Usair Arshad Assignment 4

Name: Usair Arshad
Reg No : L1F17BASF0072
Some of the major different theories of dividend in financial management are as follows: 1.
Walter’s model 2. Gordon’s model 3. Modigliani and Miller’s hypothesis.
On the relationship between dividend and the value of the firm different theories have been
advanced.
Dividend relevance theories

These are theories whose propagators argue that the dividend policy of firm affects the
value of the firm there are two main theorists
James Walter (Walter model)
Myron Gordon (Gordon model)
1. Walter’s model:
Professor James E. Walterargues that the choice of dividend policies almost always affects
the value of the enterprise. His model shows clearly the importance of the relationship
between the firm’s internal rate of return (r) and its cost of capital (k) in determining the
dividend policy that will maximise the wealth of shareholders.
Walter’s model is based on the following assumptions:

1. The firm finances all investment through retained earnings; that is debt or new equity is
not issued;
2. The firm’s internal rate of return (r), and its cost of capital (k) are constant;
3. All earnings are either distributed as dividend or reinvested internally immediately.
4. Beginning earnings and dividends never change. The values of the earnings per share
(E), and the divided per share (D) may be changed in the model to determine results, but
any given values of E and D are assumed to remain constant forever in determining a given
value.
5. The firm has a very long or infinite life.
Walter’s formula to determine the market price per share (P)
P = D/K +r(E-D)/K/K
where, P = Market price per share;
D = Dividend per share;
E = Earnings per share;
r = Internal rate of return;
k = Cost of capital or capitalization rate.
In this proposition it is evident that the optimal D/P ratio is determined by varying ‘D’ until
and unless one receives the maximum market price per share.
The model divides the firm in three type

(a) When r > k (Growth Firms):
(b) When r<k (Declining Firms):
(c) When r = k (Normal Firms)
Criticism of Walter model

Model assumes investment decision of the firm are finances by retained earing alone
Model assume a constant rate of return and
Constant cost of capital disregard the firm risk which change over time
Walter’s model is quite useful to show the effects of dividend policy on an all equity firm
under different assumptions about the rate of return. However, the simplified nature of the
model can lead to conclusions which are net true in general, though true for Walter’s
model.
2. Gordon’s Model:
One very popular model explicitly relating the market value of the firm to dividend policy is
developed by Myron Gordon
The dividend discount model is a method of valuing stock shares-based fundamentals, that
is, based on facts and expectations about a company's business, future cash flows and likely
risks. Dividend valuation is one of the oldest and most conservative stock pricing methods
still widely taught and used.
The main proposition of the model is that the value of a share reflects the value of the
future dividends accruing to that share hence the dividend payment and its growth
are relevant in valuation of share
The model holds that the share market price is equal to the sum of share discounted future
dividend payment
Assumptions:
Gordon’s model is based on the following assumptions.
1. The firm is an all Equity firm
2. No external financing is available
3. The internal rate of return (r) of the firm is constant.
4. The appropriate discount rate (K) of the firm remains constant.
5. The firm and its stream of earnings are perpetual
6. The corporate taxes do not exist.
7. The retention ratio (b), once decided upon, is constant. Thus, the growth rate (g)
= br is constant forever.
8. K > br = g if this condition is not fulfilled, we cannot get a meaningful value for the
share.
P = E(1-B)/K-Br
P= price
E = earning per share
B = retention ratio
K = cost of capital Br
=g= growth rate
Conclusion of Gorden model

The market value of Po increase with retention ratio b for the firm with growth
opportunities when r>k
The market value is not affect by the dividend policy where r=k
The market value of the share Po increase with payout ratio (1-b) for decling firm with
Dividends Irrelevance theory

The propagators of this school of thought were France Modigliani and Merton miller
They state that the dividend policy employed by firm does not affect the value of the firm
they argue
That the value of the firm is dependent on the firm earning which result from its investment
policy such that when the policy is given the dividend policy is of no consequence
3. Modigliani and Miller’s hypothesis:
According to Modigliani and Miller (M-M), dividend policy of a firm is irrelevant as it does
not affect the wealth of the shareholders. They argue that the value of the firm depends
on the firm’s earnings which result from its investment policy.
Thus, when investment decision of the firm is given, dividend decision the split of earnings
between dividends and retained earnings is of no significance in determining the value of the
firm. M – M’s hypothesis of irrelevance is based on the following assumptions.
1. The firm operates in perfect capital market

2. Taxes do not exist
3. The firm has a fixed investment policy
4. Risk of uncertainty does not exist. That is, investors are able to forecast future prices and
dividends with certainty and one discount rate is appropriate for all securities and all time
periods. Thus, r = K = Kt for all t.
Under M – M assumptions, r will be equal to the discount rate and identical for all shares. As
a result, the price of each share must adjust so that the rate of return, which is composed of
the rate of dividends and capital gains, on every share will be equal to the discount rate and
be identical for all shares.
The same can be illustrated with the help of the following formula:
Dividend policy have no effect on the market price of share and the valuation of the firm
Po = D1+P1/1+Ke
Where Po = market price per share

D1 =dividend to be received at the end if the period
P1= market price per share at the end of the period
Ke = cost of equity capital or rate of capitalization
Criticism:
Because of the unrealistic nature of the assumption, M-M’s hypothesis lacks practical
relevance in the real-world situation. Thus, it is being criticised on the following grounds.
1. The assumption that taxes do not exist is far from reality.
2. M-M argue that the internal and external financing are equivalent. This cannot be true
if the costs of floating new issues exist.
3. According to M-M’s hypothesis the wealth of a shareholder will be same whether the firm
pays dividends or not. But, because of the transactions costs and inconvenience associated with
the sale of shares to realise capital gains, shareholders prefer dividends to capital gains.

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Name: Usair Arshad

Dividend relevance theories

Walter’s model is based on the following assumptions:

The model divides the firm in three type

Criticism of Walter model

Conclusion of Gorden model

Dividends Irrelevance theory

1. The firm operates in perfect capital market

Where Po = market price per share

1. The assumption that taxes do not exist is far from reality.

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