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# Dividend Theories

Dividend Theories

Relevance Theories

Walters Model
Gordons Model

Irrelevance Theories

Relevance Theory

## When dividend decision affects value of a

firm, it is known as relevance theory.
There are two prime theories under this
approach:

Walters Model
Gordons Model

Walters Model

## This model is proposed by James Walter.

This model is based on:

## Return on investment or internal rate of return [r]

and
Cost of Capital or Required Rate of Return [Ko]

## Model divides firm into

Growth firms:

r>K o

Normal firms:

r=K o

Declining firms:

r<K o

Assumptions
Only internal source of funds used
r and K o constant
All earnings are paid as dividends or completely
reinvested
EPS; and DPS never change
Perpetual life

Formula

Where: P
D
E
(ED)
r
Ke

## = Market Price per Share

= Dividends per share;
= Earnings per share;
= Retained earnings per share;
= Rate of return on investment;
= Cost of capital.

Interpretation
r>K o=

## Optimum DP Ratio is zero

r=K o=

No optimum DP Ratio

r<K o=

## Optimum DP Ratio 100%

Criticisms
No external financing
Constant rate of return as investment
Constant cost of capital

Gordons Model

## According to this model, firms share price

is dependent on dividend pay out ratio.

Assumptions
All equity firm;
Properties financed by retained earnings;
r is constant;
K o remains constant;
K o>b. r;
Perpetual stream of earnings;
Perpetual life;
Retention ratio constant;
No corporate taxes

Formula
Where: P=
E=
b=
(1- b)=
K=
r=
b. r =

E (1 b)
P
K b r

## Price per share

Earnings per share
Retention ratio
Dividend Payout ratio
Rate of Discount
Rate of returns earned an investment made by the firm
growth rate

Interpretation

## r > Ko = Optimal DP Ratio is zero.

r = Ko = No Optimal DP Ratio.
r < Ko = Optimal DP Ratio is 100%.

MM Hypothesis

## According to this theory, value of the firm is

determined by its basic earning power and