Question

Question 3.

1. A CFO says, “The dividend growth model implies that the current stock price equals the present value of future dividends. We thus increase dividend payouts rather than retaining earnings to maximize the stock price." Do you agree with the CFO? Justify your answer. (You do not have to criticize the dividend growth model but discuss the CFO's interpretation of the model.)

2. Regarding the CFO's statement above, a treasurer responds as follows: “I do not agree. Retained earnings can be reinvested in our projects, which provide growth opportunities to our firm. We thus rather retain earnings as much as possible in any circumstances." Do you agree with the treasurer? Justify your answer. (Your objection to CFO's statement above does not necessarily imply that you agree with the treasurer. Assess the treasurer's statement independently.)

Answer 1

Before answering the question we need to understand the concept of dividend, retained earnings and Dividend Growth Model.

Dividend is defined as the amount distributed by a firm to its shareholders, out of the available profits. The dividend policy should maximize the wealth of shareholders.

Retained earnings are that part of profit which is not distributed to shareholders and kept by firm itself in its reserves. Thus after deducting dividend from Earnings, what is left is Retained Earnings.

1. Dividend Growth Model : -

This Model is generally supported by Gordon and Walter. It assumes that firm has perpetual life and it pays constantly dividend at an increasing rate out of its earnings. Therefore the Present Value of such indefinite series of future cash flows (in the form of dividend) must reflect in the price of a stock/ share/ script on valuations being done today.

In this backdrop, answering to the first part of question where, CFO opined that “The dividend growth model implies that the current stock price equals the present value of future dividends. We thus increase dividend payouts rather than retaining earnings to maximize the stock price." seems correct.

Thus in the growth model of dividend, in the long run, the price of a share is the Present Value of Expected Dividends. Thus Dividend declaration affects the market price of share and to calculate the fair value of a stock, the model takes the infinite series of dividends per share and discounts them back into the terms of present value of those future dividends, using the required rate of return.

P= D1/ (r-g)

where P=Current stock price

g=Constant growth rate expected for dividends in perpetuity

r=Constant cost of equity capital for thecompany (or rate of return)

D1​=Value of next year’s dividends​

If the value obtained from the model is higher than the current trading price of shares, then the stock is considered to be undervalued and qualifies for a buy, and vice versa. This is a Traditional Model, where more weightage is given on dividends rather than retained earnings and it does not pay attention to concept of retained earnings which can be invested in future by firm to earn additional profits.

2. Value of Stock when dividend is not declared and Entire Earning is kept as retained earnings-

This view is opined by treasurer. In this view, the firm does not pay any dividend and accumulate all the profits and invest in the visible growth opportunities or profitable avenues. Thus shareholder does not get any dividend and retained amount kept by firm out of profits is re-invested to earn more profits.

The view of treasurer can be ratified when there is boom in market and firm can earn profits over and above its cost of capital i.e. expected rate of return to shareholders. In the contrary, the excess earnings should not be retained and dividend should be paid out to increase the value of stock, when there are no growth opportunities.

To Conclude, Retained earnings are actually opportunity cost for dividends. However Modigliani Miller Model is far ahead of both the above views. It states that whether a company pays dividend or not it does not affect the value of stock because when company pays dividend the Market price of stock is appreciated as it is more demanded which reflect in acceleration in prices. On the other hand if earnings are retained, the firm re invests them in suitable growth opportunities. It results in more earning per share and by applying Price Earning Model the value of stock appreciates.

Thus both the view of treasurer and CFO is correct but depends on variables like cost of capital, available growth opportunities, state of condition of economy.