Submitted to: SIR ABID NOOR

Submitted by: MUBASHIR YASIN

Registration no: L1F15BCOM0002

DATE: 28 June 2020.

Dividend theory

A dividend theory is a formulation of an apparent relationship which purports to

explain a connection between dividend patterns and various causal factors
impacting these patterns. Practiced dividend policies on the other hand are based
upon observed corporate behavior describing its payout procedures.

Types of dividend theory

Theory 1. Modigliani-Miller (M-M) Hypothesis:

Modigliani-Miller hypothesis provides the irrelevance concept of dividend in a
comprehensive manner. According to them, the dividend policy of a firm is
irrelevant since, it does not have any effect on the price of shares of a firm, i.e., it
does not affect the shareholders’ wealth. They expressed that the value of the firm
is determined by the earnings power of the firms’ assets or its investment policy
and not the dividend decisions by splitting the earnings of retentions and dividends.
Proof of M-M Hypothesis:

According to M-M, the market price of a share at the beginning of a period is equal
to the present value of dividend paid at the end of the period plus the market price
of the share at the end of the period.

The same can be illustrated with the help of the following formula:

If no new/external financing exists, the value of the firm (V) will simply be the
number of outstanding shares (n) times the prices of each share (P) by multiplying
both sides of equation (1) we get:

If, however, the firm sells (m) number of new shares at time 1 at a price of P1, the
value of the firm (V) at time 0 will be:

It has been explained some-where in this volume that the investment programme,
at a given period of time, can be financed either from the proceeds of new issues or
from the retained earnings or from both. So, the amount of new issues will be:
That is, total financing by the new issues is determined by the amount of
investment in first period and not by retained earnings. By substituting equation (4)
into equation (3), M-M reveal that the value of the firm is unaffected by the
dividend policy, i.e., nD1, term cancels out as under:

Thus, M-M’s valuation model in equation (5) is consistent with the valuation
equation (2) and (3) stated above in terms of external financing. As the value of the
firm (V) can be restated as equation (5) without dividends, D1. it proves that
dividends have no effect on the value of the firm (when the external financing is
being applied).
Illustration:
Omega Company has a cost of equity capital of 10%, the current market value of
the firm (V) is Rs 20,00,000 (@ Rs. 20 per share). Assume values for I (new
investment), Y (earnings) and D = (Dividends) at the end of the year as I = Rs.
6,80,000, Y = Rs. 1,50,000 and D = Re. 1 per share. Show that under the M-M
(Modigliani-Miller) assumptions, the payment of D does not affect the value of the
firm.
Since the value of the firm in both the cases (i.e., when dividends are not paid and
when paid) is Rs. 20, 00, 000. It can be concluded that the payment of dividend (D)
does not affect the value of the firm.

Criticism of M-M Hypothesis:

It has already been stated in earlier paragraphs that M-M hypothesis is actually
based on some assumptions. Under these assumptions, no doubt, the conclusion
which is derived is logically sound and consistent although they are not well-based.

For instance, the assumption of perfect capital market does not usually hold good
in many countries. Since the assumptions are unrealistic in nature in real world
situation, it lacks practical relevance which indicates that internal and external
financing are not equivalent.

The shareholders/investors cannot be indifferent between dividends and capital

gains as dividend policy itself affects their perceptions, which, in other words,
proves that dividend policy is relevant.

As a result, M-M hypothesis, is criticised on the following grounds:

(i) Tax Differential:
M-M hypothesis assumes that taxes do not exist, in reality, it is impossible. On the
contrary, the shareholders have to pay taxes on the dividend so received or on
capital gains. We know that different tax rates are applicable to dividend and
capital gains and tax rate on capital gains is comparatively low than the tax rate on
dividend.

That is why, an investor should prefer the capital gains as against the dividend due
to the fact that capital gains tax is comparatively less and such capital gains tax is
payable only when the shares are actually sold in the market at a profit.

In short, the cost of internal financing is cheaper as compared to cost of external

financing. Thus, on account of tax advantages/differential, an investor will prefer a
dividend policy with retention of earnings as compared to cash dividend.
(ii) Existence of Floatation Costs:
M-M also assumes that both internal and external financing are equivalent. It
indicates that if dividend is paid in cash, a firm is to raise external funds for its own
investment opportunities. There will not be any difference in shareholders’ wealth
whether the firm retains its earnings or issues fresh shares provided there will not
be any floatation cost.

But, in reality, floatation cost exists for issuing fresh shares, and there is no such
cost if earnings are retained. As a result of the floatation cost, the external
financing becomes costlier than internal financing. Therefore, if floatation costs are
considered external and internal financing, i.e., fresh issue and retained earnings
will never be equivalent.

(iii) Existence of Transaction Costs:

M-M also assumes that whether the dividends are paid or not, the shareholders”
wealth will be the same. When the dividends are not paid in cash to the
shareholder, he may desire current income and are as such, he can sell his shares.

When a shareholder sells his shares for the desire of his current income, there
remain the transaction costs which are not considered by M-M. Because, at the
time of sale, a shareholder must have to incur some expenses by way of brokerage,
commission, etc., which is again more for small sales. A shareholder will prefer
dividends to capital gains in order to avoid the said difficulties and inconvenience.

(iv) Diversification:
M-M considers that the discount rate should be the same whether a firm uses
internal or external financing. But, practically, it does not so happen. If the share-
holders desire to diversify their portfolios they would like to distribute earnings
which they may be able to invest in such dividends in other firms.

In such a case, shareholders/investors will be inclined to have a higher value of

discount rate if internal financing is being used and vice-versa.

(v) Uncertainty:
According to M-M hypothesis, dividend policy of a firm will be irrelevant even if
uncertainty is considered. M-M reveal that if the two firms have identical invest-
ment policies, business risks and expected future earnings, the market price of the
two firms will be the same. This view is actually not accepted by some other
authorities.

According to them, under conditions of uncertainty, dividends are relevant

because, investors are risk-averters and as such, they prefer near dividends than
future dividends since future dividends are discounted at a higher rate as dividends
involve uncertainty. Thus, the value of the firm will be higher if dividend is paid
earlier than when the firm follows a retention policy.

We critically examine the two notable theories viz.:

(a) Walter’s Model, and

(b) Gordon’s Model, below.

Theory # 2. Walter’s Model:

Professor, James, E. Walter’s model suggests that dividend policy and investment
policy of a firm cannot be isolated rather they are interlinked as such, choice of the
former affects the value of a firm. His proposition clearly states the relationship
between the firms’ (i) internal rate of return (i.e., r) and its cost of capital or the
required rate of return (i.e., k).

That is, in other words, an optimum dividend policy will have to be determined by
the relationship of r and k. In short, a firm should retain its earnings it the return on
investment exceeds the cost of capital and in the opposite case, it should distribute
its earnings to the shareholders.

His proposition may be summed up as under:

(a) When r > k (Growth Firms):
When r > k, it implies that a firm has adequate profitable investment opportunities,
i.e., it can earn more what the investors expect. They are called growth firms. The
optimum dividend policy, in case of those firms, may be given by a D/P ratio
(Dividend pay-out ratio) of 0. It means a firm should retain its entire earnings
within itself and as such, the market value of the share will be maximised.

(b) When r<k (Declining Firms):

On the contrary, when r<k, it indicates that a firm does not have profitable
investment opportunities to invest their earnings. They are known as declining
firms. In this case, rate of return from new investment (r) is less than the required
rate of return or cost of capital (k), and as such, retention is not at all profitable.

The investors will be better-off if earnings are paid to them by way of dividend and
they will earn a higher rate of return by investing such amounts elsewhere. In that
case, the market price of a share will be maximised by the payment of the entire
earnings by way of dividends amongst the investors. There will be an optimum
dividend policy when D/P ratio is 100%.

(c) When r = k (Normal Firms)

If r = k, it means there is no one optimum dividend policy and it is not a matter
whether earnings are distributed or retained due to the fact that all D/P ratios,
ranging from 0 to 100, the market price of shares will remain constant. 

In other words, when the profitable investment opportunities are not available, the
return from investment (r) is equal to the cost of capital (k), i.e., when r = k, the
dividend policy does not affect the market price of a share.

Assumptions:
Walter’s model is based on the following assumptions:
(i) All financing through retained earnings is done by the firm, i.e., external
sources of funds, like, debt or new equity capital is not being used;

(ii) It assumes that the internal rate of return (r) and cost of capital (k) are constant;

(iii) It assumes that key variables do not change, viz., beginning earnings per share,
E, and dividend per share, D, may be changed in the model in order to determine
results, but any given value of E and D are assumed to remain constant in
determining a given value;

(iv) All earnings are either re-invested internally immediately or distributed by way
of dividends;

(v) The firm has perpetual or very long life.

Professor Walter has evolved a mathematical formula in order to arrive at the

appropriate dividend decision to determine the market price of a share which
is reproduced as under:
where, P = Market price per share;

D = Dividend per share;

E = Earning per share;

r = Internal rate of return;

k = Cost of capital or capitalization rate.

In this proposition it is evident that the optimal D/P ratio is determined by varying
‘D’ until and unless one receives the maximum market price per share.

Illustration:
Cost of Capital (k) = 10%

Earnings per share (E) = Rs. 10.

Assume Internal Rate of Return (r):

(i) 15%; (ii) 10%; and (iii) 8% respectively

Assuming that the D/P ratios are: 0; 40%; 76% and 100% i.e., dividend share is (a)
Rs. 0, (b) Rs. 4, (c) Rs. 7.5 and (d) Rs. 10, the effect of different dividend policies
for three alternatives of r may be shown as under:
Thus, according to the Walter’s model, the optimum dividend policy depends on
the relationship between the internal rate of return r and the cost of capital, k. The
conclusion, which can be drawn up is that the firm should retain all earnings if r >
k and it should distribute entire earnings if r < k and it will remain indifferent when
r = k.

Criticisms:
Walter’s model has been criticized on the following grounds since some of its
assumptions are unrealistic in real world situation:
They are:
(i) Walter assumes that all investments are financed only be retained earnings and
not by external financing which is seldom true in real world situation and which
ignores the benefits of optimum capital structure. Not only that, even when a firm
reaches the optimum capital structure level, the same should also be maintained in
future. In this context, it can be concluded that Walter’s model is applicable only in
limited cases.

(ii) Walter also assumes that the internal rate of return (r) of a firm will remain
constant which also stands against real world situation. Because, when more
investment proposals are taken, r also generally declines.

(iii) Finally, this model also assumes that the cost of capital, k, remains constant
which also does not hold good in real world situation. Because if the risk pattern of
a firm changes there is a corresponding change in cost of capital, k, also. Thus,
Walter’s model ignores the effect of risk on the value of the firm by assuming that
the cost of capital is constant.

Theory # 3. Gordon’s Model:

Another theory on relevance of dividend has been developed by Myron Gordon.

Gordon’s model is based on the following assumptions:

(i) The firm is an all-equity firm;

(ii) No external financing is available or used. Only retained earnings are used to
finance the investment programmes;
(iii) The internal rate of return, r, and the capitalization rate or cost of capital, k, is
constant;

(iv) The firm has perpetual or long life;

(v) Corporate taxes do not exist;

(vi) The retention ratio, b, once decided upon is constant. Thus the growth rate,

g = br, is also constant;

(vii) k > br = g.

According to Gordon’s model, the market value of a share is equal to the present
value of an infinite future stream of dividends.

Thus,

Gordon clearly states the relationship between internal rate of return, r, and the cost
of capital, k. He also contends that dividend policy depends on the profitable
investment opportunities.
However, his proposition may be summed up as under:
(a) When r > k (Growth Firms):
When r > A, the value per share P increases since the retention ratio, b, increases,
i.e., P increases with decrease in dividend pay-out ratio. In short, under this
condition, the firm should distribute smaller dividends and should retain higher
earnings.

(b) When r < k (Declining Firms):

When r<k, the value per share P decreases since the retention ratio b, increases,
i.e., P increases with increase in dividend pay-out ratio. It can be proved that the
value of b increases, the value of the share continuously falls.

If the internal rate of return is smaller than k, which is equal to the rate available in
the market, profit retention clearly becomes undesirable from the shareholders’
viewpoint. Each additional rupee retained reduces the amount of funds that
shareholders could invest at a higher rate elsewhere and thus it further reduces the
value of the company’s share.

(c) When r = k (Normal Firms):

When r = k, the value of the firm is not affected by dividend policy and is equal to
the book value of assets, i.e., when r = k, dividend policy is irrelevant.

It implies that under competitive conditions, k must be equal to the rate of return, r,
available to investors in comparable shares in such a manner that any funds distrib-
uted as dividends may be invested in the market at the rate which is equal to the
internal rate of return of the firm.
Consequently, shareholders can neither lose nor gain by any change in the
company’s dividend policy and the market value of the shares must remain
unchanged.

Illustration:

Solution:
Dividend and Uncertainty:
It has already been explained while defining Gordon’s model that when all the
assumptions are present and when r = k, the dividend policy is irrelevant.

If assumptions are modified in order to conform with practical utility, Gordon

assumes that even when r = k, dividend policy affects the value of shares which is
based on the assumption that under conditions of uncertainty, investors tend to
discount distant dividends at a higher rate than they discount near dividends.

That is, there is a twofold assumption, viz:

(a) investors are risk-averse, and

(b) they put a premium on certain return while discount uncertain returns.

Because, the investors are rational and are risk averse, as such, they prefer near
dividends than future dividends. This argument is described as a bird-in-the-hand
argument which was put forward by Krishnan in the following words.

“Of two stocks with identical earnings, record, prospectus, but the one paying a
larger dividend than the other, the former will undoubtedly command a higher
price merely because stockholders prefer present to future values.

Myopic vision plays a part in the price-making process. Stockholders often act
upon the principle that a bird in the hand is worth than .two in the bushes and for
this reason are willing to pay a premium for the stock with the higher dividend
rate, just as they discount the one with the lower rate.”

In short, a bird in the hand is better than two in the bushes oh the ground that what
is available in hand (at present) is preferable to what will be available in future. On
the basis of this argument, Gordon reveals that the future is no doubt uncertain and
as such, the more distant the future the more uncertain it will be.

Thus, if dividend policy is considered in the context of uncertainty, the cost of

capital (discount rate) cannot be assumed to be constant, i.e., it will increase with
uncertainty.

Since investors prefer to avoid uncertainty and they are willing to pay higher price
for the share which pays higher current dividend (all other things being constant),
the appropriate discount rate will be increased with the retention rate which is
shown in Fig. 11.4 below.

Therefore, distant dividends will be discounted at a higher rate than the near
dividends. The above argument (i.e., the investors prefer for current dividends to
future dividends) is not even free from certain criticisms.

That is, this may not be proved to be true in all cases due to low capital gains tax,
particularly applicable to the investors who are in high-tax brackets, i.e., they may
have a preference for capital gains (which is caused by high retention) than the
current dividends so available.