09-11-2012, 04:00 PM
Dividend Policy
8. Dividend Policy.ppt (Size: 332.5 KB / Downloads: 40)
Introduction
Every organization has two option to utilize profit after tax
Reinvest the retained earning
Distribute to shareholder
Organizations that needs fund for long-term projects will reinvest retained earning
Only organizations with good growth potential should reinvest funds
Shareholders earn returns in the form of capital gain or dividends
Dividend policy determines the retention & pay-out ratio
Limitation of Traditional Model
Status that P/E ratio is directly related to the dividend pay-out ratio
Higher pay-out ratio will increase P/E ratio & vice-versa
Share price may also increase incase of low pay-out ratio but increase in earnings
Here capital gain will be higher than cash dividend
Firm with higher pay-out ratio & low growth rate will have negative impact on share price, due to lower earning
Few investors may prefer cash dividend over capital gain & vice-versa
Walter Model
Like “Tradition Model”, Walter Model also considers that dividend affect share price
Study the relationship between return on equity (ROE) & cost of equity (Ke)
If ROE > Ke the earning can be retained by the firm as it has better investment opportunity
If ROE < Ke the investor will have a better investment opportunity (100% dividend)
If ROE = Ke the value of the firm will not be impacted by dividend policy
Limitations of Walter Model
Retained earning is the only source of finance
ROE and Ke are assumed to be constant
Additional investment will not change the risk & return profile of the firm
Firm has infinite life
For a given the value of the firm, dividend per share and earning per share remains the same
Assumptions of Gordon Model
Investors would prefer certain returns and avoid risk
Retained earning involve risk and so investors discount future dividends
Investors prefers current income over the future income which may or may not be available
Investors prefer to pay higher price for stock that pay them current dividend income
Investors will discount the stocks that postpone current income, which will also depend on retention ratio