What is the relevance theory of dividend?
M. Gorden, John Linter, James Walter and Richardson are associated with the relevance theory of dividend. According to them, Dividend Policy has a positive impact on the firm’s position in the stock market. Higher Dividend will increase the value of stock whereas low dividend wise reverse. More and more Dividend is an indication of more and more profitability.
He says Dividend Policy always affects the Goodwill of the Company. 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. Let’s suppose, r = internal rate of return and K = cost of equity capital:
1. When r > k, such firms are termed as growth firms and would follow optimum dividend policy would be to plough back the entire earnings. Thus Dividend payment Ratio would be Zero. This would maximize the market value of their shares.
2. 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. The Shareholders can use the dividend do receive in other channels when they can get a higher rate of Dividend. Thus 100% Dividend Payout ratio in their case would result in maximizing the value of the equity shares.
In case where r = k, it does not matter whether the firm retains or distribute its earnings. In their case, the value of the firm’s share would not fluctuate with a change in Dividend Rates. Thus no optimum Dividend Policy for such firms.
Assumptions of Walter Models
(i) The firm does make the entire financing through retained earnings. It does not use external sources of funds such as Debts or new equity capital.
(ii) The firm’s business risk does not change with additional investment. It means the firm’s internal rate of return (g) and cost of capital (k) remain constant.
(iii) In the beginning, earning per share (E) and Dividend (D) per share remain constant. 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.
(iv) The firm has a very long life.
Formula of Walter Approach of Relevance Theory of Dividend
Market Value of a Share:
P = (D + r) (E – D) / KE
(D + (r / KE) E-D) / KE
P = Market Price of an equity share
D = Dividend per share
r = Internal rate of return
E = Earnings per share
KE = Cost of Equity Capital or Capitalised rate
|A Ltd.||B Ltd.||C Ltd.|
Calculate the value of each share by Walter Approach. When Dividend Payment ratio is (a) 50% (b) 75% (c) 25%.
D = (50 x 8) / 100 = 4
D = (75 x 8) / 100 = 6
D = (25 x 8) / 100 = 2
Comment. A Ltd., may be charaterised as growth firm. 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. As is shown when D .P. Ratio is 25%. Value of share is $110.
1. Investments are financed through internal sources does not true. External sources are also used for financing expansion.
2. The r and k of the firm constant does not true. As investment goes up r also goes up.
3. Earnings and Dividends do not charge while determining the value.
4. The firm has a very long life. How one can predict?
Gorden’s Approach of Relevance Theory of Dividend
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. 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. This is an account of the uncertainty of the future and the Shareholder’s discount future dividends at a higher rate. According to Gorden, the market value of a share is equal to the present value of the future stream of dividends.
Gorden’s formula of relevance theory of dividend
P = E (1 – b) / (Ke – br)
P = D / (Ke – g)
P = Price of share
E = Earning per share
b = Retention Ratio
Ke = Cost of equity capital
br = g
r = Rate of return on investment
D = Dividend per share