# Dividend Decisions – CA Inter FM Notes

Dividend Decisions– CA Inter FM Notes is designed strictly as per the latest syllabus and exam pattern.

## Dividend Decisions– CA Inter FM Notes

1. Theories of Dividend: 2. Modigliani and Miller (MM) Hypothesis (1961): MM approach is in support of the irrelevance of dividends Le. firm’s dividend policy has no effect on either the price of a firm’s stock or its cost of capital.

Assumptions:

• Perfect capital markets
• No taxes or no tax discrimination
• Fixed investment policy
• No floatation or transaction cost
• Risk of uncertainty does not exist

Steps in Practical Problems:
Step 1: Calculate P1:
P0 = $$\frac{\mathrm{P}_1+\mathrm{D}_1}{1+\mathrm{K}_{\mathrm{e}}}$$ or P0
Step 2: Calculate New Shares (∆n) required to be issued:
∆n = $$\frac{\text { Funds Required }}{\mathrm{P}_1}$$ = $$\frac{\mathrm{I}-(\mathrm{E}-\mathrm{D})}{\mathrm{P}_1}$$
Step 3: Calculate Value of Firm (nP0):
nP0 = $$\frac{(\mathrm{n}+\Delta \mathrm{n}) \mathrm{P}_1-\mathrm{I}+\mathrm{E}}{1-\mathrm{K}_{\mathrm{c}}}$$ 3. Walter Model: Walter approach is in support of the relevance of dividends le. firm’s dividend policy has effect on either the price of a firm’s stock or its cost of capital.

Assumptions:

• All investment proposals of the firm are to be financed through retained earnings only
• ‘r’ rate of return & ‘Ke‘ cost of capital are constant
• Perfect capital markets
• No taxes or no tax discrimination between dividend income and capital appreciation (capital gain)
• No floatation or transaction cost
• The firm has perpetual life

Formula:
Market Price of Share (P) = $$\frac{\mathrm{D}+\frac{\mathrm{r}}{\mathrm{K}_{\mathrm{e}}}(\mathrm{E}-\mathrm{D})}{\mathrm{K}_{\mathrm{e}}}$$
Where,
P = Market Price of the share
E = Earnings per share
D = Dividend per share
Ke = Cost of equity/rate of capitalization/discount rate
R = Internal rate of return/return on investment

 Company ‘r’ VS ‘Ke‘ Optimum Dividend Payout Growth r > Ke Zero Constant r = Ke Every payout ratio is optimum Decline r < Ke 100% 4. Gordon ‘s Model: According to Gordon’s model dividend is relevant and dividend policy of a company affects its value.

Assumptions:

• Firm is an all equity firm.
• IRR will remain constant.
• Ke will remains constant.
• Retention ratio (b) is constant i.e. constant dividend payout ratio will be followed
• Growth rate (g = br) is also constant.
• Ke > g
• All investment proposals of the firm are to be financed through retained earnings only.

Formulae of MPS {Gordon’s Model or Dividend Discount Model (DDM)}:
Situation 1: Zero Growth or Constant Dividend:
P0 = $$\frac{\mathrm{D}}{\mathrm{K}_{\mathrm{e}}}$$

Situation 2: Constant Growth:
P0 = $$\frac{D_1}{\mathrm{~K}_{\mathrm{e}}-\mathrm{g}}$$ or = $$\frac{\mathrm{D}_0(1+\mathrm{g})}{\mathrm{K}_{\mathrm{e}}-\mathrm{g}}$$
g = b (earning retention ratio) × r (IRR or ROE)

Situation 3: Variable Growth:

• Phase 1: Very High Growth
• Phase 2: High Growth
• Phase 3: Average Growth equal to industry

P0 = Present Value of all future benefit from share
Note: Calculation of Intrinsic value of share and MPS of share are same

 Company ‘r’ VS ‘Ke‘ Optimum Dividend Payout Growth r > Ke Zero Constant r = Ke Every payout ratio is optimum Decline r < Ke 100% 5. The ‘Bird-in-hand theory’: Myron Gordon revised his dividend model and considered the risk and uncertainty in his model. The Bird-in-hand theory of Gordon has two arguments:

• Investors are risk averse and
• Investors put a premium on certain return and discount on uncertain return.

Investors are rational, they want to avoid risk and uncertainty. They would prefer to pay a higher price for shares on which current dividends are paid. Conversely, they would discount the value of shares of a firm which postpones dividends. The discount rate would vary with the retention rate.

6. Traditional Model: According to the traditional position expounded by Graham & Dodd, the stock market places considerably more weight on divi-dends than on retained earnings. Their view is expressed quantitatively in the following valuation model:
P = m $$\left(D+\frac{E}{3}\right)$$
Where,
P = Market price per share
D = Dividend per share
E = Earnings per share
M = a multiplier 7. John Linter’s Model: Linter’s model has two parameters:

• The target payout ratio,

D1 = D0 + [(EPS × Target payout) – D0] × Af
Where,
D1 = Dividend in year 1
D0 = Dividend in year 0 (last year dividend)
EPS = Earnings per share 