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Net income approach

Net income (NI) approach as this is also called as traditional approach. This is an approach in

which both cost of debt, and equity are independent of capital structure. The components which are

involved in it are constant and doesn't depend on how much debt the firm is using. This theory was

proposed by David Durand. In this change in financial leverage leads to change in overall cost of capitalas well as total value of firm. If financial leverage increases, weighted average cost decreases and value

of firm and market price of equity increases. If this decreases then weighted average cost of capital

increases and value of firm and market price of equity decreases. The assumptions which can be made

according to this approach is that there are no taxes involved in this and the use of debt doesn't change

the risk factor for the investors and will remain the same throughout.

Net Income (NI) Approach

Net Income theory was introduced by David Durand. According to this approach, the capital structure

decision is relevant to the valuation of the firm. This means that a change in the financial leverage will

automatically lead to a corresponding change in the overall cost of capital as well as the total value of

the firm. According to NI approach, if the financial leverage increases, the weighted average cost of

capital decreases and the value of the firm and the market price of the equity shares increases. Similarly,

if the financial leverage decreases, the weighted average cost of capital increases and the value of the

firm and the market price of the equity shares decreases.

Assumptions of NI approach:

1. There are no taxes2. The cost of debt is less than the cost of equity.3. The use of debt does not change the risk perception of the investors

Example

A company expects its annual EBIT to be $50,000. The company has $200,000 in 10% bonds and the cost

of equity is 12.5(ke)%.

Calculation of the Value of the firm:

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Effect of change in the capital structure: (Increase in debt capital)

Let us assume that the firm decides to retire $100,000 worth of equity by using the proceeds of newdebt issue worth the same amount. The cost of debt and equity would remain the same as per the

assumptions of the NI approach. This is because one of the assumptions is that the use of debt does not

change the risk perception of the investors.

Calculation of new value of the Firm

Please note:

Overall cost of capital can also be calculated by using the weights of debt and equity contents with the

respective cost of capitals.

This proves that the use of additional financial leverage (debt) causes the value of the firm to increase

and the overall cost of capital to decrease.

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Walter's Dividend Model

Walter's model supports the principle that dividends are relevant. The investment policy of a firm

cannot be separated from its dividend policy and both are inter-related. The choice of an appropriate

dividend policy affects the value of an enterprise.

Assumptions of this model:

1. Retained earnings are the only source of finance. This means that the company does not relyupon external funds like debt or new equity capital.

2. The firm's business risk does not change with additional investments undertaken. It implies thatr(internal rate of return) and k(cost of capital) are constant.

3. There is no change in the key variables, namely, beginning earnings per share(E), and dividendsper share(D). The values of D and E may be changed in the model to determine results, but any

given value of E and D are assumed to remain constant in determining a given value.

4. The firm has an indefinite life.

Formula: Walter's model

P = DKe g

Where: P = Price of equityshares

D = Initial dividendKe = Cost of equity

capital

g = Growth rate

expected

After accounting for retained earnings, the model would be:

P = DKe rb

Where: r = xpected rate of return on firms investments

b = etention rate (E - D)/E

Equation showing the value of a share (as present value of all dividends plus the present value of all

capital gains) Walter's model:

P = D + r/ke (E -D)

ke

Where: D = Dividend per share and

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Example:

A company has the following facts:

Cost of capital (ke) = 0.10

Earnings per share (E) = $10

Rate of return on investments ( r) = 8%

Dividend payout ratio: Case A: 50% Case B: 25%

Show the effect of the dividend policy on the market price of the shares.

Solution:

Case A:D/P ratio = 50%

When EPS = $10 and D/P ratio is 50%, D = 10 x 50% = $5

P =

5 + [0.08 / 0.10] [10 - 5]

0.10

=> $90

Case B:D/P ratio = 25%

When EPS = $10 and D/P ratio is 25%, D = 10 x 25% = $2.5

P =

2.5 + [0.08 / 0.10] [10 -2.5]

0.10

=> $85

Conclusions of Walter's model:

1. When r > ke, the value of shares is inversely related to the D/P ratio. As the D/P ratio increases,the market value of shares decline. Its value is the highest when D/P ratio is 0. So, if the firm

retains its earnings entirely, it will maximize the market value of the shares. The optimum

payout ratio is zero.

2. When r < ke, the D/P ratio and the value of shares are positively correlated. As the D/P ratioincreases, the market price of the shares also increases. The optimum payout ratio is 100%.

3. When r = ke, the market value of shares is constant irrespective of the D/P ratio. In this case,there is no optimum D/P ratio.

Limitations of this model:

1. Walter's model assumes that the firm's investments are purely financed by retained earnings. Sothis model would be applicable only to all-equity firms.

2. The assumption of r as constant is not realistic.3. The assumption of a constant ke ignores the effect of risk on the value of the firm.

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Clienteleeffect

Change in a firm's dividend policy may cause loss of old clientele and gain of new clientele, based on

their different dividend preferences.

Clientele Type Example

Retirees are more likely to prefer high dividend payouts over capital gains since this provides them with

cash income. Therefore, if a company discontinued paying dividends, the clientele effect may cause

retiree shareholders to sell the stock in favor of other income generating investments.

The clientele effect is the idea that the type of investors attracted to a particular kind of securitywill affect the price of the security when policies or circumstances change.

Current clientele might choose to sell their stock if a firm changes their dividend policy anddeviates considerably from the investor's preferences. Changes in policy can also lead to new

clientele, whose preferences align with the firm's new dividend policy.

In equilibrium, the changes in clientele sets will not lead to any change in stock price. The real world implication of the clientele effect lies in the importance of dividend policy

stability, rather than the content of the policy itself.

clientele effectThe theory that changes in a firm's dividend policy will cause loss of some clientele who will

choose to sell their stock, and attract new clientele who will buy stock based on dividend

preferences.

dividend clienteleSets of investors who are attracted to certain types of dividend policy.

clienteleThe body or class of people who frequent an establishment or purchase a service, especially

when considered as forming a more-or-less homogeneous group of clients in terms of values or

habits.

EXAMPLES

Suppose Firm A had been in a growth stage and did not offer dividends to its shareholders, buttheir policy changed to paying low cash dividends. Clientele interested in long term capital gains

might be alarmed, interpreting this decision as a sign of slowing growth, which would mean less

stock price appreciation in the future. This set of clientele could choose to sell the stock. On the

other hand, dividend payments could appeal to investors who are interested in regular

additional income from the investment, and they would buy Firm A's stock.

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Tax Differential

MMs assumption that taxes do not exist is far from reality. Investors have to pay taxes on dividends and

capital gains. But different tax rates are applicable to dividends and capital gains. Dividend income is

generally treated as the ordinary income why capital gains are specially treated for tax purposes. In, sot

countries, the capital gains tax rate is lower the marginal tax rate ordinary income. Form the tax point ofview, a shareholder in high tax bracket should prefer capital gains over current dividends for two reason;

(i) the capital gains tax is less than the tax on dividends and (ii) the capital gains tax is payable only earn

the share are actually sold. The effect of the favorable tax differential in case of capital gains will result

in tax savings. As a consequence, the value of the share should be higher in the internal financing case

than in the external financing one. Thus, the tax advantage of capital gains will result in tax savings; as a

consequence the value of the share should be higher in the internal financing case than in the external

financing one. Thus the tax advantage of capital gains over dividends strongly favors a low-dividend

payout policy. This implies that investors will pay more for low-dividend yield shares. Tax differential

should own attract tax clienteles investors in high-tax bracket should own high-payout shares. In reality,

most investors may have marginal income tax rate higher than the capital gains tax rate. Thus dividends,on an average, are considered bad since they will result in higher taxes and reduction in the wealth of

shareholders. Tax differential generally favour low-payout clientele.

If a tax system favours capital gains to dividend income there may still be several investors who are in

lower tax brackets. These investors investing in shares will prefer dividend income rather capital gains.

Thus there may exit high-payout clientele. In a tax system that treats dividends more favorable than

capital gains, shareholders in high tax brackets will also prefer receiving dividends rather than capital

gains. Under this tax system, dividends will be considered good and it will generally attract high-payout

clientele.

Signaling Hypothesis

Signaling theory is based on the assumption that information is not equally available to all parties at the

same time, and that information asymmetry is the rule. Information asymmetries (see also asymmetry

issuer/investor) can result in very low valuations or a sub-optimum Investment policy. Signaling theory

states that corporate financial decisions are signals sent by the company's managers to Investors in

order to shake up these asymmetries. These signals are the cornerstone of financial communications

policy.

The idea that many actions taken by economic agents are motivated chiefly by the wish to send a

positive signal to other agents, rather than by their ostensible purpose. This can be a means of

overcoming the problem of asymmetric information between transactors. For example, a business maychoose to spend an ostentatious amount of money on advertising a new product not because this is

the most cost-effective form of publicity, but because a large outlay by the company signals its faith in

the product to investors, distributors, and other stakeholders. Similarly, a generous dividend policy can

be a means by which management signals its positive view of the firm's position and future prospects to

the financial markets. In this case, such signaling is a means of overcoming the mismatch between the

information available to managers and that available to shareholders. See also agency relationship.