Dividend decisions and Valuation of Firm: Lintner Model | Commerce & Accountancy Optional Notes for UPSC PDF Download

Introduction

• The Lintner's Model, formulated by Professor John Lintner of Harvard Business School, emerged from his comprehensive study involving interviews with 28 prominent firms. The model focuses on an organization's current dividend, taking into account its current annual earnings and the dividends from the previous year. Lintner's key assumptions include the existence of predetermined dividend policies within organizations, with a preference for maintaining a consistent dividend rate.
• Lintner's observations revealed that organizations typically establish target dividends to earnings ratios based on the present net value. Moreover, he noted that changes in dividends are influenced by sustainable increases in earnings. In essence, Lintner's model suggests that organizations adjust their dividends in response to sustainable earnings growth rather than short-term fluctuations.

Lintner Dividend Model 

The dividend, in essence, involves the distribution of an organization's annual earnings among its shareholders. Dividends can take various forms, including cash, stock, and property. In the context of cooperative organizations, dividend policies become notably sensitive and intricate. To elucidate the dynamics of dividend policy, Lintner's Dividend Model was introduced. This model focuses on two primary determinants of dividend payout: recent earnings and prior dividends.
According to Lintner's model, if an organization adheres to its target payout ratio, the dividend will undergo adjustments in response to changes in earnings. The dividend payout is calculated as the current net income after tax and the lagged dividend, representing the dividend from the previous year.
Lintner's Dividend Model is expressed through the following formula:

Dt represents the total equity dividend. t represents time.
Dt-1 is the sum of the equity dividend in a span of t-1.
Pt is the current net earnings after tax. This represents an organisational capability to pay the dividend to the stakeholders.
Ut is the error term.
Lintner’s Model assumes that an investor prefers a substantial dividend payout. The dividend payout to the stakeholders is dependent on current net earnings and the sustainability of the earnings. An increase in net earnings will increase the dividend paid to the stakeholders. Lintner’s Model was formulated after interviewing 28 large firms, and it helps an organisation to understand the trend of its dividend.
Through Lintner’s Dividend Model, an organisation can identify a possibility of reluctance in different parts of the management. The model enables an organisation to achieve the laid payout plan in the long end. To ensure stability in dividend rate, organisations make partial changes to the rate annually depending on the change in the earnings.

Lintner’s Model – Assumptions 

• Lintner's Model operates under the assumption of a perfect capital market, wherein all investors are deemed rational, information is readily accessible, and securities can be infinitely divided. The model posits that each investor holds the capacity to impact security prices in the market, and there are no associated flotation costs. Additionally, Lintner's Model assumes that tax rates for capital gains and dividends are identical.
• However, the assumptions inherent in Lintner's Model are unrealistic and unattainable in real-world scenarios. The method employed to calculate dividend payouts is deemed questionable due to the imperfections present in the capital market and the inherent uncertainty resolution challenges.

Organisational dividends setting 

The dividend policy within an organization, including payout rates and distribution dates, is formulated by the board of directors.
Three primary approaches characterize organizational dividend policies:

• Residual Approach: In this approach, dividends are derived from the remaining equity after fulfilling all project requirements. Organizations employing this approach prioritize maintaining balanced debt-to-equity ratios.
• Stability Approach: This approach aims to mitigate uncertainty for investors by providing a steady source of income. Dividends are divided into four sets annually, offering a predictable payout structure.
• Hybrid Approach: Combining elements of both the residual and stability approaches, organizations adopting the hybrid approach view the debt-to-equity ratio as a long-term goal. The stability approach is implemented when current income surpasses general levels.

Sharpe Lintner Model 

The Sharpe Lintner Model is a crucial tool for assessing the cost of equity capital within an organization, streamlining a process that can be cumbersome if undertaken manually. This model elucidates the pricing of securities in financial markets and aids in determining the anticipated return on capital investments. By quantifying risks and relating them to the expected return on equity, the model offers valuable insights. It relies on two fundamental assumptions: the competitive and efficient nature of security markets, and the prevalence of rational and risk-averse investors in these markets. The first assumption posits that the market comprises well-informed buyers and sellers, while the second assumes that investors prioritize higher returns on their investments.

Advantages of the Sharpe Lintner Model

• The model gives the nature of the estimated cost of equity expected in an investment. 
• The financial manager can use the model to supplement other techniques to develop a reliable and useful cost of equity.

Assumptions of the Sharpe Lintner Model

The model operates under several assumptions, including the belief that all investors in the market possess identical information and share a consensus on the risks and anticipated returns associated with assets. It further assumes that individual investors lack the capacity to influence investment prices, and the model does not account for transaction costs and taxes. Additionally, the model presupposes that all investors aim for market value efficiency.

Conclusion

Dividend payout stands as a pivotal component of every organization's financial policy, and the adoption of models like Lintner's Dividend Model aids in comprehending dividend payout behavior. Lintner's Model centers around current net earnings and the preceding year's dividend. On the other hand, the Sharpe Lintner Model delves into the pricing of securities in financial markets, providing insights into expected returns from capital investments while evaluating associated risks. Organizations can leverage the Sharpe Lintner Model to assess risks and expected returns, informing their investment decisions.