The term "dividend" pertains to the part of profit that is distributed among the

shareholders, who own stakes in the company. Any profit that remains undistributed to
the shareholders is termed as retained earnings The distribution of returns to both
lenders and owners is a fundamental aspect of a firm's financial dynamics. Returns to
lenders take the form of interest, an obligatory payment. A corporation could possess
both preference share capital and equity share capital, allowing for the potential
issuance of dividends across various share types. However, when addressing dividend
disbursements concerning preferred shares, there tends to be minimal room for
discretionary decision-making. This arises because preference dividends are primarily
contractual commitments, involving fixed rate of dividend. In contrast, the decision to
pay of dividend to equity share holder, is discretionary. This doesn't indicate that a
company is relieved of the responsibility to issue dividends; instead, it highlights the
flexible nature of profit allocation. Equity holders inject capital with the expectation of
gaining returns, either through dividends or the possibility of future capital
appreciation.
The managerial decision regarding dividends revolves around determining whether
profits should be kept for funding investments, whether any dividends should be
disbursed, the amount of these dividends, the timing of their distribution, and the
form in which they are issued. Issuing dividends affects the firm's cash flow position.
Nonetheless, it also fosters goodwill among investors, potentially encouraging them to
contribute additional funds for the firm's investment endeavours.
A crucial aspect to address is the proportion of profits that should be allocated for
distribution. This is referred to as the dividend payout ratio. While determining this
ratio, Madhulika, the company should weigh the impact of this policy on the
overarching goal of maximizing shareholder wealth. If paying dividends is expected to
boost the market value of the company's shares, then dividends should be dispensed;
otherwise, profits could be retained and utilized as an internal financing source. The
central idea supporting the insignificance of dividends in valuation rests on the premise
that a firm's dividend policy is an integral facet of its financial decisions. Within the
framework of financial decision-making, the firm's dividend policy serves as a
byproduct of those decisions. The concept of residual theory of dividends suggests that
the dividends disbursed by a corporation should be regarded as the amount remaining
once financial obligations have been met. This implies that if a company has promising
investment prospects, it will retain its earnings to fund those endeavours. Conversely,
in cases where viable investment opportunities are limited, the earnings would be
distributed to shareholders.
In instances where ample investment prospects exist, the dividend payout ratio – the
proportion of dividends to net earnings – would trend toward zero. Conversely, when
opportunities for profitable investments are scarce, the dividend payout ratio would
approach 100. For scenarios lying between these two extremes, the dividend payout
ratio would span the range from zero to 100. Consequently, dividends can only be
dispensed from the residual amount after catering to the financial needs of all new
projects with positive Net Present Value (NPV). If no surplus remains, no dividends
would be issued. Treating dividend payments as a passive residual implies that they are
dependent decisions with limited relevance. This approach is influenced not solely by
the presence of viable opportunities, but also by the aim of maintaining a desired
target capital structure when deliberating over cash dividends.
The most comprehensive argument supporting the insignificance of dividends is
presented in the Modigliani-Miller (MM) hypothesis. This hypothesis suggests that if
dividends were irrelevant, it would imply that a firm's value remains unaffected by the
distribution of dividends and is solely determined by its earning capacity and the
associated risk. The foundation of the MM hypothesis relies on the following
assumptions: perfect capital markets, rational investor behaviour, unrestricted
information availability to all investors, absence of transaction costs and time lags,
divisibility of securities into any fractions, incapacity of any investor to influence
market prices, absence of taxes and flotation costs, and a defined investment policy
with certain future profits.
The distribution of profits between dividends and retained earnings does not hold any
significant bearing from the shareholders' standpoint. Faced with investment choices,
the firm encounters two viable paths: it can either retain its earnings to strengthen its
investment approach, or it can distribute earnings to shareholders as dividends while
simultaneously raising an equivalent amount of external capital through the issuance
of new shares.
If the firm opts for external equity financing, an arbitrage process comes into play. The
impact of distributing dividends to shareholders is directly counterbalanced by the
outcome of issuing additional share capital. As the availability of the firm's shares on
the secondary market increases, the market value of these shares experiences a
decline. The financial benefit gained by investors due to increased dividends is entirely
offset by the reduction in the market value of shares. The arbitrage process further
indicates that the combined market value along with the existing dividends of two
identical firms, differing only in their dividend payout ratios, will be equivalent.
Individual shareholders have the option to retain and invest their personal earnings.
When two firms exhibit similarity in terms of business risk, potential future earnings,
and investment strategies, the market share price must remain consistent. Modigliani
and Miller substantiate their argument through the following proof.
investors are primarily focused on overall returns and are indifferent to whether these
returns stem from dividend earnings or capital gains. The company can issue new
shares, thereby facilitating the use of profits for dividend payment In this case
shareholders will get return as dividend income. On the other hand, the firm can retain
profit and utilize internally generated funds to support growth endeavours, leading to
reduced dividends and the absence of external equity financing. Consequently, the
market value is likely to appreciate, resulting in capital gains. Hence the distinction
revolves around the nature of returns however the total return remain constant.
The conclusion of MM hypothesis is derived from restrictive assumptions that are
logically sound but are unrealistic. As a result, the notion that dividend payments and
alternative financing methods perfectly neutralize each other, leading to the
insignificance of dividends, is not a feasible proposition.

Limitation
Modigliani and Miller's assumption of perfect capital markets implies the absence of
taxes, the nonexistence of flotation costs, and the lack of transactional expenses.
However, these assumptions are implausible and unattainable in real-world scenarios
In practical situations, taxes come into play. Investors typically encounter two types of
tax liabilities: those related to dividend income and those associated with capital gains.
Under the first category, investors are subject to taxation when corporations distribute
dividends, while capital gains tax is tied to the preservation of earnings arising from
business activities. As the firm harnesses retained earnings to enhance profits derived
from lucrative ventures, the share price increases. This, in turn, results in capital gains.
Capital gains are taxed at a lower rate compared dividend income, and it only becomes
payable upon the actual sale of shares, thus functioning as a deferred tax until the
point of share transaction There is certainly an advantage for investors due to the tax
discrepancy between dividends and capital gains. Consequently, it can be anticipated
that investors would show a preference for retaining earnings. Shareholders are
required to meet tax obligations on dividend income, corresponding to the tax rates
that are relevant to their individual income level. It's worth noting that taxes could
have been avoided had earnings been retained rather than distributed as dividends. In
situations where investors need funds, they could sell a portion of their investment,
resulting in taxes incurred at a reduced rate.

Flotation cost pertains to the expenses associated with raising capital from the market.
This includes factors like underwriting commission, brokerage fees, and other related
costs. MM hypothesis hypothesis exerts that, external funds would need to be raised
equivalent to the dividend amount through the issuance of new shares to support the
investment plan. But the inclusion of flotation cost implies that the net proceeds
obtained from the sale of new shares would fall short of the shares' nominal value
depending upon the size of issue . In other words external financing through sale of
shares would be costlier than internal financing via retained earnings
Transaction costs are invariably present in capital market activities. These expenses are
linked to the sale of securities by shareholders The absence of transaction costs implies
that investors seeking current income for consumption could sell a portion of their
holdings without encountering charges such as brokerage fees and similar expenses.
However, this assumption lacks practicality, as selling securities involves costs. In order
to attain current income equivalent to the distributed dividends, investors must sell
securities exceeding the dividend amount received . Additionally, the sale of securities
is accompanied by an element of uncertainty.
The selection of dividends as an alternative is influenced by legal restrictions related to
the eligibility of certain investors to invest in specific types of ordinary shares.
Companies seeking institutional investment are compelled to distribute dividends in
accordance with these legal limitation Consequently, these legal barriers tend to
prioritize dividends over retaining earnings
Besides market imperfections, the credibility of the Modigliani-Miller (MM) hypothesis,
particularly concerning the irrelevance of dividends, becomes questionable under
conditions of uncertainty. In uncertain circumstances, investors cannot hold an
indifferent stance between dividends and retained earnings.
When earnings are utilized to pay dividends, investors get immediate returns. On the
contrary, if net earnings are retained, shareholders expect returns to materialize
gradually, possibly through share price appreciation or the distribution of bonus
shares. The prospect of future dividends introduces an element of uncertainty
concerning their exact amount and timing, rendering accurate predictions difficult. The
rationale advocating that immediate dividends mitigate uncertainty is commonly
referred to as the "bird in the hand" theory. This proposition asserts that the present
payout of dividends effectively reduces uncertainty, thereby fostering increased share
values.
The "informational content of dividends" pertains to the insights conveyed by
dividends concerning future earnings, which prompt shareholders to adjust share
prices upward or downward. Dividend payments transmit information about the
profitability of shares. A rise in the dividend amount indicates the firm's positive
expectations for enhanced future profitability, while a decrease suggests the opposite.
The importance of this element contributes to alterations in market share prices. The
third facet of uncertainty revolves around the preference of investors for immediate
income to fulfil consumption needs.
Ultimately, the validity of the MM hypothesis could also be undermined under
circumstances characterized by uncertainty. This arises due to the uncertainty
surrounding the prices at which companies can issue shares to generate funds for
funding investment initiatives., new shares might be issued in the capital market, at a
price lower than the existing market price. Consequently, the company may be
compelled to issue more shares. Considering this, the company might view the
retention of profits as a more favourable choice than disbursing dividends to
shareholders.
In stark contrast to the MM position, there exist theories that regard dividend
decisions as active variables that play a role in determining a firm's value.
Consequently, these theories hypothesise that dividend decisions hold relevance. Two
theories align with this perspective, namely Walters' model and Jordan's model.

Walters' model asserts that a firm's investment policy is inherently connected with its
dividend policy, and both factors influence the enterprise's value. The core argument
supporting the relevance proposition of Walters' model revolves around the interplay
between a firm's return on investment or internal rate of return (r) and its cost of
capital or required rate of return (K). According to Walters, an optimal dividend policy
is defined by the relationship between r and K. To elaborate, if the return on
investment exceeds the cost of capital, it is advantageous for the firm to retain
earnings. Conversely, if the cost of capital is more than the anticipated return on the
firm's investment, it's prudent to distribute earnings to shareholders. The rationale
behind this lies in the fact that when r exceeds K, the firm can generate higher earnings
by retaining them, whereas when r is lower than K, shareholders can secure better
returns by investing elsewhere.
When a firm has ample profitable investment prospects, then it can earn r greater than
K. Such firms, often termed growth firms, should ideally maintain a dividend payout
ratio (D/P) of zero, indicating the retention of all earnings within the company. This
approach maximizes the market value of shares. Conversely, when a firm lacks
promising investment opportunities, shareholders fare better by receiving earnings as
dividends. This enables them to earn higher returns by investing funds elsewhere. In
this scenario, the optimal dividend policy involves the distribution of all earnings as
dividends, resulting in a D/P ratio of 100. In cases where r equals K, whether earnings
are retained or distributed becomes irrelevant. let us understand the Walters model
through mathematical formula to arrive at appropriate dividend decision.
The limitations of the Walters model stem from its underlying assumptions. It
presupposes that a firm's investments are solely funded through retained earnings,
without any utilization of external financing. This confines the model's applicability
exclusively to firms operating with an all-equity structure. Moreover, the model
operates under the assumption of a constant internal rate of return (r) and a constant
cost of capital (K), which doesn't accurately mirror reality. As firms undertake increased
investments, these rates are subject to change. Furthermore, the assumption of a
consistent K neglects the influence of the firm's risk profile on this rate. By assuming a
fixed required rate of return, the Walters model overlooks the impact of risk on the
firm's valuation.
Another theory that upholds the relevance of dividends is the Gordon model. The
assumptions underlying the Gordon model resemble those of the Walters model. It is
founded on the following assumptions: the firm operates as an all-equity entity,
internal rate of return (r) and cost of capital (K) are constant, the firm has perpetual
existence, the established retention ratio remains steady, growth rate is consistent, and
the required rate of return surpasses the growth rate.
The Gordon model postulates that rational investors seek to mitigate risk and place a
premium on assured returns while discounting uncertain ones. By paying current
dividends, the firm eradicates any element of risk. However, if the firm retains
earnings, investors anticipate future dividends which come with uncertainty, both in
terms of amount and timing. This rationale leads investors to favor immediate
dividends, effectively discounting future dividends, thereby attributing greater
significance to present dividends.
Investors naturally seek to avoid uncertainty, resulting in a willingness to pay a higher
price for shares that guarantee current dividends. Conversely, shares of a firm that
delays dividend payments would be discounted in value. Now, let's explore the
simplified mathematical representation of gordan's model.