30 - 1

Dividend And Valuation

DIVIDEND AND VALUATION
Irrelevance of Dividends
Relevance of Dividends
Solved Problems
Walters model supports the doctrine that dividends are relevant. The
investment policy of a firm cannot be separated from its dividends policy
and both are, according to Walter, interlinked. The choice of an appropriate
dividend policy affects the value of an enterprise.
Assumptions
1. All financing is done through retained earnings: external sources of
funds like debt or new equity capital are not used.
2. With additional investments undertaken, the firms business risk does
not change. It implies that r and k are constant.
3. There is no change in the key variables, namely, beginning earnings per
share, E, and dividends per share, D. The values of D and E may be
changed in the model to determine results, but, any given value of E and
D are assumed to remain constant in determining a given value.
4. The firm has perpetual (or very long) life.
Relevance of Dividends
Valuation as per Walter model

D +r /k
e
(E-D)
P = ------------------------
k
e

where P = The prevailing market price of the share

D = Dividend per share

E= Earnings per share

r= the rate of return on the firms investment


The value of a share is the present value of all dividends plus the present value
of all capital gains. Walters model with reference to the effect of
dividend/retention policy on the market value of shares under different
assumptions of r (return on investments) is illustrated in Example 2.
Example 2
The following information is available in respect of a firm:
Capitalisation rate (k
e
) = 0.10
Earnings per share (E) = Rs 10
Assumed rate of return on investments (r): (i) 15, (ii) 8, and (iii) 10.
Show the effect of dividend policy on the market price of shares, using Walters
model.
Solution
(1) When r is 0.15, that is, r > k
e
: The effect of different D/P ratios depicted in
Table 1.
(2) When r = 0.08 and 0.10, that is, r < k
e
and r = k
e
respectively: The effect of
different D/P ratios on the value of shares is shown in Table 2.
Table 1 : Dividend Policy and Value of Shares (Walters Model)
( )
( )
( )
( )
( )
100 Rs
0.10
10 10
0.10
0.15
10
p
10) Rs share per (Dividend 100 ratio (e)D/P
112.50 Rs
0.10
7.5 10
0.10
0.15
7.5
P
7.5) Rs share per (Dividend 75 ratio (d)D/P
125 Rs
0.10
5 10
0.10
0.15
5
P
5) Rs share per (Dividend 50 ratio (c)D/P
137.50 Rs
0.10
2.5 10
0.10
0.15
2.5
P
2.5) Rs share per (Dividend 25 ratio (b)D/P
Rs150
0.10
0 10
0.10
0.15
0
P
zero) share per (Dividend 0 ratio (a)D/P
=
+
=
= =
=
+
=
= =
=
+
=
= =
=
+
=
= =
=
+
=
= =
(

Table 2: Dividend Policy and Value of Shares (Walters Model)

(A) r = 0.8 (r < k
e
) (B) r = 0.10 (r = k
e
)
( ) ( )
( ) ( )
( ) ( )
( ) ( )
( ) ( )
100 Rs
0.10
10 10
0.10
0.10
10
p 100 Rs
0.10
10 10
0.10
0.08
10
p
100 ratio D/P (e)
100 Rs
0.10
7.5 10
0.10
0.10
7.5
p 95 Rs
0.10
7.5 10
0.10
0.08
7.5
p
75 Ratio D/P (d)
100 Rs
0.10
5 10
0.10
0.10
5
p 90 Rs
0.10
5 10
0.10
0.08
5
p
50 ratio D/P (c)
100 Rs
0.10
2.5 10
0.10
0.10
2.5
p 85 Rs
0.10
2.5 10
0.10
0.08
2.5
p
25 Ratio D/P (b)
100 Rs
0.10
0 10
0.10
0.10
0
p 80 Rs
0.10
0 10
0.10
0.08
0
p
Zero ratio D/P (a)
=

+
= =

+
=
=
=

+
= =

+
=
=
=

+
= =

+
=
=
=

+
= =

+
=
=
=

+
= =

+
=
=
Gordons Model
Another theory which contends that dividends are relevant is Gordons model. This
model, which opines that dividend policy of a firm affects its value, is based on the
following assumptions:
1. The firm is an all-equity firm. No external financing is used and investment
programmes are financed exclusively by retained earnings.
2. r and k
e
are constant.
3. The firm has perpetual life.
4. The retention ratio, once decided upon, is constant. Thus, the growth rate, (g = br)
is also constant.
5. k
e
> br.
Dividend Capitalisation Model
According to Gordon, the market value of a share is equal to the present value of future
streams of dividends. A simplified version of Gordons model can be symbolically
expressed as
( )
firm. equity - all an of investment on return of rate rate Growth g br
capital of rate/cost tion Capitalisa k
dividends as d distribute earnings of percentage i.e. ratio, D/P b 1
retained. earnings of percentage or ratio Retention b
share per Earnings E
share a of Price whereP
br k
b 1 E
p
e
e
= = =
=
=
=
=
=

= ) 11 (
Example 3
The following information is available in respect of the rate of return on investment
(r), the capitalisation rate (k
e
) and earnings per share (E) of Hypothetical Ltd.
r = 12 per cent
E = Rs 20
Determine the value of its shares, assuming the following:
D/P ratio (1 b) Retention ratio (b) k
e
(%)
(a)
(b)
(c)
(d)
(e)
(f)
(g)
10
20
30
40
50
60
70
90
80
70
60
50
40
30
20
19
18
17
16
15
14
Solution
The value of shares of Hypothetical Ltd for different D/P and retention ratios is
depicted in Table 3.
Table 3: Dividend Policy and Value of Shares of Hypothetical Ltd (Gordons Model)
( )
( )
( )
( )
( )
( )
( )
134.62 Rs
0.036 - 0.14
0.3 - 1 20 Rs
P
0.036 0.12 x 0.3 br 30 ratio Retention 70 ratio (g)D/P
117.65 Rs
0.048 - 0.15
0.4 - 1 20 Rs
P
0.048 0.12 x 0.4 br 40 ratio Retention 60 ratio (f)D/P
100 Rs
0.072 - 0.17
0.5 - 1 20 Rs
P
0.060 0.12 x 0.5 br 50 ratio Retention 50 ratio (e)D/P
81.63 Rs
0.072 - 0.17
0.6 - 1 20 Rs
P
0.72 0.12 x 0.6 br 60 ratio Retention 40 ratio (d)D/P
62.50 Rs
0.084 - 0.18
0.7 - 1 20 Rs
P
0.084 0.12 x 0.7 br 70 ratio Retention 30 ratio (c)D/P
42.55 Rs
0.096 - 0.19
0.8 - 1 20 Rs
P
0.096 0.12 0.8 br 80 ratio Retention 20 ratio (b)D/P
21.74 Rs
0.108 0.20
0.9 - 1 20 Rs
P
0.108 0.12 x 0.9 br(g) 90 ratio Retention 10 ratio (a)D/P
= =
= =
= =
= =
= =
= =
= =
= =
= =
= =
= =
= =
=

=
= =
Irrelevance of Dividends
Dividend
Dividend refers to the corporate net profits distributed
among shareholders.
The crux of the argument supporting the irrelevance of
dividends to valuation is that the dividend policy of a firm is
a part of its financing decision. As a part of the financing
decision, the dividend policy of the firm is a residual
decision and dividends are a passive residual.
Residual Dividend
Residual dividend policy pays out only excess cash.
Dividends are irrelevant, or are a passive residual, is
based on the assumption that the investors are
indifferent between dividends and capital gains. So
long as the firm is able to earn more than the equity-
capitalisation rate (k
e
), the investors would be content
with the firm retaining the earnings. In contrast, if the
return is less than the k
e
, investors would prefer to
receive the earnings (i.e. dividends).
Modigliani and Miller (MM)
Hypothesis
The most comprehensive argument in support of the
irrelevance of dividends is provided by the MM
hypothesis. Modigliani and Miller maintain that
dividend policy has no effect on the share price of
the firm and is, therefore, of no consequence.
Dividend Irrelevance
Dividend irrelevance implies that the value of a firm
is unaffected by the distribution of dividends and is
determined solely by the earning power and risk of
its assets.
( )
( )
( )
( )
25,00,000 Rs
1.10
27,50,000 Rs
2,50,000
5,00,000 Rs 105 Rs
21
75,000
1
25,000
)
e
k (1
E I
1
P n n
0
nP
firm, the of Value (iv)
Shares
21
75,000
105 Rs
3,75,000 Rs
n
issued, be to shares additional of Number (iii)
3,75,000 Rs 1,25,000 Rs - 2,50,000 Rs - 5,00,000 Rs
1
nD E I
1
nP
shares, new of issue the from raised be to required Amount (ii)
1
P 105
1
P 5 Rs 110
1
P 5 Rs
1.10
1
100 Rs
1
P
1
D
e
k 1
1
0
P
1, year of end the at share per Price (i)
= = +
+ =
+
+ +
=
= =
= =
=
=
+ =
+ =
+
+
=
(

|
.
|

\
|
|
.
|

\
|
|
.
|

\
|
: Paid Are Dividends When Firm, the of Price (a)
( )
( )
25,00,000 Rs
1.1
27,50,000 Rs
2,50,000 Rs 5,00,000 Rs 110 Rs
11
25,000
1
25,000
firm the of Value (iv)
shares
11
25,000
110 Rs
2,50,000 Rs
issued, be to shares additional of Number (iii)
2,50,000 Rs 2,50,000 Rs - 5,00,000 Rs
1
n shares, new of issue the form raised be to required Amount (ii)
1
P 110 or /1.10
1
P 100 Rs 1, year the of end the at share per Price (i)
= =
+
(

+ =
= =
= =
= =
Paid Not Are Dividends When Firm the of Value (b)
Assumptions
The MM hypothesis of irrelevance of dividends is based on the
following critical assumptions:
1) Perfect capital markets in which all investors are rational.
There are no taxes. Alternatively, there are no differences in tax
rates applicable to capital gains and dividends.
2) A firm has a given investment policy which does not change.
There is a perfect certainty by every investor as to future
investments and profits of the firm.
Crux of the Argument
The crux of the MM position on the irrelevance of dividend is the arbitrage
argument. The arbitrage process involves a switching and balancing
operation. In other words, arbitrage refers to entering simultaneously into
two transactions which exactly balance or completely offset each other. The
two transactions here are the acts of paying out dividends and raising
external fundseither through the sale of new shares or raising additional
loansto finance investment programmes.
Proof: MM provide the proof in support of their argument in the following
manner.
Step 1: The market price of a share in the beginning of the period is equal
to the present value of dividends paid at the end of the period plus the
market price of share at the end of the period. Symbolically,
( )
( )
1 period of end the at share a of price Market P
1 period of end the at received be to Dividend D
capital equity of Cost k
share a of price market Prevailing whereP
(1) P D
k 1
1
P
1
1
e
0
1 1
e
0
=
=
=
=
+
+
=
Step 2: Assuming no external financing, the total capitalised value of the
firm would be simply the number of shares (n) times the price of each
share (P
0
). Thus,
( )
) 2 (
1
nP
1
nD
e
k 1
1
0
nP +
+
=
Step 3: If the firms internal sources of financing its investment
opportunities fall short of the funds required, and n is the number of
new shares issued at the end of year 1 at price of P
1
, Eq. 2 can be written
as:
( )
( ) ( ) | | ) 3 ( nP P n n nD
k 1
1
nP
1 1 1
e
0
A A + +
+
=
where n = Number of shares outstanding at the beginning of the period
n = Change in the number of shares outstanding during the
period/Additional shares issued
Equation 3 implies that the total value of the firm is the capitalised value
of the dividends to be received during the period plus the value of the
number of shares outstanding at the end of the period, considering new
shares, less the value of the new shares. Thus, in effect, Eq. 3 is
equivalent to Eq. 2.
Step 4: If the firm were to finance all investment proposals, the
total amount raised through new shares issued would be given in
Eq. 4.
nP
1
= I (E nD
1
)
or nP
1
= I E + nD
1
(4)
where nP
1
= Amount obtained from the sale of new shares of
finance capital budget.
I = Total amount/requirement of capital budget
E = Earnings of the firm during the period
nD
1
= Total dividends paid
(E nD
1
) = Retained earnings
According to Equation 4, whatever investment needs (I) are not
financed by retained earnings, must be financed through the sale
of additional equity shares.
Step 5: If we substitute Eq. 4 into Eq. 3 we derive Eq. 5.
( )
( ) ( )
( )
( )
( )
( )
(6)
e
k 1
E I
1
P n n
0
nP
have then We cancels.
1
nD Therefore, .
1
nD negative and
1
nD positive a is There
e
k 1
1
nD E I
1
P n n
1
nD
0
nP
have we 5 eq. Solving
5)
1
nD E I
1
P n n
1
nD
e
k 1
1
0
nP
+
+ +
=
+
+ + +
=
+ + +
+
= (
Step 6: Conclusion Since dividends (D) are not found in Eq. 6, Modigliani
and Miller conclude that dividends do not count and that dividend policy
has no effect on the share price.
Example 1
A company belongs to a risk class for which the approximate
capitalisation rate is 10 per cent. It currently has outstanding 25,000
shares selling at Rs 100 each. The firm is contemplating the
declaration of a dividend of Rs 5 per share at the end of the current
financial year. It expects to have a net income of Rs 2,50,000 and
has a proposal for making new investments of Rs 5,00,000. Show
that under the MM assumptions, the payment of dividend does not
affect the value of the firm.
Solution
30 - 22
SOLVED PROBLEMS
SOLVED PROBLEM 1
(a) X company earns Rs 5 per share, is capitalised at a rate of 10 per cent and has a
rate of return on investment of 18 per cent.
According to Walters model, what should be the price per share at 25 per cent
dividend payout ratio? Is this the optimum payout ratio according to Walter?
(b) Omega company has a cost of equity capital of 10 per cent, the current market
value of the firm (V) is Rs 20,00,000 (@ Rs 20 per share). Assume values for I (new
investment), Y (earnings) and D (dividends) at the end of the year as I = Rs
6,80,000, Y = Rs 1,50,000 and D = Re 1 per share. Show that under the MM
assumptions, the payment of dividend does not affect the value of the firm.
( )
( )
80 Rs
0.10
1.25 Rs - 5.0 Rs
0.10
0.18
1.25 Rs
e
k
D E
e
k
r
D
P ) a (
Solution
= =
+
=
(

This is not the optimum dividend payout ratio because Walter suggests a zero
per cent dividend payout ratio in situations where r > k
e
to maximise the value
of the firm. At this ratio, the value of the share would be maximum, that is, Rs
90.
( )
( )
( )
( )
6,30,000 Rs 1,00,000) Rs 1,50,000 (Rs 6,80,000 Rs )
1
nD - (Y I : financing new for required (ii)Amount
1
P 21 Rs
1
P
20 Rs
1
P 21 Rs
1.10
1 Re
1
P
20 Rs
1
D
1
P
e
k 1
1

0
P : year the of end the at share the of price (i)Market
: s) assumption (MM paid are dividends when firm, the of (b)Value
= =
= =
+
=
= =
+
=
+
+
=
10 . 1
1 Re
( )
( ) | |
20,00,000
1.10
1,00,000 Rs 1,50,000 Rs 6,80,000 Rs 21 Rs 30,000 1,00,000 1,00,000 Rs
nD1] - Y I -
1
n) (n
1
[nD
e
k 1
1
: firm the of (iv)Value
shares 30,000
21 Rs
6,30,000 Rs
: issued be to shares of r (iii)Numbe
=
+ + +
+ + +
+
=
= =
5,30,000 Rs 1,50,000 Rs - 6,80,000 Rs )
1
nD - (Y - I : financing new for required (ii)Amount

1
P 22 Rs ,
1.10
Zero
1
P
20 Rs : year the of end the at share the of price (i)Market
: paid not are dividends when firm the of (c)Value
= =
=
+
=
firm the of value the affect not does dividend
paid, not are dividends when and paid are dividends when situations the both in 20,00,000, Rs is firm the of value the Since
20,00,000 Rs
1.10
1,50,000 Rs 6,80,000 Rs - 22 Rs
22
5,30,000
1,00,000
] Y I -
1
Dn)P [(n
e
k 1
1
: firm the of (iv)Value
shares
22 Rs
5,30,000 Rs
issued be to shares new of Number (iii)
=
+
(

+
=
+ +
+
=
=
SOLVED PROBLEM 2
From the following information supplied to you, determine the theoretical market
value of equity shares of a company as per Walters model:
Earnings of the company Rs 5,00,000
Dividends paid 3,00,000
Number of shares outstanding 1,00,000
Price earning ratio 8
Rate of return on investment 0.15
Are you satisfied with the current dividend policy of the firm? If not, what should be
the optimal dividend payout ratio in this case?
( )
( )
zero. be should case, the of facts the given ratio, payout dividend optimal The policy. dividend current the with satisfied not are we No,
43.20 Rs
0.125
3 Rs 5 Rs
0.125
0.15
3 Rs
e
k
D E
e
k
r
D
P
Solution
=

+
=
+
=
Working Notes
(i) k
e
is the reciprocal of P/E ratio = 1/8 = 12.5 per cent
(ii) E = Total earnings Number of shares outstanding
(iii) D = Total dividends Number of shares outstanding
Determinants of Dividend Policy
Dividend Payout ratio ( Constant DPS,
Constant D/P ratio, Stable rupee dividend
plus extra dividend)
Stability of dividends
Legal, contractual and internal constraints
Owners considerations
Capital market considerations
Inflation