Understanding Dividend Policy: Relevance Theory & Modigliani-Miller Approach, Slides of Financial Management

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DIVIDEND POLICY

Content

◦ What is Dividend? ◦ What is Dividend Policy? ◦ Theories of Dividend Policy Irrelevance Theories of Dividend Residual Theory of Dividend Modigliani and Miller Approach Relevance Theories of Dividend Walter’s Model Gordon’s Model

Dividend Policy

◦ A dividend policy can be defined as the dividend distribution

guidelines provided by the board of directors of a company. It sets

the parameter for delivering returns to the equity shareholders, on the

capital invested by them in the business.

◦ While taking such decisions, the company has to maintain a proper

balance between its debt and equity composition.

Theories of Dividend Policy

Irrelevance

Theories

Residual Theory Modigliani and Miller Approach

Relevance

Theories

Walter’s Model Gordon’s Model

Irrelevance Theories

Residual Theory

◦ According to this theory, dividend policy has no effect on the wealth of the shareholders or prices of the shares and hence it is irrelevant so far as the valuation of the firm is concerned. This theory regards dividend policy merely as a part of financial decision because the earnings available may be retained in the business for reinvestment. But if the funds are not required in the business they may be distributed as dividend. Thus, the decision to pay dividends or retain the earnings may be taken as residual decision.

Modigliani and Miller Approach

◦ Modigliani-Miller have argued that firm’s dividend policy is irrelevant to the value of the firm. ◦ According to this approach, the market price of a share is dependent on the earnings of the firm on its investment and not on the dividend paid by it. Earnings of the firm which affect its value, further depends upon the investment opportunities available to it.

Assumption

◦ Perfect Capital Markets - This theory believes in the existence of ‘perfect capital markets’. It assumes that all the

investors are rational, they have access to free information, there are no flotation or transaction costs and no

large investor to influence the market price of the share.

◦ No Taxes - There is no existence of taxes. Alternatively, both dividends and capital gains are taxed at the same

rate.

◦ Fixed Investment Policy - The company does not change its existing investment policy. It means whatever may

be the dividend payment, the company will make investment as it has already decided upon. If the company is

going to pay more amount of dividend, then it will more equity shares and vice versa.

◦ No Risk of Uncertainty - All the investors are certain about the future market prices and the dividends. This

means that the same discount rate is applicable for all types of stocks in all time periods.

◦ Investor is indifferent between dividend income and capital gain income - It is assumed that investor is

indifferent between dividend income and capital gain income. It means if he requires total return of Rs. 500, he

may get Rs. 200 dividend income and Rs. 300 as capital gain income or reverse, in either of the case he gets

equal satisfaction.

◦ If the company has ‘r’ number of shares outstanding then the market value of the firm will be: ◦ 𝑟𝑃଴ = ଵ (ଵା௞௘ × 𝑟𝐷ଵ + 𝑟𝑃ଵ ( ii ) ◦ If the firm decided to issue ‘s’ number of additional equity shares at expected price 𝑃ଵ then the total additional amount raised through issue of equity shares would be s𝑃ଵ and equal to: ◦ sP1 = Total investment required – Retained earnings used for investment. ◦ = 𝑠𝑃ଵ = I – (E - 𝑟𝐷ଵ) = I – E + 𝑟𝐷ଵ ◦ Where I = Total investment required. ◦ E = Earning of a firm. ◦ Equation (ii) can also be written as follows: ◦ r𝑃଴ = ଵ (ଵା௞ ) × 𝑟𝐷ଵ + 𝑟𝑃ଵ + 𝑠𝑃ଵ − 𝑠𝑃ଵ ( iii ) ◦ 𝑟𝑃଴ = ଵ (ଵା௞೐ × [𝑟𝐷ଵ+(r + s)𝑃ଵ − s𝑃ଵ] ( iv ) ◦ Now, putting the value of 𝑠𝑃ଵ in the equation ( iv ) we have: ◦ 𝑟𝑃଴ = ଵ ଵା௞೐ × 𝑟𝐷ଵ +(r + s)𝑃ଵ - I + E - 𝑟𝐷ଵ] ( v ) ◦ And finally 𝑟𝑃଴ = ଵ (ଵା ௞೐ × [(r + s)𝑃ଵ - I +E] ( vi )

Illustration

◦ Ghajini Ltd. Currently has 10,00,000 equity shares outstanding. Current market price per share is Rs 100.the net income for the current year is Rs 3,00,00,000 and investment budget is Rs 4,00,00,000. Cost of equity is 10%. The company is contemplating declaration of dividends @ Rs 5 per share. Assuming MM approach. ◦ i) Calculate market price per share if dividend is declared and if it is not declared. ◦ ii) How many equity share are to be issued under both the options. ◦ Solution: i) Calculation of market price of share as per MM approach 𝑃଴ = (஽భା௉భ) (ଵା௞೐) = 𝑃ଵ = 𝑃଴ (1 + 𝑘௘) - 𝐷ଵ 𝑃଴ = Current market price of the share = Rs 100 𝐷ଵ = Expected dividend at the end of year one = Rs 5 𝑘௘ = Cost of equity = 10% 𝑃ଵ = Expected price of the share at the end of year one =? ◦ a) When dividend is Declared: 𝑃ଵ = 100 × (1 + 0.10) – 5 = 110 – 5 =Rs 105 ◦ b) When dividend is not declared: 𝑃ଵ = 100 × (1 + 0.10) – 0 =110 -0 =Rs 110

Relevance Theories

Walter’s Model

◦ According to Walter’s Model, value of the firm depends upon firm’s earning level, dividend payout, constant reinvestment rate and the shareholder’s expected rate of return. ◦ The model suggests that dividend policy of the company depends upon the fact that whether firm has got good investment opportunities or not. If the firm does not have enough investment opportunities then it will pay the dividend otherwise it will retain the money. ◦ If the firm pays dividend then shareholder’s invest the dividend income to get further return. The expected return on reinvestment of dividend income by shareholders is called the opportunity cost to the firm or the cost of capital ( (^) ௘) of the firm. On the other hand, if dividend is not paid then the firm will reinvest the retained earning for its future growth. The expected rate of return on reinvestment of retained earning is called rate of return (r).

Formula of Walter’s Model

P =

஽ ௞೐

ೝ ೖ೐ (ா ି஽ ) ௞೐

or

஽ା( ೝ ೖ೐ )( ா ି஽ ) ௞೐

◦ P = Market price of equity share.

◦ D = Dividend per share.

◦ E = Earning per share.

◦ r = Rate of return on investment of the firm.

◦ ௘ = Cost of equity share capital.

◦ Hence, Value of firm = N × P

◦ Where, N = No. of outstanding equity shares.

Illustration

◦ Following are the details of three companies X Ltd., Y Ltd. and Z Ltd. ◦ Calculate the value of an equity share of each of these companies applying Walter’s Model when D/P ratio is (a) 40% (b) 70% (c) 90%. ◦ Solution: Value of an Equity Share as per Walter’s Model ◦ P = ஽ ௞೐

ೝ ೖ೐ (ா^ ି஽^ ) ௞೐ or ஽ା( ೝ ೖ೐)(^ ா^ ି஽^ ) ௞೐ X Ltd. Y Ltd. Z Ltd. r = 20% 𝑘௘ = 15% E = Rs 8 r = 15% 𝑘௘ = 15% E = Rs 8 r = 10% 𝑘௘ = 15% E = Rs 8