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Dividend Theories

Dividend Theories

Relevance Theories

Walters Model
Gordons Model

Irrelevance Theories

Miller and Modigliani Hypothesis.

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
its business risk.

Assumptions
Existence of perfect capital markets
No taxes
Firm has fixed investment policy
There is no risk

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