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<p>State True or False?</p>
The value of the firm can be maximized if the shareholders wealth is maximized. There are conflicting views regarding the impact of dividend decision on valuation of the firm. According to one school of thought, dividend decision does not affect shareholders wealth and hence the valuation of firm. On other hand, according to other school of thought dividend decision materially affects the shareholders wealth and also valuation of the firm. We have discussed below the views of two schools of thought under two groups:
1. The Relevance Concept of Dividend a Theory of Relevance.
2. The Irrelevance Concept of Dividend or Theory of Irrelevance.
The Relevance Concept of Dividend
The advocates of this school of thought include Myron Gordon, James Walter and Richardson. According to them dividends communicate information to the investors about the firm’s profitability and hence dividend decision becomes relevant. Those firms which pay higher dividends will have greater value as compared to those which do not pay dividends or have a lower dividend pay out ratio. It holds that dividend decisions affect value of the firm.
Two theories representing this notion: (i) Walter’s Approach and (ii) Gordon’s Approach.
(i) Walter’s Approach: Prof. Walter’s model is based on the relationship between the firms (a) return on investment i.e. r and (b) the cost of capital or required rate of return i.e. k.
According to Prof. Walter, If r>k i.e. if the firm earns a higher rate of return on its investment than the required rate of return, the firm should retain the earnings. Such firms are termed as growth firm’s and the optimum pay-out would be zero which would maximize value of shares.
In case of declining firms which do not have profitable investments i.e. where r<k,< span=""> the shareholder would stand to gain if the firm distributes it earnings. For such firms, the optimum payout would be100% and the firms should distribute the entire earnings as dividend.</k,<>
In case of normal firms where r=k the dividend policy will not affect the market value of shares as the shareholders will get the same return from the firm as expected by them. For such firms, there is no optimum dividend payout and value of firm would not change with the change in dividend rate.
Assumptions of Walter’s model
(i) The firm has a very long life.
(ii) Earnings and dividends do not change while determining the value.
(iii) The Internal rate of return ( r ) and the cost of capital (k) of the firm are constant.
(iv) The investments of the firm are financed through retained earnings only and the firm does not use external sources of funds.
Criticism of Walter’s Model
Walter’s model has been crticised on account of various assumptions made by Prof Walter in formulating his hypothesis.
(i) The basic assumption that investments are financed through retained earnings only is seldom true in real world. Firms do raise fund by external financing.
(ii) The internal rate of return i.e. r also does not remain constant. As a matter of fact, with increased investment the rate of return also changes.
(iii) The assumption that cost of capital (k) will remain constant also does not hold good. As a firm’s risk pattern does not remain constant, it is not proper to assume that (k) will always remain constant.
(ii)Gordon’s Approach :Another theory which contends that dividends are relevant is Gordon’s model. This model which opinions that dividend policy of a firm affects its value is based on following assumptions:-
1. The firm is an all equity firm. No external financing is used and investment programmes are financed exclusively by retained earnings.
2. r and ke are constant.
3. The firm has perpetual life.
4. The retention ratio, once decided upon, is constant. Thus, the growth rate, (g=br) is also constant.
5. ke >br
Gordon argues that the investors do have a preference for current dividends and there is a direct relationship between the dividend policy and the market value of share. He has built the model on basic premise that investors are basically risk averse and they evaluate the future dividend/capital gains as a risky and uncertain proposition. Investors are certain of receiving incomes from dividend than from future capital gains. The incremental risk associated with capital gains implies a higher required rate of return for discounting the capital gains than for discounting the current dividends. In other words, an investor values current dividends more highly than an expected future capital gain.
Hence, the “bird-in-hand” argument of this model suggests that dividend policy is relevant, as investors prefer current dividends as against the future uncertain capital gains. When investors are certain about their returns they discount the firm’s earnings at lower rate and therefore placing a higher value for share and that of firm. So, the investors require a higher rate of return as retention rate increases and this would adversely affect share price.
The Irrelevance Concept of Dividend
The other school of thought on dividend policy and valuation of the firm argues that what a firm pays as dividends to share holders is irrelevant and the shareholders are indifferent about receiving current dividend in future. The advocates of this school of thought argue that dividend policy has no effect on market price of share. Two theories have been discussed here to focus on irrelevance of dividend policy for valuation of the firm which are as follows:
1. Residual’s Theory of Dividend
According to this theory, dividend decision has no effect on the wealth of shareholders or the prices of the shares and hence it is irrelevant so far as valuation of firm is concerned. This theory regards dividend decision merely as a part of financing decision because earnings available may be retained in the business for re-investment. But if the funds are not required in the business they may be distributed as dividends. Thus, the decision to pay dividend or retain the earnings may be taken as residual decision. This theory assumes that investors do not differentiate between dividends and retentions by firm. Their basic desire is to earn higher return on their investment. In case the firm has profitable opportunities giving higher rate of return than cost of retained earnings, the investors would be content with the firm retaining the earnings to finance the same. However, if the firm is not in a position to find profitable investment opportunities, the investors would prefer to receive the earnings in the form of dividends. Thus, a firm should retain earnings if it has profitable investment opportunities otherwise it should pay them as dividends.
Under the Residuals theory, the firm would treat the dividend decision in three steps:
Hence, in residual theory the dividend policy is influenced by (i) the company’s investment opportunities and (ii) the availability of internally generated funds, where dividends are paid only after all acceptable investment proposals have been financed. The dividend policy is totally passive in nature and has no direct influence on the market price of the share.
2. Modigliani and Miller Approach (MM Model)
Modigliani and Miller have expressed in the most comprehensive manner in support of theory of irrelevance. They maintain that dividend policy has no effect on market prices of shares and the value of firm is determined by earning capacity of the firm or its investment policy. As observed by M.M, “Under conditions of perfect capital markets, rational investors, absence of tax discrimination between dividend income and capital appreciation, given the firm’s investment policy, its dividend policy may have no influence on the market price of shares”. Even, the splitting of earnings between retentions and dividends does not affect value of firm.
Assumptions of MM Hypothesis
(1) There are perfect capital markets.
(2) Investors behave rationally.
(3) Information about company is available to all without any cost.
(4) There are no floatation and transaction costs.
(5) The firm has a rigid investment policy.
(6) No investor is large enough to effect the market price of shares.
(7) There are either no taxes or there are no differences in tax rates applicable to dividends and capital gains.
The Argument of MM
The argument given by MM in support of their hypothesis is that whatever increase in value of the firm results from payment of dividend, will be exactly off set by achieve in market price of shares because of external financing and there will be no change in total wealth of the shareholders. For example, if a company, having investment opportunities distributes all its earnings among the shareholders, it will have to raise additional funds from external sources. This will result in increase in number of shares or payment of interest charges, resulting in fall in earnings per share in future. Thus whatever a shareholder gains on account of dividend payment is neutralized completely by the fall in the market price of shares due to decline in expected future earnings per share. To be more specific, the market price of share in beginning of period is equal to present value of dividends paid at end of period plus the market price of shares at end of period plus the market price of shares at end of the period.
The dividends have no effect on the value of the firm when external financing is used. Given the firm’s investment decision, the firm has two alternatives, it can retain its earnings to finance the investments or it can distribute the earnings to the shareholders as dividends and can arise an equal amount externally. If the second alternative is preferred, it would involve arbitrage process. Arbitrage refers to entering simultaneously into two transactions which exactly balance or completely offset each other. Payment of dividends is associated with raising funds through other means of financing. The effect of dividend payment on shareholder’s wealth will be exactly offset by the effect of raising additional share capital. When dividends are paid to the shareholder, the market price of the shares will increase. But the issue of additional block of shares will cause a decline in the terminal value of shares. The market price before and after the payment of the dividend would be identical. This theory thus signifies that investors are indifferent about dividends and capital gains. Their principal aim is to earn higher on investment. If a firm has investment opportunities at hand promising higher rate of return than cost of capital, investor will be inclined more towards retention. However, if the expected return is likely to be less than what it would cost, they would be least interested in reinvestment of income. Modigiliani and Miller are of the opinion that value of a firm is determined by earning potentiality and investment policy and never by dividend decision.
Criticism of MM Approach
MM Hypothesis has been criticized on account of various unrealistic assumptions as given below.
1. Perfect capital markets does not exist in reality.
2. Information about company is not available to all persons.
3. The firms have to incur floatation costs which issuing securities.
4. Taxes do exit and there is normally different tax treatment for dividends and capital gains.
5. The firms do not follow rigid investment policy.
6. The investors have to pay brokerage, fees etc. which doing any transaction.
7. Shareholders may prefer current income as compared to further gains.
· Dividend decision is an important decision, which a financial manager has to take. It refers to that profits of a company which is distributed by company among its shareholders.
· There has been a difference of opinion on the effect of dividend policy on value of firm. Two schools of thought have emerged on relationship between dividend policy and value of firm.
· On one hand Walter model and Gordon model consider dividend as relevant for value of firm as investors prefer current dividend over future dividend.
· On other hand Residuals Approach and MM Model consider dividend is irrelevant for value of firm. The retention of profit for re-investment is important. MM Model have introduced arbitrage process to prove that value of firm remain same whether firm pays dividend or not.
To My opinion: False.
Following Fair Dividend Paying Policy of a firm enjoy More market value than for a firm with conservative dividend policy though the Book-value of share may increase due to retained earnings.
Dividend policy is concerned with financial policies regarding paying cash Dividend in the present or paying an increased dividend at a later stage. Whether to issue dividends, and what amount, is determined mainly on the basis of the company's unappropriated profit (excess cash) and influenced by the company's long-term earning power. When cash surplus exists and is not needed by the firm, then management is expected to pay out some or all of those surplus earnings in the form of cash dividends or to repurchase the company's stock through a share buyback program.
