Dividend Policy

EPS

DPS

Retained earnings

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Payout ratio

Retention ratio

Company

Growth Rate

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Dividend Policy Models

Traditional Position Walter Model Gordon Model Miller & Modigliani Model Rational Expectation Model

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Traditional Position

B. Graham and D.L Dodd

The stock value responds positively to higher dividends and negatively to lower dividend
P= m (D + E/3)

Limitations:
1. Expectations of the investors differ 2. Negative impact of Payout Ratio 3. Positive impact of retention ratio
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Walter Model
James E. Walter
It studies the relationship between rate of return (r) and cost of capital (k) , to give a dividend policy that maximizes the Stock value. If r>k r<k r=k

Growth Firm
Declining Firm Normal Firm

0% Payout
100% Payout 0%-100% Payout

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Assumptions of Walter model

Retained earnings - the only source of Finance r and k are assumed to be constant Firm has infinite life DPS and EPS remain constant
Formula for Market Price per share

P=D Ke
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r (E-D)/Ke Ke
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Problem:
Calculate the market price per share of ZED Ltd, using the Walter Model

Earnings per share (EPS) = Rs.8 Equity Capitalization rate (Ke) = 12% Rate of Return on investments (r) 1. r = 15% 2. r = 10% 3. r = 12% Assume Dividend Payout ratios are 0%, 25%, 50%, 75% and 100%

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1.

r > Ke (r = 15% and Ke = 12%) Payout Ratio MPS 0% 25% 50% 75% 100% Rs.83 Rs.79 Rs.75 Rs.71 Rs.67

At 0% Payout , Stock price is the highest Negative correlation between payout ratio and stock price
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2. r < Ke

(r = 10% and Ke = 12%)

Payout Ratio 0% 25% 50% 75% 100%

MPS Rs.56 Rs.58 Rs.61 Rs.64 Rs.67

At 100% Payout , Stock price is the highest. Positive correlation between payout ratio and stock price
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3. r = Ke

(r = 12% and Ke = 12%)

Payout Ratio 0% 25% 50% 75% 100%

MPS Rs.67 Rs.67 Rs.67 Rs.67 Rs.67

At all levels of Payout, Stock price is the same. No correlation between payout and stock price
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Gordon Model
Myron Gordon

It shows the relationship between retention ratio and stock price If Growth Firm Declining Firm Normal Firm
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r>k r<k r=k

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Low Payout ratio High Payout ratio Normal payout ratio

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Assumptions of Gordon Model

The firm will be an all equity firm where all new investment proposals are financed solely by the retained earnings. r and k are assumed constant. Firm has infinite life The retention ratio (b) remains constant Growth rate remains constant (g = br) K > br Formula for calculating Market Price per share P = E (1 - b) Ke - br

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Problem: If Ke = 11%, and E = Rs.15 calculate the stock value of swan Ltd. If 1. r = 12% 2. r = 10% 3. r = 11%
Assume Dividend payout ratios are 10%, 20%,30%,40% and 50%.
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1. r > Ke

(r = 12% and Ke = 11%)

Payout Ratio MPS 10% 20% 30% 40% 50% Rs.750.00 Rs.214.28 Rs.173.08 Rs.158.00 Rs.150.00

At 10% Payout ratio Stock price is highest Negative correlation exists between payout ratio and stock price

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2. r < Ke

(r = 10% and Ke = 11%)

10% 20% 30% 40% 50% Rs.75.00 Rs.100.00 Rs.112.50 Rs.120.00 Rs.125.00

Payout Ratio MPS

At 50% Payout ratio Stock price is highest. Positive correlation exists between payout ratio and stock price

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3. r = Ke

(r = 11% and Ke = 11%)

Payout Ratio 10% 20% 30% 40% 50%

MPS Rs.136.6 Rs.136.6 Rs.136.6 Rs.136.6 Rs.136.6

At all levels of Payout ,Stock price is stable No correlation between payout ratio and stock price
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Miller and Modigliani Model

Miller and Modigliani

It shows the relationship between

Investment policy and stock price

It shows irrelevance of dividend policy and

stock price

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Assumptions of Miller and Modigliani Model

Existence of Perfect Market No taxes Constant Investment Policy

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What MM theory says

If dividend is declared, the arbitrage will neutralize the value of share increased due to cash dividends, then the value of share will be constant. If dividend is not declared the retained earnings will keep the value of the firm constant. At all levels of payout the value of the firm remains constant
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Problem: The Capitalization rate of Z Ltd is 12% Outstanding shares are 25,000 shares @ Rs.100 each Anticipated net income is Rs.3,50,000 Z Ltd decided to declare a dividend of Rs.3/share The company decided to implement a new project costing Rs.5,00,000 Calculate the value of the firm a) If dividend is declared b) If dividend is not declared
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Steps:
1. To Calculate Market price per share 1 P0 = (D1 + P1) (1+Ke) 2. Amount to be raised by new issue of shares n1p1 = I - (E - nD1) 3. Number of additional shares to be raised n1 = n1p1 p1 4. Value of the Firm nP0 = (n + n1)P1 I+E (1+ke)
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Critical Analysis of MM Assumptions

Tax Effect Floatation cost Transaction cost Market Conditions Under pricing of Shares

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Rational Expectations Model

It shows the relationship between unexpected dividend and stock price When the dividend is more than expected, then the share price will be more When the dividend is less than the expected , then the fall in future earnings of the firm.
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