Page 305 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 14: Management of Surplus & Dividend Policy

3. Inclusion of a growth factor: In common shares valuation, we are primarily Notes
concerned with firm’s growth financed from retained earnings. We eliminate the
sources of funds for growth:
(a) Use of debt or other fixed return securities.
(b) Issuing additional common shares.

Analyzing the Dividend Growth Model

There are three possible situations. To do this, let us consider a company with EPS of 2 and
actual capitalization of 10%.
1. Normal capitalization rate less than actual capitalization rate: The shareholder in this
case will gain more by investing in the company. For example, he may be expecting an 8%
rate and the firm is actually achieving 10%. The shareholders want the firm to retain the
earnings and achieve 10% return on them from similar investments. Thus, he would
expect that raising the growth rate of a highly profitable firm. The intrinsic value at
different payout ratios are worked out as below:

.6 .6
30% Div. Payout = 8%  (10% 70%)  1%  60


1 1
50% Div. Payout =   33.33
8%  (10% 50%) 3%

1.4 1.4
70% Div. Payout =   28

8%  (10% 30%) 5%
2 2
100% Div. Payout =   25
8%  (10% 0%) 8%

The intrinsic value drops from 60 at a 30% dividend payout to 25 at 100% payout.
2. Normal capitalization rate equal to capitalisation rate: In this case, the firm is doing
about as well as expected and the shareholder probably does not care about the level of
dividends. Intrinsic value will be 20 at all payout levels.
3. Normal capitalisation rate more than actual capitalization rate: In this situation, the firm is
not doing as well as expected. It is expected that the intrinsic value to rise if the firm increased
its dividend payout. Since the shareholders would like to have cash to invest at higher return
elsewhere. The intrinsic value at different payout ratios are worked out as below:

.6 .6
30% Div. Payout =   12
12%  (10% 70%) 5%

1 1
50% Div. Payout =   14.3
12%  (10% 50%) 7%

1.4 1.4
70% Div. Payout =   15.55
12%  (10% 30%) 9%

2 2
100% Div. Payout =   16.67

12%  (10% 0%) 12%

LOVELY PROFESSIONAL UNIVERSITY 299