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CORPORATE FINANCE13TH JULY 2011DIVIDEND THEORIES
DIVIDEND THEORIES There are three main categories advanced:1. Dividend relevance theories2. Dividend irrelevance theories3. Dividend & uncertainty
DIVIDEND RELEVANCE THEORIES These are theories whose propagators argue that the dividend policy of a firm affects the value of the firm. There are two main theorists: James E. Walter (Walter’s model) Myron Gordon (Gordon’s model)
WALTER’S MODEL Shows relationship btwn a firm’s 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 issued.2. Constant return and cost of capital – the firm’s rate of return, r, and its cost of capital k are constant3. 100% payout or retention – all earnings are either distributed as dividends or reinvested internally immediately.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
Walter’s formula for determining MPS is as follows:P = (DPS/k) + [r (EPS – DPS)/k]/kWhere: P = market price per share DPS = dividend per share EPS = earnings per share r = firm’s average rate of return k = firm’s cost of capital
the market value is determined as the present value of two sources of income:1. PV of constant stream of dividend (DPS/k)2. PV of infinite stream of capital gains: r(EPS-DPS)/kHence the formula can be rewritten as P = DPS + (r/k) (EPS – DPS) k
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 wil maximize value per share if they reinvest all earnings.2. Normal firm: there aren’t 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 aren’t 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.
CRITICISMS OF WALTER’S 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 firm’s risk which changes over time hence the discount rate will change over time in proportion.
GORDON’S MODEL Assumptions:1. The firm is an all equity firm, i.e. no debt2. No external financing is available; consequently retained earnings would be used to finance any expansion of the firm. Similar argument as Walter’s for the dividend and investment policies.3. Constant return which ignores diminishing marginal efficiency of investment as represented in the diagram on Walter’s model.4. Constant cost of capital; model also ignores the risk-effect as did Walter’s
5. Perpetual stream of earnings for the firm6. Corporate taxes do not exist7. Constant retention ratio b, i.e. once decided upon stays as such forever. The growth rate g = br stays constant in that case.8. 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 Gordon’s 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 [EPS X (1-b)]. To determine the value of the firm therefore based on the dividend growth model the value of the firm will be: P0 = EPS (1 – b) k–g
Where: (1 – b) = the retention ratio of the firm given b as the payout ratio. g = the growth rate determined as br g is always less than k
The conclusions of Gordon’s model are similar to Walter’s 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<k3. 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 (1961). 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 firm’s earnings which result from its investment policy, such that when the policy is given the dividend policy is of no consequence.
Conditions that face a firm operating in a perfect capital market, either;1. The firm has sufficient funds to pay dividend2. The firm does not have sufficient funds to pay dividend therefore it issues stocks in order to finance payment of dividends3. The firm does not pay dividends but the shareholders need cash.
ASSUMPTIONS OF M-M HYPOTHESIS 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) 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.
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.
CRITICISMS? Presence of Market Imperfections: Tax differentials (low-payout clientele) Floatation costs Transaction and agency costs Information asymmetry Diversification Uncertainty (high-payout clientele) Desire for steady income No or low taxes on dividends
THE BIRD-IN-THE-HAND THEORY Relaxing of Gordon’s simplifying assumptions to conform slightly to reality, he concludes that even when r = k, the dividend policy does affect the value of the share based on the view that: under conditions of uncertainty, investors tend to discount distant dividends (capital gains) at a higher rate than they discount near dividends. Investors behave rationally, are risk-averse and therefore have a preference for near dividends to future dividends.
Put forth by Kirshman (1969) in the following terms:“Of two stocks with identical earnings record and prospects but the one paying higher dividend than the other, the former will undoubtedly command higher dividend than the latter merely because stockholders prefer present to future values….stockholders normally act on the premise that a bird in the hand is worth two in the bush and for this reason are willing to pay a premium price for the stock with the higher dividend rate just as they discount the one with the lower rate”.
Uncertainty of dividends increases with futurity, i.e. the further one looks the more uncertain dividends become When dividend is considered with respect to uncertainty the discount rate cannot be held constant, it increase with uncertainty. Investors prefer to avoid uncertainty and would be willing to pay a higher price for the share that pays the higher current dividend, all things held constant. The appropriate discount rate would thus increase with the retention ratio.