CHAPTER 4 DIVIDEND THEORY 1. What are the essentials of Walters dividend model? Explain its shortcomings. Prof.

J E Walter argues that the choice of dividend policies almost always affects the value of the firm. Walters model is based on the following assumptions: The firm finances all its investment through retained earnings; The firms rate of return r, and its cost of capital, k, are constant; The firm have 100% dividend payment or retention ratio; The firms EPS and DPS are constant forever in determining a given value of firm. The market price of share is the sum total of present value of infinite stream of constant dividend, DIV/k; and infinite stream of capital gains, [r(EPS-DPS)/k]/k].

According to the Walters model, the optimum dividend policy depends on the relationship between r and k. If r>k, the share value will increase as the firm retains more earnings; the price will be maximum when the firm retains 100%. If r<k, the price will be maximum if the firm distributes 100% dividend. The Walters model assumes that the firms investment opportunities are financed by retained earnings only. In the long-term, r does not remain constant; it decreases as more and more investment is made. The firms cost of capital also does not remain constant; it changes directly with firms risk.
2. What are the assumptions which underlie Gordons model of dividend

effect? Does dividend policy affect the value of the firm under Gordons model? Gordons model is based on the following assumptions. 1. The firm is an all-equity firm. 2. No external financing is available for expansion. 3. Constant internal rate of return, r3 and constant cost of capital, k. 4. The firm and its stream of earnings are perpetual. 5. Corporate taxes do not exist. 6. The retention ratio, b, once decided upon, is constant. 7. The firms cost of capital is greater than growth rates where growth rate is retention ration multiplied by internal rate of return, i.e., g = br. Gordons model is expressed as follows:

where b is retention ratio; EPS is earnings per share; g is growth rate and it is equal to br (retention ration multiplied by rate of return).The Gordon model suffers from the same limitations as the Walter model.

3. Walters and Gordons models are essentially based on the same assumptions. Thus, there is no basic difference between the two models. Do you agree or not? Why? Yes, because both models, in short, conclude that, 1. The market value of the share increases with increase in retention ratio when r>k. 2. The market value per share is not affected by the dividend policy when r=k. 3. The market value per share decrease with retention if r<k. According to Walters model the optimum payout ratio can be either zero or 100 per cent. Explain the circumstances, when this is true. In the case of growth firm (r>k), the market value per share, P, increases as payout ratio declines (optimum payout ratio is zero). In the case of declining firm (r<k), the market value per share, P, increases as payout ratio increases (optimum payout ratio is 100%). In the case of normal firm (r=k), the payout ratio has no effect on the market value per share. Example: Growth firm Normal firm Declining firm
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5. The contention that dividends have an impact on the share price has

been characterized as the bird-in-the-hand argument. Explain the essential of this argument. Why this argument is considered fallacious? According to the bird-in-the-hand argument, investors tend to behave rationally, are risk averse and, therefore, have a preference for near dividends to future dividends. They most certainly prefer to have their dividend today and let tomorrow take care of itself. Further, given two companies with identical earnings record, and prospects but one paying a larger dividend will always command higher share price because investors prefer present to future values. This argument is fallacious, on the contention that, if the firm does not pay any dividend, a shareholder can create a home-made dividend by selling a part of his/her shares at the fair market price in the capital market for obtaining cash. This will not make any dilution in the wealth.
6. What is Modigliani-Millers dividend irrelevance hypothesis? Critically

evaluate its assumptions. MM hypothesis of irrelevance is based on the assumptions like perfect capital market existence, no transaction and flotation costs, no corporate taxes, no difference in the tax rates applicable to capital gains and dividends, and risk of uncertainty does not exist. As per MM, in the equilibrium, r (rate of return) will be equal to k (cost of capital), and identical for all shares. 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, for every share will be equal to the discount rate. Hence, todays market price per share is as follows:

MM argument implies that when the firm pays dividends, its advantage is offset by external financing. This means that terminal value (Pl) of the share declines when dividends are paid. Above assumptions may not always be found valid because capital markets are not perfect, existence of flotation and transaction costs, dividend may be taxed differently than capital gains, etc. The assumptions underlying the irrelevance hypothesis of Modigliani and Miller are unrealistic. Explain and illustrate. The MM assumptions on dividend irrelevance are considered unrealistic on account of the following reasons. 1. Investors have to pay different taxes on dividend income and capital gains. 2. The firms internal and external financing are not equivalent, because flotation costs (e.g., underwriting and brokers commission, etc.) are involved if new shares are issued. 3. The home-made dividend benefit cannot be fully realized by investors on account of transaction costs (such as brokerage fee). Further, it is inconvenient to sell the shares by investors.
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4. Investors may have a desire to diversify the portfolios from the dividend income. If firm does not distribute the dividends, then investors will be inclined to use a higher value of k if they expect the firm to use retained earnings for internal financing. 5. The current receipt of money in the form of dividends is considered safer than the uncertain potential gain in future by investors, etc. 8. Explain the nature of the factors which influence the dividend policy of a firm. The following factors generally influence the dividend policy of the firm. 1. Shareholders expectations: Shareholders expectation relating to dividends or capital gains depends on their economic status, effect of differential tax system, need for regular income, etc. 2. Firms financial needs: Financial needs of the company to finance the profitable investment opportunities. 3. Legal restrictions: Legal restrictions like dividend to be paid out of current or past profits do influence dividend policy of a firm. 4. Liquidity: The overall liquidity of a company has an effect on the dividend decision of a firm. In the absence of sufficient cash, a firm may be unable to pay dividends even if it has profits. 5. Firms financial condition: The financial condition or capability of a firm depends on its use of borrowings and interest charges payable. A high levered firm is expected to retain more profits and distribute lesser dividends in order to strengthen its equity base. 6. Capital market accessibility: Accessibility by firm to the capital market becomes an important factor to declare dividends. For example, a fast growing company which has a tight liquidity position will not face any difficulty in paying dividends if it has access to the capital markets. 7. Institutional lenders: Lenders of funds like financial institutions and banks may generally put restrictions on dividend payments to protect their interests when the firm is experiencing low liquidity or low profitability, etc. Therefore, irrespective of the firms needs and the desires of shareholders, a firm should follow a policy of very high dividend payout. Do you agree? Why or why not? This statement is not true. The primary purpose of the firm is not payment of dividend. Rather, it is to maximize shareholders wealth. Paying dividend in certain situations, may harm, rather than enhance, the shareholders wealth. The MM view is that dividends are irrelevant. If we consider taxes and assume that dividend incomes are taxed and capital gains are tax exempt, then paying dividends will be harmful. On the contrary if capital gains are taxed and dividends are tax exempt, then it may be in the interest of shareholders if dividends are paid. A company having profitable growth opportunities will like to retain more and create shareholder wealth.
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10. What is a stable dividend policy? Why should it be followed? What can

be the consequences of changing a stable dividend policy? Stable dividend policy means regularity in paying some dividend annually, even though the amount of dividend may fluctuate over years, and may not be related with earnings. Precisely, stability of dividends refers to the amount paid out regularly. This policy should be followed, because by and large, shareholders favour this policy and value stable dividends higher than the fluctuating ones. The stable dividend may have a positive impact as the market price of the share. This policy resolves uncertainty in the minds of investors about future earnings, and satisfies the desire of many investors, such as old, retired persons, etc. If the companies change from the stable dividend policy to an irregular or fluctuating dividend policy, it gives an unfavourable signal to shareholders about the stability of the firms operations.