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Dividend Policy and Firm Value

This document discusses two models of the relationship between dividend policy and firm value: the Walter model and Gordon model. Both models assume the rate of return on investments is constant and the cost of equity is constant. The Walter model also assumes the firm is all-equity financed and has an infinite life. Both models show that for a growth firm, the optimal dividend payout ratio is zero, for a normal firm the payout ratio is irrelevant, and for a declining firm the optimal payout ratio is 100%.

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Krishan Borwal
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98 views10 pages

Dividend Policy and Firm Value

This document discusses two models of the relationship between dividend policy and firm value: the Walter model and Gordon model. Both models assume the rate of return on investments is constant and the cost of equity is constant. The Walter model also assumes the firm is all-equity financed and has an infinite life. Both models show that for a growth firm, the optimal dividend payout ratio is zero, for a normal firm the payout ratio is irrelevant, and for a declining firm the optimal payout ratio is 100%.

Uploaded by

Krishan Borwal
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Dividend policy and firm value

Introduction
Dividend policy what proportion of

earnings is paid to shareholders by the way


of dividends and what proportion is
ploughed back in the firm for reinvestment
A higher payout may cause shrinkage in
funds available for reinvestment -> higher
dependence on external borrowing
Objective is to maximise the market value
of equity shares
Key question: What is the relationship
between dividend policy and market price

Models in which dividend policy and firm

value are related


1. Walter model
2. Gordon model

Walter model - assumptions


Firm is all equity financed -> firm will rely

only on retained earnings for future


investment decisions -> investment decision
is dependent on dividend decision
The rate of return on investments is constant
The firm has an infinite life

Walter model valuation


formula
P = (D+(E-D)r/k) / k
P = price per share
D = dividend per share
E = earnings per share
E-D = retained earnings per share
r = rate of return on investment
k = cost of equity capital

Walter model valuation


formula
P = D/k + ((E-D)r/k)/k
Component 1 = D/k = PV of infinite stream

of dividends
Component 2 = ((E-D)r/k)/k = PV of infinite
returns from retained earnings

Walter model - implications


Growth firm: r>k : the price per share

increases as the dividend payout ratio


decreases
Normal firm : r=k : the price per share does
not vary with changes in dividend payout
ratio
Declining firm : r<k : the price per share
increases as the dividend payout ratio
increases
In nut shell:
Growth firm: optimal payout ratio is

zero
Normal firm: optimal payout ratio is

Gordon model - assumptions


Retained earnings are the only source of

financing for the firm -> investment


decision and dividend decision are related
Rate of return on firms investment is
constant
The growth rate of firm is product of its
retention ratio and its rate of return
The cost of capital is constant and it is
greater than the growth rate
The firm has perpetual life
Taxes do not exist

Gordon model valuation


formula
P0 = E1(1-b)/(k-br)
P0 : price per share at the end of year 0
E1: Earnings per share at the end of year 1
(1-b) : fraction of earnings the firm

distributes by the way of dividends


b = fraction of earnings the firm retains
k = rate of return required by the
shareholders
r = rate of return earned on the
investments
br = growth rate of earnings and dividends

Gordon model - implications


Growth firm: r>k : the price per share increases as

the dividend payout ratio decreases


Normal firm : r=k : the price per share does not
vary with changes in dividend payout ratio
Declining firm : r<k : the price per share increases
as the dividend payout ratio increases
In nut shell:
Growth firm: optimal payout ratio is zero
Normal firm: optimal payout ratio is irrelevant
Declining firm: optimal payout ratio is 100%

Implications of both Walter and Gordon model are


same

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