There is perfect certainty by every investor as to future investments and profits of the firm. The argue that the shareholders do not differentiate between the present dividend and the future capital gains and are basically interested in higher returns either earned by the firm by investing the profits in future profitable investments. The determinants of the market value of the share are the perpetual stream of future dividends to be paid, the cost of capitaland the expected annual growth rate of the company. If a company’s dividend policy affects the value of the business, it is considered relevant. Thus there are conflicting theories on dividends. Relevance of Dividend: Walter and Gordon suggested that shareholders prefer current dividends and hence a positive relationship exists between dividend and market value. M. Gorden, John Linter, James Walter and Richardson are associated with the relevance theory of dividend. 3. The relevance theory of dividend argues that dividend decision affects the market value of the firm and therefore dividend matters. r = Internal rate of return Thus investors are able to forecast earnings and dividends with certainty. He has also given a model on the line of Prof. Walter suggesting that dividends are relevant and the dividend of a firm affects its value. They believe that the profits are distributed as dividends only if no adequate investment opportunities for investments for the business. Higher Dividend will increase the value of stock whereas low dividend wise reverse. The Walter’s model is based on the following assumptions: Where,VE = market value of equity sharesD = initial dividendKE = costs of equity andg = expected growth rate of earnings. (ii) The firm’s business risk does not change with additional investment. Relevance of dividend policydividends paid by the firms are viewed positively both by the investors and the firms. 2. Dividend Relevance Theories Dividend Irrelevance Theories. Dividend relevance theory definition It is important not to confuse the bird-in-hand theory with the dividend signalling theory . The Relevance Concept of Dividend or the Theory of Relevance. The firm has a very long life. In their opinion investors do not differentiate dividend the capitalgains. If the company’s reinvestment rate on retained earnings is the less than shareholders’ rate of return, the company should not retain earnings. The Gordon’s Model is based on the following assumptions: According to Gordon, the market value of a share is equal to the present value of the future streams of dividends. With the residual dividend policy, the primary focus of the firm’s management is indeed on investment, not dividends. The bird-in-the-hand theory, hypothesized independently by Gordon (1963) and by Lintner (1962) states that dividends are relevant to determining of the value of the firm. They argue that the value of the firm depends on the firm’s earnings which result from its investment policy. Therefore, according to this theory, optimal dividend policy should be determined which will ensure maximization of the wealth of the shareholders. 4. Prof. James E Walter developed a model for relevant theory related to dividends. P = Market Price of an equity share A Ltd., may be charaterised as growth firm. The market value of the shares will depend entirely on the expected future earnings of the firm. According to one school of thought the dividends are irrelevant and the amount of dividends paid does not affect the value of the firm while the other theory considers that the dividend decision is relevant to the value of the firm. br = g Modigliani – Miller theory was proposed by Franco Modigliani and Merton Miller in 1961. When r > k, such firms are termed as growth firms and would follow optimum dividend policy would be to plough back the entire earnings. Earnings and Dividends do not charge while determining the value. The retention ratio (b) once decided upon is constant. sumption of no-retention made by MM makes dividend irrelevance a “meaningless tautology” (p. 306). Thus what is gained by the shareholders as a result of dividends is completely neutralized by the reduction in the market value of the shares. If an investor considers the dividend is too low, it will sell some portion of its stock to replicate the expected dividends. This lack of concern is because they can sell a portion of their portfolio for equities if there is a desire to have cash. D = (50 x 8) / 100 = 4 The r and k of the firm constant does not true. The crux of the argument of Gordon’s model is the value of a dollar of dividend income is more than the value of a dollar of capital gain. Dividend relevance implies tha t shareholders prefer current dividend and there is no direct relationship between dividend policy and the value of the firm. Proponents believe that there is a dividend policy that strikes a balance between current dividends and future growth that maximizes the firm’s stock price. Dividend policy. In case of a firm which does not have profitable Investment opportunity it r < k the optimum dividend Policy would be to distribute the entire earnings as Dividend. Internal rate of return (r) and cost of capital (KE) of the firm remains constant. Save my name, email, and website in this browser for the next time I comment. Miller and Modigliani (1961) disagree and call the theory that a high dividend payout ratio will maximize a firm’s value the bird-in-the-hand fallacy. P = Price of share What is the relevance theory of dividend? This would maximize the market value of their shares. According to them, Dividend Policy has a positive impact on the firm’s position in the stock market. The arbitrage theory suggests that the dividend effect will be exactly offset by the effect of raising additional share capital. Irrelevance theory of dividend is associated with Soloman, Modigliani and Miller. The firm has a very long or infinite life. The dividend irrelevance theory states that the dividend policy of a given company should not be considered particularly important by investors. Save my name, email, and website in this browser for the next time I comment. No transaction costs associated with share floatation. 2. The key implication, as argued by Litner and Gordon, is that because of the less risky nature dividends, shareholders and investors will discount the firm’s dividend stream at a lower rate of return, ‘r’, thus increasing the value of the firm’s shares. The investment opportunities available to the business. Residual Approach: According to this theory, dividend decision has no effect on the wealth of the shareholders or the prices of the shares, and hence it is irrelevant so far as the valuation of the firm is concerned. Dividend theory includes an argument called dividend irrelevance which was proposed by two Noble Laureates, Modigliani and Miller. However, their argument was based on some assumptions. It does not use external sources of funds such as Debts or new equity capital. More and more Dividend is an indication of more and more profitability. The firm finances its investment by retained earnings or by retaining earnings. The dividend theories relates with the impact of dividend on the value of the firm. Thus no optimum Dividend Policy for such firms. Internal rate of return (R) of the firm remains constant. In that case a change in the dividend payout ratio will be followed by a change in the market value of the firm. There is no outside financing and all investments are financed exclusively by retained earnings. 1. D = Dividend per share. A dividend theory is a formulation of an apparent relationship which purports to explain a connection between dividend patterns and various causal factors impacting these patterns. Relevance theory can discussed with following models: The Walter approach was given by James E Walter and is based on a simple argument that where the reinvestment rate, that is, rate of return that the company may earn on retained earnings, is higher than cost of equity (rate of return of the shareholders), then it would be in the interest of the firm to retain the earnings. It may be noted that the values of (E) and (D) may be changed in the model for determining the results, but any given values of E and D are assumed to remain constant. In case where r = k, it does not matter whether the firm retains or distribute its earnings. This theory suggests that investors are generally risk averse and would rather have dividends today (“bird-in-the-hand”) than possible share appreciation and dividends tomorrow. If the internal funds are excessive and all the investments are finances the residual is paid as dividends. This theory states that dividend patterns have no effect on share values. Myron Gordon’s model explicitly relates the market value of the company to its dividend policy. According to MM, the investors will thus be indifferent between dividends and retained earnings. According to him, it is a relationship between the firm’s return on investment or internal rate of return and cost of capital or required rate of return. Thus, the dividends are irrelevant to investors because they can control their own cash flows depending on their cash needs. Gordon Approch (The Bird-in-the-Hand Theory): The essence of the bird-in-the-hand theory of dividend policy (advanced by John Litner in 1962 and Myron Gordon in 1963) is that shareholders are risk-averse and prefer to receive dividend payments rather than future capital gains. How one can predict? Thus the growth rate (g) is also constant (g = br). In a perfect market - Miller and Modigliani. Cost of capital (KE) of the firm also remains same regardless of the, The firm derives its earnings in perpetuity. The two transactions are paying of dividends and raising external capital. D = (75 x 8) / 100 = 6 The Theory Modigliani and Miller suggested that in a perfect world with no taxes or bankruptcy cost, the dividend policy is irrelevant. Economics and finance Definition of dividend relevance theory dividend relevance theory: The theory, attributed to Gordon and Lintner, that shareholders prefer current dividends and that there is a direct relationship between a firm’s dividend policy and its market value. The dividend irrelevance theory states that investors may affect cash flows regardless of a company’s dividend policy. In practice, change in a firm’s dividend policy can be observed to have an effect on its share price- an increase in dividend producing an increasing in share price and a reduction in dividends producing a decrease in share price. KE = Cost of Equity Capital or Capitalised rate. What is the relevance theory of dividend? Ke = Cost of equity capital The Relevance Concept of Dividend. The value of the firm therefore depends on the investment decisions and not the dividend decision. D = (25 x 8) / 100 = 2. Comment. If the dividend is relevant, there must be an optimum payout ratio. If a particular investor considers the dividend is too high, the surplus will be used to buy additional company stock. Thus Dividend payment Ratio would be Zero. There are three models, which have been developed under this approach. The retaining earnings are that portion of profits that is not distributed to the investors. The advocates of this school of thought argue that the dividends have no impact on the share price or market value of the firm. As investment goes up r also goes up. Gordon contended that the payment of current dividends “resolves investor uncertainty”. b. When the dividends are paid to the shareholders, the market price of share decreases (because of external financing). In particular, MM argue that the dividend policy does not have an influence on the stock’s price or its cost of capital. The Irrelevance Concept of Dividend or the Theory of Irrelevance The Relevance Concept of Dividends: According to this school of thought, dividends are relevant and the amount of dividend affects the value of the firm. Dividend Relevance Theory. This theory suggests that investors are generally risk averse and would rather have dividends today (“bird-in-the-hand”) than possible share appreciation and dividends tomorrow. The effect of this assumption is that the new investments out of retained earnings will not change and there will not change in the required rate of return of the firm. This paper shows that relevance or irrelevance of dividend policy has not to do with So, according to this theory, once the invest… M. Gorden, John Linter, James Walter and Richardson are associated with the relevance theory of dividend. In their case, the value of the firm’s share would not fluctuate with a change in Dividend Rates. Arbitrage leads to entering into two transactions which exactly balance or completely offset the effect of each other. The various theories supporting this thought are as follows: The theory is based upon the assumptions that since the external financing has excessive costs and may not be available to the firm. Relevant Theory If the choice of the dividend policy affects the value of a firm, it is considered as relevant. In that case a change in the dividend payout ratio will be followed by a change in the market value of the firm. Thus the firm’s decision to pay the dividends is influenced by: Thus, the divided policy is totally passive in nature and has no influence on the market price of the firm. Optimal Dividend Policy. Relevance Theory : According to relevance theory dividend decisions affects value of firm, thus it is called relevance theory. Calculate the value of each share by Walter Approach. Relevance Theory of Dividend The relevance theory of dividend argues that dividend decision affects the market value of the firm and therefore dividend matters. The dividend irrelevance theory maintains that investors are indifferent to whether their returns from holding stock arise from dividends or capital gains. Dividend Relevance Theory. Formula of Walter Approach of Relevance Theory of Dividend, Gorden’s Approach of Relevance Theory of Dividend, Gorden’s formula of relevance theory of dividend, 8 Things You Need to Remember When Creating a Winning Custom Office Envelope Design, Limitations of Historical Cost Accounting, Factory Overhead Practical Problems and Solutions, Important Techniques of Factory Overhead Costing, Labour Costing Practical questions with answers, Job Order Costing Examples, Practical Problems and Solutions, Cost of production report (CPR) questions and answers. According to Gorden, the market value of a share is equal to the present value of the future stream of dividends. Investments are financed through internal sources does not true. The Company has adequate investment opportunities giving a higher rate of return than the cost of retained earnings, the investors would be contented with the firm retains the earnings. As with most investment theories, the dividend irrelevance theory has its share of supporters and detractors. The dividend is a relevant variable in determining the value of the firm, it implies that there exists an optimal dividend policy, which the managers should seek to determine, that maximises the value of the firm. a. Walter, Gordon and others propounded that dividend decisions are relevant in influencing the value of the firm. Generally, a rise in dividend payment is viewed as a positive signal, conveying positive information about a firm’s future earnings prospects resulting in an increase in share price. Dividend Theories 2 / 2. As Internal rate higher than to cost of capital in such case it is better to retain the earnings rather than the distribution as Dividend. The Irrelevance Concept of Dividend 2. Since the firm uses retained earnings to finance new investments, the paying of dividends will require the firm to raise the capital externally. 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