Debt Equity substitution theory This theory describes the relationship between

Debt equity substitution theory this theory describes

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Debt-Equity substitution theory This theory describes the relationship between debt-equity, after tax earnings and share prices of quoted companies; managers adjust the debt and equity structure in the balance sheet in order to increase the earnings per share. The resulting effect of debt- equity in a firm’s balance sheet shows the reasons companies often adopt dividends payments and others do not. When distributing earnings to stakeholders in form of dividend, management typically choose between cash dividend or share repurchases; the theory explains the reasons why some firms repurchased agreement lead to a reduction in earnings, such companies prefer cash dividend over share repurchases. Mathematical representation of debt-equity theory K D > 1 - T C -1 E Q 1 - T D Where: K D = total long term debt Eq = total equity Tc = tax rate on capital gain Td = the tax rate on dividends Walter’s Model Relevant theory argued that dividend policy is significant to the share price of a firm. The relevant theory shows clearly the significant relationship between the firm’s internal rate of return (r) and its cost of capital (k) in computing the dividend yield as reflected in shareholders’ wealth maximization. Mathematical formula of Walter’s theory to compute the current price per share is as follows P 0 = D 1 + (r) (E – D 1 )/K c K c Where, P 0 = share value per share D 1 = Dividend per share r = internal rate of return on the firm’s investment K e = Cost of equity E = Earnings per share Gordon’s Model The theory also known as relevant theory believes that consistent dividend’s payment affect the value of the firm; the theory highlight the significant between dividend pay-out ratio, internal rate of return, cost of fund and the current value of the share price. Mathematical formula of the model P 0 = E (1 – Rt) K f - g Where, P 0 = Market price per share E = Earnings per share Rt = Retention ratio (1-payout ratio) r = Rate of return
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Research Journal of Finance and Accounting ISSN 2222-1697 (Paper) ISSN 2222-2847 (Online) Vol.7, No.3, 2016 19 k f = Cost of fund g = Growth rate (g) M&M THEORY Modigliani and Miller (M&M), postulates the irrelevancy of dividend in determining the share value of a firm as it does not impact on the shareholder’s wealth. They argued that the worth of a firm is reflected by total earnings born out of the investment decisions of the firm. Mathematical formula of M&M theory r= D 1 + (P 1 + P 0 ) P 0 Where, D 1 = Current Dividend per share P 1 = Market price per share P 0 = Current market price per share CONCEPTUAL FRAME WORK Functions of finance managers is to strike balance between dividend payout ratio and retained earnings; this is very difficult because of the conflicting interest of shareholders – heterogeneous expectation- some shareholders prefer consistent payment of dividend whereas others will prefer capital gains arising from increased share prices (Aivazian et al, 2002) Finance manager will choose the type of dividend payment methods to adopt when making decisions regarding cash dividends or through stock repurchased. Various factors may be taken into consideration; where
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  • Spring '19
  • BEM
  • Dividend, Dividend yield, ISSN, Research Journal of Finance and Accounting

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