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- Firms can either plough the earnings by retaining them or distribute the same to the shareholders as dividends.
- The second option of declaring cash dividends out of the after tax profits will lead to maximization of the shareholders wealth.
- The returns to the shareholders either by way of the dividend receipts or capital gains are affected by the dividend policies of the firms.
- The dividend policy of the firm gains importance especially due to unambiguous relationship that exists between the dividend policy and the equity returns.
- The traditional approach to the dividend policy, which was given by B Graham and DL Dodd lays a clear empasis on the relationship between the dividends and the stock market. According to this approach, the stock value responds positively to higher dividends and negatively when there are low dividends.
- The traditional approach, states that the P/E ratio are directly related to the dividend pay-out ratios.
- The dividend policy given by James E Walter also considers that dividends are relevant and they do affect the share price. In this model he studied the relationship between the internal rate of return (r) and the cost of capital of the firm (k), to give a dividends policy that maximizes the shareholder's wealth.
- According to the Walter Model, when the return on investment is more than the cost of equity capital, the earnings can be retained by the firm since it has better and more profitable investment opportunities than the investor.
- Firms which have their r > ke are the growth firms and the dividend policy that suits such firms is the one which has a zero pay-out ratio. This policy will enhance the value of the firm..
- When the firm has a rate of return that is equal to the cost of equity capital, the firm's dividends policy will not affect the value of the firm. The optimum dividend policy for such normal firms will range between zero to a 100% pay-out ratio, since the value of the firm will remain constant in all cases.
- Gordon's Model assumes that the investors are rational and risk-averse. They prefer certain returns to uncertain returns and thus put a premium to the certain returns and disscount the uncertain returns. Thus, investors would prfer current dividends and avoid risk. Retained earnings involve risk and so the investor discounts the future dividends. The risk will also affect the stock value of the firm.
- Gordon explains this preference for current income by the bird-in-hand argument.
- Miller and Modigiliani have propounded the MM hypothesis to explain the irrelevance of the firm's dividend policy.
- According to the model, it is only the firm's investment policy that will have an impact on the share value of the firm and hence should be given more importance.
- According to the rational expectations model, there would be no impact of the dividend declaration on the market price of the share as long as it is at the expected rate.
- The rational expectations model suggests that alterations in the market price will not be necessary where the dividends meet the expectations and only in case of unexpected dividends will there be a change in the market price.