Dividend Irrelevance Theory

Topics: Economics

Dividend, a periodic payment made to stockholders to compensate them for delaying consumption and for the use of and risk to their investment funds O1. A firm’s decisions about the dividends are often mixed up with other financing and investment decisions. Some firms pay low dividends because management is optimistic about the firm’s future and wishes to retain earnings for expansion. In this case the dividend is a by-product of the firm’s capital budgeting decision. Another firm might finance capital expenditures largely by borrowing.

This releases cash for dividends.

In this case the dividend is a by-product of the borrowing decision O2. Once a company makes a profit, it must decide on what to do with those profits: either continues to retain the profits within the company, or pays them out to the owners of the firm in the form of dividends. Once the company decides to pay dividends, a somewhat permanent dividend policy may need to be established, which may in turn impact on investors and perceptions of the company in the financial markets.

What kind of decision is depended on the situation of the company now and in the future.

It also depends on the preferences of current investors and potential investors. Fisher Black (1976) wrote: “The harder we look at the dividend picture, the more it seems like a puzzle. ” Based on our study, this article won’t cover all the aspects of Dividend Policy, but from the view of a finance director, it attempts to provide a summary report to Board of Directors, regarding some related issues on dividend policy decision making in UK market.

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Dividend Theories Theoretically, there are 3 typical extensions trying to explain the relationship of a firm’s dividend policy and common stock value:

Dividend Irrelevance Theory (Miller & Modigliani, 1961) O3: which is lately known as M&M. This theory purports that, in a world without any market imperfections like taxes, transaction costs or asymmetric information, a firm’s dividend policy has no effect on either its value or its cost of capital (Figure 1. 1). Investors value dividends and capital gains equally. However, the crucial assumption here is the independence of a company’s investment policy from its dividend policy. Investment policy is all that matters, since value of the firm equals present value of future cash flows.

How these cash flows are split between dividends and retained earnings are then irrelevant. Given the company’s investment policy, dividend policies affects only the level of outside financing required (in addition to retained earnings) to fund new investment and pay the dividend. This means that each dollar of dividends represents a dollar of capital gains lost. According to M&M, the only important determinant of a company’s market value is its investment policy because it is responsible for the company’s future profitability. As a result, it does not matter whether the firm pays out its earnings or not.

The basic contention (and recommendation) underlying the M&M proposition is that manager should subordinate the dividend decision to investment decisions O4. Optimal Dividend Policy (Gorden & Lintner, 1962) O5: Proponents believe that there is a dividend policy that strikes a balance between current dividends and future growth that maximizes the firm’s stock price. Addresses the investor preference for receiving dividends without selling stock, arguing that a capital gain “in the bush” is perceived as riskier than a dividend “in the hand.

” Miller & Modigliani refer to this theory as the “bird in the hand fallacy,” suggesting that most investors will reinvest their dividends in the same or similar firms anyway and that in the long run risk is determined by asset cash flows not dividend policy. This theory from Myron Gordon is rather an argument about investment policy than about dividends. What the “Bird in the Hand”-Theory is really saying is that companies paying low dividends tend to have riskier investments.

For this reason – and not for the low dividend perse – investors discount the earnings of low dividend (and therefore risky) company more heavily. The market discounts future earnings according to the risk of the company, regardless of whether those earnings will be retained or distributed. However, what is important to recognize is that higher risk causes lower dividend, and not the reverse. Dividend Relevance Theory (Graham & Dodd, 1988) O6: The value of a firm is affected by its dividend policy. The optimal dividend policy is the one that maximizes the firm’s value.

Since dividends are taxed at higher rates than capital gains, investors require higher rates of return as dividend yields increase. This theory suggests that a low dividend payout ratio will maximize firm value. Results of empirical tests of these theories are mixed and have not led to definitive conclusions. In the less than theoretical “real world”, companies budget future dividend payments the same way that they budget any other cash outflow such as debt service requirements, capital expenditures, or any foreseeable demand for cash.

As a result, when a board of directors sets a general dividend policy, it is often in terms of and always in consideration of projected cash flows – not earnings. Thus, the internal policy might well be described as a certain percentage of cash flow, even for companies that express their policy publicly in terms of payout ratios or a percent of earnings In the real world, markets cannot be absolutely efficient or wholly inefficient.

Markets are essentially a mixture of both, and daily decisions and events cannot always be reflected immediately into a market; moreover, if all participants were to believe that the market is efficient, no one would seek extraordinary profits, the force that keeps the wheels of the market turning. Semi-strong market efficiency, as indicated by Jack Treynor, holds that the market will not be always either quick or accurate in processing new information. On the other hand, it is not easy to transform the resulting opportunities to trade profitably against the market consensus into superior portfolio performance O7.

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Dividend Irrelevance Theory. (2018, Jan 20). Retrieved from https://paperap.com/paper-on-dividend-irrelevance-theory/

Dividend Irrelevance Theory
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