Gordon's Approach

Dividend Policy Theories: Relevance vs. Irrelevance

The impact of dividend policy on a firm's valuation is a topic of ongoing debate. This section explores two contrasting viewpoints: those who believe dividends are relevant and those who argue they are irrelevant.

I. Dividend Relevance: The Case for Dividends Mattering

Gordon's Approach (Bird-in-Hand Theory)

Gordon's model contends that a firm's dividend policy does affect its value. Key assumptions of this model are:

1. All-Equity Firm: The company uses only equity financing and funds investments with retained earnings.
2. Constant r and k: The rate of return on investment (r) and the cost of equity (k) are constant.
3. Perpetual Life: The firm is assumed to have an indefinite lifespan.
4. Constant Retention Ratio: The retention ratio (b) is constant, resulting in a constant growth rate (g = br).
5. k>br

Gordon argues that:

• Investors prefer current dividends: Investors are risk-averse and view future dividends/capital gains as riskier than current dividends.
• Direct Relationship: There's a direct relationship between dividend policy and the market value of a share.

The "Bird-in-Hand" Argument:

Investors perceive dividends as a "bird in hand" – a sure thing today – compared to the uncertain prospect of future capital gains (the bird in the bush). This perception of higher certainty leads investors to:

• Discount dividends at a lower rate.
• Value current dividends more highly than future capital gains.

Symbolic Representation: P0 = E(1 - b) / (k - br) Where:

• P0 = Market price of equity share
• E = Earnings per share
• b = Retention ratio (1 – payout ratio)
• r = Rate of return on investment
• k = Cost of equity capital
• br = g (growth rate)

Implications:

According to Gordon, as the retention rate increases, investors require a higher rate of return, which negatively impacts the share price.

II. Dividend Irrelevance: The Case for Dividends Not Mattering

The other school of thought believes that investors are indifferent to dividend policy.

Residuals Theory of Dividend

According to this theory, dividend decision has no effect on the wealth of shareholders or the prices of the shares and hence it is irrelevant so far as valuation of firm is concerned. This theory regards dividend decision merely as a part of financing decision because earnings available may be retained in the business for re-investment. But if the funds are not required in the business they may be distributed as dividends. Thus, the decision to pay dividend or retain the earnings may be taken as residual decision.

This theory assumes that investors do not differentiate between dividends and retentions by firm. Their basic desire is to earn higher return on their investment. In case the firm has profitable opportunities giving higher rate of return than cost of retained earnings, the investors would be content with the firm retaining the earnings to finance the same. However, if the firm is not in a position to find profitable investment opportunities, the investors would prefer to receive the earnings in the form of dividends. Thus, a firm should retain earnings if it has profitable investment opportunities otherwise it should pay them as dividends.

Core Idea:

Dividend decisions are merely a result of the availability of profitable investment opportunities:

Step 1: Determine Capital expenditures (investment opportunities).

Step 2: With the best financing mix, determine equity funding (for Step 1).

Step 3: Use retained earnings (If retained earnings exceed equity funding, pay them out as dividends).

Investor Indifference:

• The theory assumes investors are primarily focused on maximizing returns and are indifferent between dividends and retained earnings.

• If a company has profitable investment opportunities, investors are happy for the company to reinvest earnings.

• If there are no good investment opportunities, investors would prefer to receive dividends.

• Limited Influence of DividendsThe Residual Theory suggests that dividend policy has no direct influence on the market price of shares.

• Availability of internally generated funds and opportunity for investments are the major influences for payment of dividends dividends are paid only after acceptable projects have been financed.

Conclusion of the Theory

The residual approach views dividend policy as a passive aspect, with minimal effect on market share price. Dividend is paid only if all excellent investment proposals have been funded.