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Chapter 29 –
Dividend and
Valuation
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Learning Objectives
• Describe the residual theory of dividends and Modigliani-Miller (MM) approach
to the irrelevance of dividends and evaluate its validity
• Explain and illustrate the two models — Walter’s and Gordon’s —according to
which dividends are relevant and affect the value of the firm

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Introduction
• Dividend refers to the corporate net profits distributed among shareholders.
• The retained earnings constitute an easily accessible important source of
financing the investment requirements of firms.
• There is, thus, a type of inverse relationship between retained earnings and cash
dividends: larger retentions, lesser dividends; smaller retentions, larger dividends.

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Irrelevance of Dividends
General
• The crux of the argument supporting the irrelevance of dividends to valuation is
that the dividend policy of a firm is a part of its financing decision.
• As a part of the financing decision, the dividend policy of the firm is a residual
decision and dividends are a passive residual.
• Residual dividend policy pays out only excess cash.

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Residual Theory of Dividends
• It suggests that the dividends paid by a corporate should be viewed as a residual,
that is, the amount left over after meeting the financing requirements of all the
acceptable/ profitable investment projects.
• Dividends can be paid only out of the left over amount after financing all new
projects with positive NPV.
• If no amount is left, there will be no dividend payments.
• The residual theory of dividends provides an explanation why mature industries
(with few opportunities for growth) have large dividend payments and high
dividend-payment ratios.
• They succeed in attracting equity investors–clientele who prefer high dividends.
• In contrast, high growth industries with abundant investment opportunities,
prefer low dividend payments and attract equity investors who prefer capital
gains.

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Modigliani and Miller (MM) Hypothesis
• The most comprehensive argument in support of the irrelevance of dividends is
provided by the MM hypothesis.
• Dividend irrelevance implies that the value of a firm is unaffected by the distribution
of dividends and is determined solely by the earning power and risk of its assets.
• Modigliani and Miller maintain that dividend policy has no effect on the share price of
the firm and is, therefore, of no consequence.
• What matters, according to them, is the investment policy through which the firm can
increase its earnings and thereby the value of the firm.
• Given the investment decision of the firm, the dividend decision — splitting the
earnings into packages of retentions and dividends — is a matter of detail and does
not matter.

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Assumptions
• The MM hypothesis of irrelevance of dividends is based on the following critical
assumptions:
Perfect capital markets in which all investors are rational.
There are no taxes.
A firm has a given investment policy which does not change.
There is a perfect certainty by every investor as to the future investments and profits of
the firm.

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Crux of the Argument
• The crux of the MM position on the irrelevance of dividend is the arbitrage
argument.
• Arbitrage implies the distribution of earnings to shareholders and raising an
equal amount externally; the effect of dividend payment would be offset by the
effect of raising additional funds.
• The arbitrage process involves a switching and balancing operation.

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Proof
• MM provide the proof in support of their argument in the following manner.
Step 1
• The market price of the share in the beginning of the period is equal to the
present value of dividends paid at the end of the period plus the market price of
share at the end of the period.
• Symbolically,

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Step 2
• Assuming no external financing, the total capitalised value of the firm would be simply
the number of shares (n) times the price of each share (𝑃0).
• Thus,

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Step 3
• If the firm’s internal sources of financing its investment opportunities fall short of the
funds required, and ∆n is the number of new shares issued at the end of year 1 at price
of 𝑃1, then:

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Step 4
• If the firm were to finance all investment proposals, the total amount raised through new
shares issued would be given in following equation:

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Step 5
Step 6 Conclusion
• Since dividends (D) are not found in above equation, Modigliani and Miller conclude
that dividends do not count and that dividend policy has no effect on the share price.

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A Critique
• Modigliani and Miller argue that the dividend decision of the firm is irrelevant in
the sense that the value of the firm is independent of it.
• The crux of their argument is that the investors are indifferent between dividend
and retention of earnings.
• The validity of the MM Approach is open to question on two counts:
Imperfection of capital market, and
Resolution of uncertainty.

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Market Imperfection
• Modigliani and Miller assume that capital markets are perfect.
• This implies that there are
no taxes;
flotation costs do not exist and
there is absence of transaction costs.
• These assumptions are untenable in actual situations.
Tax Effect
• Tax differentials are the different rates of taxes applicable to dividend and capital
gains.
Flotation Costs
• Flotation cost is the cost involved in raising capital from the market.
Transaction and Inconvenience Costs
• Transaction costs are costs involved in selling securities by the shareholders

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Institutional Restrictions
• The dividend alternative is also supported by legal restrictions as to the type of
ordinary shares in which certain investors can invest.
Resolution of Uncertainty
• Apart from the market imperfection, the validity of the MM hypothesis, insofar as
it argues that dividends are irrelevant, is questionable under conditions of
uncertainty.
Near Vs Distant Dividend
• Bird-in-hand argument is the belief that current dividend payments reduce
uncertainty and result in higher value of shares of a firm.
Informational Content of Dividends
• Informational content is the information provided by dividends of a firm with
respect to future earnings which causes owners to bid up or down the price of
shares.

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Preference for Current Income
• The third aspect of the uncertainty question relating to dividends is based on the
desire of investors for current income to meet consumption requirements.
Underpricing
• Underpricing implies sale of shares at prices lower than the current market price.

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Relevance of Dividends
• Dividend relevance implies that shareholders prefer current dividends and there
is no direct relationship between dividend policy and market value of a firm.
• The two theories representing dividend decision are relevant are:
Walter’s Model and
Gordon’s Model.

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Walter’s Model
Proposition
• Walter’s model supports the doctrine that dividends are relevant.
• The investment policy of a firm cannot be separated from its dividends policy and
both are, according to Walter, interlinked.
• The choice of an appropriate dividend policy affects the value of an enterprise.

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Assumptions
• The critical assumptions of Walter’s Model are as follow:
 All financing is done through retained earning.
 With additional investments undertaken, the firm’s business risk does not change.
 There is no change in the key variables, namely, beginning earnings per share, E, and
dividends per share, D.
 The firm has perpetual (or very long) life.

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Formula
• Walter has evolved a mathematical formula to arrive at the appropriate dividend
decision.
• His formula is based on a share valuation model which states:

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Interpretation
 When the firm is able to earn a return on investments exceeding the required rate of
return that is, r > Ke, the value of shares is inversely related to the D/P ratio.
 When r < ke that is, when the firm does not have ample profitable investment
opportunities, the D/P ratio and the value of shares are positively correlated.
 For a situation in which r = ke, the market value of shares is constant irrespective of
the D/P ratio; there is no optimum dividend policy (D/P) ratio.

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Limitations
• The model would be only applicable to all-equity firms.
• The model assumes that r is constant, this is not a realistic assumption because
when increased investments are made by the firm, r also changes.
• By assuming a constant ke, Walter’s model ignores the effect of risk on the value
of the firm.

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Gordon’s Model
• Another theory which contends that dividends are relevant is Gordon’s model.
• This model, which opines that dividend policy of a firm affects its value, is based on the
following assumptions:
 The firm is an all-equity firm.
 r is constant, ke increases with retention rate.
The firm has perpetual life.
 The retention ratio, once decided upon, is constant.
 ke > br.

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Arguments
• Gordon’s model contends that dividend policy of the firm is relevant and that
investors put a positive premium on current incomes/dividends.
• The crux of Gordon’s arguments is a two-fold assumption:
investors are risk averse, and
they put a premium on a certain return and discount/ penalise uncertain
returns.
• Gordon’s model of dividend relevance is also described as a bird-in-the-hand
argument.
• That a bird in hand is better than two in the bush is based on the logic that what
is available at present is preferable to what may be available in the future.

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Retention Rate and Discount Rate

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Dividend Capitalisation Model
• According to Gordon, the market value of a share is equal to the present value of future
streams of dividends.
• A simplified version of Gordon’s model can be symbolically expressed as:
• Gordon, thus, contends that the dividend decision has a bearing on the market price of
the share.
• The market price of the share is favourably affected with more dividends.