Notes on Dividend Theory

Dividend:

The term dividend refers to that part of profits of accompany which is distributed by the company among its shareholders. It is the reward of the shareholders for investments made by them in the shares of the company.

 Dividend theories:

  1. The Irrelevance Concept of Dividend or the Theory of Irrelevance
  2. The Relevance Concept of Dividend or the Theory of Relevance

 Theory of Irrelevance:

 According to this concept, the dividend decision does not affect the shareholders’ wealth and hence the valuation of the firm.

 i. Modogliani and Miller approach (MM Model)

            According to this approach, the dividend policy has not effect on the market price of the shares and the value of the firm is determined by the earning capacity of the firm or its investment policy. As observed by MM, under conditions of perfect capital markets, rational investors, absence of tax, given the firm’s investment policy, its dividend policy may have no influence on the market price of the shares.

 Assumptions of MM Hypothesis:

 There are perfect capital markets

  1. Investors behave rationally
  2. Information is available to all without cost
  3. There are not floatation costs and transaction costs
  4. No investor is large enough to effect the market price of shares
  5. There is either no taxes or there are no differences in the tax rates applicable to dividends and capital gains
  6. The firm has a rigid investment policy
  7. There is no risk or uncertainty in regard to the future of the firm.

 Arguments of MM

             The argument given by MM in support of their hypothesis is that whatever increase in the value of the firm results from the payment of dividend, will be exactly off set by the decline in the market price of shares because of external financing and there will be no change in the total wealth of the shareholders.

This can be pit in the form of the following formula

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