How Dividend policy will affect the valuation of a firm?
This article is all about a detailed study of the impact of dividend decisions on a
firm's valuation. Understanding the importance of Internal financing, various
types of Dividend policy, and approaches to dividend policy like Modigliani and
Miller approach, Walter and Gordon’s approach.
Introduction to dividend policy
The term dividend refers to that part of a company that is distributed by a
company among its shareholders. It is the reward of shareholders for the
investment made by them in the shares of the company. Investors are interested
in earning the maximum return on their investment and maximizing their wealth.
On the other hand, a company needs to provide funds to finance its long-term
growth. If a company pays out as dividend most of what it earns, then for business
requirements and further expansion it will have to depend upon outside resources
such as the issue of debt or new shares. The dividend policy of a firm thus affects
both long-term financing and the wealth of shareholders. As a result, the firm’s
decision to pay dividends must be reached in such a manner to equitably
apportion the distributed profit and retained earnings. Such dividend is a right of
shareholders to participate in the profit and surplus of the company for their
investment in the company's share capital. Thus, the company should distribute a
reasonable amount as dividends to its members and retain the rest for its growth
and survival.
INTERNAL FINANCING
A new company can raise finance only through external sources, such as shares,
debentures, loans, public deposits, etc. However, an existing or a going concern
that needs finance for its future growth and expansion can also generate finance
through its internal sources like Retained or plowing back of profit, capitalization
of profit, and depreciation.
What is Retained earnings or plowing back of profit?
The “Ploughing back of Profit” is a technique of financial management under all
profit of a company is not distributed amongst the shareholders as a dividend, but
a part of the profit is retained or reinvested in the company. this process of
retaining profit year after year and their utilization in the business is also known as
Ploughing back of profits.
it is an economical step which a company takes, in the sense, that instead of
distributing the entire by way of dividend. it keeps a certain percentage re-
introduced into business for its development. Such phenomenon is also known as
Self-Financing or Internal financing.
The need for re-investment of retained earnings or plowing back of profit arises
for the following purpose:
1)For the replacement of old assets which have become obsolete
2)For expansion and growth of the business
, 3)For contributing towards the fixed as well as working capital needs of the
company.
4)For improving the efficiency of the plant and equipment
5)For making the company self-dependent on finance from outside sources
6)For redemption of loans and debentures
Dividend Decision and Valuation of a firm
The value of the firm can be maximized if the shareholder's wealth is maximized.
There are conflicting views regarding the impact of dividend decisions on the
valuation of the firm. According to" one school of thought, dividend decision does
not affect the shareholder's wealth and hence the valuation of the firm. on the
other hand, according to the school of thought, dividend decisions materially
affect the shareholders' wealth and also the valuation of the firm. The two
concepts under School of thought were:
1)The Irrelevance concept of dividend or the Theory of Irrelevance, and
2) The relevance concept of dividend or Theory of Relevance.
Irrelevance concept of dividend or Theory of Irrelevance
The dividend irrelevance theory suggests that a company’s declaration and
payment of dividends should have little to no impact on the stock price. If this
theory holds, it would mean that dividends do not add value to a company’s stock
price.
The premise of the theory is that a company's ability to earn a profit and grow its
business determines a company's market value and drives the stock price; not
dividend payments. Those who believe in the dividend irrelevance theory argue
that dividends don't offer any added benefit to investors and, in some cases,
argue that dividend payments can hurt the company's financial health.
Key points:
• The dividend irrelevance theory suggests that a company’s dividend
payments don't add value to a company’s stock price.
• The dividend irrelevance theory also argues that dividends hurt a company
since the money would be better reinvested in the company.
• The theory has merits when companies take on debt to honor their
dividend payments instead of paying down debt to improve their balance
sheet.
Modigliani and Miller Approach ( MM Model)
Modigliani and Miller suggested that in a perfect world with no taxes or
bankruptcy costs, the dividend policy is irrelevant. They proposed that the
dividend policy of a company does not affect the stock price of a company or the
company’s capital structure.
MM says that if an investor gets a dividend that’s more than he expected then he
This article is all about a detailed study of the impact of dividend decisions on a
firm's valuation. Understanding the importance of Internal financing, various
types of Dividend policy, and approaches to dividend policy like Modigliani and
Miller approach, Walter and Gordon’s approach.
Introduction to dividend policy
The term dividend refers to that part of a company that is distributed by a
company among its shareholders. It is the reward of shareholders for the
investment made by them in the shares of the company. Investors are interested
in earning the maximum return on their investment and maximizing their wealth.
On the other hand, a company needs to provide funds to finance its long-term
growth. If a company pays out as dividend most of what it earns, then for business
requirements and further expansion it will have to depend upon outside resources
such as the issue of debt or new shares. The dividend policy of a firm thus affects
both long-term financing and the wealth of shareholders. As a result, the firm’s
decision to pay dividends must be reached in such a manner to equitably
apportion the distributed profit and retained earnings. Such dividend is a right of
shareholders to participate in the profit and surplus of the company for their
investment in the company's share capital. Thus, the company should distribute a
reasonable amount as dividends to its members and retain the rest for its growth
and survival.
INTERNAL FINANCING
A new company can raise finance only through external sources, such as shares,
debentures, loans, public deposits, etc. However, an existing or a going concern
that needs finance for its future growth and expansion can also generate finance
through its internal sources like Retained or plowing back of profit, capitalization
of profit, and depreciation.
What is Retained earnings or plowing back of profit?
The “Ploughing back of Profit” is a technique of financial management under all
profit of a company is not distributed amongst the shareholders as a dividend, but
a part of the profit is retained or reinvested in the company. this process of
retaining profit year after year and their utilization in the business is also known as
Ploughing back of profits.
it is an economical step which a company takes, in the sense, that instead of
distributing the entire by way of dividend. it keeps a certain percentage re-
introduced into business for its development. Such phenomenon is also known as
Self-Financing or Internal financing.
The need for re-investment of retained earnings or plowing back of profit arises
for the following purpose:
1)For the replacement of old assets which have become obsolete
2)For expansion and growth of the business
, 3)For contributing towards the fixed as well as working capital needs of the
company.
4)For improving the efficiency of the plant and equipment
5)For making the company self-dependent on finance from outside sources
6)For redemption of loans and debentures
Dividend Decision and Valuation of a firm
The value of the firm can be maximized if the shareholder's wealth is maximized.
There are conflicting views regarding the impact of dividend decisions on the
valuation of the firm. According to" one school of thought, dividend decision does
not affect the shareholder's wealth and hence the valuation of the firm. on the
other hand, according to the school of thought, dividend decisions materially
affect the shareholders' wealth and also the valuation of the firm. The two
concepts under School of thought were:
1)The Irrelevance concept of dividend or the Theory of Irrelevance, and
2) The relevance concept of dividend or Theory of Relevance.
Irrelevance concept of dividend or Theory of Irrelevance
The dividend irrelevance theory suggests that a company’s declaration and
payment of dividends should have little to no impact on the stock price. If this
theory holds, it would mean that dividends do not add value to a company’s stock
price.
The premise of the theory is that a company's ability to earn a profit and grow its
business determines a company's market value and drives the stock price; not
dividend payments. Those who believe in the dividend irrelevance theory argue
that dividends don't offer any added benefit to investors and, in some cases,
argue that dividend payments can hurt the company's financial health.
Key points:
• The dividend irrelevance theory suggests that a company’s dividend
payments don't add value to a company’s stock price.
• The dividend irrelevance theory also argues that dividends hurt a company
since the money would be better reinvested in the company.
• The theory has merits when companies take on debt to honor their
dividend payments instead of paying down debt to improve their balance
sheet.
Modigliani and Miller Approach ( MM Model)
Modigliani and Miller suggested that in a perfect world with no taxes or
bankruptcy costs, the dividend policy is irrelevant. They proposed that the
dividend policy of a company does not affect the stock price of a company or the
company’s capital structure.
MM says that if an investor gets a dividend that’s more than he expected then he
