Graham And Dodd Model On Dividend Payout Finance Essay

Dividend policy of a company is really important in order to keep good dealingss with the investors ( specially the stockholders ) of the company. When a company makes a net income, the direction decides on what to make with those net incomes.

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They have the option of retaining the net incomes and reinvesting them so as to gain more net incomes and increase stockholder wealth in footings of addition in portion monetary values or paying the net incomes earned as dividend to stockholders so that the stockholders can hold some hard currency in manus.

However, once the company decides to pay dividends, it should set up a lasting dividend policy, which may impact on investors and perceptual experiences of the company in the fiscal markets. Generally, companies paying dividends are respected by the stockholders given the liquidness penchant theory. If the company thinks that it has adequate investing chances and they would be able to well increase the value of the company for the stockholders, it should retain the net incomes. What they decide depends on the state of affairs of the company now and in the hereafter. It besides depends on the penchants of investors and possible investors.

Factors Favoring Higher Dividend Payout

AGENCY COSTS- Agency costs are differences between the involvements of shareholders and the involvements of direction. More external capital is required to pay higher dividends. This leads to a greater examination in the market therby cut downing bureau costs.

“ BIRD-IN-HAND ” – This statement holds that future net incomes are less predictable and more unsure than dividends, at least because they are further in the hereafter. The greater uncertainness of future net incomes should be reflected in a higher price reduction rate on capital additions than on dividends. This in bend would do investors to prefer a more certain $ 1.00 of dividends over a less certain $ 1.00 of future net incomes.

“ PROSPECT THEORY ” – This statement suggests that investors have a different attitude toward capital additions than toward dividends. Capital additions become portion of the investing base or lasting capital, which investors hesitate to cut down. Paid dividends, nevertheless, are considered as current income and are expendable. Because “ homemade ” dividends require decrease of capital, they have a different psychological impact than paid dividends and are an imperfect replacement.

Factors Favoring a Lower Dividend Payout

TAXES- Although both capital additions and dividends are taxed, the revenue enhancement on capital additions is lower and will non be paid until the stock is sold. Since payment of capital additions revenue enhancement can be delayed, investors will be loath to make dividends by selling stock. Investors trying to undo a dividend payment by purchasing stock with dividends must pay revenue enhancements on the dividends, and can non wholly change by reversal the dividend. The investor will be better off if the house retains the net incomes and reinvests them to bring forth capital additions, since revenue enhancement payment is deferred.

TRANSACTIONS COSTS- In add-on to revenue enhancements, investors reinvesting dividends will besides confront assorted minutess costs such a securities firm fees. Conversely, a house that pays dividends and so must turn to external beginnings besides faces minutess costs such as the “ floatation costs ” of publishing new securities. If the house retains the financess and reinvests straight, both types of cost are avoided.

Other Considerations

DIVIDENDS AS A RESIDUAL- The statement for dividend irrelevance assumes that all investing takes topographic point at the needed rate of return for the house. In actuality, it is likely that the house faces a mix of hazard and return possibilities. The house should therefore accept all undertakings with a positive net nowadays value, and pay dividends merely if it has more financess than are expected to be required for attractive undertakings. While attractive to faculty members, this attack is rarely used in pattern because it consequences in unsure dividends and a greater perceptual experience of hazard by investors.

CLIENTELE EFFECT- The clientele consequence indicates that investors will be given to keep stocks whose dividend policy fits their demands. That is, investors preferring more certain dividends over unsure future net incomes, or holding a penchant for current income over capital additions, will be given to keep stocks with comparatively high dividend payout, and frailty versa ( i.e. , a stock will hold a patronage attracted by its dividend policy ) . Under these conditions, it is non the dividend policy itself that is relevant, but the stableness of the policy.

SIGNALING- Most theoretical theoretical accounts assume that information is freely available to all. It has been suggested that in world entree to information varies. Management may hold entree to inside information, doing an “ information dissymmetry ” between direction and shareholders. Signing refers to the usage of dividends and dividend alterations to convey information to investors. Similar to the clientele consequence, it is non the absolute but instead the comparative degree of dividends that is of import. Under this statement direction will avoid increasing dividends unless it is extremely likely that the higher degree of dividends can be maintained. This implies that a dividend addition is a signal that the house has reached a new degree of profitableness, and is a positive signal. A dividend lessening, on the other manus, indicates that profitableness has decreased and the former dividend degree can non be supported, a negative signal. Note that under the residuary statement, nevertheless, a dividend addition ( lessening ) signals a deficiency ( copiousness ) of attractive undertakings and reduced ( increased ) future house growing. Because of the potency for false signals, more dearly-won signalling is considered more dependable.

Graham and Dodd Model

Graham and Dodd Model holds that the stock market favor companies, which give more dividends than on, retained net incomes. Hence an investor should measure a common stock by using one multiplier to the part of net incomes paid out as dividends and a smaller multiplier to undistributed net incomes. In other words, more weight should be put on dividends than on maintained net incomes.

Their point of view is expressed as

P=m x ( D + E/3 )


P = Market price/share ;

m = multiplier ;

D = DPS ;



The chief premises of this theoretical account are:

Investors are rational.

Under conditions of uncertainness they turn risk averse.

Deductions and Criticism

The chief deduction of this theoretical account is that weight attached to dividends is equal to four times the weight attached to retained net incomes. This can be shown by re-arranging the above expression:

P=m x ( D + ( D+R ) /3 )

The weights provided by Graham and Dodd are based on their subjective opinions. So the decision of this theoretical account is that a broad payout policy has a favorable impact on the stock monetary value.


Alpha Ltd. has recorded an EPS of Rs. 6 for 1998-99. The company follows a fixed dividend payout ratio of 75 % . If the multiplier for the industry is 12, compute the expected market monetary value for the portion based on the Graham-Dodd Model.


The dividend per portion is Rs. 6 * 0.75 = Rs.4.50

Based on the Graham-Dodd Model, the expected market monetary value would be

P = m ( D + E/3 )

= 12 ( 4.50 + 6/3 )

= Rs. 78 per portion.


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