Page 222 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 9: Dividend Decisions

The firm retains a 60% share of the 10% post-tax profits for a 6% growth rate. The stream of Notes
dividend payments at a 6% growth rate is as follows:
1 1
Value of the share = = = 16.67
12% – (10%) (60%) 0.06

Factors Incorporated in the Dividend Growth Model

1. Restriction of the shareholders' return to a single variable: In this model the income factor
is limited to the current dividend earnings retained in the firm are part of the growth
factor that will operate to increase the current dividend, but only the dividend and its
expected increases are considered as a return.

2. Inclusion of two capitalization rates:
(a) Normal Capitalization Rate (CR ) i.e., reciprocal of PE ratio: If the firm is not able to
norm
achieve such a return at the existing market price, shareholders will sell their shares,
thus depressing the market price and raising the rate of return.
(b) Actual Capitalization Rate: The firm's actual capitalization rate is the relationship of its
actual EPS to the market price of its stock. This is an important factor influencing
growth. A firm with higher profits will have more funds to retain and hence more
money to finance growth, as compared with firms with lower profits.
3. Inclusion of a growth factor: In common shares valuation, we are primarily 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
= = 60
30% Div. Payout =
8% – (10% ×70%) 1%
1 1
= = 33.33
50% Div. Payout =
8% – (10% ×50%) 3%
1.4 1.4
= = 28
70% Div. Payout =
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.

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