Relevance Theory of Dividends

True Tamplin

Written by True Tamplin, BSc, CEPF®
Updated on August 27, 2021

Relevance Theory of Dividends: Definition

Several authors, including M. Gorden, John Linter, James Walter, and Richardson, are associated with the relevance theory of dividends.

According to these authors, a well-reasoned dividend policy can positively influences a firm’s position in the stock market. Higher dividends will increase the value of stock, whereas low dividends will have the opposite effect.

It is increasingly a reality today that dividends provide an indication of an organization’s growing profitability over time.

Walter’s Approach

According to James Walter, dividend policy always affects the goodwill of a company. Walter argued that dividend policy reflects the relationship between the firm’s return on investment or internal rate of return and the cost of capital or required rate of return.

Suppose that r is the internal rate of return and K is the cost of equity capital. Then, for any given company, we have the following cases:

Case 1: When r > k

Firms with r > k are termed growth firms. Their optimal dividend policy involves ploughing back the company’s entire earnings. Thus, the dividend payment ratio would be zero. This would also maximize the market value of the company’s shares.

Case 2: When r < k

Firms with r < k do not offer profitable investment opportunities. For these firms, the optimal dividend policy involves distributing the entire earnings in the form of dividends.

Shareholders can use dividends to receive in other channels when they can get a higher rate of dividends. Thus, 100% dividend payout ratio in their case would result in maximizing the value of the equity shares.

Case 3: When r = k

For firms with r = k, it does not matter whether the firm retains or distributes its earnings. In their case, the share price would not fluctuate with a change in dividend rates. Thus, no optimal dividend policy exists for such firms.

Assumptions in Models Based on Walter’s Approach

(i) The firm undertakes its financing entirely through retained earnings. It does not use external sources of funds such as debts or new equity capital.

(ii) The firm’s business risk does not change with additional investment. This means that the firm’s internal rate of return and cost of capital remain constant.

(iii) Initially, earnings per share (EPS) and dividend per share (DPS) remain constant. The choice of values for EPS and DPS varies depending on the model, but any given values are assumed to remain constant.

(iv) The firm has a very long life.

Formula for Walter’s Approach

The market value of a share (P) can be expressed as follows:

P = (D + r) (E – D) / KE

or

P = (D + (r / KE) E-D) / KE

where

  • P = Market price of an equity share
  • D = Dividend per share
  • r = Internal rate of return
  • E = Earnings per share
  • KE = Cost of equity capital or capitalization rate

Example

Required: Based on the table shown below concerning companies A, B, and C, calculate the value of each share using Walter’s approach when the dividend payment ratio is 50%, 75%, and 25%. 

In addition,

  • D = (50 x 8) / 100 = 4
  • D = (75 x 8) / 100 = 6
  • D = (25 x 8) / 100 = 2
  A Ltd. B Ltd. C Ltd.
r 15% 5% 10%
Ke 10% 10% 10%
e $8 $8 $8

 

Solution

Relevance Theory of dividend - Walter and Gordan approach
Comment: A Ltd. is a growth firm because its internal rate of return exceeds the cost of capital. Here, it is better to retain the earnings rather than to distribute them as dividends. As is shown, when the D.P. Ratio is 25%, the share price is $110.

Criticisms:

  • The assumption that investments are financed through internal sources is not true. External sources are also used for financing.
  • The ratio between r and k is not constant in an organization. As investment increases, r also increases.
  • Earnings and dividends do not charge while determining the value.
  • The assumption that a firm will have a long life is difficult to predict.

Gorden’s Approach

Gorden proposed a model along the lines of Walter, suggesting that dividends are relevant and that the dividends of a firm influence its value.

The defining feature of Gorden’s model is that the value of a dollar in dividend income is greater than the value of a dollar in capital gain. This is due to the uncertainty of the future and the shareholder’s discount future dividends at a higher rate.

According to Gorden, the market value of a share is equal to the present value of the future stream of dividends.

Formula for Gorden’s Approach

The formula is given as follows:

P = E (1 – b) / (K– br)

or

P = D / (Ke – g)

where

  • P = Share price
  • E = Earnings per share
  • b = Retention ratio
  • Ke = Cost of equity capital
  • br = g
  • r = Rate of return on investment
  • D = Dividend per share

 

Leave a Comment