Unit 4: Dividend Relevance

Dividend Relevance

Dividend relevance theory suggests that dividends affect the value of a firm and hence are important for shareholders and investors.

Supported by

• Walter’s Model
• Gordon’s Model

These models argue that investors prefer current dividends over future capital gains, especially if the company’s return on investment is high.

🧭 Factors Affecting Dividend Policy

Dividend policy = Company’s decision on how much profit to distribute as dividends and how much to retain for reinvestment.

🔑 Key Factors

Forms of Dividends

Companies can distribute profits in various forms:

• In Short, Dividend relevance theories suggest that dividend policy impacts firm value and investor perception.
• The right dividend policy balances shareholder satisfaction and future growth.
• Companies choose different forms of dividends based on cash availability, financial health, and strategic goals.

Types of Dividend Policies

Dividend Policy refers to the strategy a company follows in deciding how much of its profits to distribute as dividends and how much to retain for reinvestment.

1. Stable Dividend Policy

The company pays a fixed and regular dividend every year, regardless of fluctuations in profits.

🔹 Features

• May increase gradually over time.
• Provides confidence to investors.
• Maintains consistency.

🔹 Types

• Constant Dividend per Share
• Constant Payout Ratio
• Stable Rupee Dividend Plus Extra Dividend

✔️ Suitable for: Companies with stable and predictable earnings.

2. Constant Dividend Payout Ratio Policy

The company pays a fixed percentage of its earnings as dividend.

Example: If payout ratio = 40%, and earnings = ₹10 lakhs → Dividend = ₹4 lakhs

Features

• Dividend changes as profits change.
• Fluctuating income for shareholders.

✔️ Suitable for: Firms with fluctuating profits or growth-stage firms.

3. Residual Dividend Policy

Company pays dividends only after meeting its capital investment needs.

🔹 Features

• Priority to funding business growth.
• Dividend is residual = Profit – Retained earnings for investments.

✔️ Suitable for: Firms with many growth opportunities and need to reinvest profits.

4. No Dividend Policy

Company does not pay any dividend and retains all profits for reinvestment.

🔹 Features

• Focus on internal financing.
• May be due to low profits, expansion needs, or early business stage.

✔️ Suitable for: Startups or new businesses with high reinvestment requirements.

🧾 Comparison Table

• In Short, Dividend policy depends on profit stability, growth needs, investor expectations, and financial goals.
• Stable dividend policy is most preferred by investors.
• Residual policy focuses on maximizing internal growth

Walter’s Model (Dividend Relevance Theory)

🔹 Proposed by: Prof. James E. Walter

📌 Assumption: Dividends affect the value of the firm. The choice between dividend payout vs. reinvestment depends on the firm’s return (r) and cost of capital (k).

📐 Formula:

Where:

• P = Price of the share
• D = Dividend per share
• E = Earnings per share
• r = Internal rate of return
• k = Cost of capital

🔍 Implications:

Gordon’s Model (Bird-in-Hand Theory)

🔹 Proposed by: Myron Gordon

📌 Assumption: Investors prefer certain (current) dividends over uncertain (future) capital gains.

📐 Formula:

Where:

• P = Price of share
• E = Earnings per share
• b = Retention ratio
• r = Rate of return on reinvested earnings
• ke = Cost of equity

🔍 Implications

Miller and Modigliani (MM) Hypothesis (Dividend Irrelevance Theory)

🔹 Proposed by: Franco Modigliani & Merton Miller

📌 Assumption: Dividend policy has no effect on firm value or shareholders' wealth under ideal market conditions.

🧠 Key Assumptions:

• Perfect capital market
• No taxes or transaction costs
• No flotation costs
• Investors behave rationally
• Investment decisions are fixed

🧾 Explanation: According to MM, investors are indifferent between dividends and capital gains. The value of the firm depends only on its earning power and investment decisions, not on dividend decisions.

📐 Formula:

Where:

• 𝑃0 = Current market price of share
• 𝐷1= Dividend at end of year
• 𝑃1 = Price of share at end of year
• 𝑘𝑒 = Cost of equity

🔍 Comparison Table

Dividend Irrelevance Theory

🔹 Proposed by: Modigliani and Miller (MM)

📌 Core Idea: Dividend policy does NOT affect the value of the firm or shareholder wealth in a perfect market.

🧠 Assumptions:

• Perfect capital markets (no taxes, no transaction costs).
• Investors behave rationally.
• Investment decisions are fixed.
• No flotation cost or risk differences.

🔍 Explanation: Investors can create their own “dividend” by selling shares if they want cash. So whether a company pays dividends or reinvests profits, it doesn't impact the firm’s value.

🎯 Conclusion: Dividend policy is irrelevant in determining the market value of a firm.

Bird-in-Hand Theory

🔹 Proposed by: Myron Gordon & John Lintner

📌 Core Idea: Investors prefer current (certain) dividends over future (uncertain) capital gains.

🔍 Explanation: A “bird in hand” (current dividend) is better than “two in the bush” (future profits).

• Investors see future earnings as risky.
• So, firms that pay higher dividends are valued higher.

🎯 Conclusion: Dividend policy is relevant and higher dividends increase firm value.

Tax Preference Theory

🔹 Proposed by: R.H. Litzenberger & K. Ramaswamy

📌 Core Idea: Investors prefer capital gains over dividends due to lower tax rates on capital gains.

🔍 Explanation:

• Dividends are taxed as regular income.
• Capital gains are taxed later (and sometimes at a lower rate).
• Investors prefer firms that retain earnings and increase share price.

🎯 Conclusion:

• Low or no dividend payout is preferred by investors to minimize taxes.

🔍 Comparison Table