Dividend Decision

DIVIDEND
DECISION
Topics
1.Introduction to Dividend
2. Irrelevance Theory
Decision
3. MM Theory 4. Relevance Theory
5. Walter’s Model 6. Gordon’s Model

INTRODUCTION TO
DIVIDEND DECISION
• Dividends: A company’s earnings distributed to shareholders, in
cash or stock.
• Importance of Dividend Decisions: Impacts stock price, investor
confidence, and financial health.
Overview of Theories:
• Relevance Theories: Dividends influence a firm’s value (e.g.,
Gordon’s Model).
• Irrelevance Theories: Dividends do not affect a firm’s value (MM
Theory).
Irrelevance Theory
Overview
Introduction to the Irrelevance Theory:
1 The Irrelevance Theory of dividends, proposed by Franco Modigliani and Merton Miller (MM
Theory), argues that in a perfect market, the dividend policy of a firm does not affect its value.
Key Proponents: Franco Modigliani and Merton Miller (MM Theory):

2 Modigliani and Miller’s 1961 paper on dividend policy asserts that the market value of a firm is
determined by its earning power and risk of its underlying assets, not by the way it distributes
dividends.
Main Idea: Dividend Policy Does Not Affect the Value of the Firm:
3 According to MM Theory, investors are indifferent between dividends and capital gains, because
they can create "homemade dividends" by selling portions of their portfolio. Thus, dividend policy
is irrelevant in determining the value of the company under perfect market conditions (no taxes,
transaction costs, or asymmetric information).
MM Theory (Modigliani-Miller)
• The Modigliani-Miller (MM) Theory, proposed by Franco
Modigliani and Merton Miller in 1958, explains the impact of
capital structure on a firm's value.
• It argues that under certain conditions, the firm's market value
is not affected by its dividend policy or financing decisions.
Key Assumptions
• No Taxes: Assumes no corporate or personal income taxes.
• No Transaction Costs: No costs involved in trading securities.
• Perfect Capital Markets: All investors have access to the same
information, and securities are fairly priced.
MM Theory
Applications
Proposition I
• The firm’s total value is determined solely by its
assets, not by how those assets are financed
(through equity or debt).
• Dividend decisions do not impact the overall value of
the firm.
Proposition II
• In the presence of taxes, increasing debt can lower
the cost of capital due to tax shields on interest.
• Suggests a firm’s leverage can affect its risk and,
subsequently, the cost of equity.
Introduction to
Relevance
Theory
Key Idea:
• Dividends affect a firm's value by influencing investor decisions.
• Dividend policy matters according to proponents like John
Lintner and Myron Gordon.
Why Dividends Matter:

• Dividends provide certainty to shareholders, reducing perceived
risk.
• Shareholders often prefer dividends now rather than uncertain
future capital gains.
JESSICA
Bird in Hand Argument
Main Concept:
• “A bird in the hand is worth two in the bush”—
investors prefer the certainty of dividends.
• Dividends reduce the risk of uncertain future returns,
giving shareholders immediate, tangible gains.
Impact:
• By paying dividends, companies can increase their stock
price, as investors value the certainty of returns.
JESSICA
Signaling Effect and
Investor Preferences
Dividends act as a signal of financial health. Stable or
rising dividends suggest confidence in future earnings.
Investor Preferences:
• Many investors, especially those seeking steady
income, prefer companies with consistent dividend
payouts.
• This demand can raise the company’s stock price,
linking dividend policy to firm value.
JESSICA
WALTER’S MODEL
Walter’s Model of Dividend
Relevance
• Walter’s model explains the relevance of dividend
policy in a firm's valuation.
• It emphasizes the relationship between the Return on

Investment (r) and Cost of Capital (k).
• The model assumes that a firm's internal financing is

more significant than external financing. • P = Price of the share
• D = Dividends
• E = Earnings per share
D + r( E - • r = Return on Investment
P= K
D) • k = Cost of Capital
Application of Walter's Model
The model determines the optimal dividend payout ratio

1
based on the firm’s ROI and cost of capital.
2 If r > k, firms should retain earnings to maximize shareholder

value.
If r < k, firms should distribute dividends since returns on
3
reinvestment would not cover capital costs.
Graphical Representation
Impact & Limitations of Walter’s Model
IMPACT
Firms with high ROI benefit from retaining earnings, while firms with low ROI
should distribute dividends.
LIMITATIONS
• Assumes constant r and k over time.
• Ignores external financing and taxation effects.
Gordon's
Model
Gordon Growth Model (GGM), is a financial model used to value
a company based on the assumption that dividends grow at a
constant rate. Proposed by Myron Gordon, it calculates a stock's
intrinsic value and is a key part of dividend discount models in
corporate finance.
Key Assumptions of Gordon's Model:

Constant Growth Rate: The dividends paid by the
company are assumed to grow at a constant rate indefinitely.
Perpetuity: The model assumes that the company will

continue to exist and pay dividends forever.
Cost of Capital (Ke): The required rate of return for

shareholders remains constant over time.
Retention and Reinvestment: A portion of earnings is

retained and reinvested to support future growth.
Dividend Decision in
Gordon's Model
Gordon’s Model suggests that dividends and dividend
policy significantly impact a company’s valuation. A higher
dividend payout increases stock value, as investors prefer
immediate returns. The model also highlights the balance
between retaining earnings for growth and paying
dividends, influencing stock valuation.
Retention Ratio: Gordon’s model also touches on the payout ratio

and retention ratio. Companies can either retain their earnings for
growth (retention) or distribute them as dividends.
Limitations of Gordon's
Model
• Constant Growth Assumption: The model assumes a
constant growth rate of dividends, which may not be realistic,
especially for firms with fluctuating earnings.
• Stable Business Environment: It is best suited for mature

companies with stable dividend policies and consistent growth.
It may not be applicable to young companies or those in
dynamic industries.
• Ke > g: The model only works when the required return on

equity (Ke) is greater than the growth rate (g). If Ke ≤ g, the
model gives unrealistic results.
Conclusion
• Dividend policy plays a crucial role in determining a firm's financial
strategy and value.
• Irrelevance Theories (MM Theory) argue that dividends do not affect

firm value under ideal market conditions.
• Relevance Theories (Walter, Gordon, Lintner) emphasize that dividends

impact firm value due to investor preferences, signaling effects, and
certainty of returns.
• Firms must balance retaining earnings for growth and paying dividends
to shareholders, taking into account market conditions and investor
expectations.
ThankYou
Kunal Shenoy - A123
Jessica Joy - A119
Saswati Panda - A120
Varad Moradiya - A137
Kushagra Mehrotra - A117

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DIVIDEND

3. MM Theory 4. Relevance Theory

5. Walter’s Model 6. Gordon’s Model

Key Proponents: Franco Modigliani and Merton Miller (MM Theory):

Why Dividends Matter:

• It emphasizes the relationship between the Return on

• The model assumes that a firm's internal financing is

The model determines the optimal dividend payout ratio

2 If r > k, firms should retain earnings to maximize shareholder

Key Assumptions of Gordon's Model:

Perpetuity: The model assumes that the company will

Cost of Capital (Ke): The required rate of return for

Retention and Reinvestment: A portion of earnings is

Retention Ratio: Gordon’s model also touches on the payout ratio

• Stable Business Environment: It is best suited for mature

• Ke > g: The model only works when the required return on

• Irrelevance Theories (MM Theory) argue that dividends do not affect

• Relevance Theories (Walter, Gordon, Lintner) emphasize that dividends

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