Page 221 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes 2. The assumption that the return on investment remains constant will not be true for firms
making high investments.
3. It ignores the business risk of the firm, which has a direct impact on the value of the firm.

Example: Illustrate approaches to dividend decisions using Walter Model: Let us consider
a firm with 4 earnings per share and 3 current dividend. The firm is currently selling for 22
per share and thus has an actual capitalization rate of 4/22 or 18%. The normal capitalization rate
for the industry is 12 per cent. The firm has a need for cash and is considering lowering the
dividend to 2 per share. What effect would this have on the value of common share by using
Walter Model?
Solution:
3  18/12 1 4.5

3 dividend = =  37.5
.12 .12
2  18/12 2 5

2 dividend = =  41.67
.12 .12
Gordon's Dividend Capitalization Model

Another model that has given importance to dividend policy of the firm is the Gordon Model.
Gordon Model assumes that future dividends are the sole determinant of the intrinsic value of
the common shares.
The model may be written:
Div. Curr.
Value of the share =
CR – (CR ) (% RE)
norm act
Where
Div. Curr = Current Dividend in rupees (annual basis)

CR = Capitalization rate demanded by the market for the stock
norm
of the type.
CR = Actual capitalization rate based on the firms current
act
earnings (provided they are relatively normal) and current
market price.

%RE = Percentage of Future earnings, the firm is likely to retain.
The dividend growth model shows the value of a share as the shares current dividend divided
by the amount that the demanded profit exceeded the rate of growth in the dividend, stated
graphically. The model shows value as:
Current dividend
Value of the share =
Demanded after tax profit > dividend growth

Example: If a firm has a 10% actual capitalization rate, a dividend payout of 40% and
declares a Re. 1 dividend in 2005. What is the growth rate? What is the likely stream of dividends
through 2009? If the firm is in industry with a 12% normal capitalization rate, what is the
intrinsic value using the dividend growth model?
Solution: Multiplying the actual capitalization rate by the percentage of retained earnings gives
the growth rate in dividend per share, assuming no change in dividend payout.

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