Dividend Policy and
Value of Firm
Corporate Finance
Dividend Theories
Dividend Theories
Irrelevanc
Relevance
e
Walter’s Gordon’s Miller and Modigliani
model Model Hypothesis
Walter’s Model
• James Walter has proposed a model of share valuation that supports the
view of dividend policy of an enterprise, has a biering on value of enterprise.
• The model is based on:
• Return on investment / Internal rate of return = r
• Cost of capital / required rate of return/ capitalization rate = Ko
• The model relates to the payment of earnings as dividend or retention of
earnings, model divides firms into three groups
• Growth firms = r>Ko
• Normal firms = r=Ko
• Declining firms= r<Ko
Walter’s Model
• According to walter firms optimum dividend policy is determined based on the
relationship between internal rate of return (r) and cost of capital (Ko)
• If r > Ko – Firms will earn more retaining and investing the money rather than
declaring dividend
• If r< Ko – Firm will earn more declaring dividend
Walter’s Model Assumptions
• All investments are financed through retained earnings, external
sources of funds like debt or fresh equity capital are not issued
• Firms return on investment and cost of capital are constant
• All earnings are either distributed as dividends or reinvested internally
immediately (100% dividend pay out or 100% retention ratio)
• Firms has perpetual life
Walter’s model numerical
• Market price per share
• P = {D + (r / Ko) * (E – D)} / Ko
• P = Price per equity share
• D = Dividend per share
• E = Earnings per share
• (E-D) = Retained earnings per share
• r= rate of return on investment / internal rate of return
• Ko = cost of capital / required rate of return / capitalization rate
Example: 1
Venkat company ltd has capitalization rate (Ko) of 10%. Its earnings per share is Rs 20. the
company declares Rs 10 dividend. You are required to calculate share price assuming 20%
returns on investment.
R>Ko = 20% > 10%
Solution:
• P = {D + (r / Ko) * (E – D)} / Ko
• P = { 10 + ( 0.20 / 0.10) * (20 – 10)} / 0.10
• P = {10 + 2 * 10} / 0.10
• P = {10 + 20} / 0.10
• P = 30/0.10
• P = 300
Example: 2
Venkat company ltd has capitalization rate (Ko) of 10%. Its earnings per share is Rs
20. the company declares Rs 5 dividend. You are required to calculate share price
assuming 20% returns on investment.
Solution:
• P = {D + (r / Ko) * (E – D)} / Ko
• P = { 5 + ( 0.20 / 0.10) * (20 – 5)} / 0.10
• P = {5 + 2 * 15} / 0.10
• P = {5 + 30} / 0.10
• P = 35/0.10
• P = 350
Example: 3
Venkat company ltd has capitalization rate (Ko) of 10%. Its earnings per share is Rs 20.
the company declares Rs 15 dividend. You are required to calculate share price
assuming 20% returns on investment
Solution:
• P = {D + (r / Ko) * (E – D)} / Ko
• P = { 15 + ( 0.20 / 0.10) * (20 – 15)} / 0.10
• P = {15 + 2 * 5} / 0.10
• P = {15 + 10} / 0.10
• P = 25/0.10
• P = 250
Gordon’s Model
• This is another popular model which argues that dividends are relevant and
dividend decision of firms affects its value.
• According to Gordon model firms share price is dependent on dividend pay-out ratio
• Assumptions:
• Firms is all equity firm no debt
• All investments are financed exclusively by retained earnings – no external financing
• Rate of return on firms investment is constant
• Cost of capital remains constant and is greater than growth rate (Ko > b.r)
• Firm has perpetual life
• Retention ratio once decided is constant
• There are no corporate taxes
Gordon’s Model Numerical
• Market price per share
• P = E (1 – b) / Ko – (b.r)
• P = Price per equity share
• E = Earnings per share
• b = Retention ratio
• (1- b) = proportion of earnings of the firm distributed as dividend
• r= rate of return on investment / internal rate of return
• Ko = cost of capital / required rate of return / capitalization rate
• g= b.r = growth rate
Gordon’s Model Numerical
A firms has given the following information and requested you to
determine share price:
EPS = 10 Rs per share
Retention ratio = 40%
Capitalization rate = 15%
Returns on investment = 14%
P = E (1 – b) / Ko – (b.r)
P = 10 ( 1 -0.40) / 0.15 – ( 0.40 * 0.14)
P = 6 / 0.15 – 0.056
P = 6 / 0.094
P = 63.829
