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Payment of dividend has two opposing effects:

1) It increases stock price
2) It reduce the funds available for investment

Various models have been developed to

evaluate the perfect dividend policy. There is
different schools of thought over the
relationship between dividends and the value
of the share or the wealth of the shareholders.

1) Relevance Theory :
> Walters Model
> Gordons Model
2) Irrelevance Theory :
> Miller & Modigliani Hypothesis ( MM

James E. Walter andMyron J. Gordon,

who believe that current cash dividends
are less risky than future capital gains.
Thus, they say that investors prefer
those firms which pay regular dividends
and such dividends affect the market
price of the share.
Modigliani and Millerbelieves that
investors don't really choose between
future gains and cash dividends.


Dividends paid by the firms are viewed
positively both by the investors and the
firms. The firms which do not pay dividends
are rated negatively by investors thus
affect the share price.
There are two main theorists:
James E. Walter (Walters model)
Myron Gordon (Gordons model)

Walters Models theory :

Relevance Theory

According to relevance theory dividend decisions

affects value of firm thus it is called relevance

This model is based on

1) Return on investment OR Internal rate of return (r).
2) Cost of capital OR Required rate of return.
Here, the model divides the firm into three groups
1) Growth firms
2) Normal firms
3) Declining firms

Walters Model
Shows relationship b/w a firms rate of return r and its cost
of capital k. it is based on the following assumptions:
1.Internal financing The firm finances all its investments
through retained earnings. (debt or new equity is not
2.Constant return and cost of capital The firms rate of
return r, and its cost of capital k are constant
3.100% payout or retention all earnings are either
4.Constant EPS and DPS beginning earnings and dividends
never change. The values of the EPS and DPS may be
changed in the model to determine results but are assumed
to remain unchanged in determining a given value.
5.Infinite time the firm has a very long or infinite life

Given three types of firms or scenarios of firms

the model can be summarized as follows:
1. Growth firm: there are several investment
opportunities (r > k) and the firm can reinvest
earnings at a higher rate r than that which is
expected by shareholders k. thus they will
maximize value per share if they reinvest all
2. Normal firm: there arent any investments
available for the firm that are yielding higher
rates of return (r = k) thus the dividend policy
has no effect on market price.

3. Declining firm: there arent any

profitable investments for the firm
to reinvest its earnings, i.e. any
investments would earn the firm a
rate less than its cost of capital (r <
k). The firm will therefore maximize
its value per share if it pays out all
its earnings as dividend.

In a nutshell:
If r>ke, the firm should have
zero payout and make
If r<ke, the firm should have
100% payouts and no investment
of retained earnings.
If r=ke, the firm is indifferent
between dividends and

Walter concludes:
The optimum payout ratio is nil in
case of growth firm, the payout ratio
of a constant firm is irrelevant, the
optimum payout ratio for a declining
firm is 100 per cent.

Mathematical representation
Walter has given a mathematical
model for the above made

P = Market price of the share
D = Dividend per share
r = Rate of return on the firm's
ke= Cost of equity

Criticisms of Walters model

Model assumes investment decisions of the
firm are financed by retained earnings alone
Model assumes a constant rate of return and;
constant cost of capital, i.e. disregards the
firms risk which changes over time hence the
discount rate will change over time in
The constant r and keare seldom found in real
life, because as and when a firm invests more
the business risks change

Gordons Model :

According to this model a firm share price

is dependent on dividend pay out ratio.
> Assumptions :

1) The firm is all equity firm.

2) All investment projects are financed by

exclusively retained earnings.

3) The rate of return firms is constant.
4) The cost of capital remains constant.
5) The firm has perpetual life.
6) There are no corporate taxes.

1. No external financing is available;
consequently retained earnings would be used
to finance any expansion of the firm. Similar
argument as Walters for the dividend and
investment policies.
2. Constant return which ignores diminishing
marginal efficiency of investment as
represented in the diagram on Walters model.
3. Constant cost of capital; model also ignores
the risk-effect as did Walters

5. Constant retention ratio b, i.e. once
decided upon stays as such forever.
The growth rate g = br stays
constant in that case.
6. Cost of capital greater than the
growth rate (k > br = g); otherwise
it is not possible to obtain a
meaningful value for the share.

According to Gordons model dividend

per share is expected to grow when
earnings are retained. The dividend per
share is equal to the payout ratio
multiplied by earnings [ (1-b) X EPS ].
the value of the firm based on the
dividend growth model will be:
P0 = EPS (1 b)

(1 b) = dividend payout ratio where
retention ratio of the firm is b
g = the growth rate determined as br
g is always less than k

The conclusions of Gordons model are similar

to Walters model due to the fact that their sets
of assumptions are similar.
1. The market value of P0 increases with retention
ratio b, for firms with growth opportunities, i.e.
when r > k.
2. The market value of the share P0 increases with
payout ratio (1 b), for declining firms with r <
3. The market value is not affected by the
dividend policy where r = k

Dividends Irrelevance
The propagators of this school of thought
were France Modigliani and Merton Miller
They state that the dividend policy employed
by a firm does not affect the value of the
firm. They argue that the value of the firm
is dependent on the firms earnings
which result from its investment policy,
so that when the investment policy is given
the dividend policy is of no use.

Conditions that face a firm operating

in a perfect capital market, either;
1. The firm has sufficient funds to pay
2. The firm does not have sufficient
funds to pay dividend therefore it
issues stocks in order to finance
payment of dividends
3. The firm does not pay dividends but
the shareholders need cash.

Assumptions of M-M
Perfect capital markets, i.e. investors behave
rationally, information is freely available to all
investors, transaction and floatation costs do not
exist, no investor is large enough to influence the
price of a share.
Taxes do not exist; or there is no difference in the tax
rates applicable to both dividends and capital gains.
The firm has a fixed investment policy
The risk of uncertainty does not exist, i.e. all
investors are able to forecast future prices and
dividends with certainty and one discount rate is
appropriate for all securities over all time periods.

Under the assumptions the rate of return, r, will

be equal to the discount rate, k.
As a result the price of each share must adjust so
that the rate of return, which is composed of the
rate of dividends and capital gains on every
share, will be equal to the discount rate and
be identical for all shares.
The return is computed as follows:
r = Dividends + Capital gains (loss)
Share price
r = DIV1 + (P1 P0)

As hypothesised, r should be equal for all

the shares otherwise the lower yielding
securities will be traded for the higher
yielding ones thus reducing the price of
the low yielding ones and increasing the
price of the high yielding ones.
This arbitraging or switching continues
until the differentials in rates of return
are eliminated.

This discount rate will also be equal
for all firms under the M-M
assumption since there are no risk
From the above M-M fundamental
principle we can derive their
valuation model as follows:

The value of the firm if no new

financing exists If the firm sells m number of new
shares at time 1 at a price of P^, the
value of the firm at time 0 will be

No of shares issued for additional

investment :
N =


Conclusions of the model

A firm which pays dividends will have to raise funds
externally in order to finance its investment plans.
When a firm pays dividend therefore, its advantage is
offset by external financing.
This means that the terminal value of the share
declines when dividends are paid.
Thus the wealth of the shareholders dividends
plus the terminal share price remains unchanged.
Consequently the present value per share after
dividends and external financing is equal to the present
value per share before the payment of dividends.
Thus the shareholders are indifferent between the
payment of dividends and retention of earnings.


Presence of Market Imperfections

Tax differentials (low-payout clientele)
Floatation costs
Transaction and agency costs
Information asymmetry
Uncertainty (high-payout clientele)
Desire for steady income
No or low taxes on dividends

Dividend Irrelevance Theory

Miller and Modigliani also showed
algebraically that dividend policy didnt
They showed that as long as the firm was
realizing the returns expected by the market, it
didnt matter whether that return came back to
the shareholder as dividends now, or reinvested.
They would see it in dividend or value
The shareholder can create their own dividend
by selling the stock when cash is needed.