n1)P1 - I + E - nD1 ]
(1 + ke)

= nD1 + (n + n1)P1 - I + E - nD1

(1 + ke)

nP0 = (n + n1)P1 - I + E
(1 + ke)

Thus, according to the M&M model, the market value of the share is
not 10
affected by the dividend policy and this is clear from the last equation
DIVIDEND CLIENTELE EFFECT :According to this theory, dividend
policy is irrelevant in determining the firm’s value.
Different firms may follow different dividend policies
depending upon their own needs and circumstances.
One firm may decide on a higher payout ratio whereas
others may decide on lower dividend payout.
Similarly,different shareholders may have different
needs – some may prefer current dividends whereas
others may be more interested in capital gains. Those
investors who prefer current dividends would like to
become shareholders in companies which declare
generous dividends whereas those investors who are
more interested in capital gains would folk to
companies having relatively lower payout ratios.
RATIONAL EXPECTATIONS MODEL: According to this model there
would be no effect of dividend declaration on the
market price as long as the dividend declared is in line
with the expected dividends. If dividend <expected
dividend – MP will decline and vice versa. Thus, so far
as dividend declared ratifies the market expectation
the dividend policy is not relevant in determining the 11

MP.
PRACTICAL CONSIDERATIONS IN THE
FORMULATION OF DIVIDEND POLICY
► Profitability and Liquidity

► Legal Constraints

► Contractual Constraints

► Growth Prospects

► Owner Considerations

► Market Considerations

► Industry Practice

► Shareholders Expectations
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