The Dividend Theory: Financial Irrelevance Theory
The dividend policy is a major financing decision that involves payment to shareholders in return of their investments in a company. Each and every company listed follows some sort of dividend payment pattern and it is obviously a financial indictor of the specific company. Once a company makes a profit, management must decide on what to do with those profits. They could continue to retain the profits within the company, or they could pay out the profits to the owners of the firm in the form of dividends. Once the company decides on whether to pay dividends they may establish a somewhat permanent dividend policy, which may in turn impact on investors and perceptions of the company in the financial markets. What they decide depends …show more content…
Each corporation would tend to attract to itself a clientele consisting of those preferring its particular payout ratio, but one clientele would be entirely as good as another in terms of the valuation it would imply for the firm.”
Dividend Irrelevance Theories:
1) Miller and Modigliani Theorem
They argued that subject to several assumptions, investors should be indifferent on whether firms pay dividends or not. The value of the firm therefore depends on the investment decisions but not the dividend decision and are based on the perfect market assumptions.
2) The Residual Theory
This theory hold the fact that all dividend paid are residual, after the firm has retained cash for available investments and positive NPV projects. This being said it was seen that dividend being only the residual cash available cannot be a factor in movement of share …show more content…
The model holds that when dividends are paid to the shareholders, they are reinvested by the shareholder further, to get higher returns.
Walter’s formula to determine the market price per share (P) is as follows:
P = D/K +r(E-D)/K/K
Where P – Market price D – Dividend per share E – Earning per share K – Cost of equity r – Rate of return on investment
3) Signaling Theory
Ross (1977) argued that in an inefficient market, management can use dividend payment to signal important information to the market which is only known to them. If management increases dividend, it signals expected high profit and therefore share prices will increase.
4) The Clientele Effect Theory
It was proposed by Pettit (1977) who stated that different groups of shareholders have different preference for dividend. For example the low income earners will prefer higher dividend to meet their consumption needs while the high income earners will prefer less dividend so as to avoid the payment of taxes. Therefore when a firm sets a certain dividend policy there will be shifting of investors to it and out of it until equilibrium position is reached. At equilibrium, the dividend policy set by the firm will be consistent with the clientele it