Aspects Of Dividend Policy
Relevance Of Dividend
According to this concept, dividend policy is considered to affect the value of the firm. Dividend relevance implies that shareholders prefer curre nt dividend and there is no direct relations hip between dividend policy and value of the firm. Relevance of dividend concept is supported by two e mine nt persons like Walter and Gordon.
Prof. James E. Walter argues that the dividend policy almost always affects the value of the firm.
Walter model is based in the relationship between the following important factors:
• Rate of return I
• Cost of capital (k)
According to the Walter‘s model, if r > k, the firm is able to earn more than what the shareholders could by reinvesting, if the earnings are paid to them. The implication of r > k is that the shareholders can earn a higher return by investing elsewhere.
If the firm has r = k, it is a matter of indifferent whether earnings are retained or distributed.
Walters model is based on the following important assumptions :
1. The firm uses only internal finance.
2. The firm does not use debt or equity finance.
3. The firm has constant return and cost of capital.
4. The firm has 100 recent payout.
5. The firm has constant EPS and dividend.
6. The firm has a very long life.
Walter has evolved a mathematical formula for determining the value of market share.
Criticism of Gordon’s Model
Gordon‘s model consists of the following important criticisms:
Gordon model assumes that there is no debt and equity finance used by the firm.
It is not applicable to present day business.
Ke and r cannot be constant in the real practice.
According to Gordon‘s model, there are no tax paid by the firm. It is not practically applicable.