Page 310 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes 3. Transaction costs: It is an unrealistic assumption that investors do not have to incur
transaction costs like brokerage when disposing off the shares. Further, the inconvenience
and the uncertainty involved in the share price movements make the investors prefer
current income by way of dividend to plough back of profits by the company.
4. Market conditions: Sometimes, market conditions do effect the investment decisions of
the firm. For instance, though a firm has profitable investment opportunities, the bad
market condition may not allow it to mobilize the funds. In such cases, firm will have to
depend on the retained earnings and will have a low dividend payout ratio.

14.3.5 Rational Expectations Model

According to rational expectation model, there would be no impact of the dividend declaration
on the market price of the share so long as it is at the expected rate. If the dividend declared is
higher or lower than the expected level it may show some adjustments. For example, in case the
firm declares dividend higher than what was expected, it would result in an upward movement
of the share price, as there would be expectations of higher earnings in future. Similarly, low
dividends would be taken as a fall in future earnings and hence market price will fall.

Example: The Agro Chemicals Company belongs to a risk class for which the appropriate
capitalization rate is 10%. It currently has 100,000 shares selling at 100 each. The firm has
proposed to declare 5 as dividend at the end of the current financial year, which has just begun.
What will be the price of the share at the end of the year, if a dividend is not declared? What will
be the price if one is? Answer on the basis of Modigliani and Miller model and assume no taxes.

Solution:
1. According to Walter’s formula, the optimum dividend payout ratio would be 0%
as R > R
a c
D R /R (E D)


c
a
V =
R c
0  12/10 5
=  60
10%
2. (a) Price of the shares, when dividends are declared (MM)
1
P =  (D 1  P )
1
(1  k )
e
1
100 = ( 5  P ) ,
1
1.10
Hence P = 105
1
(b) Price of the shares when dividends are not declared
1
100 = P ,
1.10 1
Hence P = 110
1

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