Friday, July 26, 2019

THEORY OF RELEVANCE MODEL OF DIVIDEND BY WALTER FOR UGC NET COMMERCE/MARKETING


  • DIVIDEND POLICY 2
    THEORY OF RELEVANCE
     ( WALTER)
    UGC NET COMMERCE /MANAGEMENT
  • FINANCIAL MANAGEMENT
  • WALTER’ S MODEL
  • CHOICE OF DIVIDEND POLICIES ALWAYS AFFECTS THE VALUE OF FIRM. HIS MODEL HIGHLIGHTED THE IMPORTANCE OF RELATION BETWEEN THE FIRM’S RATE OF RETURN, R AND COST OF CAPITAL ,K IN DETERMINING THE DIVIDEND POLICY THAT WILL MAXIMIZE  THE WEALTH OF SHAREHOLDERS.
  • ASSUMPTIONS
  1. INTERNAL FINANCING : USE OF RETAINED EARNING AND NO EXTERNAL DEBT
  2. CONSTANT RETURN AND COST OF CAPITAL
  3. 100 PERCENT PAYOUT AND RETENTION
  4. CONSTANT EARNING PER SHARE AND DIVIDEND PER SHARE
  5. INFINITE TIME
  • APPLICATION OF WALTER’S MODEL
  1. GROWTH FIRM : INTERNAL RATE MORE THEN OPPORTUNITY COST OF CAPITAL ( R>K). THEY WILL MAXIMIZE THE VALUE PER SHARE IF THEY FOLLOW A POLICY OF RETAINING ALL EARNINGS FOR INTERNAL INVESTMENT.
  2. NORMAL FIRMS :- INTERNAL RATE EQUALS OPPORTUNITY COST OF CAPITAL ( R=K).  NO UNIQUE OPTIMUM PAY OUT RATIO FOR A NORMAL FIRM. MARKET VALUE PER SHARE IS NOT EFFECTED.
  3. DECLINING FIRMS :- INTERNAL RATE EQUAL LESS THAN OPPORTUNITY COST OF CAPITAL ( R<K)
  • FORMULA
  • P = D/KE +( R(E-D)/KE)/KE
  1. P MEANS MARKET PRICE PER SHARE
  2. D MEANS DIVIDEND PER SHARE
  3. R MEANS INTERNAL RATE OF RETURN
  4. E MEANS EARNING PER SHARE
  5. KE MEANS COST OF EQUITY CAPITAL
  • INDICATES THAT MARKET PRICE PER SHARE IS THE SUM OF THE PRESENT VALUE OF TWO SOURCES OF INCOME
  1. D/KE   =PRESENT VALUE OF INFINITE STREAM OF CONSTANT DIVIDEND
  2. +( R(E-D)/KE)/KE=THE PRESENT VALUE OF THE INFINITE STREAM OF CAPITAL GAINS. IT OCCURS WHEN EARNINGS ARE RETAINED WITH IN THE FIRM


  • EXAMPLE
  • CAPITALIZATION RATE = 10%
  • EARNINGS PER SHARE =RS 50
  • ASSUMED RATE OF  RETURN ON INVESTMENT
  1. 12%
  2. 8%
  3. 10%
  • SHOW THE EFFECT OF DIVIDEND PAY OUT RATIO IS

  1. 0%
  2. 20%
  3. 40%
  4. 60%
  5. 80%
  6. 100%

  • SOLUTION ( WHEN R =12%)
  • P = D/ke +( r(E-D)/ke)/ke
  • WHEN DIVIDEND PAY OUT RATIO IS 0%
  • P = 0/.10 + (.12( 50-0)/.10)/.10 =RS 600
  • WHEN DIVIDEND PAY OUT IS 20%
  • P = 10/.10 +  (.12( 50-10)/.10)/.10 =RS 580
  • WHEN DIVIDEND PAY OUT IS 100%.
  • P = 50/.10 +  (.12( 50-50)/.10)/.10 =500
  • SOLUTION (WHEN R = 8%)
  • P = D/ke +( r(E-D)/ke)/ke
  • WHEN DIVIDEND PAY OUT RATIO IS 0%
  • P = 0/.10+ (.8( 50-0)/.10)/.10 =RS 400
  • WHEN DIVIDEND PAY OUT IS 20%
  • P = 10/.10 +  (.8( 50-10)/.10)/.10 =RS 420
  • WHEN DIVIDEND PAY OUT IS 100%.
  • P = 50/.10 +  (.8( 50-50)/.10)/.10 =500

  • SOLUTION( WHEN R=10%
  • P = D/ke +( r(E-D)/ke)/ke
  • WHEN DIVIDEND PAY OUT RATIO IS 0%
  • P = 0/.10 + (.10( 50-0)/.10)/.10 =RS 500
  • WHEN DIVIDEND PAY OUT IS 20%
  • P = 10/.10 +  (.10( 50-10)/.10)/.10 =RS 500
  • WHEN DIVIDEND PAY OUT IS 100%.
  • P = 50/.10 +  (.10( 50-50)/.10)/.10 =500

  • CONCLUSION VERY IMPORTANT
  1. WALTER’S MODEL,THE DIVIDEND POLICY OF THE FIRM DEPENDS ON THE AVIALABILITY OF INVESTMENT OPPORTUNITIES AND THE RELATIONSHIP BETWEEN THE FIRM ‘S INTERNAL RATE OF RETURN,COST OF CAPITAL K
  2. RETAIN ALL EARNING WHEN r>k
  3. DISTRIBUTE ALL EARNING WHEN r<k
  4. DIVIDEND OR RETENTION POLICY HAS NO EFFECT WHEN r=k
·         MOST IMPORTANT
·         DIVIDEND POLICY IN WALTER’S MODEL IS A FINANCING DECISIONS. WHEN DIVIDEND POLICY IS TREATED AS A FINANCING DECISION ,THE PAYMENT OF CASH DIVIDEND IS PASSIVE RESIDUAL
  • CRITICISM
  • FIRMS ALSO RELY ON EXTERNAL FINANCING
a)    MIXES DIVIDEND POLICY WITH INVESTMENT POLICY OF THE FIRM
b)    ASSUMES THAT RETAINED EARNING FINANCE THE INVESTMENT OPPORTUNITIES AND NO EXTERNAL FINANCING
c)    THEN FIRM’S INVESTMENT OR DIVIDEND POLICY OR BOTH WILL BE SUB OPTIMUM
d)    THE WEALTH OF THE SHAREHOLDER WILL BE MAXIMIZED WHEN OPTIMUM INVESTMENT IS MADE
  • THE INTERNAL RATE OF RETURN DOES NOT REMAIN CONSTANT
  • THE COST OF CAPITAL DOES NOT REMAIN CONSTANT . IT CHANGES DIRECTLY WITH FIRM’S RISK. PRESENT VALUE OF THE FIRM’S INCOME MOVES INVERSELY WITH THE COST OF CAPITAL,

  • MCQ ON WALTER MODEL
  • WHICH ONE OF THE ASSUMPTION IS NOT INCLUDED IN THE JAMES E WALTER VALUATION MODEL
a)    NO CHANGE IN THE KEY VARIABLE SUCH AS EPS AND DPS
b)    ALL EARNINGS ARE EITHER DISTRIBUTED AS DIVIDEND OR INVESTED INTERNALLY IMMEDIATELY
c)    ALL FINANCING BY RETAINED EARNINGS
d)    THE FIRM HAS FINITE LIFE
  • WHICH ONE OF THE FOLLOWING STATEMENT IS FALSE
a)    ACCORDING TO WALTER,THE OPTIMAL PAYOUT RATION FOR A GROWTH FIRM IS 100%
b)    EFFECTIVE DIVIDEND POLICY IS AN IMPORTANT TOOL TO ACHIEVE THE GOAL OF WEALTH MAXIMIZATION
c)    MM MODEL ASSERTS THAT THE VALUE IS NOT AFFECTED WHETHER THE FIRM PAYS DIVIDEND OR NOT
d)    BIRD –IN- HAND THEORY IN REFERENCE TO DIVIDEND DECISIONS HAS BEEN DEVELOPED BY MYRON GORDON
  • THE PROPORTION OF THE EARNING WHICH IS  DISTRIBUTED AMONG SHAREHOLDERS IN THE FORM OF DIVIDEND IS CALLED:
a)    PROPRIETARY RATIO
b)    EARNING YIELD RATIO
c)    PAYOUT RATIO
d)    RETENTION RATIO
  • DIVIDEND IS NOT RELEVENT IN DETERMINING THE VALUE OF THE COMPANY WHO AMONG THE FOLLOWING HELD THIS VIEW
a)    JE WALTER
b)    MODIGLIANI MILLER
c)    EZRA SOLOMAN
d)    MJ GORDON
  • MCQ
  • WHICH COMBINATION OF THE FOLLOWING REPRESENTS THE ASSUMPTIONS OF THE WALTER’S DIVIDEND POLICY
  1. THE COMPANY HAS  A VERY LONG OR PERPETUAL LIFE
  2. ALL EARNING EITHER REINVESTED INTERNALLY OR DISTRIBUTED AS DIVIDEND
  3. COST OF THE CAPITAL OF THE COMPANY IS CONSTANT
  4. NO FLOTATION COST FOR THE COMPANY
  • CODES
  1. 1,2,3
  2. 2,3,4
  3. 1,2,4
  4. 1,2,3,4


  • ABC LTD EARNS RS 10 PER SHARE,CAPITALIZED AT 10% AND HAS RETURN ON INVESTMENT OF 12%. WHAT IS THE OPTIMUM DIVIDEND PAYOUT RATIO AS PER WALTER ;S DIVIDEND POLICY MODEL
  1. 0%
  2. 2%
  3. 10%
  4. 12%

  • SOLUTION
  • P = D/ke +( r(E-D)/ke)/ke
  • P=0/.10 +( .12(10-0)/.10)/.10
  • = 0 + ( .12X10/.10=120)/.10=12X100/10=120
  • WHEN PAY OUT IS 2% IT MEANS DIVIDEND IS PAID =10x2/100=,2
  • P = D/ke +( r(E-D)/ke)/ke
  • P=,2/.10 +(.12(10-.2)/,10)/.10
  • P= (2/10X100/10=2) +(12/10(9.80)/.10) = 2+ ( 12 X9.80)=2+117.6=119.6
WHEN PAY OUT IS 10%
  • P = D/ke +( r(E-D)/ke)/ke
  • P=1/.10 +( .12(10-1)/.10)/.10
  • = 10 + ( .12X9/.10= 108/10)/.10= 10+108/10X100/10=10+108=118
  • WHEN PAY OUT IS 1 2% IT MEANS DIVIDEND IS PAID =10x12/100=1.20
  • P = 1.20/ke +( r(E-D)/ke)/ke
  • P=1,2/.10 +(.12(10-.1.20)/,10)/.10
  • P= (12) +(12/10(8,80)/.10) = 2+ ( 12 X8.80)=12 +105,6=117.6

  • WHICH ONE OF THE FOLLOWING ASSUMPTIONS IS NOT  COVERED IN THE WALTER’S MODEL OF THE DIVIDEND POLICY
  1. ALL FINANCING IS DONE THROUGH RETAINED EARNING
  2. FIRM’S BUSINESS RISK DOES NOT  CHANGE DUE TO ADDITIONAL INVESTMENTS
  3. THE FIRM HAS AN INFINITE LIFE
  4. THE KEY VARIABLES LIKE EPS AND DPS  KEEP ON CHANGING
  • DIVIDEND IRRELEVANCE ARGUMENT OF MM MODEL IS BASED ON
  1. HEDGING
  2. ISSUE OF DEBENTURES
  3. LIQUIDITY
  4. ARBITRAGE

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