Dividend and Valuation
Dividend and Valuation
Dividend and Valuation
Irrelevance of dividends
General
Assumptions
Where,
Where,
Above equation 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 new shares.
Step .4. If the firm were to finance all investment proposals, the total
amount raised through new shares will be –
∆nP1 = I – E + nD1
Where,
Step .6. Conclusion: Since dividends are not found in the above
equation, MM conclude that dividends do not count and that
dividend policy has no effect on the share price.
Example:
Solution:
Thus, whether dividends are paid or not the value of the firm
remains the same.
MM assumes that capital markets are perfect. This implies that there
are no taxes; no flotation cost exists and there is absence of
transaction cost.
Tax Effect
While the first type of tax is payable by investors when the firm pays
dividends, the capital gain tax is related to retention of earnings.
From an operational point of view capital gains tax is:
Flotation Costs
The another assumption of MM hypothesis is the absence of
flotation cost, according to MM given the investment decision of the
firm, external funds would have to be raised, equal to the amount of
dividend, through the sale of new shares to finance the investment
programme. The two methods of financing are not the perfect
substitutes because of flotation costs. The introduction of such cost
will imply that the net proceeds from the sale of new shares would
be less than face value of the shares, depending on their size. It
means that to be able to make use of external funds, equivalent to
dividend payments, the firm would have to sell shares for an amount
excess of retained earnings.
Institutional Restrictions
Resolution of Uncertainty
Underpricing
Relevance of Dividends
Walter’s Model
According to formula:
P = (D + r/ke(E – D)/ke
Where,
Assumed rate of return on investments (r): (i) 15, (ii) 8 and (iii) 10.
We have to calculate the effect of dividend policy on the market
price of shares, using walter’s model.
Solution:
Limitations
Gordon’s Model
Another theory which supports the relevance of dividends is
Gordon’s Model. This theory as Walter’s also support that dividend
policy of a firm affects its value.
Arguments
P = E( 1 – b)/(ke – br)
Where,
P = Price of a share
Example:
P = E( 1 – b)/(ke – br)
(b)D/P ratio = 20
P = E( 1 – b)/(ke – br)
(c) 62.50
(d 81.63
)
(e) 100
(f) 117.65
(g) 134.62
(i) Factors
(ii) Bonus shares (Stock Dividend) and Stock splits
(iii) Legal, procedural and tax aspects.
Factors
(b)Stability of dividends
Why investors would prefer a stable dividend policy and pay a higher
price for a firm’s shares which observes stability in dividends
payments?
Legal Requirements
Capital impairment
Net profits and
Insolvency
Contractual Requirements
Internal Constraints
Liquid Assets
Growth Prospects
Financial Requirements
Availability of Funds
Earning Stability
Control
Owner’s Consideration
Inflation
From the above table it is clear that a share split is similar to bonus
issue from the economic point of view though there are some
differences from accounting point of view. In the equity portion of
the firm, a bonus issue reduces the retained earnings and
correspondingly increases paid-up equity and share premium, if any,
whereas stock/share split has no such effect. The economic effect of
both is to increase the number of equity shares outstanding.
Rationale