Dividend Theories
by Dividend theories explain the relationship between a company’s dividend decisions, retained earnings, share price and shareholder wealth. They help determine whether dividend policy affects the market value of a firm or whether investors are indifferent between receiving dividends and earning capital gains. These theories are important for understanding how management should distribute profits.
1. Walter’s Dividend Model
Walter’s Dividend Model explains the relationship between dividend policy and the market value of equity shares. According to James E. Walter, the value of a share depends on the relationship between the firm’s internal rate of return and its cost of equity. If the return on retained earnings is higher than the cost of equity, the company should retain more profits. If the return is lower, higher dividends are preferred. When both rates are equal, dividend policy becomes irrelevant to share value. Thus, the model suggests that dividend policy can influence firm value.
Formula:
P = [D+r / Ke(E−D) ] / Ke
Where:
P = Market Price per Share
D = Dividend per Share
E = Earnings per Share
r = Internal Rate of Return
Kₑ = Cost of Equity
2. Gordon’s Dividend Model
Gordon’s Dividend Model, developed by Myron Gordon, states that dividend policy affects the market value of shares. The model assumes that investors prefer certain current dividends over uncertain future capital gains. It is based on the relationship between the firm’s return on investment, cost of equity and growth rate. If the return on retained earnings is greater than the cost of equity, retaining earnings can increase share value. If the return is lower, paying higher dividends may be beneficial. Therefore, the model supports the relevance of dividend policy in determining shareholder wealth.
Formula:
P = E(1−b) / Ke − br
Where:
P = Market Price per Share
E = Earnings per Share
b = Retention Ratio
Kₑ = Cost of Equity
r = Rate of Return
3. Modigliani and Miller Dividend Theory
Modigliani and Miller proposed that dividend policy is irrelevant to the market value of a firm under perfect market conditions. According to this theory, the value of the firm depends primarily on its earning capacity and investment decisions rather than on how profits are divided between dividends and retained earnings. Investors can create their desired cash flows by selling shares when necessary. Therefore, whether profits are distributed as dividends or retained does not affect total shareholder wealth under the model’s assumptions. This theory assumes perfect capital markets, no taxes, no transaction costs and rational investors.
Basic Relationship:
P₀ = D1+P1 / 1+Ke
Where:
P₀ = Current Share Price
D₁ = Dividend at the End of Period
P₁ = Expected Share Price
Kₑ = Cost of Equity
4. Residual Dividend Theory
Residual Dividend Theory states that dividends should be paid only after the company has financed all acceptable investment opportunities using available retained earnings. The company first determines its investment requirements and desired capital structure. The remaining earnings are then distributed to shareholders as dividends. Under this approach, investment decisions receive priority over dividend payments. Dividend amounts may therefore fluctuate depending on the company’s profitability and investment requirements. The theory is particularly relevant for growing companies with significant profitable investment opportunities. It helps management balance internal financing requirements with shareholders’ expectations for dividend income.
Formula:
Dividend = Net Income − Required Equity Financing
5. Bird in the Hand Theory
Bird in the Hand Theory suggests that investors may prefer current dividends over uncertain future capital gains. The theory is associated with the view that a dividend received today provides greater certainty than an expected increase in share price in the future. Therefore, companies paying regular and stable dividends may be considered less risky by investors. According to this perspective, a higher dividend payout can reduce perceived uncertainty and potentially increase the market value of shares. The theory supports the relevance of dividend policy and highlights the importance of investor preferences for current income.
Basic Concept:
Higher Dividend → Lower Perceived Risk → Higher Share Value
6. Dividend Irrelevance Theory
Dividend Irrelevance Theory argues that, under ideal market conditions, the dividend decision does not affect the value of the firm. Investors are assumed to be indifferent between receiving dividends and obtaining returns through capital appreciation. If a company retains profits, investors can sell a portion of their shares to create their desired income. If the company pays dividends, investors can reinvest them when desired. Therefore, total shareholder wealth depends on the firm’s earning capacity and investment decisions rather than its dividend policy. This theory is mainly associated with Modigliani and Miller.
Basic Relationship:
Firm Value = Earning Capacity + Investment Decisions
Thus, under the theory: