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A custom essay is the best learning aid you can buy SEE HOW WE CAN HELP The essay examples we publish have been submitted to us by students The essays are the student's work and are not examples of our expert essay writers' work READ MORE The Dividend Policy Rationale and Theories If a company thinks that by investing its retained earnings it will generate more than the market returns, then it should retain higher profit and should not pay more dividends (or also may not pay dividend at all) If a company is not so confident that it will not be able to generate more than the market returns, it should pay out more dividends (or 100% dividends) Dividend Policy Firm’s dividend policy divides net earnings into retained earnings and dividends Dividend is a part of the after tax profit for a company and that part of after tax profit is divided into the shareholders of that company The remaining of the PAT is called as “Retained Earnings” Dividend policy of the firm is governed by: Long term financing decision: When dividend decision is treated as a financing decision, www.ukessays.com/essays/finance/the-dividend-policy-rationale-and-theories-finance-essay.php 1/10 3/20/13 The Dividend Policy Rationale and Theories net earnings are viewed as a source of long term financing When the firm does not have profitable investment opportunities, dividends will be paid Wealth maximization decision: Because of market imperfections and uncertainty, shareholders give higher value to near dividends and capital gains When the firm increases retained earnings, shareholders’ dividends decrease and consequently market price is affected Use of retained earnings to finance profitable investments increase future earnings per share On the other hand, increase in dividends may cause the firm to forego investment opportunities for lack of funds and thereby decrease the future earnings per share Thus, the management should develop a dividend policy which divides net earnings into dividends and retained earnings in an optimum way so as to achieve the objective of wealth maximization for shareholders The formulation of dividend policy depends upon answers to the questions: Whether there should be a stable pattern of dividends over the years; or Whether the company should treat each dividend decision completely independent The various theories on dividend policies are discussed in the report hereafter MODIGLIANI AND MILLER THEORY OF IRREVELANCE Theory of irrelevance of dividend policy states that a company's dividend has no effect on its market value or cost of capital Modigliani and Miller proposed that dividend is a relevant factor in assessing the corporate market They argue that shareholder value is determined solely by real considerations namely the earning capacity of the company and its investment policy The dividends not affect the valuation of the company The proceeds are split between dividends and retained earnings and have no effect on shareholder wealth According to M & M, it does not matter how it is divided between profits In M & M the decision of the dividends is one in which leaders not need to agony, trying to find the optimal policy of dividends, as the optimal dividend policy does not exist FAQs Forum For example, suppose that an investor's point of view is that a company's profits are too high The investor can then buy more stock with the dividends of investor confidence Similarly, dividends from a company are too small, Blogif, from the standpoint Contact of the investor, Buy Now an investor could sell part of its portfolio to replicate the cash he or she should Thus investors care little sense for dividend policy of a company because they can simulate their own My account MM hypothesis is built on assumptions about an ideal economy An ideal economy is characterized by perfect capital markets, rational behaviour and perfect certainty Rational behaviour It implies that investors prefer more wealth to less In addition, they are indifferent to whether a given increase in their wealth is in the form of dividends or increasing the value of its shares Modigliani and Miller continue the usual assumption of rational behavior, introducing the concept of symmetric market rationality Symmetric market rationality hypothesis is based on the assumption that each investor is also alleged to market opportunities It is assumed that all other investors are rational and in turn also responsible for the rationality of the market This applies only to the choice behavior of individuals but also their expectations for the selection behavior of others symmetric market rationality can not conclude that the rational individual behavior If a reasonable investor is usually a good reason to believe that other investors not behave rationally, then it might be sensible, that takes the strategy he would otherwise have rejected the absurd This hypothesis therefore excludes the possibility of "bubbles" that would otherwise reasonable investor to buy overpriced security (too expensive in relation to its long-term expected return on investment to justify the addition of its portfolio), in the hope that it can sell at inflated prices even before the bubble bursts This www.ukessays.com/essays/finance/the-dividend-policy-rationale-and-theories-finance-essay.php 2/10 3/20/13 The Dividend Policy Rationale and Theories hypothesis symmetric market rationality to extend the concept of adequacy of the overall market Perfect certainty means full security of a portion of an investor with respect to the future investment program and the future profits of all firms The latter proved that the MM approach applies even if this assumption is abandoned Perfect Capital Market It has a large number of issuers and investors The operations of non-participant may have a significant impact on market prices The information is free and is also accessible to all There is no transaction in the form of commissions, transfer taxes, etc to buy or sell securities No costs of flotation, such as issuance costs and prices under the issuer, the issuing of new shares Not among the distributed profits and retained earnings, or between dividends and capital gains The presence of taxes M&M assume that there are no personal taxes Taxes on dividends (ordinary income) are higher than taxes on capital gains Thus, in the presence of personal taxes, companies should not pay dividends because investors require higher returns for companies that pay dividends If the fees are payable, shareholders of the company should opt for other alternatives, such as share repurchases This is the truth, if taxes on dividends are higher than taxes on capital gains However, different investors have different tax rates People with high tax rates that the company prefers to invest more, while those with low taxes may prefer the company not to invest and pay dividends Investors choose their own customers However, the presence of customers does not explain why companies decide to start paying dividends Information asymmetries It argues that in perfect markets dividend policy is irrelevant One of the assumptions of the model is that all individuals have the same information Managers and insiders have access to private information Business managers who expect a high cash flow stream (type of business law) to communicate this information to the market Remember the good and bad companies are encouraged to report that they are good companies, so we need a sign of unity that we can separate the good from the bad deals And indicate that the use of debt sends a positive signal to the market This signal is credible because firms can issue debt bonds, but bad because companies can’t have financial problems in the future The contract includes the signal, (companies that issue bonds are good companies) and reward companies that issue bonds with an increase in value Dividends can be used in a similar manner to convey a good (or bad) information A company that increases the signs of the dividends expected future cash flows, dividend policy because it tends to remain stable over the years Bad company can also increase dividends, but they are bad and companies in the future, will reduce its dividend, and the market penalize them This perspective may signal why companies pay dividends: the dissemination of private property on the market Walter’s Model To start off with the Walter’s model, let’s go through the basics Dividend is a part of the after tax profit for a company and that part of after tax profit is divided into the shareholders of that company And the remaining of the PAT is called as “Retained Earnings” Therefore if the dividend pay-out is high, the retained earnings will be lower www.ukessays.com/essays/finance/the-dividend-policy-rationale-and-theories-finance-essay.php 3/10 3/20/13 The Dividend Policy Rationale and Theories If a company thinks that by investing its retained earnings it will generate more than the market returns, then it should retain higher profit and should not pay more dividends (or also may not pay dividend at all) Other way around, if a company is not so confident that it will not be able to generate more than the market returns, it should pay out more dividends (or 100% dividends) There are two reasons for doing this:Shareholders usually prefer early inflow of cash Shareholders also believe in investing this cash to generate more returns (since market returns are expected to be higher than returns generated by the company) How Does Walter Model Work? He has given a formula in which he has delivered a way by which dividends can be used to maximise the wealth proposition of the shareholders Considering a long run situation, according to Walter, share price gives an idea about the present value of future stream of dividends Retained earnings influence stock prices only through their effect on further dividends Assumptions There are some assumptions that we need to consider before implementing the formula proposed by Walter These assumptions are:The company is a going concern with perpetual life span For this company, retained earnings are the only source of finance and it doesn’t have any other alternative of finance The cost of capital and return on investment are constant throughout the life of the company If there is an additional investment taking place, then firm’s business risk doesn’t change (This means that ‘r’ (internal rate of return) and ‘k’ (cost of capital) are constant.) The firm has an indefinite life Walter’s Model (Formula) P=D Ke – g Where:P = Price of equity shares Ke = Cost of equity capital D = Initial dividend g = Growth rate expected After accounting for retained earnings, the model would be: P=D Ke – rb Where: b = Retention rate (E - D)/E r = Expected rate of return on firm’s investments Equation showing the value of a share (as present value of all dividends plus the present value of all capital gains) – Walter's model:P = [D + r/Ke(E – D)] / Ke Where: D = Dividend per share and E = Earnings per share www.ukessays.com/essays/finance/the-dividend-policy-rationale-and-theories-finance-essay.php 4/10 3/20/13 The Dividend Policy Rationale and Theories Example A Ltd paid a dividend of INR 10 per share for 2009-10 The company follows a fixed dividend pay-out ratio of 35% and earns a return of 19% on its investments Cost of capital is 12% The expected price of the shares of A Ltd using Walter Model would be calculated as follows EPS = Dividend / pay-out Ratio =10 / 0.35 = Rs.28.57 According to Walter Model, P = [D + (E - D) x ROI / Kc] / Kc P = [10 + (28.57 – 10.00) x 0.19 / 0.14] / 0.14 P = 251.44 Example These are some facts given for a company Cost of capital (ke) = 0.12 Earnings per share (E) = $13 Rate of return on investments ( r) = 9.2% Dividend pay-out ratio: Case A: 60% Case B: 30% Show the effect of the dividend policy on the market price of the shares Case 1:D/P ratio = 60% When EPS = $13 and D/P Ratio = 60%, D = 13 * 60%= $7.8 P = {7.8 + [0.092/13]*[13 – 6]} / 0.12 = $65.41 Case 2:D/P ratio = 30% When EPS = $13 and D/P Ratio = 30%, D = 13 * 30%= $3.9 P = {3.9 + [0.092/13]*[13 – 3]} / 0.12 = $38.9 Conclusion If r > ke, then the value of shares will be inversely related to the D/P ratio If r < ke, the D/P ratio and the value of shares will be positively correlated When r = ke, the market value of shares is constant irrespective of the D/P ratio In this case, there is no optimum D/P ratio Gordon Growth Model The market value of the firm to dividend policy can be explicitly related by this model In this model, the current ex-dividend at the amount which shareholders expected rate of return exceeds the constant growth rate of dividends Assumptions It is based on the following assumptions: The firm is completely financed by equity and it has no debt www.ukessays.com/essays/finance/the-dividend-policy-rationale-and-theories-finance-essay.php 5/10 3/20/13 The Dividend Policy Rationale and Theories No external financing is used and investment programs are financed by retained earnings The internal rate of return, r, of the firm is constant The discount rate, ke, for the firm remains constant The retention ratio (i.e % of earnings retained), b, is constant Thus the growth rate, g = br, is also constant The discount rate, ke, is greater than the growth rate, g According to Myron Gordon, what is available at present is preferable to what may be available in the future Being rational, the investors want to avoid risk and uncertainty They would prefer to pay a higher price for shares on which current dividends are paid However, they would discount the value of shares of a firm which postpones dividends Formula The relationship between dividend and share price on the basis of Gordon growth model is as follows: Where V = Market price per share (ex-dividend) ke = cost of equity capital (Expected rate of return) Do = Current year dividend g = constant annual growth rate of dividends Example 1: Starlite Ltd is having its shares quoted in major stock exchanges Its share current market price after dividend distributed at the rate of 20% per annum having paidup shares capital of Rs.10 lakhs is Rs 10 each Annual growth rate in dividend expected is 2% The expected rate of return on its equity capital is 15% Calculate the value of Starlite Ltd.’s share based on Gordon’s model Answer: When the growth is incorporated in earnings and dividends, the present value of market price per share (Po) is given by: Po = Present market price per share E = Earnings per share b = Retention ratio (i.e % of earnings retained) r = Internal rate of return (IRR) k = cost of capital Example 2: Calculate the market price of a share of a company by dividend growth model (Gordon Growth model) for the given data: Earnings per share (EPS) = Rs 10 Cost of capital (k) = 20% Internal rate of return (IRR) on investment = 25% Retention ratio = 60% Answer: Market price per share, Advantages The primary advantage of this model is that readily available or easily estimated inputs are www.ukessays.com/essays/finance/the-dividend-policy-rationale-and-theories-finance-essay.php 6/10 3/20/13 The Dividend Policy Rationale and Theories used to perform the valuation calculation The model is particularly useful among companies or industries having relatively stable and strong cash flows; and having consistent leverage patterns It has wide applications in providing guideline fair values in mature industries – viz Financial services and large-scale real-estate ventures Disadvantages One of its drawbacks is that it takes no account of qualitative factors such as industry trends or management strategy For example, in a company generating high cash, nearfuture dividend payouts could be limited by management’s strategy of retaining cash to fund a likely future investment As the model is simple, it is not flexible enough to consider projected changes in the rate of future dividend growth It is less suitable for use in industries that are rapidly growing like software or mobile telecommunications This is because the basic premise is that future dividends will grow at a constant rate in perpetuity Graham and Dodd Model Introduction Dividend policy of a company is very crucial in order to maintain good relations with the investors (specially the shareholders) of the company When a company makes a profit, the management decides on what to with those profits They have the option of retaining the profits and reinvesting them so as to earn more profits and increase shareholder wealth in terms of increase in share prices or paying the profits earned as dividend to shareholders so that the shareholders can have some cash in hand However, once the company decides to pay dividends, it should establish a permanent dividend policy, which may impact on investors and perceptions of the company in the financial markets Generally, companies paying dividends are respected by the shareholders given the liquidity preference theory If the company thinks that it has enough investment opportunities and they would be able to substantially increase the value of the company for the shareholders, it should retain the profits What they decide depends on the situation of the company now and in the future It also depends on the preferences of investors and potential investors Factors Favouring Higher Dividend Payout AGENCY COSTS- Agency costs are differences between the interests of stockholders and the interests of management More external capital is required to pay higher dividends This leads to a greater scrutiny in the market therby reducing agency costs "BIRD-IN-HAND"- This argument holds that future earnings are less predictable and more uncertain than dividends, at least because they are further in the future The greater uncertainty of future earnings should be reflected in a higher discount rate on capital gains than on dividends This in turn would cause investors to prefer a more certain $1.00 of dividends over a less certain $1.00 of future earnings "PROSPECT THEORY"- This argument suggests that investors have a different attitude toward capital gains than toward dividends Capital gains become part of the investment base or permanent capital, which investors hesitate to reduce Paid dividends, however, are considered as current income and are spendable Because "homemade" dividends require reduction of capital, they have a different psychological impact than paid dividends and are an imperfect substitute Factors Favouring a Lower Dividend Payout www.ukessays.com/essays/finance/the-dividend-policy-rationale-and-theories-finance-essay.php 7/10 3/20/13 The Dividend Policy Rationale and Theories TAXES- Although both capital gains and dividends are taxed, the tax on capital gains is lower and will not be paid until the stock is sold Since payment of capital gains tax can be delayed, investors will be reluctant to create dividends by selling stock Investors attempting to undo a dividend payment by buying stock with dividends must pay taxes on the dividends, and cannot totally reverse the dividend The investor will be better off if the firm retains the earnings and reinvests them to produce capital gains, since tax payment is deferred TRANSACTIONS COSTS- In addition to taxes, investors reinvesting dividends will also face various transactions costs such a brokerage fees Conversely, a firm that pays dividends and then must turn to external sources also faces transactions costs such as the "flotation costs" of issuing new securities If the firm retains the funds and reinvests directly, both types of cost are avoided Other Considerations DIVIDENDS AS A RESIDUAL- The argument for dividend irrelevancy assumes that all investment takes place at the required rate of return for the firm In actuality, it is likely that the firm faces a mix of risk and return possibilities The firm should thus accept all projects with a positive net present value, and pay dividends only if it has more funds than are expected to be required for attractive projects While attractive to academics, this approach is seldom used in practice because it results in uncertain dividends and a greater perception of risk by investors CLIENTELE EFFECT- The clientele effect indicates that investors will tend to hold stocks whose dividend policy fits their needs That is, investors preferring more certain dividends over uncertain future earnings, or having a preference for current income over capital gains, will tend to hold stocks with relatively high dividend payout, and vice versa (i.e., a stock will have a clientele attracted by its dividend policy) Under these conditions, it is not the dividend policy itself that is relevant, but the stability of the policy SIGNALING- Most theoretical models assume that information is freely available to all It has been suggested that in reality access to information varies Management may have access to inside information, causing an "information asymmetry" between management and stockholders Signaling refers to the use of dividends and dividend changes to convey information to investors Similar to the clientele effect, it is not the absolute but rather the relative level of dividends that is important Under this argument management will avoid increasing dividends unless it is highly likely that the higher level of dividends can be maintained This implies that a dividend increase is a signal that the firm has reached a new level of profitability, and is a positive signal A dividend decrease, on the other hand, indicates that profitability has decreased and the former dividend level cannot be supported, a negative signal Note that under the residual argument, however, a dividend increase (decrease) signals a lack (abundance) of attractive projects and decreased (increased) future firm growth Because of the potential for false signals, more costly signaling is considered more reliable Graham and Dodd Model Graham and Dodd Model holds that the stock market favours companies, which give more dividends than on, retained earnings Hence an investor should evaluate a common stock by applying one multiplier to the portion of earnings paid out as dividends and a smaller multiplier to undistributed profits In other words, more weight should be put on dividends than on retained earnings Their viewpoint is expressed as P=m x (D + E/3) Where, P = Market price/share; m = multiplier; www.ukessays.com/essays/finance/the-dividend-policy-rationale-and-theories-finance-essay.php 8/10 3/20/13 The Dividend Policy Rationale and Theories D = DPS; E = EPS Assumptions The main assumptions of this model are: Investors are rational Under conditions of uncertainty they turn risk averse Implications and Criticism The main implication of this model is that weight attached to dividends is equal to four times the weight attached to retained earnings.This can be shown by re-arranging the above formula: P=mx (D + (D+R)/3) The weights provided by Graham and Dodd are based on their subjective judgements So the conclusion of this model is that a liberal payout policy has a favourable impact on the stock price Example Alpha Ltd has recorded an EPS of Rs for 1998-99 The company follows a fixed dividend payout ratio of 75% If the multiplier for the industry is 12, compute the expected market price for the share based on the Graham-Dodd Model Solution The dividend per share is Rs * 0.75 = Rs.4.50 Based on the Graham-Dodd Model, the expected market price would be P = m (D + E/3) = 12 (4.50 + 6/3) = Rs 78 per share Summary/Conclusion Need an essay? 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Poor Share & download: You can get your essay custom written by an expert in your subject area Fully researched and referenced, the perfect model answer www.ukessays.com/essays/finance/the-dividend-policy-rationale-and-theories-finance-essay.php Like 2.4k Tw eet Print Download 9/10 3/20/13 The Dividend Policy Rationale and Theories Get a quote here Email Request the removal of this essay Find out how UKEssays.com can help you with your Essays GET HELP WITH YOUR ESSAY Sign up and be the first to receive our latest offers: Instant Price Your email address S IGN UP Order Now Join our circle on Google+ Find us on Facebook Follow us on Twitter Get our latest updates Copyright © 2003 - 2013 - UK Essays is a trading name of All Answers Ltd All Answers Ltd is a company registered in England and Wales Company Registration No: 4964706 VAT Registration No: 842417633 Licensed under the Consumer Credit Act under Licence No: 0612201 Registered Data Controller No: Z1821391 Registered office: Venture House, Cross Street, Arnold, Nottingham, Nottinghamshire, NG5 7PJ Writer Jobs Fair Use Policy Terms & Conditions Privacy Policy Cookie Info Complaints Policy www.ukessays.com/essays/finance/the-dividend-policy-rationale-and-theories-finance-essay.php Get Verified Fraud Corporate Client Services Sitemap 10/10 ... profits In M & M the decision of the dividends is one in which leaders not need to agony, trying to find the optimal policy of dividends, as the optimal dividend policy does not exist FAQs Forum... if the dividend pay-out is high, the retained earnings will be lower www.ukessays.com/essays/finance/the -dividend- policy- rationale-and-theories-finance-essay.php 3/10 3/20/13 The Dividend Policy. .. www.ukessays.com/essays/finance/the -dividend- policy- rationale-and-theories-finance-essay.php 4/10 3/20/13 The Dividend Policy Rationale and Theories Example A Ltd paid a dividend of INR 10 per share