Dividend irrelevance comes from ModiglianiMiller's capital irrelevance model, which works under

specific market conditionsno taxes, no transaction costs,

and no flotation costs. Investors and firms must have
identical borrowing and lending rates and the same
information on the firm's prospects.
o
Firms that pay more dividends offer
less stock price appreciation. However, the
total return from both dividends and capital
gains to stockholders should be the same, so stockholders
would ultimately be indifferent between the two choices.
o
If dividends are too small, a stockholder can
simply choose to sell some portion of their stock for cash
and vice versa.
o

TERMS[ EDIT ]

dividend irrelevance
Theory that a firm's dividend policy is not relevant because
stockholders are ultimately indifferent between receiving
returns from dividends or capital gain.

flotation costs
Costs paid by a firm for the issuance of new stocks or bonds.

capital gains
Profit that results from a disposition of a capital asset, such
as stock, bond, or real estate due to arbitrage.
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FULL TEXT[ EDIT ]

Economists Modigliani and Miller put forth a theory

that only the firm's ability to earn money and riskiness
of its activity can have an impact on the value of the
company; the value of a firm is unaffected by how that
firm is financed. It does not matter if the firm's capital

is raised by issuing stock or selling debt, nor does it

matter what the firm'sdividend policy is. Dividend
irrelevance follows from
this capital structure irrelevance.

Merton Miller
Merton Miller, one of the co-authors of the capital irrelevance theory
which implied dividend irrelevance.

Modigliani-Miller grounded their theory on a set of

assumptions:
No time lag and transaction costs exist.
Securities can be split into any parts (i.e., they
are divisible).

No taxes and flotation costs.

Financial leverage does not affect the cost of
capital.
Both managers and investors have access to the
same information.
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
budget
Under these frictionless perfect capital market
assumptions, dividend irrelevance follows from the
Modigliani-Miller theorem. Essentially, firms that pay
more dividends offer less stock price appreciation that
would benefit stock owners who could choose to profit
from selling the stock. However, the total return from
both dividends and capital gains to stockholders should
be the same. If dividends are too small, a stockholder
can simply choose to sell some portion of his stock.

Therefore, if there are no tax advantages or

disadvantages involved with these two options,
stockholders would ultimately be indifferent between
returns from dividends or returns from capital gains.
Since the publication of the papers by Modigliani and
Miller, numerous studies have shown that it does not
make any difference to the wealth
of shareholders whether a company has a
high dividend yield or if a company uses its earnings
to reinvest in the company and achieves higher
growth. However, the importance of a firm's dividend
decision is still contested, with a number of theories
arguing for dividend relevance.
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Under the Modigliani-Miller theorem in finance, the value of a

company depends on:

the competitive situation of the company and the projects that
the company undertakes and plans., stock returns and
dividends., the capital structure of the company., or how
managers work together.
The Modigliani-Miller theory suggests that it doesn't matter to
a shareholder whether a company issues dividends. Why
might that theory not be applicable to the US stock market as
it currently exists?
All of these answers., There are transaction costs associated with
trading stock., There is information asymmetry between the
company's managers and its investors., or Financial leverage
does affect a company's cost of capital.

Source: Boundless. Dividend Irrelevance Theory. Boundless Finance.

Boundless, 21 Jul. 2015. Retrieved 28 Mar. 2016
from https://www.boundless.com/finance/textbooks/boundless-financetextbook/dividends-15/introduction-to-dividends-113/dividend-irrelevancetheory-477-8290/

Dividend Policy
P.V. Viswanath, 1997, 1999, 2000, 2004

Introductory Material
o

Different types of dividends

Dividend Payment procedure

Empirical characteristics of dividends

Measures of dividend payment

The Theory of Dividend Irrelevance

o

Sufficient Assumptions for Dividend Irrelevance

Implications of Dividend Irrelevance

Overview of reasons for Paying Dividends

Tax Differentials, Transaction Costs and Clienteles

Clientele effects and equilibrium

Taxation of dividends

A Framework for analyzing dividend policy

o

Factors to be taken into account in determining

dividend policy

Steps in setting Dividend Policy

Dividend Policy and leverage

Share Repurchases
o

Irrelevance Under Perfect Capital Markets

Impact of Share Repurchases on EPS

Reasons for Share Repurchase in an Imperfect Market

Value Enhancing Reasons

Value Decreasing Reasons

Exercises

Introductory Material
Different types of dividends

Cash Dividends: Firms pay out cash to

stockholders of the company on a regular

basis, usually quarterly.

Extra Cash Dividend: An additional cash

dividend paid out of cycle.

Stock dividend: A dividend paid out in

shares of stock

Stock split: A stock dividend where the

number of shares paid out per original
share is much larger. A stock dividend (or
a stock split) increases the number of
share outstanding.

Dividend Payment Procedure:

Declaration date: The board of directors declares a

payment
Record date: The declared dividends are distributable
to shareholders of record on this date.
Payment date: The dividend checks are mailed to
shareholders of record.
Ex-dividend date: A share of stock becomes exdividend on the date the seller is entitled to keep the
dividend. At this point, the stock is said to be
trading ex-dividend. The buyer of an ex-dividend stock is not
entitled to the next dividend payment. For example, a dividend may be
declared as payable to stockholders of record on a given Friday. Since
three business days are allowed for delivery of stock in a regular
transaction on the New York Stock Exchange, the Exchange would
declare the stock "ex-dividend" as of the opening of the market on the
preceding Wednesday. That means anyone who bought it on or after
that Wednesday would not be entitled to that dividend. When stocks go
"ex-dividend", the stock tables include the symbol "x" following the
name. (Source: http://www.nyse.com)
Empirical Characteristics of Dividends:

Dividends follow earnings (Lintner's model)

Dividends are sticky

A firm's dividend policy tends to follow the life cycle of

the firm

Funding
Needs

Stage 1
Introduction

Stage 2
Rapid
expansion

Limited by size
and other
infrastructure
limits

Moderate
High relative
relative to
to firm value
firm value

Stage 3
Stage 4
Mature growth Decline
Low as
projects dry
up

Cash flow
Negative as
Cash flow
Cash flow
Cash flows
increases as
investments are low relative
high relative
generated
percentage of
made
to firm value
to firm value
firm value
Dividend
Policy

No dividends
New Stock
Issues

No or very
low
dividends

Increase
dividends

Special
dividends
Repurchase
stock

Measures of dividend payment:

Dividend Yield = Dividend/Price: this ratio tends to be

large for firms that are not growing. Hence their stock
prices reflect current dividends to a larger extent,
rather than expected future dividends. Concomitantly,
their P/E ratios are also lower.

Dividend Payout Ratio = Dividend/Earnings: this ratio

tends to be larger for more mature firms.

Dividend Irrelevance
What does dividend irrelevance mean? Obviously it cannot mean that
shareholders don't value dividends. Rather, what it means is that under
the right assumptions, shareholders' wealth is unaffected by the
dividend decision. It will be easiest to see this by means of an example:

Example:
Stellar, Inc. has decided to invest $10 m. in a new
project with a NPV of $20 m., but it has not made an
announcement. The company has $10 m. in cash to
finance the new project. Stellar has 10 m. shares of
stock outstanding, selling for $24 each, and no debt.
Hence, its aggregate value is $240 m. prior to the
announcement ($24 per share).
Consider the following alternatives:
1.

Pay no dividend and finance the project

with cash.
The value of each share rises to $26
following the announcement. Each
shareholder can sell 0.0385 (= 1/26)
shares to obtain a $1 dividend, leaving
him with .9615 shares value at $25 (26 x
0.9615).
Hence the shareholder has one share
worth $26, or one share worth $25 plus
$1 in cash.
2.

Pay a dividend of $1 per share, and sell

$10 m. worth of new shares to finance
the project.

After the company announces the new project and

pays the $1 dividend, each share will be worth $25.
To raise the $10 m. needed for the project, the
company must sell 400,000 (=10,000,000/25)
shares. Immediately following the share issue, Stellar
will have 10,400,000 shares trading for $25 each,
giving the company an aggregate value of 25 x
10,400,000 = $260 m. If a shareholder does not
want the $1 dividend, he can buy 0.04 shares (1/25).
Hence, the shareholder has one share worth $25 and
$1 in dividends, or 1.04 shares worth $26 in total.
We see that in both cases, the shareholder obtains
the same value. When will this be true? Here is a
sufficient set of conditions.
Sufficient Assumptions for Dividend Irrelevance
1.

The issue of new stock (to replace excess

dividends) is costless and can, therefore, cover
the shortfall caused by paying excess dividends.

2.

Firms that face a cash shortfall do not respond

by cutting back on projects and thereby affect
future operating cash flows.

3.

Stockholders are indifferent between receiving

dividends and price appreciation.

4.

Any cash remaining in the firm is invested in

projects that have zero net present value. (such
as financial investments) rather than used to
take on poor projects (i.e. there are no agency
costs of outside equity).

Implications of Dividend Irrelevance:

A firm cannot resurrect its image with stockholders by

offering higher dividends when its true prospects are
bad.

The price of a company's stock will not be affected by

its dividend policy, all other things being the same. (Of
course, the price will fall on the ex-dividend date.)

Overview of Reasons for Paying Dividends:

Defensible:
o

Dividend Clienteles based on age, tax bracket

and income.

Signalling
A manager who perceives his firm's stock price
to be undervalued, may choose to increase
dividends to signal to the market his belief that
the true market value of the stock is higher.
Managers of overvalued firms (bad firms) will
not mimic the undervalued firm (good firm)
manager's actions because the cost of
increasing dividends is much higher for the
overvalued firm manager. For example, bad
firms will be more likely to run into liquidity
problems with a higher dividend, and are more
likely to have to resort to expensive outside
financing to pay the higher dividend.

Psychological Theories of Dividend

Preference
Dividends and Capital Gains may
not be perfect substitutes for each
other. A lack of self-control may
lead an investor to prefer regular
cash fdividends. If the investor
must sell stock to get income he
might have a tendency to sell too
much stock too soon. Hence an
investor might choose to invest in a

firm that follows a particular type of

dividend policy to minimize the total
agency costs of shareholding,
including the investor's human
frailties.
o

Tax and Transaction Clienteles

Disciplinary Effects on Managers

Contracts between the firm and its managers
cannot always be designed to take into account
all possible contingencies. Hence, managers
may sometimes take actions that reduce firm
value. For example, it may be in the interest of
managers to increase firm size or to unduly
reduce the riskiness of the firm in order to
reduce the probability of bankruptcy, and
increase the present value of their firm specific
skills. This may lead them to accept negative
NPV projects or to engage in undesirable
mergers.
This may lead some managers to reduce
dividends to a suboptimal level. In contrast,
managers, who want to assure the market of
their desire to maximize firm value by reducing
the amount of disposable resources (free cash
flow beyond current investment needs)
available to them, may choose to increase
dividends. By doing so, they force themselves
to submit to the discipline of the markets any
time that they wish to raise funds to invest in a
project. Such credible proof of a manager's
unwillingness to take NPV < 0 projects will be
rewarded by the market with an increase in the
price of the stock.

Indefensible:
o

Bird-in-the-hand Fallacy
This argument, which is often made by naive
investors, is that dividends

represent
cash in hand, whereas reinvesting
that cash in the hope of greater
dividends in the future is a risky
prospect. Hence, shareholders are
better off with the dividend. The
proper rebuttal to this assertion is
that if cash flows are priced
correctly in the market, then the
present value of the larger riskier

future dividends is equal to the

present certain dividend. Any
shareholder that decides otherwise
can undo the firm's dividend
decision.
o

Temporary Excess Cash

This argument is also faulty. If the excess is a
temporary situation, then paying it out now as
dividends will necessitate higher costs of raising
funds in the future when it becomes necessary.
It would be preferable to invest it in some
short-term liquid asset.

Tax Differentials, Transaction Costs and Clienteles

A simple shareholder preference for dividends will not
change the irrelevance of dividend policy because
individual shareholders can always create homemade dividends. But there are two conditions under
which this conclusion must be modified.
I. If dividends and capital gains are treated
differently:
For individual investors, dividends are more heavily
taxed than capital gains because of the tax-timing
option--the ability for individual investors to postpone
the tax liability on capital gains income. Hence
individuals may prefer capital gains.
Corporate shareholders pay income tax at a 34%
peak marginal rate, but are permitted to claim a 70%
dividends-received deduction. Hence the top marginal
tax rate on dividend income for a corporation is only
(1-.7) x 34 = 10.2%. They have a greater preference
for dividends.
Tax-exempt institutions, such as pension funds, do
not have a bias in favor of capital gains or dividends.
II. Trading in shares is costly:
A shareholder who desires a high income stream

would prefer real cash dividend payments over

homemade dividends if the firm can sell new shares
more cheaply than the shareholder can sell his/her
own shares. Hence such shareholders might prefer
firms with a high payout ratio, while other
shareholders may prefer firms with a low payout
policy.
Consequently, some investors prefer equity income in
the form of dividends, while others prefer capital
gains.

Clientele Effects and Equilibrium:

Taxes and transaction costs reduce the return to
shareholders. Therefore, investors should invest in a
company that follows the dividend policy that is
optimal for themselves. Thus, a clientele group will be
better off if they pay up to some maximum premium
for shares of firms that follow their optimal policy.
The maximum premium is the additional cost if they
invest in the next best company that is otherwise
identical but does not follow their optimal policy.
As long as a premium is offered, companies have the
incentive to change their policy and sell shares to the
clientele group offering the premium. Over time,
competition among companies drives the premium to
zero. In the aggregate, companies will supply enough
of each type of stock so that all the positive-NPVs
resulting from dividend policy choices have been
extracted and the premiums have been driven to
zero. In equilibrium, the marginal gain from changing
dividend policy is zero.
But, whenever there are changes in tax laws, or in
transaction costs, there may opportunities for firms
that are willing to change dividend policies. It may be
possible to earn a premium for supplying a dividend
policy that is in short supply.
Taxation of Dividends:
Historically, dividends have been taxed at a higher rate than capital

gains (except for a short period in 1986). This implies that there are
disadvantages to paying dividends compared to capital gains. However,
not all shareholders find capital gains more attractive than dividends.
Pension funds and other tax-exempt entities do not have any
preference for capital gains over dividends, since they are not taxed at
all. Stock brokers and dealers who trade for their own account are
taxed on both dividends and capital gains at the same rate.
Corporations are only taxed on 70% of their dividends, while they pay
taxes on all of their capital gains. Furthermore, some investors may
prefer dividends over capital gains for reasons of transactions costs.
Finally, firms that do not have profitable projects to invest in, will be
better off paying out earnings as dividends. Consequently, in
equilibrium, different firms might have different payout ratios. One
implication of the tax disadvantages of dividends relative to capital
gains is that stock prices might not fall by the same amount as the
dividend payment:
Suppose to represents the tax rate on ordinary dividends and
tcg represents the tax rate on capital gains. Let PB denote the cumdividend stock price, and PA the ex-dividend stock price, and P the price
at which the stock was acquired. Then, for the marginal investor,
PB-(PB-P)tcg = PA-(PA-P)tcg + D(1-to), where the LHS is the after-tax gain
from selling the stock cum-dividend and the RHS is the after-tax gain
from selling the stock ex-dividend. This yields the

relationship
. By examining the empirical price drop,
one may then infer the marginal tax bracket for holders of the firm's
stock. Studies in 1970 found that the difference between the cumdividend and ex-dividend prices was about 78% on average, and they
concluded that there must be a tax clientele effect. They also found
that the drop was largest for firms with the highest dividend yields.
They argued that this was due to the fact that the investors in these
firms were in the lowest tax brackets, as would be predicted by the
relationship above. However, consider the possibility of dividend
capture, where a low tax bracket investor can buy the cum-dividend
stock, obtain the dividends sell it at the ex-dividend price, thus
capturing the difference between the theoretical no-clientele effect
price drop and the actual price drop.
Here is an example of dividend capture (no recommendation intended)
A Framework for Analyzing Dividend Policy
Factors to be taken into account in determining Dividend Policy:

Investment Opportunities: A firm with more investment

opportunities should pay a lower fraction of its
earnings.

Stability of earnings: A firm with more volatile earnings

should pay, on average, a lower proportion of its
earnings, so that it will not have to cut dividends.

Alternative sources of capital: To the extent that a firm

can raise alternative capital at low cost, it can afford to
pay higher dividends

Degree of financial leverage: If a firm has high

leverage, it will probably also have covenants restricting
the payment of dividends. Furthermore, to a certain
extent, dividends and debt can be considered
substitutes for the purpose of manager discipline.

Signalling incentives: To the extent that a firm can

signal using other less costly means, for example debt,
it should pay lower dividends.

Stockholder Characteristics: If a firm's stockholders

want higher dividends, it should provide them.

In analyzing dividend policy, two questions need to be answered:

How much cash is available to be paid out as dividends?

How good are the projects available to the firm?

The funds available to be paid out as dividends are essentially equal to

free cash flow to equity (FCFE), where FCFE = Net Income - (Capital
Expenditures - Depreciation)(1- Debt Ratio) - change in Non-cash
Working Capital (1-Debt Ratio).
If FCFE greatly exceed Dividends, the CFO must check to see how funds
are being invested. If the actual rate of return (accounting rate of
return) is greater than the required rate of return, then the NPV or
projects is positive. Then, if other such NPV>0 projects are available,
the excess FCFE should be employed in those projects; if not, it should
be redistributed to stockholders, unless the excess slack is necessary to
hedge against uncertainty or to smooth dividends.
If the actual rate of return is low relative to the required rate of return,
then investment is unprofitable; it would make sense, then, that
investment should be reduced and dividends increased.
On the other hand, if FCFE is much lower than the amount of dividends
paid, dividends should be cut. If the rate of return on equity is greater
than the cost of equity, the released funds should be invested in new
projects and if funds are inadequate, funding should be sought from
elsewhere. If projects are unprofitable, investment should be reduced.
FCFE>>Dividends

FCFE<<Dividends

ROE>Cost of Equity

Good Projects
No Change

Good Projects
Cut Dividends
Invest in Projects

ROE<Cost of Equity

Poor Projects
Increase Dividends
Reduce Investment

Poor Projects
Cut Dividends
Reduce Investment

However, the analyst should be careful to ensure that the accounting

numbers are not incorrect or misleading.
Setting Dividends
The following are some important steps in the determination of a
dividend policy:
1. Estimate Future Residual Funds (FCFE): Project the firm's operating
cash flows and capital expenditure needs over a reasonable time
horizon, say 5 years.
2. Determine Feasible Payout Ratios: Taking into account available
future free cash flow, flotation costs of new security issues, and cash
flow uncertainties, determine a range of feasible target payout ratios.
3. Set Target Payout Ratio: Analyze payout ratios of comparable firms
(those in the same industry and of similar size and with similar product
mix and other operating characteristics) and special shareholder mix
considerations and set long-term target payout ratio.
4. Set Quarterly Dividend Rate: Because of the informational content of
dividends, a fluctuating regular dividend is undesirable; such a policy
may also lead to shifts in the shareholder clientele and reduce firm
value. Given target payout ratio and cash flow projections, set quartely
dividend rate at highest sustainable level.
Dividend Policy and Leverage
Many of the same factors that affect capital structure also affect
dividend policy. (See exercises.)
However, in addition to this, there maybe some interactions between
dividend policy and capital structure. For example, it is possible to pay
out more in dividends than the amount of FCFE for a while, by
borrowing. This would be desirable if the firm is underlevered. On the
other hand, if the firm is overleveraged, then it may be desirable to use
FCFE to repay debt, and bring leverage back into line.
The Share Repurchase Alternative
Irrelevance Under Perfect Capital Markets
The value of the shareholders' wealth is not affected by share
repurchases, if capital markets are perfect. This can be seen in the
following example:
Buttle Wilson and Co. has $50 m. available for distribution. Buttle has
10 m. shares outstanding. It expects to earn $2.50 a share, and the
current market value per share is $25. The firm has unused cash that
could be used to pay a cash dividend of $5 per share, implying an exdividend value of $20 per share.
Alternatively, the firm could use the $50 m. to repurchase 2 m. shares

($50,000,000/$25). Following the share repurchase, each share would

be worth

Thus, as long as the firm repurchases the shares at the market price of
$25, a shareholder who does not sell will have the same wealth as a
shareholder who does sell--$25. The difference is that the former has it
in stock, the latter in cash.
If Buttle paid the $5 dividend, every shareholder would have their
wealth in the same form--$5 in cash plus $20 in stock.
Impact of share repurchases on EPS:
Following the distribution of the $50 m. whether through a stock
repurchase or through a dividend payment, the firm's shares will trade
at a P/E ratio of 8 (= $20/$2.50).
Neither the firm's capital structure nor its capital investment policies
are affected by the method of cash distribution; hence the risk-return
tradeoff is the same.
Under the dividend alternative, the EPS is unchanged at $2.50, because
the $50 m. paid out were unused, and the number of shares is
unchanged. Each shareholder gets (EPS x P/E = $2.50 x 8 =) $20 + $5
= $25 in total value.
Under the share repurchase alternative, the projected EPS is higher at

However, shareholder value is (EPS x P/E =) $3.125 x 8 = $25, once

again. The higher EPS is exactly offset by the drop in the P/E ratio from
($25/2.5 =) 10 before the stock repurchase to 8 afterwards.
The confusion over the impact of share repurchases results from the
mistaken view that share repurchase will not alter the P/E ratio. But
paying out cash results in a riskier firm and hence the P/E ratio must
drop (the required rate of return must rise).
Reasons for share repurchase in an imperfect market:
VALUE ENHANCING REASONS
Tax considerations:
Gains to individual shareholders from share repurchases are taxed at
the capital gains rate, which is usually smaller than the tax rate on cash
dividends. However, a regular policy of repurchasing shares could be

disallowed by the IRS for favorable capital gains treatment.

Eliminate Small Shareholdings:
The cost of servicing a small shareholder account is roughly the same
as that of servicing a large shareholder account. Hence repurchasing
shares of small stockholders could reduce overall stockholder service
costs.
Increase Leverage:
If the firm wishes to increase debt in its capital structure, it could
borrow funds and use the proceeds to repurchases shares or offer it
sshareholders the opportunity to exchange their shares for a new debt
issue.
Exploit Perceived Undervaluation:
If a firm's stock is perceived by the management to be undervalued,
repurchasing shares at a favorable price could increase the wealth of
the firm's remaining shareholders. However, if investors believe that the
share repurchase is being undertaken for this purpose, share prices will
jump to reflect market belief in a higher share value. If so, the true
wealth of the firm's remaining shareholders would not increase;
however, the market value of their shareholdings will increase, which
can be valuable for shareholders who desire liquidity.
VALUE DECREASING REASONS
Consolidation of Insider Control:
Firms sometimes purchase stock from contentious minority
stockholders, sometimes at a premium (greenmail). At other times,
they may do so to reduce public float--to reduce the percentage of
stock held by persons not affiliated with the insider group.
Protection against Takeovers
Stock repurchases may also be designed to reduce the attractiveness of
the company as an acquisition candidate, thus enhancing
management's security.
These objectives may not be consistent with firm value maximization.
Exercises
1.

Go to Hoover's Online and select firms that have zero

dividend yield. Set the required beta between -0.5 and
100 and the debt/equity ratio between 0 and 100 as
well. Can you find a connection between the two?
Explain. Follow-up the exceptions and explain them.