DIVIDEND POLICY THEORIES

1. Dividend Policy Irrelevance Theory

It has been agreed that dividend policy has no effect on either the price of a firm's stock or its cost of
capital - that is that dividend policy is irrelevant. Thus, the shareholder is indifferent to a choice between
dividends today or a claim on future earnings. The principal proponents of the dividend policy irrelevance
theory are Merton Miller and Franco Modigliani (MM). They argue that the only important determinants
of a company's market value are the expected level and risk of its cash flows or the income produced by
its assets, not on how this income is split between dividends and retained earnings. There is agreement
that, in a world of perfect capital markets, dividend policy does not affect shareholder wealth.

2. Dividend Policy Relevance Theory

The dividend relevance viewpoint states that in a world with market imperfections such as taxes,
flotation costs, and transaction cost, a company's dividends policy affects it's market value. There are
several arguments for the dividend relevance viewpoint:

1. Dividends may resolve uncertainty in the minds of investor and may lower their required rate of
return on equity. Because of the high variability of stock prices, dividends represent a more reliable form
of return than capital gains. The greater the certainty associated with dividends may also lead investors to
place a higher value on dividends than on an equivalent amount of uncertain and riskier capital gains. This
is also known as the " bird-in-hand" theory.

2. Dividend payments and dividend policy statements may impart information to investors about
management's future expectations for the firm. This "information content effect" which is the reaction of
the market to dividend action may affect stock prices favorably or unfavorably depending on the
inferences and conclusions drawn by investors.

3. The "clientele effect" is the observable fact that stocks attract particular groups based on dividend
yield and the resulting tax effect should. This implies that investors are attracted to firms whose dividend
policies meet their particular needs. Income-oriented investors and tax exempt organizations may seek
out firms that pay large cash dividends. Likewise, investors seeking to minimize their taxes or who do not
need cash income may prefer firms that pay no or low dividends but that offer the potential for significant
growth. Thus, investors may place a higher value on firms whose dividends policies meet their particular
needs. Opponents of this view argue that one clientele is as good as another.

3. Residual Theory of Dividends Policy

 The residual theory of dividends policy views that dividends are paid out of the residual or leftover
earnings remaining after profitable investments opportunities are exhausted. In practice, dividend policy is
very much influenced by investment opportunities and by the availability of funds with which to finance
new investments.

Under this concept, a firm should follow these steps when deciding on it's payout ratio:

1. Determine the optional capital budget as in Chapter 18.

2. Determine the amount of capital needed to finance the budget.

3. Use retained earnings to supply the equity component to the extent possible.

4. Pay dividends only if more earnings are available than are needed to support the optimal capital
budget.

The residual dividend theory is based on the fact that investors prefer to have the firm retain reinvest
earnings rather than pay them out in dividends if the rate of return the firm can earn on reinvested
earnings exceed the rate investors, on average, can themselves obtain on other investments of
comparable risk.

Illustrative Example: Residual Theory of Dividends Policy

Magnum Inc. has an optional capital structure of 40 percent debt and 60 percent equity. Total earnings
available to ordinary equity shareholders for the coming year are expected to be P1,500,000. The firm's
marginal cost of capital is 14 percent. Magnum has the following investment opportunities schedule:

Project Investment IRR(%)

A P1 000 000 24

B 600 000 18

C 400 000 15

D 500 000 12

E 300 000 10

The firm's optimal capital budget consist of Projects A, B and C because the IRR for each of these projects
exceeds the firm's marginal cost of capital. These three projects require a total investment of P2 000 000
of which only P1 200 000 (.60 x P2 000 000) is ordinary (common) equity shares. If dividends are treated as
residual, the firm would pay P300 000 (P1 500 000 - P 1 200 000) in dividens to maintain it's optimal
capital structure.