Dividend growth model and Dividend irrelevancy theory: Difference between pages

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''Equity valuation and cost of capital''.
In financial theory, dividend payments and policies should be irrelevant when financial markets are efficient.  


(DGM).  
This is because amounts retained - or distributed - by the company would in theory earn the same future rate of return for the investors.


The Dividend growth model links the value of a firm’s equity and its market cost of equity, by modelling the expected future dividends receivable by the shareholders as a constantly growing perpetuity.
Moreover, investors who require cash could sell part of their holdings.


While investors who don't require cash could use any dividend distributions to buy more shares in the company.


==Applications of the DGM==


Common applications of the dividend growth model include:
But in practice decisions about dividend levels are important because of:


(1) Estimating the market <u>cost of equity</u> from the current share price; and
#Their informational content. This informational content is known as ''[[signalling]]''.
 
#The potential to move closer to, or away from, a firm's optimal capital structure.
(2) Estimating the fair <u>value</u> of equity from a given or assumed cost of equity.
#Possibly, [[clientele]] effects, including taxes on investors.
 
 
==DGM formulae==
 
The DGM is commonly expressed as a formula in two different forms:
 
Ke = (D<sub>1</sub> / P<sub>0</sub>) + g
 
''or (rearranging the formula)''
 
P<sub>0</sub> = D<sub>1</sub> / (Ke - g)
 
 
''Where:''
 
P<sub>0</sub> = ex-dividend equity value today.
 
D<sub>1</sub> = expected future dividend at Time 1 period later.
 
Ke = cost of equity per period.
 
g = constant periodic rate of growth in dividend from Time 1 to infinity.
 
 
This is an application of the general formula for calculating the present value of a growing perpetuity.
 
 
 
<span style="color:#4B0082">'''Example 1: Market value of equity'''</span>
 
Calculating the market <u>value</u> of equity.
 
 
''Where:''
 
D<sub>1</sub> = expected dividend at future Time 1 = $10m.
 
Ke = cost of equity per period = 10%.
 
g = constant periodic rate of growth in dividend from Time 1 to infinity = 2%.
 
 
P<sub>0</sub> = D<sub>1</sub> / (Ke - g)
 
= 10 / (0.10 - 0.02)
 
= 10 / 0.08
 
= $'''125'''m.
 
 
 
<span style="color:#4B0082">'''Example 2: Cost of equity'''</span>
 
Or alternatively calculating the current market <u>cost of equity</u> using the rearranged formula:
 
Ke = (D<sub>1</sub> / P<sub>0</sub>) + g
 
 
Where:
 
D<sub>1</sub> = expected future dividend at Time 1 = $10m.
 
P<sub>0</sub> = current market value of equity, ex-dividend = $125m.
 
g = constant periodic rate of growth in dividend from Time 1 to infinity = 2%.
 
 
Ke = (10 / 125) + 2%
 
= 8% + 2%
 
= '''10%.'''
 
 
The dividend growth model is also known as the Dividend discount model, the Dividend valuation model or the Gordon growth model.




== See also ==
== See also ==
* [[Capital asset pricing model]]
* [[Capital structure]]
* [[Cost of equity]]
* [[Clientele]]
* [[Corporate finance]]
* [[Dividend]]
* [[Ex-dividend]]
* [[Lintner]]
* [[Perpetuity]]
* [[Residual theory]]
 
* [[Rights issue]]
 
*[[Signalling]]
==Student article==
* [[Theoretical ex-rights price]]
[[Media:2013_10_Oct_-_The_real_deal.pdf| The real deal, The Treasurer]]
 
''Real rates of corporate decline often lead to miscalculation, overpaying for acquisitions and disastrous losses.''
 
''This article shows how to avoid the most common errors and add value for your organisation.''


[[Category:The_business_context]]
[[Category:Corporate_finance]]
[[Category:Corporate_finance]]
[[Category:Investment]]
[[Category:Financial_products_and_markets]]
[[Category:Financial_products_and_markets]]

Revision as of 22:05, 4 January 2021

In financial theory, dividend payments and policies should be irrelevant when financial markets are efficient.

This is because amounts retained - or distributed - by the company would in theory earn the same future rate of return for the investors.

Moreover, investors who require cash could sell part of their holdings.

While investors who don't require cash could use any dividend distributions to buy more shares in the company.


But in practice decisions about dividend levels are important because of:

  1. Their informational content. This informational content is known as signalling.
  2. The potential to move closer to, or away from, a firm's optimal capital structure.
  3. Possibly, clientele effects, including taxes on investors.


See also

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