DIVIDEND THEORY

CHAPTER 17
 LEARNING OBJECTIVES

• Highlight the issues of dividend policy

• Critically evaluate why some experts feel that dividend
policy matters
• Discuss the bird-in-the-hand argument for paying
current dividends
• Explain the logic of the dividend irrelevance
• Identify the market imperfections that make dividend
policy relevant
• Understand information content of dividend policy

2
 INTRODUCTION

•Dividend policy involves the

balancing of the shareholders’
desire for current dividends and
the firm’s needs for funds for
growth.

3
 Issues in Dividend Policy

•Earnings to be Distributed – High Vs.

Low Payout.
•Objective – Maximize Shareholders
Return.
•Effects – Taxes, Investment and
Financing Decision.

4
 Relevance Vs. Irrelevance

•Walter's Model
•Gordon's Model
•Modigliani and Miller Hypothesis
•The Bird in the Hand Argument
•Informational Content
•Market Imperfections

5
 DIVIDEND RELEVANCE: WALTER’S MODEL

Walter’s model is based on the

following assumptions:
•Internal financing
•Constant return and cost of capital
•100 per cent payout or retention
•Constant EPS and DIV
•Infinite time
6
 Walter’s formula to determine the
market price per share:

7
 Optimum Payout Ratio

•Growth Firms – Retain all

earnings
•Normal Firms – Distribute all
earnings
•Declining Firms – No effect

8
Example: Dividend Policy: Application of
Walter’s Model

9
 Criticism of Walter’s Model

•No external financing

•Constant return, r
•Constant opportunity cost of
capital, k

10
 DIVIDEND RELEVANCE: GORDON’S MODEL
Gordon’s model is based on the
following assumptions:
•All-equity firm
•No external financing
•Constant return
•Constant cost of capital
•Perpetual earnings
•No taxes
•Constant retention
11
•Cost of capital greater than growth rate
Valuation

•Market value of a share is equal to the

present value of an infinite stream of
dividends to be received by
shareholders.
Example: Application of Gordon’s Dividend
Model

13
 It is revealed that under Gordon’s model:

14
DIVIDEND AND UNCERTAINTY:
THE BIRD-IN-THE-HAND ARGUMENT

•Argument put forward, first of all, by

Kirshman

•Investors are risk averters. They consider

distant dividends as less certain than near
dividends. Rate at which an investor
discounts his dividend stream from a given
firm increases with the futurity of dividend
stream and hence lowering share prices.
DIVIDEND IRRELEVANCE: THE MILLER–
MODIGLIANI (MM) HYPOTHESIS
• According to M-M, under a perfect market situation, the
dividend policy of a firm is irrelevant as it does not affect the
value of the firm. They argue that the value of the firm
depends on firm earnings which results from its investment
policy. Thus when investment decision of the firm is given,
dividend decision is of no significance.

• It is based on the following assumptions:-

• Perfect capital markets
• No taxes
• Investment policy
• No risk
 Market Imperfections

1. Tax Differential – Low Payout Clientele

2. Flotation Cost
3. Transaction and Agency Cost
4. Information Asymmetry
5. Diversification
6. Uncertainty – High Payout Clientele
7. Desire for Steady Income
8. No or Low Tax on Dividends
17
 Informational Content of Dividend
• …. In an uncertain world in which verbal
statements can be ignored or misinterpreted,
dividend action does provide a clear cut means of
‘making a statement’ that speaks louder than a
thousand words. — Solomon