9.
Dividend decision and Valuation of
the Firm
9.1. Introduction
Two basic
schools of thoughts on dividend policy have been expressed in the theoretical
literature of finance. One school, associated with Myron Gordon and John
Lintner, holds that the capital gains expected from earnings retention are more
risky than are dividend expectations. Accordingly, this school suggested that
the earnings of a firm with a low payout ratio will typically be capitalized at
higher rates than the earnings of a high payout firm. The other school
associated with Merton Miller & Franco Modigliani, holds that investors are
basically indifferent to returns in the form of dividends or capital gains.
Empirically, when firms raise or lower their dividend, their stock prices tend
to rise or fall in like manner; does this not prove that investors prefer
dividends?
The term
dividend refers to that portion of profit (after tax) which is distributed
among the owners/shareholders of the firm and the profit which is not
distributed is known as retained earnings. A company may have preference share
capital as well as equity share capital and dividends may be paid on both types
of capital. However there is no decision involved as far as the dividend
payable to preference shareholders is concerned. The reason being that the
preference dividend is more or less, a contractual liability and is payable at
a fixed rate. On the other hand a firm has to consider a lot of factors before
deciding for the equity dividend. The dividend decision may seem simple enough,
but it evokes a surprising amount of controversy, which we will deal with
later.
The
dividend decision is one of the three basic decisions which a financial manager
may be required to take, the other two being the investment and financing
decisions.
In dividend decision the financial
manager is concerned to decide one or more of the following:
·
Should the profits be ploughed back
to finance the investments decisions?
·
Whether any dividend be paid? If
yes, how much dividends be paid?
·
When these dividend be paid?
Interim or Final?
·
In what form the dividends be paid?
Cash Dividend or Bonus Share?
All these
decisions are inter related and have bearing on the future growth plans of the
firm. If a firm pays dividend, it affects the cash flow position of the firm
but earns goodwill among the investors who therefore, may be willing to provide
additional funds for the financing of investment plans of the firm. On the
other hand, the profits which are not distributed as dividends become an easily
available source of funds at no explicit cost. Every aspects of the decision is
to be critically evaluated. The most important of these considerations is to
decide as to what portion of profit should be distributed. This is also known
as the dividend payout ratio.
While deciding
the dividend payout ratio the firm should consider the effect of such policy on
the objective of maximization of shareholders wealth. If the dividend is
expected to increase the market value of the share the dividend must be paid,
otherwise, the profits may be retained and used as an internal source of
finance. So, the firm must find out and establish a relationship between the
dividend policy and the market value of the share. There are conflicting views
on the relationship between the dividend policy and value of the firm.
Dividend policy and Value of the Firm
Dividend
policy is basically concerned with deciding whether to pay dividend in cash
now, or to pay increased dividends at a later stage or distribution of profits
in the form of bonus shares. The current dividend provides liquidity to the
investors but the bonus share will bring capital gains to the shareholders. The
investor’s preference between the current cash dividend and the future capital
gain has been viewed differently. Some are of the opinion that the future gain
are more risky than the current dividends while others argue that the investors
are indifferent between the current dividend and the future capital gains.
Various
models have been proposed to evaluate the dividend policy decision in relation
to value of the firm. While agreement is not found among the models as to the
precise relationship, it is still worthwhile to examine some of these models to
gain insight into the effect which the dividend policy might have on the market
price of the share and hence on the wealth of the shareholders. Two schools of
thoughts have emerged on the relationship between the dividend policy and value
of the firm.
One school
associated with Walter, Gordon, etc holds that the future capital gains are
more risky and the investors have preference for current dividends. The
investors do have a tilt towards those firms which pay regular dividend. So,
the dividend affects the market value of the share and as a result the dividend
policy is relevant for the overall value of the firm. On the other hand, the
other school of thought associated with Modigliani and Miller holds that the
investors are basically indifferent between current cash dividends and capital
gains. Both these schools of thought on the relationship between dividend
policy and value of the firm have been discussed as follows:
9.2
Relevance of Dividend Policy
Generally,
the firms pay dividend and view such dividend payments positively. The
investors also expect and like to receive dividend income on their investments.
The firm not paying dividends may be adversely rated by the investors thereby
affecting the market value of the share. The basic argument of those supporting
the dividend relevance is that because current cash dividends reduce investor’s
uncertainty, the investors will discount the firm’s earnings at a lower rate. Ke,
thereby placing a higher value on the shares. If the dividends are not paid
then the uncertainty of shareholders/investors will increase, raising the
required rate, ke, resulting in relatively lower market value of the
share and the value of the firm. The market price of the share will increase if
the firm pays dividends, otherwise it may decrease. A firm must therefore pay
dividend to shareholders to fulfil the expectations of the shareholders in
order to maintain or increase the market price of the share.
Two models
representing this argument are discussed below:
9.2.1.
Walter’s Model
Walter J.E.
supports the view that the dividend policy has a bearing on the market price of
the share and has presented a model to explain the relevance of dividend policy
for valuation of the firm based on the following assumptions:
·
All investment proposals of the
firm are to be financed through retained earnings only and no external finance
is available to the firm.
·
The business risk complexion of the
firm remains same even after fresh investment decisions are taken. In other
words, the rate of return on investment i.e. ‘r’ and the cost of capital of the
firm i.e. ke, are constant.
·
The firm has an infinite life.
This model
considers that the investment decisions and dividend of a firm are
interrelated. A firm should or should not pay dividends upon whether it has got
the suitable investment opportunities to invest the retained or not.
The model
is presented below:
If a firm
pays dividend to shareholders, they in turn, will invest this income to get
further returns. This expected return to shareholder is the opportunity cost of
the firm and hence the cost of capital, ke, to the firm. On the
other hand, if the firm does not pay dividends, and instead retains, then these
retained earnings will be reinvested by the firm to get return on these
retained earnings will be reinvested by the firm to get return on these
investment. This rate of return on the investment, r. Of the firm must be at
least equal to the cost of capital, ke. If r= ke, the
firm is earning a return just equal to what the shareholders could have earned
had the dividends been paid to them.
However,
what happen if the rate of return, r, is more than the cost of capital, ke?
In such case, the firm can earn more by retaining the profits, than the
shareholders can earn by investing their dividend income. The Walter’s model,
thus says that if r>ke, the firm should refrain from should
reinvest the retained earnings and thereby increase the wealth of the
shareholders. However, if the investment opportunities before the firm to
reinvest the retained earnings are expected to give a rate of return which is
less than the opportunity cost of the shareholders of the firm, then the firm
should better distribute the entire profits. This will give opportunity to the
shareholders to reinvest this dividend income and get higher returns.
In a
nutshell, therefore, the dividend policy of a firm depends upon the
relationship between r & k. If r>ke (a case of a growth
firm), the firm should have zero payout and reinvest the entire profits to earn
more than the investors. If however, r<ke, then the firm should
have 100% payout ratio and let the shareholders reinvest their dividend income
to earn higher returns, if ‘r’ happens to be just equal to ke, the
shareholders will be indifferent whether the firm pays dividends or retain the
profits. In such a case, the returns of the firm from reinvesting the retained
earnings will be just equal to the earnings available to the shareholders on
their investment of dividend income.
Thus, a
firm can maximise the market value of its share and the value of the firm by
adopting a dividend policy as follows:
·
If r>ke, the payout
ratio should be zero
·
If r<ke, the payout
ratio should be 100% and the firm should not retain any profit, and
·
If r=ke, the dividend is
irrelevant and the dividend policy is not expected to affect the market value
of the share.
In order to testify the above, Walter has suggested a
mathematical valuation model i.e.,
P = D + (r/ke)
(E-D)
Ke ke
Where,
P = Market price of
equity share
D = Dividend per
share paid by the firm.
R = Rate of return on
investment of the Firm
Ke = Cost
of Equity share capital, and
E = Earnings per
share of the firm.
As per the above formula,
the market price of a share is the sum of two components i.e.,
·
The present value of an infinite
stream of dividends, and
·
The present value of an infinite
stream of return from retained earnings.
Thus, the
Walter’s formula shows that the market value of a share is the present value of
the expected stream of dividends and capital gains. The effect of varying
payout ratio on the market price of the share under different rate of returns,
r, have been shown below:
The
following information is available in respect of Axis Ltd.
Earning per
share (EPS or E) $ 10
Cost of
Capital, ke, 10%
Find out
the market price of the share under different rate of return, r, of 8%, 10%,
and 15% for different payouts of 0%, 40%, 80% and 100%.
Answer:
The market
price of the share as per Walter’s Model may be calculated for different
combinations of rates and dividend payout ratios (the earnings per share, E,
and the cost of capital, ke, taken as constant) as follows:
If the rate
of return, r= 15% and the dividend payout ratio is 40%, then
P = D + (r/ke)
(E-D)
Ke ke
= 40 + 90
= 130
Similarly,
if r= 8% and dividend Payout ratio = 80%, then
P = 80+ 16
= 96
The
expected market price of the share under different combinations of ‘r’ and ke
have been calculated and presented in the table below:
r = 15% 10% 8%
D/P Ratio 0% $150 $100 $80
40% 130
100 88
80% 110
100 96
100% 100
100 100
It may be
seen from the table that for a growth firm (r= 15% and r>ke), the
market price is highest at $ 150 when the firm adopts a zero payout and retains
the entire earnings. As the payout increases gradually from 0% to 100%, the
market price tends to decrease from $ 150 to $ 100 and the firm retains no
profit. However if r=ke= 10%, then the price is constant at $ 100
for different payouts ratios. Such a firm does not have any optimum ratio and
every payout ratio is good as any other.
Critical Appraisal
The
Walter’s model provides a theoretical and simple frame work to explain the
relationship between policy and value of the firm. As far as the assumptions
underlying the model hold well, the behaviour of the market price of the share
in response to the dividend policy of the firm can be explained with the help
of this model.
However,
the limitation of this model is that these underlying assumptions are too
unrealistic. The financing of investments proposals only by retaining earnings
and no external financing is seldom found in real life. The assumption of
constant ‘r’ and constant ‘ke’ is also unrealistic and does not hold
good. As more and more investment is made, the risk complexion of the firm will
change and consequently the ke may not remain constant.
9.2.2.
Gordon’s Model
Myron
Gordon has also proposed a model suggesting that the dividend is relevant and
can affect the value of the share and that of the firm. This model is also
based on the assumptions similar to that Walter’s model. However, two additional
assumptions made by this model are as follows:
·
The growth rate of firm ‘g’ is the
product of retention ratio, b, and its rate of return, r, i.e., r= br, and
·
The cost of capital besides being
constant is more than the growth rate i.e., ke>g
Gordon argues that the investors do have a preference
for current dividends and this is a direct relationship between the dividend
policy and the market value of the share. The basic premise of the model is
that the investors are basically risk averse and they evaluate the future
dividends/ capital gains as a risky and uncertain proposition. Dividends are
more predictable than capital gains; management can control dividends but it
cannot dictate the market price of the share. Investors are certain of
receiving incomes 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 dividend more highly than an expected
future capital gain.
So, the “bird in the hand” argument of this model
suggests that the dividend policy is relevant as the investors prefer current
dividends as against the future uncertain capital gains. When the investors are
certain about their returns, they discount the firms earning at a lower rate
and therefore, placing a higher value for the share and that of the firm. So,
the investors require a higher rate of return as retention rate increases and
this would adversely affect the share price.
Thus, Gordon’s Model is a share
valuation model. Under this model, the market price of a share can be
calculated as follows:
P = E
(1-b)
ke- br
Where,
P = Market price of equity share
E = Earnings per share of the firm
B = Retention ratio (1- payout ratio)
R = Rate of return on investment of the firm
Ke
= Cost of Equity share capital, and
Br = g i.e., Growth rate of the firm
This model shows that there is a
relationship between payout ratio (i.e., 1-b), cost of capital ke,
rate of return, r, and the market value of the share. This can be explained
with the help of the following example:
The
following information is available in respect of Axis Ltd.
Earning per
share (EPS or E) $ 10
Cost of
Capital, ke, 10%
Find out
the market price of the share under different rate of return, r, of 8%, 10%,
and 15% for different payouts of 0%, 40%, 80% and 100%.
ANSWER:
The market
price of the share as per Gorden’s model may be calculated as follows:
If r=15%
and payout ratio is 40%, then the retention ratio, b, is .6 (i.e. 1-.4) and the
growth rate, g= br= .09 (i.e., .6*.15) and the market price of the share is
P = E (1-b)
ke- br
P =
10(1-.6)/.10-.09
P = $ 400
If r= 8%
and payout ratio is 80%, then the retention ratio, b, .2 (i.e., 1-.8) and the
growth rate, g=br=.016 (i.e., .2*.08) and the market price of the share is
P = 10(1-.2)//10-.016
P = $ 95
Similarly
the expected market price under different combinations of ‘r’ and dividend
payout ratio have been calculated and shown below:
r = 15% 10% 8%
D/P Ratio 0%
0 0 0
40% $400
$100 $77
80% 114.3 100 95
100% 100
100 100
On the
basis of figures given in the table above, it can be seen that if the firm
adopts a zero payout then the investor may not be willing to offer any price.
For a growth firm (i.e., r>ke>br), the market price decreases
when the payout is increased. For a firm having r<ke, the market
price increases when the payout is increased.
If r=ke,
the dividend policy is irrelevant and the market price remains constant at $100
only. Gordon had also argued that even if r=ke, the dividend payout
ratio matters and the investors being risk averse prefer current dividends
which are certain to future capital gains which are uncertain. The investors
will apply a higher capitalization rate i.e., ke to discount the
future capital gains. This will compensate them for the future uncertain
capital gain and thus, the market price of the share of a firm which retains
profit will be adversely affected.
9.3
Irrelevance of dividend policy
The other school of thought on dividend policy and
valuation argues that what a firm pays as dividend to shareholders is
irrelevant and the shareholders are indifferent about receiving current
dividends receiving capital in future. The advocates of this school of thought
argue that the dividend policy has no effect on the market price of a share.
The shareholders do not differentiate between the present dividend or future
capital gains. They are basically interested in higher returns earned either by
the firm by investing profits in profitable investment opportunity or earned by
them by making investment of dividend income.
The conclusion that dividends are not relevant is
based on two pre conditions:
·
That investment and financing
decisions are already being made and that these decisions will not be altered
by the amount of dividend payments.
·
That the perfect capital market is
there in which an investor can buy and sell the shares without any transaction
cost and that the companies can issue shares without any flotation cost.
Two theories have been discussed below to focus the
irrelevance of dividend policy for valuation of the firm though it is well
accepted that like the capital structure irrelevance proposition, the dividend
irrelevance argument has its roots in the Modigliani-Miller Analysis.
9.3.1
Residuals theory of Dividends
This theory is based on the assumption that either he
eternal financing is not available to the firm or if available, cannot be used
due to its excessive costs of financing the profitable investment opportunities
of the firm. Therefore, the firm finances its investments decisions by
retaining profits. The quantum of profits to be distributed is a balancing figure
and thus depends upon what portions of profits to be retained. If a firm has
sufficient profitable investment opportunities, then the wealth of the
shareholders will be maximised by retaining profits and reinvesting them in the
financing of investment opportunities either by reducing dividend or even by
paying no dividend to the shareholder. If a firm has no such investment
opportunity, then the profits may be distributes among the shareholders.
Thus firm does not decide how much dividends to be
paid rather it decide as to how much profits should be retained. The dividends
are a distribution of residual profits after retaining sufficient profit for
financing the available opportunities. This is referred to as Residuals Theory
of Dividends.
9.3.2
Modigliani and Miller Approach
The residuals theory of dividends tends to imply that
the dividends are irrelevant and the value of the firm is independent of its
dividend policy. The irrelevance of dividend policy for a valuation of the firm
has been most comprehensively presented by Modigliani and Miller. They have
argued that the market price of a share is affected by the earnings of the firm
and not influenced by the pattern of income distribution. What matters, on the
other hand, is the investment decisions which determine the earnings of the
firm and thus affect the value of the firm. They argue that subject to a number
of assumptions, the way a firm splits its earnings between dividends and
retained earnings has no effect on the value of the firm.
Assumption
of the MM approach
The MM approach to irrelevance of dividend is based on
the following assumptions:
·
The capital markets are perfect and
the investors behave rationally.
·
All information is freely available
to all the investors.
·
There is no transaction cost.
·
Securities are divisible and can be
split into any fraction. No investor can affect the market price.
·
There are no taxes and no flotation
cost.
·
The firm has a defined investment
policy and the future profits are known with certainty. The implication is that
the investment decisions are unaffected by the dividend decision and the
operating cash flows are same no matter which dividend policy is adopted.
The model
Under the assumptions stated above, MM argue that
neither the firm paying dividends nor the shareholders receiving the dividends
will be adversely affected by firms paying either too little or too much
dividends. They have used the arbitrage process to show that the division of
profits between dividends and retained earnings is irrelevant from the point of
view of the shareholders. They have shown that given the investment
opportunities, a firm will finance these either by ploughing back profits of if
pays dividends, then will raise an equal amount of new share capital externally
by selling new shares. The amount of dividends paid to existing shareholders
will be replaced by new share capital raised externally.
In order to satisfy their model, MM has started with
the following valuation model.
P0=
1* (D1+P1)/ (1+ke)
Where,
P0
= Present market price of the share
Ke
= Cost of equity share capital
D1
= Expected dividend at the end of year
1
P1
= Expected market price of the share
at the end of year 1
With the help of this valuation
model we will create a arbitrage process, i.e., replacement of amount paid as
dividend by the issue of fresh capital. The arbitrage process involves two
simultaneous actions. With reference to dividend policy the two actions are:
·
Payment of dividend by the firm
·
Rising of fresh capital.
With the help of arbitrage process,
MM have shown that the dividend payment will not have any effect on the value
of the firm. Even if the firm pays dividends, resulting in a increase in market
value of the share, the effect on the value of the firm will be neutralised by
the decrease in terminal value of the share. The working of the arbitrage
process is substantiated as follows:
Suppose
a firm has 100000 shares outstanding and is planning to declare a dividend of
$5 at the end of current financial year. The present market price of the share
is $100. The cost of equity capital, ke, may be taken at 10%. The
expected market price at the end of the year 1 may be found under two options:
·
If dividend of $5 is paid
·
If dividend is not paid
When
Dividend of $5 is paid (the value of D1 is 5) :
P0
= (D1 + P1)/
(1+ ke)
P0
(1+ ke) = D1 + P1
P1
= P0 (1+ ke)
– D1
= 100(1.10) – 5
= 105
So, the
market price is expected to be $105, if the firm pays dividend of $5
When,
Dividend of $5 is not pain (the value of D1 is 0):
P0 = (D1 + P1)/ (1+ ke)
P0 (1+ ke) = D1 + P1
P1 = P0 (1+ ke) – D1
= 100(1.1)
= 110
So,
the market price of the share is expected to be $110, if the firm does not pay
any dividend.
However,
in both the cases, the position of the shareholders would be the same. A
shareholder having for example 1 share will be having same worth of his holding
if the firm pays dividend or not. In case, the dividend of $5 is paid, he will
receive $5 from the firm as dividend and the market price of the share would be
$105, giving a total worth of $110. In case, the dividend is not paid then the
market price of the share or the worth of the shareholder would be still $110.
So, the shareholder would be indifferent if dividend is paid or not to him. The
same example can be extended further to analyze the effect of arbitrage
employed by the firm.
Say,
the firm has total profits of $1000000 during the year 1 and is planning to
make an investment of $2000000 at the end of the year 1. The arbitrage process
and value of the firm may be explained as follows:
·
If
dividend of $5 is paid by the firm at the end of year 1:
Total
Earnings $1000000
Dividends
Paid (100000 * $5) $500000
Retained
Earnings $500000
Total
funds required for investment $2000000
Therefore,
fresh capital to be issued $1500000
Market
price at the end of year 1 $105
Number
of shares to be issued (1500000/105) 14285.71
Total
number of shares (100000+14285.71) 114285.71
Applying
the formula, the value of the firm, nP0 is
nP0 = [(n
+ m)P1 – I +E] / (1+ ke)
= [(114285.71)105 – 2000000 +
1000000] / (1.10)
= $10000000
·
If
dividend of $5 is not paid by the firm at the end of the year 1:
Total
earnings $1000000
Dividends
Paid -
Retained
Earnings $1000000
Total
funds required for investment $2000000
Therefore,
fresh capital to be issued $1000000
Market
price at the end of year 1 $110
Number
of share to be issued (1000000/110) 9090.9
Total
number of shares (100000+9090.0) 109090.9
Applying
the formula, the value of the firm, nP0 is
nP0 = [(n
+ m) P1 – I +E] / (1+ ke)
= [(109090.9)110
– 2000000 + 1000000]
= $10000000
So,
the value of the firm remains same at $10000000 if the dividend is paid or not.
With the help of above process, it can be showed that dividend policy is
irrelevant for the valuation of the firm. Dividend payment does not affect the
value of the firm.
It
should be noted that, the formula used above, gives the current market value of
the firm. The MM model shows that if dividend is paid or not at the end of
current year, the present market value of the firm remains same at $10000000.
The same example can be applied to find out the expected market value of the
firm at the end of current year as follows:
·
If
dividend of $5 is paid
Total
number of shares 114285.71
Market
price $105
Total
market value $12000000
·
If
dividend of $5 is not paid
Total
number of shares 109090.90
Market
price $110
Total
market value $12000000
Thus,
the expected market value remains same at $12000000, whether the firm pays
dividend of $5 or not. The MM Model shows therefore, that the current market
value or the expected market value of the firm, both are unaffected by the
dividend decision of the firm.
Critical Appraisal
Under
the assumptions set by MM, this model testifies that dividend is irrelevant and
the investors are indifferent between the current dividends and the future
capital gains. Given these assumptions, the effect of a dividend decision may
be stated as: that there is not relationship between dividend policy and value of
the share. One dividend policy is as good as other. Investors are concerned
only with the total returns and are indifferent if these returns are from
dividend income or capital gains. That is, to finance the growth, the firm may
choose to issue shares and thereby allowing profits to be used to pay dividend,
or may use internally generated funds for financing the growth and thereby
paying less in dividends and not issuing any shares.
9.3.3
Conclusion
The
discussion of different models is indicative of the fact that investors do
prefer current dividends to retained earnings. The reason for this is obvious
that the present dividends are certain. Investors assign higher value to
certain stream of dividends. A financial manager should also recognize the
existence of different types of investors. A low payout and consequently higher
retention with higher growth will attract and satisfy the risk oriented
investors while the high payout and consequently low retention and low growth
rate will attract and satisfy the risk averse and conservative investors.
Therefore,
neither 100% payout nor 0% payout will bring the maximum market price. The
optimum point lies somewhere in between. Too much payment in spite of
reinvestment opportunities causes the investor to penalize the share price
while too little payout also causes the investors to penalise the share price.
Still the dividend payout ratio should be lower among the firms having good
growth opportunities than the dividend payout ratio among those firms which
have less opportunities of growth.