In this article, we will go through the approaches of dividend policy which are useful for commerce and management students.
Definition: The Dividend Policy is a financial decision that refers to the proportion of the firm’s earnings to be paid out to the shareholders. Here, a firm decides on the portion of revenue that is to be distributed to the shareholders as dividends or to be ploughed back into the firm.
The amount of earnings to be retained back within the firm depends upon the availability of investment opportunities. To evaluate the efficiency of an opportunity, the firm assesses a relationship between the rate of return on investments “r” and the cost of capital “K.”
As per the dividend models, some practitioners believe that the shareholders are not concerned with the firm’s dividend policy and can realize cash by selling their shares if required. While the others believed that, dividends are relevant and have a bearing on the share prices of the firm. This gave rise to the following models:
- Miller and Modigliani theory – Dividend Irrelevance Theory
- Walter`s MODEL-dividend relevance Theory
- Gordon`s model- dividend relevance Theory
As long as returns are more than the cost, a firm will retain the earnings to finance the projects, and the shareholders will be paid the residual dividends i.e. the earnings left after financing all the potential investments. Thus, the dividend payout fluctuates from year to year, depending on the availability of investment opportunities.
Miller and Modigliani theory on Dividend Policy
Definition: According to Miller and Modigliani Hypothesis or MM Approach, dividend policy has no effect on the price of the shares of the firm and believes that it is the investment policy that increases the firm’s share value.
The investors are satisfied with the firm’s retained earnings as long as the returns are more than the equity capitalization rate “Ke”. What is an equity capitalization rate? The rate at which the earnings, dividends or cash flows are converted into equity or value of the firm. If the returns are less than “Ke” then, the shareholders would like to receive the earnings in the form of dividends.
Miller and Modigliani have given the proof of their argument, that dividends have no effect on the firm’s share price, in the form of a set of equations, which are explained in the content below:
Assumptions of Miller and Modigliani Hypothesis
- There is a perfect capital market, i.e. investors are rational and have access to all the information free of cost. There are no flotation or transaction costs, no investor is large enough to influence the market price, and the securities are infinitely divisible.
- There are no taxes. Both the dividends and the capital gains are taxed at the similar rate.
- It is assumed that a company follows a constant investment policy. This implies that there is no change in the business risk position and the rate of return on the investments in new projects.
- There is no uncertainty about the future profits, all the investors are certain about the future investments, dividends and the profits of the firm, as there is no risk involved.
Criticism of Miller and Modigliani Hypothesis
- It is assumed that a perfect capital market exists, which implies no taxes, no flotation, and the transaction costs are there, but, however, these are untenable in the real life situations.
- The Flotation cost is incurred when the capital is raised from the market and thus cannot be ignored since the underwriting commission, brokerage and other costs have to be paid.
- The transaction cost is incurred when the investors sell their securities. It is believed that in case no dividends are paid; the investors can sell their securities to realize cash. But however, there is a cost involved in making the sale of securities, i.e. the investors in the desire of current income has to sell a higher number of shares.
- There are taxes imposed on the dividend and the capital gains. However, the tax paid on the dividend is high as compared to the tax paid on capital gains. The tax on capital gains is a deferred tax, paid only when the shares are sold.
- The assumption of certain future profits is uncertain. The future is full of uncertainties, and the dividend policy does get affected by the economic conditions.
Thus, the MM Approach posits that the shareholders are indifferent between the dividends and the capital gains, i.e., the increased value of capital assets.
Definition: According to the Walter’s Model, given by prof. James E. Walter, the dividends are relevant and have a bearing on the firm’s share prices. Also, the investment policy cannot be separated from the dividend policy since both are interlinked.
Walter’s Model shows the clear relationship between the return on investments or internal rate of return (r) and the cost of capital (K). The choice of an appropriate dividend policy affects the overall value of the firm. The efficiency of dividend policy can be shown through a relationship between returns and the cost.
- If r>K,the firm should retain the earnings because it possesses better investment opportunities and can gain more than what the shareholder can by re-investing. The firms with more returns than a cost are called the “Growth firms” and have a zero payout ratio.
- If r<K,the firm should pay all its earnings to the shareholders in the form of dividends, because they have better investment opportunities than a firm. Here the payout ratio is 100%.
- If r=K,the firm’s dividend policy has no effect on the firm’s value. Here the firm is indifferent towards how much is to be retained and how much is to be distributed among the shareholders. The payout ratio can vary from zero to 100%.
Assumptions of Walter’s Model
- All the financing is done through the retained earnings; no external financing is used.
- The rate of return (r) and the cost of capital (K) remain constant irrespective of any changes in the investments.
- All the earnings are either retained or distributed completely among the shareholders.
- The earnings per share (EPS) and Dividend per share (DPS) remains constant.
- The firm has a perpetual life.
Criticism of Walter’s Model
- It is assumed that the investment opportunities of the firm are financed through the retained earnings and no external financing such as debt, or equity is used. In such a case either the investment policy or the dividend policy or both will be below the standards.
- The Walter’s Model is only applicable to all equity firms. Also, it is assumed that the rate of return (r) is constant, but, however, it decreases with more investments.
- It is assumed that the cost of capital (K) remains constant, but, however, it is not realistic since it ignores the business risk of the firm, that has a direct impact on the firm’s value.
Note: Here, the cost of capital (K) = Cost of equity (Ke), because no external source of financing is used.
Definition: The Gordon’s Model, given by Myron Gordon, also supports the doctrine that dividends are relevant to the share prices of a firm. Here the Dividend Capitalization Model is used to study the effects of dividend policy on a stock price of the firm.
Gordon’s Model assumes that the investors are risk averse i.e. not willing to take risks and prefers certain returns to uncertain returns. Therefore, they put a premium on a certain return and a discount on the uncertain returns. The investors prefer current dividends to avoid risk; here the risk is the possibility of not getting the returns from the investments.
But in case, the company retains the earnings; then the investors can expect a dividend in future. But the future dividends are uncertain with respect to the amount as well as the time, i.e. how much and when the dividends will be received. Thus, an investor would discount the future dividends, i.e. puts less importance on it as compared to the current dividends.
According to the Gordon’s Model, the market value of the share is equal to the present value of future dividends. It is represented as:
P = [E (1-b)] / Ke-br
Where, P = price of a share
E = Earnings per share
b = retention ratio
1-b = proportion of earnings distributed as dividends
Ke = capitalization rate
Br = growth rate
Assumptions of Gordon’s Model
- The firm is an all-equity firm; only the retained earnings are used to finance the investments, no external source of financing is used.
- The rate of return (r) and cost of capital (K) are constant.
- The life of a firm is indefinite.
- Retention ratio once decided remains constant.
- Growth rate is constant (g = br)
- Cost of Capital is greater than br
Criticism of Gordon’s Model
- It is assumed that firm’s investment opportunities are financed only through the retained earnings and no external financing viz. Debt or equity is raised. Thus, the investment policy or the dividend policy or both can be sub-optimal.
- The Gordon’s Model is only applicable to all equity firms. It is assumed that the rate of returns is constant, but, however, it decreases with more and more investments.
- It is assumed that the cost of capital (K) remains constant but, however, it is not realistic in the real life situations, as it ignores the business risk, which has a direct impact on the firm’s value.
Thus, Gordon model posits that the dividend plays an important role in determining the share price of the firm.