DIVIDEND

RELEVENCE THEORIES









RELEVENCE OF DIVIDENDS
In contrast to MM approach, there are some
theories that consider dividend decisions to be an
attractive variable in determining the value of a
firm. Two theories represent this notion:
Walters model
Gordons model

WALTERS MODEL
Walters model supports the doctrine that dividends
are relevant. The choice of an appropriate dividend
policy affects the value of an enterprise.
The key argument in support of relevance of
dividend is the relationship between IRR and its
Ke.
If IRR exceeds Ke, the firm should retain the
earnings and vice-versa.







ASSUMPTIONS

1. No external financing is available.
2. IRR and Ke of the firms remains constant.
3. The firm has a very long or infinite life.
4. The firms earning are either distributed or
reinvested internally.
5. EPS and dividend of the firm remains constant.
FORMULA
Walter has evolved a Mathematical formula to arrive at the
appropriate dividend decision.





P= Market price of a share
D= Dividend per share
E= Earnings per share
r= The rate of return on investment
ke= cost of capital


LIMITATIONS OF WALTERS MODEL
Walters model based on certain assumptions, which
are true for walter but not true in the financial world.
These limitations are that

o No external financing
o Constant rate of return or IRR
o Constant cost of capital or Ke

GORDONS MODEL

This model contends that dividend policy of the firm is relevant
and investors put a positive premium on current dividends and
opines that dividend policy of firm affects its value. The crux
of argument is based on two assumptions
(i) Investors are risk averse,
(ii) Investor put a premium on certain rate and discount /penalize
uncertain return.

ASSUMPTIONS
1. The firm is an all equity firm.
2. There is no external financing.
3. IRR and Ke of the firm remains constant.
4. Corporate tax does not exist.
5. The firm and its stream of earnings are perpetual.
6. Cost of capital is greater than growth rate
or
Ke > br=g
A BIRD IN HAND ARGUMENT
A bird in hand is better than two in the bush is
based on the logic that what is available at
present is preferable to what may be
available in future. Investor would like to
avoid uncertainty. They would be inclined to
pay a higher price for shares on which
current dividends are paid.

FORMULA
Gordon has evolved a Mathematical formula to arrive at the appropriate
dividend decision.



P= Price of a share
E= Earning per share
b = Retention ratio or percentage of earning retained
1-b= Dividend payout ratio
Ke= cost of capital
br= g=growth rate =rate of return on investment
TAX DIFFERTIAL : HIGH-PAYOUT AND LOW
PAYOUT CLIENTELE
Investor has to pay tax on dividend and capital gains,
but different tax rates are applicable on them.
In most countries except India, the capital gain tax rate
is lower then the tax rate for dividends. So a
shareholder in high tax bracket would prefer capital
gain over current dividends.
If a tax system favours capital gains to dividend income,
the low as well as high tax bracket investors will prefer
dividend income rather capital gains. This situation
currently prevails in India. Capital gains are taxed at 20
percent. There is no tax on dividend income in the
hands of shareholders, but company need to pay tax at
12.5 percent.
Thus the preference for dividend income depends on the
tax structure of the country.
TAXES AND DIVIDENDS
Shareholders earnings are taxed differently in
different countries. we can describe the following
four tax system regarding shareholders earnings as
follows:
1. Double taxation
2. Single taxation
3. Split-rate taxation
4. Imputation taxation
CONCLUSION
In an extreme situation like the one currently
prevailing in India, where dividends are not taxed
while capital gains are taxed, investors will prefer
dividends.
Thus, there does not seem to be a consensus on
whether dividends matter or not. In practice, a
number of factors have to be considered before
deciding appropriate dividend policy.
REFERENCES

1. Pandey I.M.,Financial Management, Vikas
Publishing house Pvt Limited, New Delhi, 2008

2. Khan M.Y., and jain P.K., Financial Management,
Tata McGraw Hill Education Private Limited, New
Delhi, 2011

3. Bhat Sudhindra, Financial Management, Excel
Books, New Delhi, 2008

Thank you