Relevant Theory Homework Help

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Basically there are two types of theories related to the dividend policy: – Relevant theory and Irrelevant theory. If the value of a firm is affected by the choice of the dividend policy, it is considered to be relevant. And in such situations, any change in the dividend pay-out is followed by a change in the market value of a firm. A relevant dividend always has an optimum pay-out ratio. The relevant theory has been explained in a quite detailed way by the following great mathematicians Gordon and Walter.Their theories believe in the relevance of the dividend. The details of their theories have been mentioned below in the Relevant Theory Homework Help.
 

Theories of Gordon and Walter

 

Let us first go through the Gordon’s theory on Dividend Policy.
 

Myron Gordon’s theory is also known as the ‘Bird-in-the-hand’ theory which states that the current dividends are quite essential in determining the value of the firm. This theory is used to calculate the market value of a company using its market value. Students can refer Relevant Theory Homework Help for the assumptions of Gordon’s model.
 

• There is an all equity in the company with no debt in the capital structure.
• No external financing is required for a company if all its investments are financed by retained earnings.
• This model assumes that a constant internal rate of return as well as constant cost of capital is maintained.
• Also a constant retention ratio is assumed by this model.
• No corporate taxes are accounted for this model.
 

Gordon’s formula to calculate the market price per share: – P={EPS*(1-b)}/(k-g) where
 

P= market price per share, EPS= earnings per share, b= retention ratio of the firm, k= cost of capital, (1-b) = pay-out ratio, g=b*r growth rate, r= rate of return.
 

Now let us have a look on the Walter’s theory on Dividend Policy.

According to this theory, the concept that the value of companies paying higher dividends is more as compared to those paying low is explained in a mathematical method. A dividend decision of the company affects the valuation. The assumptions of this model are given below in the Relevant Theory Homework Help.
 

• The model assumes internal financing of all the investments.
• The cost of capital and internal rate of return are constant.
• The EPS and DPS are assumed to be constant.
• The earnings of the company are paid out i.e. the rate of retention is 100%.
• The company is assumed to have a very long infinite life.
 

Walter’s formula to calculate market share per price is mentioned in Relevant Theory Homework Help as: – P = D/k + {r*(E-D)/k}/k where
P = market price per share, D = dividend per share, E = earnings per share, r = rate of return and k = capital cost.
 

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