Irrelevance of Dividend Policy Dividend irrelevance theory is one of the major theories concerning dividend policy in an entreprise.

It was first developed by Franco Modigliani and Merton Miller in a famous seminal paper in1961. The authors claimed that neither the price of firm's stock nor its cost of capital are affected by its dividend policy. According to MM, only the firm's ability to earn money and riskiness of its activity can have an impact on the value of the company. Assumptions MM had to make the following assumptions in order to make their theory manageable: 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 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 MM's conclusions concerning dividend irrelevance might prove to be wrong in the real world. The Modigliani and Miller school of thought believes that investors do not state any preference between current dividends and capital gains. They say that dividend policy is irrelevant and is not deterministic of the market value. Therefore, the shareholders are indifferent between the two types of dividends. All they want are high returns either in the form of dividends or in the form of re-investment of retained earnings by the firm. There are two conditions discussed in relation to this approach: Decisions regarding financing and investments are made and do not change with respect to the amounts of dividends received. When an investor buys and sells shares without facing any transaction costs and firms issue shares without facing any floatation cost, it is termed as a perfect capital market. Two important theories discussed relating to the irrelevance approach, the residuals theory and the Modigliani and Miller approach. Bird-in-the-hand Theory Bird-in-the-hand Theory is one of the major theories concerning dividend policy in an entreprise. This theory was developed by Myron Gordon and John Lintner as a response to Modigliani and Miller's dividend irrelevance theory.

Gordon and Lintner claimed that MM made a mistake assuming lack of impact of dividend policy on firm's cost of capital. They argued that lower payouts result in higher costs of capital. They suggested that investors prefer dividend as it is more certain than capital gains that might or might not appear if they let the firm retain its earnings. The authors indicated that the higher capital gains/dividend ratio is, the larger total return is required by investors due to increased risk. In other words, Gordon and Lintner claimed that one percent drop in dividend payout has to be offset by more than one percent of additional growth. Bird-in-the-hand theory was criticised by Modigliani and Miller who claimed that dividend policy does not affect the firm's cost of capital and that investors are totally indifferent if they receive more dividend or capital gains. They called Gordon and Lintner's theory a bird-in-thehand fallacy indicating that most investors will reinvest the dividend in the similar or even the same company and that company's riskiness is only affected by its cash-flows from operating assets. Tax preference theory Tax preference theory is one of the major theories concerning dividend policy in an entreprise. It was first developed by Litzenberger and Ramaswamy. This theory claims that investors prefer lower payout companies for tax reasons. Litzenberger and Ramaswamy based this theory on observation of American stock market. They presented three major reasons why investors might prefer lower payout comapnies. Firstly, unlike dividend, long-term capital gains allow the investor to deffer tax payment until they decide to sell the stock. Because of time value effects, tax paid immediately has a higher effective capital cost than the same tax paid in the future. Secondly, up until 1986 all dividend and only 40 percent of capital gains were taxed. At a taxation rate of 50%, this gives us a 50% tax rate on dividends and (0,4)(0,5) = 20% on longterm capital gains. Therefore, investors might want the companies to retain their earnings in order to avoid higher taxes. As of 1989 dividend and capital gains tax rates are equal but defferal issue still remains. Finally, if a stockholder dies, no capital gains tax is collected at all. Those who inherit the stocks can sell them on the death day at their base costs and avoid capital gains tax payment.

What is dividend policy? It is the decision about how much of earnings to pay out as dividends versus retaining and reinvesting earnings in the firm. With more and more firms using stock repurchases semi-regularly, a better term might be distribution policy. Do investors prefer high or low payouts? There are three theories:

Irrelevant: Investors do not care what payout is set. Bird-in-the-hand: Investors prefer a high payout. Tax preference: Investors prefer a low payout in order to get growth and capital gains. Therefore, if a companys stock price increases at the time it announces a dividend increase, this could reflect expectations for higher future EPS, not a preference for dividends over retentions and capital gains. Conversely, a dividend cut would be a signal that managers are worried about future earnings The signaling impact constrains dividend decisions by imposing a large cost on a dividend cut and by discouraging managers from raising dividends until they are sure about future earnings. Managers tend to raise dividends only when they believe future earnings can comfortably support a higher dividend level and they cut dividends only as a last resort. What impact might dividend policy have on agency costs?

Firms with high payouts will have to go to the capital markets more frequently. Bankers will supply capital more willingly to better-managed firms. Lower retentions mean less opportunity for managers to invest unwisely. So, stockholders worry less if the pay-out is high Conclusion Consider residual model when setting long-run target payout ratio, but dont follow it rigidly in the short run. Pay a stable, dependable dividend.

Supplement dividends with stock repurchases when warranted.