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Dividend Policy and Share Value

Introduction

The dividend policy of a company determines what proportion of earnings is distributed to the shareholders by way of dividends, and what proportion is ploughed back for reinvestment purposes. Since the main objective of financial management is to maximise the market value of equity shares, one key area of study is the relationship between the dividend policy and market price of equity shares.

There are four models available to show the above relationship, these are briefly described as follows:

Traditional model: according to this model founded by Graham and Dodd, the market price of the shares will increase when a company declares a dividend rather than when it does not. Quantitatively P=m (D+E/3)

Where:

P is the market price per share

M is a multiplier

D is the dividend per share

E is the earning per share

Walter model: according to this model founded by James Walter, the dividend policy of a company has an impact on the share valuation.

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

Where:

P, D, E have the same connotations as above and r is the internal rate of return on the investments and k is the cost of capital.

The impact of dividend payment on the share price is studied by comparing the rate of return with the cost of capital.

  • When r>k, the price per share increases as the payout ratio decreases (optimal payout ratio is nil)
  • When r=k, the price per share does not vary with the changes in the payout ratio (optimal payout ratio does not exist)
  • When r<k, the price per share increases as the payout ratio increases (optimal payout ratio is 100%)

Gordon model: according to this model founded by Myron Gordon, the dividend policy of the company has an impact on share valuation.

Quantitatively P= Y (1-b)/(k-br)

Where P is the price per share

Y is the earnings per share

b is the retention ratio

1-b is the payout ratio

br is the growth rate

r is the return on investment

k is the rate of return required by shareholders

On comparing r and k, the relationship between market price and the payout ratio is exactly the same as compared to the Walter model.

MM model: according to this model, as founded by Miller and Modiliani, the market price of the share does not depend on the dividend payout, i.e. the dividend policy is irrelevant. This model explains the irrelevance of the dividend policy in the following manner:

When profits are used to declare dividends, the market price increases. But at the same time there is a fall in the reserves for reinvestment. Hence for expansion, the company raises additional capital by issuing new shares. Increase in the overall number of shares, will lead to a fall in the market price per share. Hence the shareholders would be indifferent towards the dividend policy.

   

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