RELEVANCE OF DIVIDENDS Homework Help

RELEVANCE OF DIVIDENDS

In sharp contrast to the MM position, there are some theories that consider dividend decisions be an active variable in determining the value of a firm. The dividend decision is, therefore, relevant. We critically examine below two theories representing this notion: (i) Walter’s Model and (ii) Gordon’s Model.

Walter(s) Model

Proposition Walter’s model’? supports the doctrine that dividends are relevant. The investment policy of a firm cannot be separated from its dividends policy and both are, according to Walter interlinked. The choice of an appropriate dividend policy affects the value of an enterprise.

The key argument in support of the relevance proposition of Walter’s model is the relationship between the return on a firm’s investment or its internal rate of return r and its cost of capital and the required rate of return (k). The firm would have an optimum dividend policy which will be determined by the relationship of r and k. In other words, if the return on investments exceeds the cost of capital, the firm should retain the earnings, whereas it should distribute the earnings to the shareholders in case the required rate of return exceeds the expected return on the firms  investments. The rationale is that if r < k, the firm is able to earn more than what the shareholders could by reinvesting, if the earnings are paid to them. The implication of r < k is that shareholders can earn a higher return by investing elsewhere.

Walter’s model, thus, relates the distribution of dividends (retention of earnings) investment opportunities. If a firm has adequate profitable investment opportunities, it to earn more than what the investors expect so that r > k. Such firms may be called growths firms. For growth firms, the optimal dividend policy would be given by a DIP ratio of zero. That is to say, the firm should plough back the entire earnings within the firm. The market value of the shares will be maximised as a result.

In contrast, if a firm docs not have profitable investment opportunities (when r < k), the shareholders will be better of if earnings are paid out to them so as to enable them to earn a higher return by using the funds elsewhere. In such a case, the market price of shares will be maximized by the distribution of the entire earnings as dividends. A DIP ratio of 100 would give an optimum dividends policy.

Finally, when r = k(normal firms), it is a matter of indifference whether earnings are retained or distributed. This b so because for all D,P ratios (ranging between zero and 100) the market price of shares will remain constant. For such firms, there is no optimum dividend policy (D/P ratio).

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