Amity business school

1. Amity Business School
1
Amity Business School
Financial Management

2. Amity Business School
Walter ‘s approach
According to Prof. Walter dividend decision is relevant and do have impact on the
Value of the Firm.
The relationship between internal rate of return (r) and cost of capital (k) is very
Significant in determining the dividend policy to achieve the ultimate goal of
Maximizing the wealth of the shareholder
If r > k 100% retention
If r< k 100% payout.

3. Amity Business School
assumptions
a.The investments of the firm are financed through the retained earnings and the
firm does not use external sources of funds
b.The internal rate of return and the cost of capital of the firm are constant
c.The life of the firm is infinite.
P = D
Ke
+
r(E-D)/ke
Ke
P is the market price of the share

4. Amity Business School
Question
Cost of capital is 10%
Earning per share is Rs.50
Assume Rate of return
i.12%
ii.8%
iii.10%
Show the effect of dividend policy on the market price of the share using Walter
Model when dividend payout are as follows
i.0%
ii.20%
iii.80%
iv.100%

5. Amity Business School
Gordon Model
Gordon has also developed a model on the lines of Prof. Walter
suggesting that Dividends are relevant and it do effect the value of the firm.
The theory is based on the following assumptions
a.The firm is all equity firm
b.No external financing is available or used. RE is the only source of
financing new investments
c. The rate of return on the firms investment is constant
d. The retention ratio once decided upon will remain constant
e. The firm has perpetual life
f. Corporate taxes do not exist.
P = E(1-b)/ Ke - br

6. Amity Business School
Gordon’s theory on dividend policy is one of the theories believing in the
‘relevance of dividends’ concept. It is also called as ‘Bird-in-the-hand’ theory
that states that the current dividends are important in determining the value of
the firm. Gordon’s model is one of the most popular mathematical models to
calculate the market value of the company using its dividend policy
Relationship
between r and k
Increase in Dividend
Payout
r>k
Price per share
decreases
r<k
Price per share
increases
r=k
No change in the
price per share

7. Amity Business School
The above model indicates that the market value of the company’s share is the sum
total of the present values of infinite future dividends to be declared.
The EPS of the company is Rs. 15.
The market rate of discount applicable to the company is 12%.
The dividends are expected to grow at 10% annually.
The company retains 70% of its earnings.
Calculate the market value of the share using the Gordon’s model.
Here, E = 15
b = 70%
k = 12%
g = 10%
Market price of the share = P = {15 * (1-.70)} / (.12-.10) = 15*.30 / .02 = 225

8. Amity Business School
Gordon’s model believes that the dividend policy impacts the company in various
scenarios as follows:
Growth Firm: A growth firm’s internal rate of return (r) > cost of capital (k). It
benefits the shareholders more if the company reinvests the dividends rather than
distributing it. So, the optimum payout ratio for growth firms is zero.
Normal Firm: A normal firm’s internal rate of return (r) = cost of the capital (k).
So, it does not make any difference if the company reinvested the dividends or
distributed to its shareholders. So, there is no optimum dividend payout ratio for
normal firms.
However, Gordon revised this theory later and stated that the dividend policy of
the firm impacts the market value even when r=k. Investors will always prefer a
share where more current dividends are paid.
Declining Firm: The internal rate of return (r) < cost of the capital (k) in the
declining firms. The shareholders are benefitted more if the dividends are
distributed rather than reinvested. So, the optimum dividend payout ratio for
declining firms is 100%.

9. Amity Business School
Question
Rate of return on investment (r) i. 15% ii. 12% iii. 10%
Cost of Capital (k) 12%
Earning per share Rs.10
Determine the value of the firm using Gordon Model
If Dividend retention ratio is
i.10%
ii.50%
iii.80%

10. Amity Business School
Question
For each of the companies describe below, would you expect it to
have a medium/high or a low dividend payout ratio? Explain
why?
• A company with a large proportion of inside ownership, all of
whom are high income individual
• A growth company with an abundance of good investment
opportunities
• A company experiencing ordinary growth that has liquidity and
much unused borrowing capacity
• A dividend paying company that experiences an unexpected
drop in earnings from a trend
• A company with volatile earnings and high business risk