THEORIES OF

DIVIDEND POLICY
SUBMITTED BY: SIMERPREET KAUR
MCOM(HONS.)
ROLL NO.- 28

SUBMITTED TO: Dr. KARAMJEET SINGH

 WHAT IS DIVIDEND?
The term dividend refers to that portion of profits of a
company which is distributed by the company among
its shareholders. It is the reward of shareholders for
investments made by them in the shares of the
company.
DIVIDEND DECISION AND
VALUATION OF FIRMS
The value of firm can be maximised if the
shareholders’ wealth is maximised. There are two
school of thoughts regarding the impact of
dividend decision on the valuation of firm.

 The Theory of IRRELEVANCE

 The Theory of RELEVANCE
 DIVIDEND THEORIES

IRRELEVANCE
THEORIES
(Which consider dividend decision to be irrelevant as it does not affect the
value of firm)

RESIDUAL MODIGLIANI AND

APPROACH MILLER APPROACH
 THE THEORY OF
IRRELEVANCE
RESIDUAL APPROACH : This theory suggests
that the dividends paid by a corporate should be viewed as a
residual, that is the amount left over after meeting the
financing requirements of all the profitable/acceptable
projects.

The test of adequate acceptable investment opportunities is

the relationship between the return on the investments (r)
and the cost of capital(k).
r>k (acceptable investment opportunity): retaining
profits
r<k (not acceptable):distribution of profits as dividend.
 MODIGLIANI AND MILLER
HYPOTHESIS
They maintain that dividend policy has no
effect on the market price of the shares
and the value of the firm is determined by
the earning capacity of the firm and its
investment policy. The splitting of
earnings between retentions and
dividends, may be in any manner the firm
likes, does not affect the value of the firm.
 ASSUMPTIONS
There are perfect capital markets
Investors behave rationally
Information about the company is available without
any cost
There are no floatation and transaction costs
No investor is large enough to effect the market
price of shares
The firm has a rigid investment policy
there are either no taxes or there are no
differences in the tax rates applicable to dividends
and capital gains.
CRUX OF THE ARGUEMENT
The crux of the MM position on the irrelevance
of the dividend is the arbitrage argument.

The arbitrage process involves switching and

balancing of operations. This means whatever
increase in the value of the firm results from
the payment of dividend will be exactly set off
by the decline in the market price of shares
because of external financing and there will be
no change in the total wealth of shareholders.
FOR EXAMPLE:
If a company, having investment opportunity,
distributes all its earnings among the
shareholders, it will have to raise additional
funds from external sources. This will result in
the increase in number of shares or payment of
interest charges, resulting in the fall in
earnings per share in the future.

Thus, whatever a shareholder gains on account

of dividend payment is neutralised completely
by the fall in the market price of shares due to
decline in expected future earnings .
CRITICISM OF MM APPROACH
 Perfect capital market does not exist in reality
 Information about the company is not available
to all the persons
 The firms have to incur floatation costs while
issuing securities
 The firms do not follow rigid investment policy
 The investors have to pay brokerage, fees, etc.
while doing any transaction
 Taxes do exist and there is normally different tax
treatment for dividends and capital gains