Question

Explain whether the dividend policy of a company affects its value, by describing the
various theories that have been put forward in the literature. Provide for each theory at
least two references from published papers in scientific journals (approximately 1,000
words).

Answer 1

#Dividend is relevant: Walter's Model

As per this model, the choice of dividend policy always affects the value of the firm. He argues, the firm's rate of return and the cost of capital have a major role in determining the dividend policy of the firm which maximizes the wealth of the shareholders.

There are certain assumptions of this model:

A) The firm finances all its investments through retained earnings only

B) The rate of return on investments and cost of capital remains constant.

C) 100 % payout as dividends or 100% retention

D) The firm has an infinite life.

The formula of market price per share:  

P = D/k + {r * (E-D)/k}/k, where

P = market price per share

D = dividend per share

E = earnings per share

r = internal rate of return of the firm

k = cost of capital of the firm

Three types of firms

GROWTH FIRM ( r > k)

If the rate of return on investments is greater than the opportunity cost of capital then, the payout should be zero and no dividend should be paid. The optimum dividend payout ratio would be 0%.

NORMAL FIRM (r=k)

The dividend policy will have no effect on the market value of the firm. The firm can either pay dividend or not, it will not change the market price of the share.

DECLINING FIRMS (r<k)

These firms do not have any profitable investments and do not earn a rate of return higher than the minimum rate required by the shareholders. The payout ratio in such a case should be 100% as retaining earnings would lead to a decline in the value of the firm.

Reference: Dividend Policy: Its Influence on the Value of the Enterprise by James E. Walter, The Journal of Finance

The Effect of Dividend Policy on Share Price: An Evaluative Study by Md. Abdullah Al- Hasan, Md. Asaduzzaman, Rashed al Karim, Journal of Economics and Finance

#DIVIDEND IS RELEVANT: GORDON MODEL

As per this model, the market value of a firm is equal to the present value of the infinite series of dividends received by the shareholders.

Assumptions of the model are:

a) All equity firm, no debt

b) Only retained earning are used for financing

c) COnstant rate of return on investments and constant cost of capital

d) no taxes

e) Constant retention and growth rate

f) Cost of capital is greater than the growth rate

P= D1​​/ r−g {g = br}

where:

P=Current stock price

g=Constant growth rate expected for dividends, in perpetuity

b = retention ratio

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

D1​=Value of next year’s dividends​

3 cases

when r=k,

The same case as discussed above, the dividend policy does not have any effect on the market value of the firm but Gordon gives an argument of bird in the hand. The shareholder can earn the same return outside that he earns if the dividend is not paid and remains invested in the firm but a person is risk-averse and considers future as uncertain so he will like today's dividend in comparison to the future's promise of gain. So some payout should be made in such a case.

WHEN r>k

The market value of the firm increases as the retention ratio increases.

WHEN r<k

The market value of the firm increases with the increase in the payout ratio.

Reference papers: Dividends, Earnings, and Stock Prices by M. J. Gordon, The Review of Economics and Statistics

Testing the Gordon’s Growth Model by Wairimu Mercy Mwangi, Research Journal of Finance and Accounting

#DIVIDEND IS IRRELEVANT: MILLER MODIGLIANI THEORY

According to MM theory, the dividend policy is irrelevant as the value of the firm depends on its earnings which subsequently depends on the investment decision and not the dividend decision. If the company pays out a dividend then it is just a shift of funds from one pocket to another pocket of the investors. As dividend might be cash in their hands but it leads to decline in cash in the balance sheet of the company which means their assets get reduced, that is their claims reduces.

The share price formula is

r = (DIV + CAPITAL GAIN/LOSS) / Share price at time 0

Capital gain/ loss = Price after a year - the price at time 0

P0 = (D1 + P1) / (1+k)

Reference:

The Irrelevance of the MM Dividend Irrelevance Theorem by Harry and Linda, Journal of Financial Economics

Capital Structure and Dividend Irrelevance with Asymmetric Information by Philip H. Dybvig and Jaime F. Zender, The Review of Financial Studies