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.
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
