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Understanding Dividend Policy Models

Dividend policy refers to a company's decision to retain earnings for reinvestment in the business or pay out earnings as dividends to shareholders. There are several approaches to analyzing dividend policy: 1. The traditional approach views dividends favorably and as a primary driver of share price. 2. The Walter model ties share price to dividends and the return on retained earnings. It suggests optimal payout ratios of 0% for growing firms and 100% for declining firms. 3. The Gordon model provides a valuation formula for share price based on dividends, earnings growth, and required rates of return. 4. The Miller and Modigliani position is that dividend policy does

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69 views16 pages

Understanding Dividend Policy Models

Dividend policy refers to a company's decision to retain earnings for reinvestment in the business or pay out earnings as dividends to shareholders. There are several approaches to analyzing dividend policy: 1. The traditional approach views dividends favorably and as a primary driver of share price. 2. The Walter model ties share price to dividends and the return on retained earnings. It suggests optimal payout ratios of 0% for growing firms and 100% for declining firms. 3. The Gordon model provides a valuation formula for share price based on dividends, earnings growth, and required rates of return. 4. The Miller and Modigliani position is that dividend policy does

Uploaded by

santosh san
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© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd

Dividend Policy

Background
Dividend policy means
What proportion of earnings are retained by the business, and What proportion is paid out as dividend to investors

Capital budgeting and dividend policy


If capital budgeting and dividend policy are independent, then
Higher dividend pay out will mean higher dependence on external financing

If capital budgeting and dividend policy are dependent on each other, then
Higher dividend will cause shrinkage of capital budget

Various approaches to look at dividend policy


1. Traditional approach 2. Walter model 3. Gordon model 4. Miller and Modigliani position

Traditional approach
As per this approach, market gives more weight to dividend than retained earnings As per this approach P = m (D + E/3)
P market price per share, D- Dividend per share , E Earning per share, M a multiplier

P = m ( D + (D+R)/3) = m4D/3 + m R/3

Illustration of traditional approach

Walter model
It states that
Dividend policy has bearing on share valuation

Assumptions
Retained earnings are only source of financing for a firm Cost of capital and RoI of firm remain constant

Price per share = P = (D + ((E-D) r/k)) *1/k


P- price per share, D- Dividend per share, E- earnings per share, (ED) retained earnings per share, r RoI, k Cost of Capital

Illustration of Walter model

Implications of Walter model


When return is greater than cost of capital, (r>k) price of share increases , as dividend pay out decreases
Hence, optimal pay out ratio for growing firm should be nil

When r = k, price per share does not vary with change in dividend pay out ratio
Hence, Pay out ratio for a normal firm is irrelevant

When r< k , then price per share increases as dividend pay out ratio increases
Hence, Optimal Payout ratio for a declining firm is 100 %

Gordon Model
Gordons basic valuation formula
P0

Y0 (1-b)/ (k-br)

P0 -Price per share at the beginning of the year


Y0 - EPS at the end of the year B - retained earning ( 1-b) dividend k- rate of return required by shareholders r RoI br - growth rate of earnings and dividends

Gordon Model
Implications of Gordon model are similar to Walter model Do it as home work

Miller and Modigliani position


Dividend irrelevance theorem Assumptions of M & M model
Markets are perfect Investors are rational Floatation costs are nil There are no taxes

Dividend irrelevance theorem


If company retains earnings, instead of giving as dividend
Shareholder benefits by way of capital appreciation

If company gives dividend,


shareholder benefits by way of dividend in his hands

Hence, it does not matter whether earnings are retained or distributed


What matters is level of earnings

Criticism of M & M model


Dividends paid by the company tell investors Information about the prospect of the company Not all investors want current income Issue cost Transaction cost Different rates of taxes

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