This lesson examines the two classic dividend relevance models that argue dividend policy does affect firm value. It explores the Walter and Gordon models, their assumptions, their implications, and the conditions under which dividends matter.

 

  • Walter’s Model: This model, proposed by James E. Walter, argues that dividend policy affects the value of the firm. It assumes that the firm’s internal rate of return (r) and cost of capital (k) are constant, and that all earnings are either distributed or retained. The market price per share is calculated as:

    • Ve = [D + (Ra/Rc)(E – D)] / Rc where Ra is the rate earned on retained profits, Rc is the cost of capital, E is earnings per share, and D is dividend per share .

  • Implications of Walter’s Model: The optimal dividend policy depends on the relationship between r (return on retained earnings) and k (cost of capital) :

    • If r > k (Growth Firm): Price per share increases as dividend payout ratio decreases. The optimum payout ratio is nil (100% retention).

    • If r = k (Normal Firm): Price per share remains unchanged with changes in payout ratio. Dividend policy is irrelevant.

    • If r < k (Declining Firm): Price per share increases as dividend payout ratio increases. The optimum payout ratio is 100%.

  • Gordon’s Model: Myron Gordon’s model also asserts that dividend policy affects firm value. It argues that investors prefer current dividends over future capital gains due to the “bird-in-the-hand” argument—dividends are certain, while capital gains are uncertain and risky . The model uses a dividend growth model formula:

    • Ve = [dâ‚€(1 + g)] / (ke – g) where dâ‚€ is current dividend, g is the constant growth rate of dividends, and ke is the cost of capital .

  • The “Bird-in-the-Hand” Argument: Gordon’s model is based on the premise that investors are risk-averse and prefer dividends (current income) to capital gains (future income). Because dividends are more certain than capital gains, a firm paying dividends should have a higher valuation than an equivalent firm retaining earnings .

 

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