CHAPTER 17 DIVIDEND THEORY

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1 CHAPTER 17 DIVIDEND THEORY Q.1 What are the essentials of Walter s dividend model? Explain its shortcomings. A1. Prof. J E Walter argues that the choice of dividend policies almost always affects the value of the firm. Walter s model is based on the following assumptions: 1. The firm finances all its investment through retained earnings; 2. The firm s rate of return r, and its cost of capital, k, are constant; 3. The firm have 100% dividend payment or retention ratio; 4. The firm s EPS and DPS are constant forever in determining a given value of firm. The market price of share is the sum total of present value of infinite stream of constant dividend, DIV/k; and infinite stream of capital gains, [r (EPS-DPS)/k]/k. DIV + r / k(eps DPS) P = k According to the Walter s model, the optimum dividend policy depends on the relationship between r and k. If r>k, the share value will increase as the firm retains more earnings; the price will be maximum when the firm retains 100%. If r<k, the price will be maximum if the firm distributes 100% dividend. The Walter s model assumes that the firm s investment opportunities are financed by retained earnings only. In the long-term, r does not remain constant; it decreases as more and more investment is made. The firm s cost of capital also does not remain constant; it changes directly with firm s risk. Q.2 What are the assumptions which underlie Gordon s model of dividend effect? Does dividend policy affect the value of the firm under Gordon s model? A.2 Gordon s model is based on the following assumptions. 1. The firm is an all-equity firm. 2. No external financing is available for expansion. 3. Constant internal rate of return, r 3 and constant cost of capital, k. 4. The firm and its stream of earnings are perpetual.

2 5. Corporate taxes do not exist. 6. The retention ratio, b, once decided upon, is constant. 7. The firm s cost of capital is greater than growth rates where growth rate is retention ration multiplied by internal rate of return, i.e., g = br. Gordon s model is expressed as follows: EPS1(1 b) Po = k g where b is retention ratio; EPS is earnings per share; g is growth rate and it is equal to br (retention ration multiplied by rate of return). The Gordon model suffers from the same limitations as the Walter model. Q.3 Walter s and Gordon s models are essentially based on the same assumptions. Thus, there is no basic difference between the two models. Do you agree or not? Why? A.3 Yes, because both models, in short, concludes that, 1. The market value of the share increases with increase in retention ratio when r > k. 2. The market value per share is not affected by the dividend policy when r = k. 3. The market value per share decrease with retention if r < k. Q.4 According to Walter s model the optimum payout ratio can be either zero or 100 per cent. Explain the circumstances, when this is true. A.4 In the case of growth firm (r > k), the market value per share, P, increases as payout ratio declines (optimum payout ratio is zero). In the case of declining firm (r < k), the market value per share, P, increases as payout ratio increases (optimum payout ratio is 100%). In the case of normal firm (r = k), the payout ratio has no effect on the market value per share Example:

3 Growth firm Normal firm Declining firm r > k r = k r < k Basic data r = 0.15 r = 0.10 r = 0.08 k = 0.10 k = 0.10 k = 0.10 EPS Rs. 10 Rs. 10 Rs. 10 DIV + r / k(eps DPS) P = k Payout ratio = 0% P = Rs. 150 P =Rs. 100 P = Rs. 80 Payout ratio = 100% P = Rs. 100 P = Rs. 100 P = Rs. 100 Q.5 The contention that dividends have an impact on the share price has been characterized as the bird-in-the-hand argument. Explain the essential of this argument. Why this argument is considered fallacious? A.5 According to the bird-in-the-hand argument, investors tend to behave rationally, are risk averse and, therefore, have a preference for near dividends to future dividends. They most certainly prefer to have their dividend today and let tomorrow take care of itself. Further, given two companies with identical earnings record, and prospects but one paying a larger dividend will always command higher share price because investors prefer present to future values. This argument is fallacious, on the contention that, if the firm does not pay any dividend a shareholder can create a home made dividend by selling a part of his/her shares at the fair market price in the capital market for obtaining cash. This will not make any dilution in their wealth. Q.6 What is Modigliani-Miller s dividend irrelevance hypothesis? Critically evaluate its assumptions. A.6 M-M hypothesis of irrelevance is based on the assumptions like perfect capital market existence, no transaction and flotation costs, no corporate taxes, no

4 difference in the tax rates applicable to capital gains and dividends, and risk of uncertainty does not exist. As per M-M, in the equilibrium, r (rate of return) will be equal to k (cost of capital), and identical for all shares. As a result, the price of each share must adjust so that the rate of return, which is composed of the rate of dividends and capital gains, for every share will be equal to the discount rate. Hence, today s market price per share is as follows: DIV1 + P1 Po = (1 + k) M-M argument implies that when the firm pays dividends, its advantage is offset by external financing. This means that terminal value (P 1 ) of the share declines when dividends are paid. Above assumptions may not always be found valid because capital markets are not perfect, existence of flotation and transaction costs, dividend may be taxed differently than capital gains, etc. Q.7 The assumptions underlying the irrelevance hypothesis of Modigliani and Miller are unrealistic. Explain and illustrate. A.7 The M-M assumptions on dividend irrelevance are considered unrealistic on account of the following reasons. 1. Investors have to pay different taxes on dividend income and capital gains. 2. The firm s internal and external financing are not equivalent, because flotation costs (e.g. underwriting and brokers commission, etc.) are involved if new shares are issued. 3. The homemade dividend benefit cannot be fully realised by investors on account of transaction costs (such as brokerage fee). Further, it is inconvenient to sell the shares by investors. 4. Investors may have a desire to diversify the portfolios from the dividend income. If firm does not distribute the dividends, then investors will be inclined to use a higher value of k if they expect the firm to use retained earnings for internal financing.

5 5. The current receipt of money in the form of dividends is considered safer than the uncertain potential gain in future by investors, etc. Q.8 Give arguments to support the view that dividends are relevant. A.8 Market imperfections may make dividends relevant. Dividends are relevant because some shareholders need a steady source of income. Some shareholders are better off receiving dividends now rather than in the future on account of risk of uncertainty. A tax system that treats dividends favourably than capital gains can also result in high expectation by shareholders for dividend income. In India, as per the existing law, the dividend income is non taxable, capital gains arising within a year are taxable. Q.9 What is the informational content of dividend payments? How does it affect the share value? A.9 It is contended that dividends are relevant because they have informational value. The payment of dividends conveys that the company is profitable and financially strong. It is also contended that dividends may offer tangible evidence of the firm s ability to generate cash, and, as a result, the dividend policy of the firm affects the share price. If a company follows a dividend policy of changing dividends with every cyclical change in earnings, the market price of share may be affected little because shareholders knew the information. A greater increase in the dividends than the earnings may convey to the shareholders that profitable investment opportunities of the firm are diminishing. This may depress the market price of share in spite of an increase in dividend payments. Q.10 What is the relationship between taxes and dividend policy? Explain by citing the impact of different tax system.

6 A.10 From the tax point of view, a shareholder should prefer dividend over capital gains on account of dividend income tax exempted, while capital gain is taxable in India. In most countries, different tax rates are applicable to dividends and capital gains. On account of tax differential, some investors prefer lesser dividend income while others prefer larger dividend income. Generally, following differential tax systems are implemented in different countries regarding taxation of shareholders earnings. 1. Double taxation: The shareholders earnings are taxed twice; first the corporate tax is levied on profit of companies, and then dividends are taxed as ordinary income in the hands of shareholders. 2. Single taxation: The shareholders are exempt from tax on dividend income; while earnings are taxed at the corporate level. 3. Split-rate taxation: Corporate profits are divided into retained earnings and dividends for tax purpose. Different tax rates are applied to retained earnings and amount distributed by way of dividend. 4. Imputation taxation: The shareholders earnings are not subjected to double taxation. A company pays corporate tax on its earnings; shareholders pay personal taxes on dividend but get full or partial tax relief for the tax paid by the company.