Dividend irrelevance theory
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Dividend Irrelevance Theory is one of the major theories concerning dividend policy in an enterprise. It was first developed by Franco Modigliani and Merton Miller in a famous seminal paper in 1961. The authors claimed that neither the price of firm's stock nor its cost of capital are affected by its dividend policy. According to Modigliani and Miller, only the company's ability to earn money and riskiness of its activity can have an impact on its value.
Assumptions in dividend irrelevance theory
Dividend irrelevance theory makes the following assumptions:
- personal or corporate income taxes do not exist,
- there are no stock flotation or transaction costs,
- financial leverage does not affect the cost of capital,
- both managers and investors have access to the same information concerning firm's future prospects,
- firm's cost of equity is not affected in any way by distribution of income between dividend and retained earnings,
- dividend policy has no impact on firm's capital budgeting.
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Meaning of dividend irrelevance theory
It is obvious that the above assumptions are not realistic and do not hold in reality. Both firms and investors have to pay income taxes, flotation and transaction costs are often significant. Further, firm's cost of equity might be affected by dividend policy due to taxation and transaction costs. Finally, investors rarely have access to same information as managers. Therefore, it has to be said that Modigliani and Miller's conclusions concerning dividend irrelevance might prove to be wrong in the real world.
Examples of Dividend irrelevance theory
- A company declares a dividend of $1 per share for the next quarter. According to the Dividend Irrelevance Theory, the company's stock price and cost of capital will remain unchanged.
- A company decides to reinvest its earnings instead of paying out dividends to shareholders. According to the Dividend Irrelevance Theory, the company's stock price and cost of capital will remain unchanged.
- A company pays out a special dividend of $3 per share. According to the Dividend Irrelevance Theory, the company's stock price and cost of capital will remain unchanged.
Advantages of Dividend irrelevance theory
- The Dividend Irrelevance Theory has several advantages. Firstly, it simplifies the decision-making process for firms as it eliminates the need to analyze and consider the impact of dividend decisions on the stock price. Secondly, the theory eliminates agency costs and conflicts of interest between managers and shareholders since no preference is given to either dividends or retained earnings. Thirdly, the theory allows firms to focus on the long-term growth of the company instead of worrying about short-term dividend decisions. Finally, the theory allows companies to keep their flexibility and access to capital by not committing to a particular dividend policy.
Limitations of Dividend irrelevance theory
The Dividend Irrelevance Theory is subject to certain limitations. These include:
- Agency cost: Agency cost, which is the cost of monitoring and managing corporate activities, is not taken into account in the Dividend Irrelevance Theory. This cost can potentially be affected by dividend policy and therefore influence the value of the firm.
- Tax effects: The Dividend Irrelevance Theory does not take into account the tax effects of dividends, which can affect the value of the firm. Investors may prefer to receive dividends due to the tax advantages associated with them.
- Signalling effect: The Dividend Irrelevance Theory does not consider the signalling effect of dividend payment. A company which pays dividend may be seen as more stable and less risky, and this can affect the value of its stock.
- Cost of capital: The Dividend Irrelevance Theory ignores the effect of dividend payment on the cost of capital of a firm. Investors may prefer to invest in companies which pay a dividend, which can lead to a lower cost of capital.
- Investor preference: The Dividend Irrelevance Theory ignores investor preference, which can affect the value of the firm. Investors may have different preferences for dividend payment and this can influence the stock price of the company.
- Introduction: Apart from the Dividend Irrelevance Theory, there are several other approaches to dividend policy.
- The Bird in the Hand Theory states that investors prefer to receive a dividend rather than expecting capital gains from share price appreciation.
- The Tax Preference Theory claims that investors prefer higher dividends because of the tax advantages associated with them.
- The Signaling Theory suggests that dividends may be used to signal firms' future prospects to the market.
- The Clientele Effect Theory states that firms may choose their dividend policy based on the preferences of their current shareholders.
- The Agency Cost Theory claims that dividends may be used to reduce the agency costs associated with the separation of ownership and control.
In summary, there are a number of different approaches to dividend policy, including Dividend Irrelevance Theory, Bird in the Hand Theory, Tax Preference Theory, Signaling Theory, Clientele Effect Theory, and Agency Cost Theory. Each of these approaches provides insights into the impact of dividend policy on companies' stock prices and cost of capital.
References
- Brennan, M. (1971). A note on dividend irrelevance and the Gordon valuation model. The Journal of Finance, 26(5), 1115-1121.
- Brigham E.F., Gapenski L.C., (1990). Intermediate financial management, The Dryden Press, p. 422.
- Brigham E.F., (1992). Fundamentals of financial management, The Dryden Press, p. 497-498.
- DeAngelo, H., & DeAngelo, L. (2006). The irrelevance of the MM dividend irrelevance theorem. Journal of financial economics, 79(2), 293-315.
- Miller, M. H., & Modigliani, F. (1961). Dividend policy, growth, and the valuation of shares. The Journal of Business, 34(4), 411-433.
- Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. The American economic review, 48(3), 261-297.
- Vancil R.F., Makela B.R., (1986). The CFO's handbook, Dow Jones-Irwin, Homewood, p. 228-229.
- Dividend policy @ Wikipedia.
- Midigliani-Miller theorem @ Wikipedia
Author: Michał Pilarczyk
