The document discusses several theories on corporate dividend policies: 1. Dividend relevance theories argue that a firm's dividend policy impacts its value. Walter's and Gordon's models show how value is determined based on factors like earnings, dividends, growth rates, and costs of capital. 2. Dividend irrelevance theories, proposed by Modigliani and Miller, state that a firm's value depends only on its investment policy, not its dividend policy. 3. The bird-in-hand theory suggests that even in situations of equal growth rates and costs of capital, investors prefer dividends in-hand to future capital gains due to uncertainty.

1. CORPORATE FINANCE
13TH JULY 2011
DIVIDEND THEORIES

2. DIVIDEND THEORIES
 There are three main categories advanced:
1. Dividend relevance theories
2. Dividend irrelevance theories
3. Dividend & uncertainty

3. DIVIDEND RELEVANCE THEORIES
 These are theories whose propagators argue
that the dividend policy of a firm affects the
value of the firm. There are two main
theorists:
 James E. Walter (Walter’s model)
 Myron Gordon (Gordon’s model)

4. WALTER’S MODEL
 Shows relationship btwn a firm’s rate of return r and its cost of
capital k. it is based on the following assumptions:
1. Internal financing – the firm finances all its investments through
retained earnings; debt or new equity is not issued.
2. Constant return and cost of capital – the firm’s rate of
return, r, and its cost of capital k are constant
3. 100% payout or retention – all earnings are either distributed as
dividends or reinvested internally immediately.
4. Constant EPS and DPS – beginning earnings and dividends
never change. The values of the EPS and DPS may be changed
in the model to determine results but are assumed to remain
unchanged in determining a given value.
5. Infinite time – the firm has a very long or infinite life

5.  Walter’s formula for determining MPS is as
follows:
P = (DPS/k) + [r (EPS – DPS)/k]/k
Where:
 P = market price per share
 DPS = dividend per share
 EPS = earnings per share
 r = firm’s average rate of return
 k = firm’s cost of capital

6.  the market value is determined as the
present value of two sources of income:
1. PV of constant stream of dividend (DPS/k)
2. PV of infinite stream of capital gains:
r(EPS-DPS)/k
Hence the formula can be rewritten as
P = DPS + (r/k) (EPS – DPS)
k

7.  Given three types of firms or scenarios of firms the
model can be summarized as follows:
1. Growth firm: there are several investment
opportunities (r > k) and the firm can reinvest
earnings at a higher rate r than that which is
expected by shareholders k. thus they wil maximize
value per share if they reinvest all earnings.
2. Normal firm: there aren’t any investments available
for the firm that are yielding higher rates of return (r
= k) thus the dividend policy has no effect on market
price.

8. 3. Declining firm: there aren’t any profitable
investments for the firm to reinvest its
earnings, i.e. any investments would earn
the firm a rate less than its cost of capital (r
< k). The firm will therefore maximize its
value per share if it pays out all its earnings
as dividend.

9. CRITICISMS OF WALTER’S MODEL
 Model assumes investment decisions of the
firm are financed by retained earnings alone
 Model assumes a constant rate of return
and;
 constant cost of capital, i.e. disregards the
firm’s risk which changes over time hence
the discount rate will change over time in
proportion.

10. GORDON’S MODEL
 Assumptions:
1. The firm is an all equity firm, i.e. no debt
2. No external financing is available;
consequently retained earnings would be used
to finance any expansion of the firm. Similar
argument as Walter’s for the dividend and
investment policies.
3. Constant return which ignores diminishing
marginal efficiency of investment as
represented in the diagram on Walter’s model.
4. Constant cost of capital; model also ignores
the risk-effect as did Walter’s

11. 5. Perpetual stream of earnings for the firm
6. Corporate taxes do not exist
7. Constant retention ratio b, i.e. once decided
upon stays as such forever. The growth rate
g = br stays constant in that case.
8. Cost of capital greater than the growth rate
(k > br = g); otherwise it is not possible to
obtain a meaningful value for the share.

12.  According to Gordon’s model dividend per
share is expected to grow when earnings are
retained. The dividend per share is equal to
the payout ratio multiplied by earnings [EPS
X (1-b)]. To determine the value of the firm
therefore based on the dividend growth
model the value of the firm will be:
 P0 = EPS (1 – b)
k–g

13.  Where:
 (1 – b) = the retention ratio of the firm given b as
the payout ratio.
 g = the growth rate determined as br
 g is always less than k

14.  The conclusions of Gordon’s model are similar
to Walter’s model due to the fact that their sets
of assumptions are similar.
1. The market value of P0 increases with retention
ratio b, for firms with growth opportunities, i.e.
when r > k.
2. The market value of the share P0 increases
with payout ratio (1 – b), for declining firms with
r<k
3. The market value is not affected by the
dividend policy where r = k

15. DIVIDENDS IRRELEVANCE
 The propagators of this school of thought
were France Modigliani and Merton Miller
(1961).
 They state that the dividend policy employed
by a firm does not affect the value of the firm.
They argue that the value of the firm is
dependent on the firm’s earnings which result
from its investment policy, such that when the
policy is given the dividend policy is of no
consequence.

16.  Conditions that face a firm operating in a
perfect capital market, either;
1. The firm has sufficient funds to pay dividend
2. The firm does not have sufficient funds to
pay dividend therefore it issues stocks in
order to finance payment of dividends
3. The firm does not pay dividends but the
shareholders need cash.

17. ASSUMPTIONS OF M-M HYPOTHESIS
 Perfect capital markets, i.e. investors behave
rationally, information is freely available to all
investors, transaction and floatation costs do not
exist, no investor is large enough to influence the
price of a share.
 Taxes do not exist; or there is no difference in the tax
rates applicable to both dividends and capital gains.
 The firm has a fixed investment policy
 The risk of uncertainty does not exist, i.e. all investors
are able to forecast future prices and dividends with
certainty and one discount rate is appropriate for all
securities over all time periods.

18.  Under the assumptions the rate of
return, r, will be equal to the discount rate, k.
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 on every share, will be equal to the
discount rate and be identical for all shares.
 The return is computed as follows:
r = Dividends + Capital gains (loss)
Share price
r = DIV1 + (P1 – P0)
P0

19.  As hypothesised, r should be equal for all the
shares otherwise the lower yielding securities
will be traded for the higher yielding ones
thus reducing the price of the low yielding
ones and increasing the price of the high
yielding ones.
 This arbitraging or switching continues until
the differentials in rates of return are
eliminated.

20. CONCLUSIONS OF THE MODEL
 A firm which pays dividends will have to raise funds
externally in order to finance its investment plans. When a
firm pays dividend therefore, its advantage is offset by
external financing.
 This means that the terminal value of the share declines
when dividends are paid. Thus the wealth of the
shareholders – dividends plus the terminal share price –
remains unchanged.
 Consequently the present value per share after dividends
and external financing is equal to the present value per
share before the payment of dividends.
 Thus the shareholders are indifferent between the
payment of dividends and retention of earnings.

21. CRITICISMS?
 Presence of Market Imperfections:
 Tax differentials (low-payout clientele)
 Floatation costs
 Transaction and agency costs
 Information asymmetry
 Diversification
 Uncertainty (high-payout clientele)
 Desire for steady income
 No or low taxes on dividends

22. THE BIRD-IN-THE-HAND THEORY
 Relaxing of Gordon’s simplifying assumptions
to conform slightly to reality, he concludes
that even when r = k, the dividend policy
does affect the value of the share based on
the view that: under conditions of
uncertainty, investors tend to discount
distant dividends (capital gains) at a
higher rate than they discount near
dividends.
 Investors behave rationally, are risk-averse
and therefore have a preference for near
dividends to future dividends.

23.  Put forth by Kirshman (1969) in the following terms:
“Of two stocks with identical earnings record and
prospects but the one paying higher dividend than the
other, the former will undoubtedly command higher
dividend than the latter merely because stockholders
prefer present to future values….stockholders
normally act on the premise that a bird in the
hand is worth two in the bush and for this reason
are willing to pay a premium price for the stock with
the higher dividend rate just as they discount the one
with the lower rate”.

24.  Uncertainty of dividends increases with
futurity, i.e. the further one looks the more
uncertain dividends become
 When dividend is considered with respect to
uncertainty the discount rate cannot be held
constant, it increase with uncertainty.
 Investors prefer to avoid uncertainty and
would be willing to pay a higher price for the
share that pays the higher current
dividend, all things held constant.
 The appropriate discount rate would thus
increase with the retention ratio.

25. QUESTIONS?