Question

Please explain in Detail:

Discuss any 10 theories of dividend and their implications to the real world
- Put citations to back up the theories

Answer 1

Dividends iand ishare iprice igrowth iare ithe itwo iways iin iwhich iwealth ican ibe iprovided ito ishareholders. iThere iis ian iinteraction ibetween idividends iand ishare iprice igrowth: iif iall iearnings iare ipaid iout ias idividends, inone ican ibe ireinvested ito icreate igrowth, iso iall iprofitable icompanies ihave ito idecide ion iwhat ifraction iof iearnings ithey ishould ipay iout ito iinvestors ias idividends iand iwhat ifraction iof iearnings ishould ibe iretained.

Theories

The irelevant itheories iare:

1. The idividend ivaluation imodel

2. The iGordon igrowth imodel

3. Modigliani iand iMiller’s idividend iirrelevancy itheory

1. The idividend ivaluation imodel

This istates ithat ithe ivalue iof ia icompany’s ishares iis isustained iby ithe iexpectation iof ifuture idividends. iShareholders iacquire ishares iby ipaying ithe icurrent ishare iprice iand ithey iwould inot ipay ithat iamount iif ithey idid inot ithink ithat ithe ipresent ivalue iof ifuture iinflows i(i.e. idividends) imatched ithe icurrent ishare iprice. iThe iformula ifor ithe idividend ivaluation imodel iprovided iin ithe iformula isheet iis:

P0 i= iD0 i(1+ ig)/ i(re i– ig)

Where:

P0 i= ithe iex-div ishare iprice iat itime i0 i(i.e. ithe icurrent iex idiv ishare iprice)

D0 i= ithe itime i0 idividend i(i.e. ithe idividend ithat ihas ieither ijust ibeen ipaid ior iwhich iis iabout ito ibe ipaid)

re i= ithe irate iof ireturn iof iequity i(i.e. ithe icost iof iequity)

g i= ithe ifuture iannual idividend igrowth irate.

2. The iGordon igrowth imodel

This imodel iexamines ithe icause iof idividend igrowth. iAssuming ithat ia icompany imakes ineither ia idramatic itrading ibreakthrough i(which iwould iunexpectedly iboost igrowth) inor isuffers ifrom ia idreadful ierror ior imisfortune i(which iwould iunexpectedly iharm igrowth), ithen igrowth iarises ifrom idoing imore iof ithe isame, isuch ias iexpanding ifrom ifour ifactories ito ifive iby iinvesting iin imore inon-current iassets. iApart ifrom iraising imore ioutside icapital, iexpansion ican ionly ihappen iif isome iearnings iare iretained. iIf iall iearnings iwere idistributed ias idividend ithe icompany ihas ino iadditional icapital ito iinvest, ican iacquire ino imore iassets iand icannot imake ihigher iprofits.

It ican ibe irelatively ieasily ishown ithat iboth iearnings igrowth iand idividend igrowth iis igiven iby:

g i= ibR

Where ib iis ithe iproportion iof iearnings iretained iand iR iis ithe irate ithat iprofits iare iearned ion inew iinvestment. iTherefore, i(1 i– ib) iwill ibe ithe iproportion iof iearnings ipaid ias ia idividend. iNote ithat ithe ihigher ib iis, ithe ihigher iis ithe igrowth irate: imore iearnings iretained iallow imore iinvestment ito ithat iwill ithen iproduce ihigher iprofits iand iallow ihigher idividends.

3. Modigliani iand iMiller’s idividend iirrelevancy itheory

This itheory istates ithat idividend ipatterns ihave ino ieffect ion ishare ivalues. iBroadly iit isuggests ithat iif ia idividend iis icut inow ithen ithe iextra iretained iearnings ireinvested iwill iallow ifutures iearnings iand ihence ifuture idividends ito igrow. iDividend ireceipts iby iinvestors iare ilower inow ibut ithis iis iprecisely ioffset iby ithe iincreased ipresent ivalue iof ifuture idividends.

However, ithis iequilibrium iis ireached ionly iif ithe iamounts iretained iare ireinvested iat ithe icost iof iequity.

Dividend ipayment ipolicies

a. Constant idividends: iin ithis iapproach idividends iare ipredictable ibut ishareholders imight ibe idissatisfied iif ithey isee iearnings irising ibut ithey iare istuck iwill ilow idividends. iIf ia ilarger iand ilarger ifraction iof iearnings iis iretained, ishareholders imight ibegin ito iquestion iwhether ithe icompany ican ifind ienough iinvestment iopportunities iof ithe iright iquality.

b. Constant igrowth: iagain, ipredictable iand ivery iattractive ito ishareholders. iHowever, ithe idividend igrowth irate imight inot imatch iearnings igrowth irate.

c. Constant ipay-out iratio: ifor iexample, i(1 i– ib) i= i25%. iA iclear iand ipresumably ilogical ilink ibetween idividends iand iearnings. iHowever, iin isome icircumstances ithis ipolicy imight iproduce isignals ithat iare imisinterpreted. iDirectors iknow ithat ishareholders iprefer ipredictable idividends iand ishareholders iknow ithat idirectors iknow itheir ipreference. iTherefore, ishareholders imight iinterpret ithe icut ias isignaling ithat iearnings iare ipoor iand iwill inot iimprove iany itime isoon. iIf, ihowever, iearnings ifall iyet ithe idirectors imaintain ithe idividend, ithis iis ioften iinterpreted ias isignaling ithat ithe ifall iin iearnings iis itemporary iand ithe idirectors ifeel isufficiently iconfident iin ithe icompany’s ifuture ito imaintain ithe idividend iin iabsolute iterms.

d. Dividends ias iresiduals: irelating iback ito iwhat iwas icovered iin ithe ifirst isection iof ithe iarticle, ibefore ipaying idividends, idirectors ishould ifirst ispend iearnings ion iinvestments iin ithe icompany ithat iyield:

Investments ithat iyield imore ithan ithe icost iof iequity i(this iwill iincrease ishareholder ivalue)

Investments ithat iyield ithe icost iof iequity.

Only iafter ithese iinvestment iopportunities irun iout ishould ithe icompany ipay idividends ifrom ithe iresidual iearnings, ithus iallowing ishareholders ito imake ithe ibest iuse ithey ican iof itheir ireceipts.

e. No idividend: iMicrosoft iand iApple iboth iwent imany iyears iwithout ipaying ia idividend. iIt iis idifficult ito iuse ithe idividend ivaluation imodel iin ithis icircumstance iwithout imaking ivery icontentious iassumptions iabout iwhat ifuture idividends imight ibe. iNevertheless, ishare ivalues irose idramatically ias iboth icompanies iwere iimmensely isuccessful iand, ion ia iP/E iapproach ito ivaluation, ithey iwere iplainly ivery ivaluable iindeed.

Dividends iand idividend ipolicy iwill ibe ia icontinuing icause iof idebate iand icomment. iThe itheoretical iposition iis iclear: iprovided iretained iearnings iare ireinvested iat ithe icost iof iequity, ior ihigher, ishareholder iwealth iis iincreased iby icutting idividends. iHowever, iin ithe ireal iworld, iwhere inot inecessarily iall iinvestors iare ilogical iand iwhere itransaction icosts iand iother imarket iimperfections iintervene, idetermining ia isuccessful iand ipopular idividend ipolicy iis irather imore idifficult.