Dividend Irrelevance Theory

Much like their work on the capital-structure irrelevance proposition, Modigliani and
Miller also theorized that, with no taxes or bankruptcy costs, dividend policy is also
irrelevant. This is known as the "dividend-irrelevance theory", indicating that there is
no effect from dividends on a company's capital structure or stock price.

MM's dividend-irrelevance theory says that investors can affect their return on a
stock regardless of the stock's dividend. For example, suppose, from an investor's
perspective, that a company's dividend is too big. That investor could then buy more
stock with the dividend that is over the investor's expectations. Likewise, if, from an
investor's perspective, a company's dividend is too small, an investor could sell
some of the company's stock to replicate the cash flow he or she expected. As such,
the dividend is irrelevant to investors, meaning investors care little about a
company's dividend policy since they can simulate their own.

Bird-in-the-Hand Theory
The bird-in-the-hand theory, however, states that dividends are relevant. Remember
that total return (k) is equal to dividend yield plus capital gains. Myron Gordon and
John Lintner (Gordon/Litner) took this equation and assumed that k would decrease
as a company's payout increased. As such, as a company increases its payout ratio,
investors become concerned that the company's future capital gains will dissipate
since the retained earnings that the company reinvests into the business will be
less.

Gordon and Lintner argued that investors value dividends more than capital gains
when making decisions related to stocks. The bird-in-the-hand may sound familiar
as it is taken from an old saying: "a bird in the hand is worth two in the bush." In this
theory "the bird in the hand' is referring to dividends and "the bush" is referring to
capital gains.

Tax-Preference Theory
Taxes are important considerations for investors. Remember capital gains are taxed
at a lower rate than dividends. As such, investors may prefer capital gains to
dividends. This is known as the "tax Preference theory".
Additionally, capital gains are not paid until an investment is actually sold. Investors
can control when capital gains are realized, but, they can't control dividend
payments, over which the related company has control.

Capital gains are also not realized in an estate situation. For example, suppose an
investor purchased a stock in a company 50 years ago. The investor held the stock
until his or her death, when it is passed on to an heir. That heir does not have to pay
taxes on that stock's appreciation.

The Dividend-Irrelevance Theory and Company Valuation

In the determination of the value of a company, dividends are often used. However,
MM's dividend-irrelevance theory indicates that there is no effect from dividends on
a company's capital structure or stock price.

MM's dividend-irrelevance theory says that investors can affect their return on a
stock regardless of the stock's dividend.

For example, suppose, from an investor's perspective, that a company's dividend is

too big. That investor could then buy more stock with the dividend that is over his or
her expectations. Likewise, if, from an investor's perspective, a company's dividend
is too small, an investor could sell some of the company's stock to replicate the cash
flow he or she expected. As such, the dividend is irrelevant to investors, meaning
investors care little about a company's dividend policy since they can simulate their
own.

The Principal Conclusion for Dividend Policy

The dividend-irrelevance theory, recall, with no taxes or bankruptcy costs, assumes

that a company's dividend policy is irrelevant. The dividend-irrelevance theory
indicates that there is no effect from dividends on a company's capital structure or
stock price.

MM's dividend-irrelevance theory assumes that investors can affect their return on a
stock regardless of the stock's dividend. As such, the dividend is irrelevant to an
investor, meaning investors care little about a company's dividend policy when
making their purchasing decision since they can simulate their own dividend policy.

How Any Shareholder Can Construct His or Her Own Dividend Policy.
Recall that the MM's dividend-irrelevance theory says that investors can affect their
return on a stock regardless of the stock's dividend. As a result, a stockholder can
construct his or her own dividend policy.

 Suppose, from an investor's perspective, that a company's dividend is too big.

That investor could then buy more stock with the dividend that is over the
investor's expectations.
 Likewise, if, from an investor's perspective, a company's dividend is too small,
an investor can sell some of the company's stock to replicate the cash flow
the investor expected.

As such, the dividend is irrelevant to an investor, meaning investors care little about
a company's dividend policy since they can simulate their own.

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The practical considerations in dividend policy of a
company are briefly discussed below:
(a)Financial Needs of The Company: Retained earnings
can be a source of finance for creating profitable
investment opportunities. As we discussed earlier, when
internal rate of return of a company is greater than return
required by shareholders, it would be advantageous for the
shareholders to re-invest their earnings. Risk and financial
obligations increase if a company raises debt through issue
of new share capital where floatation costs are involved.
Mature Companies Growth Companies
1. Mature companies having few investment opportunities
will show high payout ratios; 1. Growth companies, on the
other hand, have low payout ratios. They are in need of
funds to finance fast growing fixed assets. 2. Share prices
of such companies are sensitive to dividend charges. 2.
Distribution of earnings reduces the funds of the company.
They retain all the earnings and declare bonus shares to
offset the dividend requirements of the shareholders. 3. So
a small portion of the earnings are kept to meet emergent
and occasional financial needs. 3. These companies
increase the amount of dividends gradually as the
profitable investment opportunities start falling.

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10.8 FINANCIAL MANAGEMENT (b)Constraints on
Paying Dividends (i)Legal: Under Section 123 of the
Companies Act 2013, Dividend shall be declared or
paid by a company for any financial year only: a)Out of
the profits of the company for that year arrived at after
providing for depreciation in accordance with the
provisions of section 123(2), or b)Out of the profits of
the company for any previous financial year or years
arrived at after providing for depreciation in
accordance with the provisions of that sub-section
and remaining undistributed, or c)Out of both; or d)Out
of money provided by the Central Government or a
State Government for the payment of dividend by the
company in pursuance of a guarantee given by that
Government (ii)Liquidity: Payment of dividends means
outflow of cash. Ability to pay dividends depends on
cash and liquidity position of the firm. A mature
company does not have much investment
opportunities, nor are funds tied up in permanent
working capital and, therefore has a sound cash
position. For a growth oriented company in spite of
good profits, it will need funds for expanding activities
and permanent working capital and therefore it is not
in a position to declare dividends. (iii)Access to the
Capital Market: By paying large dividends, cash
position is affected. If new shares have to be issued to
raise funds for financing investment programmes and
if the existing shareholders cannot buy additional
shares, control is diluted. Payment of dividends may
be withheld and earnings are utilised for financing
firm’s investment opportunities.

Top 10 Factors for

Consideration of Dividend
Policy
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ADVERTISEMENTS:

This article throws light upon the top ten factors for
consideration of dividend policy. The factors are: 1.
General State of Economy 2. Capital Market
Considerations 3. Legal, Contractual Constraints and
Restrictions 4. Tax Policy/Tax Consideration 5.
Inflation 6. Stability of Dividends 7. Dividend Pay-Out
(D/P) Ratio 8. Owner’s Considerations 9. Nature of
Earnings 10. Liquidity Position.
Factor # 1. General State of Economy:
As a whole, it affects the decision of the management to a
great extent whether the dividend should be retained or
the same should be distributed amongst the shareholders.

In the following cases, the business may prefer to

retain the whole or part of the earnings in order to
build up reserves:
ADVERTISEMENTS:

(i) Where there are uncertain economic and business

conditions;

(ii) If there is a period of depression (management may

withhold the payment of dividends for maintaining the
liquidity position of the firm);

(iii) If there is a period of prosperity (since there is large

profitable investment opportunities); and

(iv) Where there is a period of inflation.

Factor # 2. Capital Market Considerations:

ADVERTISEMENTS:
This also affects the dividend policy to the extent to which
the firm has access to the capital market In other words, if
easy access to the capital market is possible whether due
to financially strong or, big in size, the firm in that case,
may adopt a liberal dividend policy.

In the opposite case, i.e., if easy access to capital market is

not possible, it must have to adopt a low dividend pay-out
ratio, i.e., they have to follow a conservative dividend
policy. As such, they must have to rely more on their own
funds, viz retained earnings.

Factor # 3. Legal, Contractual Constraints and

Restrictions:
This is one of the most significant factors which are to be
taken into account while considering dividend policy of a
firm since it has to be evolved within the legal framework
and restrictions. It is not legally binding on the part of the
directors to declare dividends.

Dividend shall be declared or paid only out of current

profit or past profits after charging depreciation although
the Central Government has empowered to allow any
company for paying dividends out of current profits for any
financial year before charging depreciation.

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The dividend must be paid in cash although a company can

capitalize its profits/reserves for the purpose of issuing
fully paid bonus shares or making partly paid shares into
fully paid. Capital profits cannot be distributed by way of
dividend.

Sometimes a company may declare dividend out of past

accumulated profits if the Central Government so permits
Moreover, the Indian Income-tax Act also prescribes
certain restrictions about the payment of dividend. From
the above, it becomes clear that the directors while
declaring dividends, should consider all the relevant legal
formalities prescribed by the Companies Act, Income-tax
Act etc.

Contractual restrictions, on the other hand, which are

imposed by certain lenders of the firm also affect the
dividend policy of a firm. Because, they impose certain
conditions about the payment of dividend particularly,
during the period when the firm is experiencing liquidity
or profitability crisis.

For instance, there may be an agreement between the firm

and the lenders that the former shall not pay dividend to
its shareholder more than 10% until the loan is repaid or
dividend shall not be declared if the liquidity ratio is found
to be less than 1:1.

Factor # 4. Tax Policy/Tax Consideration:

The tax policy which is followed be a Government also
affects the dividend policy of a firm. Whether it is better to
declare and pay dividend in cash or by the issue of bonus
shares, depends to some extent on the tax policy. Because,
cash dividends are not even so attractive to the investors
who are in higher tax brackets.

For this purpose, a firm should follow a tax-oriented

dividend policy by:
(i) Not declaring dividends and assisting the shareholders
to secure their returns by the sale of appropriated shares,

(ii) Following a policy of regular share dividend in lieu of

cash dividend,

(iii) Using classified equity share dividend.

Factor # 5. Inflation:
Inflation may also affect the dividend policy of a firm. With
rising prices, funds which are generated by way of
depreciation may fall short in order to replace obsolete
equipment. The shortfall may be made from retained
earnings (as a source of funds). This is very significant
when the assets are to be replaced in the near future. As
such, the dividend pay-out ratio tends to be low during the
periods of inflation.

Factor # 6. Stability of Dividends:

It should be given due weight-age for this purpose
although the same may differ from one firm to another.
The dividend policy, of course, should have a degree of
stability, i.e., earnings/profits may fluctuate from year to
year but not the dividend since the equity shareholders
prefer to value stable dividends than the fluctuating ones.

In other words, the investors favour a stable dividend in as

much as they do the payment of dividend. Stable dividends
refer to the consistency or lack of variability in the stream
of dividends, payments, i.e., a certain minimum amount of
dividend should be paid regularly.

The stability of dividends can be in any of the

following three forms:
(a) Constant Dividend Per Share;

(b) Constant Percentage of Net Earnings (Constant D/P

ratio); and

(c) Constant Dividend Per Share plus Extra Dividend.

(a) Constant Dividend Per Share:

Under this form, a firm pays a certain fixed amount per
share by way of dividend. For example, a firm may pay a
fixed amount of, say, Rs. 5 as dividend per share having a
face value of Rs. 50, The Fixed amount would be paid
regularly year after year irrespective of the actual
earnings, i.e., the firm will pay dividend even if there is a
loss.

In short, fluctuation in earnings will not affect the payment

of dividend. Of course, it does not necessarily mean that
the amount of dividend will remain fixed for all times in
future.

When the earnings of the company will increase the rate of

dividend also will increase provided the new level can be
maintained in future. If there is a temporary increase in
earnings, there will not be any change in the payment of
dividends.

The relationship between the EPS (Earning per

share) and DPS (Dividend per share) can better be
represented with the help of the following diagram:

From the above, it becomes clear that earnings (EPS) may

fluctuate from year to year but the DPS is constant. In
order to formulate this policy, a firm whose earnings are
not stable may have to make provisions to those years
when there is higher earnings, i.e., a Dividend
Equalization Reserve’ fund may be created for the
purpose.
(b) Constant Percentage of Net Earnings:
According to this policy, a certain percentage of the net
earnings/profits is paid by way of dividend to the
shareholders year after year, i.e., when a constant pay-out
ratio is followed by a firm. In other words, it implies that
the percentage of earnings paid out each year is fixed and
as such, dividends would fluctuate proportionately with
earnings.

This is particularly very useful in cases where there are

wide fluctuations in the earnings of a firm. This policy
suggests that when the earnings of a firm decline the
dividend would naturally be low.

For instance, if a firm adopts a 40% dividend pay-out ratio

(it indicates that for one rupee earned, it will pay 40 paisa
to the shareholders), i.e., if a firm earns Rs. 5 per share
then it will pay Rs. 2 to the shareholders by way of
dividend. The relationship under this policy between the
EPS and DPS is presented below with the help of a
diagram that shows.

(c) Constant Dividend Per Share Plus Extra Dividend:

Under this policy, firm usually pays a fixed dividend per
share to the shareholders. At the time of market
prosperity, additional or extra dividend is paid over and
above the regular dividend. This extra dividend is waived
as soon as the normal conditions return.

Now, the questions that arise before us are which one is

the most appropriate one and what is their relative
suitability or which one is most favourable to the investors
or what are the implications to the shareholders.

The most appropriate policy may be considered as the first

one, viz.. Constant Dividend Per Share. Because, most of
the investors desire a fixed rate of return from their
investment which will gradually increase over a period of
time.

This is satisfied by the said policy. But in case of Constant

percentage (of net earnings) the return actually fluctuates
with the amount of earnings and it also involves
uncertainties and that is why it is not preferred by the
shareholders although the same is favoured by the
management since it correlates the amount of dividends to
the ability of the company to pay its dividend.

At the same time, in case of Constant Dividend per Share

plus Extra Dividend, there is always an uncertainty about
the extra dividend and as a result it is not generally
preferred by the shareholders.

A stable dividend policy is advantageous due to the

following:
(i) Desire for Current Income:
There are investors, like, old and retired persons, widows
etc., who desire to have a stable income in order to meet
their current living expenses since such expenses are
almost fixed in nature. Such a stable dividend policy will
help them.
(ii) Resolution of Investors’ Uncertainly:
If a firm adopts a stable dividend policy, it must have to
declare and pay dividend even if the earnings are
temporarily reduced. It actually conveys to the investors
that the future is bright.

On the contrary, if it follows a policy of changing dividend

with cyclical changes in the rate of earnings, the investors
will not be confined about their return which may induce
them to require a higher discount factor. The same is not
desired in case of a stable dividend policy.

(iii) Raising Additional Finance:

If stable dividend policy is adopted by a firm, raising
additional funds from external sources become
advantageous on the part of the company since it will
make the shares of a firm an investment. The
shareholders/investors will hold the shares for a long time
as it will create some confidence in the company and as
such, for further issue of shares, they would be more
receptive to the offer by the company.

This dividend policy also helps the company to sale

preference shares and debentures. Because, past trend
regarding the payment of dividend informs them that the
company has been regularly paying the dividends and their
interest/dividend naturally will be paid by the company
when it will mature for repayment together with the
principal.

(iv) Requirements of Institutional Investors:

Sometimes the shares of a company are purchased by
financial institutions, like, IFC, IDB, LIC, UTI etc.,
educational and social institutions in addition to the
individuals.
These financial institutions are the largest purchasers of
shares in corporate securities in our country and every
firm is intended to sell their shares to these institutions.
These financial institutions are interested to buy the
shares of those companies who have a stable dividend
policy.

Danger of Stability of Dividends:

Once this policy is being adopted by a firm it cannot be
changed with an immediate effect which will adversely
affect the investors’ attitude towards the financial stability
of the company. Because, if a company, with stable
dividend policy, fails to pay the dividend in any year, there
will be a severe effect on the investors than the failure to
pay dividend under unstable dividend policy.

That is why, in order to maintain that rate, sometimes the

directors pay dividend, even if there is insufficient earning,
i.e., declaring dividend out of capital which ultimately
invites the liquidation of a firm.

The rate of dividend should be fixed at a conservative

figure which is possible to pay even in a lean period for
several years. Extra dividend can be declared out of extra
earnings which, in other words, will not create any adverse
effect in future.

Factor # 7. Dividend Pay-Out (D/P) Ratio:

Dividend Pay-out (D/P) ratio (i.e., percentage share of the
net earnings/profits distributed to the shareholders by way
of dividends) also affects the dividend policy of a firm. It
involves the decisions either to pay out the earnings or to
retain the same for re-investment within the firm.
Needless to mention that retained earnings also constitute
a reliable source of funds.
Therefore, if dividend is paid, cash will be reduced to that
extent. For maintaining assets level and financing
investment opportunities, a firm should obtain necessary
funds either from the issue of additional equity shares or
from debt and consequently if the firm fails to raise funds
from outside, its growth will be adversely affected.

So, payment of dividends imply outflow of cash which

adversely affect the future growth of the firm. In short, it
affects both the owner’s wealth as well as the long-term
growth of a firm. Thus, the optimum dividend policy should
strike that balance between current dividends and future
growth which maximise the price of the firm’s share.

Therefore, this ratio will have to be determined in such a

manner so that it will maximise the firm’s wealth and at
the same time, will provide sufficient funds for the growth
in future.

Factor # 8. Owner’s Considerations:

The dividend policy is also to be affected by the
owner’s consideration of:
(a) Their opportunities of investment; and

(b) The dilution of ownership.

(a) Owner’s opportunities of Investment:

If the rate of return which is earned by a firm is less than
the return which have been earned by the investors from
outside investment, a firm should not retain such funds,
which in other words, will be detrimental to the interest of
the members although it is difficult to ascertain the rate of
alternative investment as well as alternative investment
opportunities of its shareholders.

Of course, the firm may evaluate such external rate from

the firms belonging to the same risk class.
And if is found that the said rate is comparatively high, it
should opt for a high (D/P) ratio or vice-versa. Thus, while
deciding dividend policy of a firm, external investment
opportunities should also be carefully considered.

(b) Dilution of Ownership:

A high (D/P) Ratio recognises the dilution of ownership
both from the standpoint of control as well as from the
view point of earnings of the existing shareholders. These
two aspects adversely affect the existing shareholders
right.

Because, in the latter case, (dilution of earnings) low

retentions may compel the firm to issue first equity shares
which will increase the total number of equity shares and
as such, the same will lower the earning per share (EPS)
and market price will go down consequently. On the
contrary, if percentage of retained earnings becomes high,
dilution of earnings will be minimised.

Factor # 9. Nature of Earnings:

If the income of a firm is stable, it can afford, a higher
dividend pay-out ratio in comparison with a firm which has
not such stability in its income. For instance, public utility
consensus can have a higher dividend pay-out ratio since
they have some monopoly rights which are not enjoyed by
other companies who operate in a highly competitive
market.

Factor # 10. Liquidity Position:

While deciding the dividend policy, the liquidity aspect
should also be considered. Because, if dividend is paid in
cash, there is an outflow of cash. It is interesting to note in
this regard that a firm may have an adequate income/profit
but it may not have sufficient cash to pay dividend.
Thus, it is the duty of the management to see the cash
position i.e., liquidity aspect, before and after the payment
of dividends at the time of taking decision about the
dividend policy of a firm. If there is a shortage of cash,
question of payment of dividends does not arise, even if
the company makes a sufficient profit.

This problem is, particularly, to be faced by new

firms who are still in the process of extension and
development. One particular point is to be noted by
the management, i.e, to see that the liquid ratio must
not be less than 1: 1 after the payment of dividends.
Practical Considerations in Dividend Policy

A discussion on internal financing ultimately turns to practical

considerations which determine the dividend policy of a company. The
formulation of dividend policy depends upon answers to the questions:

• whether there should be a stable pattern of dividends over the years or

• whether the company should treat each dividend decision completely

independent.

The practical considerations in dividend policy of a company are briefly

discussed below:

(a) Financial Needs of The Company: Retained earnings can be a source

of finance for creating profitable investment opportunities. When internal
rate of return of a company is greater than return required by shareholders,
it would be advantageous for the shareholders to re-invest their earnings.
Risk and financial obligations increase if a company raises debt through
issue of new share capital where floatation costs are involved.

(b) Constraints on Paying Dividends

(i) Legal: Under Section 205(1) of the Companies Act 1956, dividend is to
be paid out of current profits or past profits after depreciation. The Central
Government can allow a company to pay dividend for any financial year out
of profits of the company without providing for depreciation if it is in the
public interest. Dividend is to be paid in cash but a company is allowed to
capitalise profits or reserves (retained earnings) for issuing fully paid bonus
shares.

(ii) Liquidity: Payment of dividends means outflow of cash. Ability to pay

dividends depends on cash and liquidity position of the firm. A mature
company does not have much investment opportunities, nor are funds tied
up in permanent working capital and, therefore has a sound cash position.
For a growth oriented company in spite of good profits, it will need funds
for expanding activities and permanent working capital and therefore it is
not in a position to declare dividends.

Practical Considerations in Dividend Policy

(iii) Access to the Capital Market: By paying large dividends, cash position
is affected. If new shares have to be issued to raise funds for financing
investment programmes and if the existing shareholders cannot buy
additional shares, control is diluted. Payment of dividends may be withheld
and earnings areutilised for financing firm’s investment opportunities.

(iv) Investment Opportunities: If investment opportunities are inadequate, it

is better to pay dividends and raise external funds whenever necessary for
such opportunities.

(c) Desire of Shareholders: The desire of shareholders (whether they

prefer regular income by way of dividend or maximize their wealth by way
of gaining on sale of the shares). In this connection it is to be noted that as
per the current provisions of the Income Tax Act, 1961, tax on dividend is
borne by the corporate as (Dividend Distribution Tax) and shareholders
need not pay any tax on income received by way of dividend from domestic
companies.
(d) Stability of Dividends: Regular payment of dividend annually even if the
amount of dividend may fluctuate year to year may not be, related with
earnings.

Practical Considerations in Dividend Policy