Management is to maximise shareholders wealth market

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Management is to maximise shareholders wealth market price of equity shares the relationship between the dividend policy & market price of equity shares needs to be understood
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Dividend policy Some of the key dividend theories/ positions are: Walter Model Gordan model MM model
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Walter Model James Walter has proposed a model of share valuation which supports the view that the dividend policy of the firm has a bearing on share valuation Assumptions : The firm is an all equity financed entity. Further, it will rely only on retained earnings to finance its future investments The rate of return on investments is constant Firm has an infinite life
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Walter Model Based on the above assumptions, Walter put forward the following valuation formula: where P = price per equity share D = dividend per share E = Earnings per share r = cost of capital RoI = Return on investments PV of infinite stream of Retained earnings PV of infinite stream of dividends r r RoI D E D P r r RoI D E r D P
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Implications of Walter model: When the rate of return is greater than the cost of capital (RoI > r), the price per share increases as the dividend payout ratio decreases. Optimal payout ratio is NIL When the rate of return is equal to the cost of capital (RoI = r), the price per share does not vary with changes in dividend payout ratio. Optimal payout ratio is Irrelevant When the rate of return is lesser than the cost of capital (RoI < r), the price per share increases as the dividend payout ratio increases. Optimal payout ratio is 100%
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Gordon Model Assumptions : The firm will rely only on retained earnings to finance its future investments The rate of return on investments is constant Growth rate of the firm is the product of its retention ratio (b) & its rate of return Cost of capital for the firm is constant Firm has an infinite life Taxes are absent
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Gordon Model Based on the above assumptions, Gordon put forward the following valuation formula: where P0 = price per equity share at the end of year 0 E1 = Earnings per share at the end of year 1 r = rate of return expected by investors RoI = Rate of return on investments b = plough back ratio E 1 ( 1 - b) r - ( RoI x b ) P 0 =
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Implications of Gordon model When RoI > r, Optimal payout ratio is NIL When RoI = r, Optimal payout ratio is Irrelevant When RoI < r, Optimal payout ratio is 100%
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