Irrelevance Theory of Dividends
There are conflicting theories of dividends regarding the influence of dividend decisions on the valuation of a firm.
One school of thought suggests that dividend decisions do not affect shareholder wealth or firm valuation. However, others feel that divided decisions materially impact shareholder wealth and the goodwill of the firm.
These two contrasting dividend theories are referred to as follows:
- Irrelevance theory of dividends
- Relevance theory of dividends
Irrelevance Theory of Dividends
The irrelevance theory of dividends is associated with Soloman, Modigliani, and Miller. According to these authors, dividend policy has no effect on a company’s share price.
In the opinion of Soloman, Modigliani, and Miller, investors do not differentiate between dividends and capital gains. Ultimately, their sole aim is to maximize their return on investment.
Companies have adequate opportunities to invest and achieve a higher rate of return than the cost of retained earnings. In these cases, investors are likely to be contented if the firm retains the earnings.
Dividend decisions are financial decisions concerning the matter of whether to finance a company’s funding requirements through retained earnings or not.
If a company has profitable investment opportunities, it will retain the earnings to finance them; otherwise, they will be distributed. Nevertheless, the primary interest of shareholders is income, whether it comes in the form of dividends or capital gains.
Modigliani and Miller (MM) Approach
Modigliani and Miller (MM) expressed their opinion in a more comprehensive way. The authors argue that a company’s share price is determined by its earning potential and investment policy, not by the pattern of income distribution.
Under the condition of a perfect capital market, rational investors, absence of tax discrimination between dividend income and capital appreciation given in the company’s investment policy. If dividends have no influence on share price.
The logic given by the above school of thought is that whatever increase in shareholder wealth results from dividend payments, it will be exactly offset by the effect of raising additional capital.
If a company with investment opportunities distributes its earnings to shareholders, it will need to raise capital externally. This will increase the number of shares, leading to a decline in share price.
Therefore, whatever a shareholder receives due to the higher dividend payment will be counterbalanced and neutralized with the falling share price and declining expected earnings per share.
Assumptions of MM Hypothesis
The MM hypothesis is based on the following assumptions:
- Capital markets are perfect.
- Investors behave rationally. Information is freely available to them and there are no floatation and transaction costs.
- There are no taxes and no differences in the tax rates applicable to capital gains and dividends.
- The firm has a fixed investment policy.
- Risk or uncertainty does not exist. Investors can forecast future prices and dividends with certainty. One discount rate can be used for all securities at all times.
Proof of MM Hypothesis
The market value of a share at the beginning of a period is equal to the present value of dividends paid at the end of the period plus the share price at the end of the period. This can be expressed as follows:
PO = (D1 + P1) / (I + K)
- PO = Prevailing market price of a share
- P1 = Market price of share at the end of period one
- K = Cost of equity share
- D1 = Dividend to be received at the end of period one
- I = Investment
The value of P1 can be further expressed as:
P1 = PO (I+K) – D1
Computation of New Shares to Be Issued
The Investment Programme of a Company in a given period of time can be financed, either by retained earning or by new shares or both. The following formula:
m x P1 = i – ( X – ND1 )
- M = Number of new shares to be issued
- P1 = Price at which new shares will be issued
- I = Amount of investment required
- X = Firm’s net profit during the period
- ND1 = Total dividends paid during the year
Z Ltd. has 1,000 share at $100 per share. The company is contemplating a $10 per share dividend at the end of the year. It expects a net income of $25,000.
Required: Calculate the company’s share price under the following conditions:
- Dividend declared
- Dividend not declared
Also, assuming that the company pays dividends and makes a new investment of $48,000 in the coming period, how many new shares will need to be issued to the Finance Investment Programme (as per the MM) approach with a 20% risk factor?
The price of share can be expressed as follows:
P1 = PO (1 + k) – D1
When a dividend is not paid:
P1 = $100 (1 + 10) – 0
= 100 x 1.10
When a dividend is paid:
P1 = 100 (1 + .10) – 10
M x P1 = i – (X – ND1)
M x 100 = 48,000 – (25,000 – 10,000)
110M = 33,000
M = 33,000 / 100
M = 330 shares
Criticisms of MM Hypothesis
The main criticisms of the MM hypothesis focus on its assumptions.
1. Tax differential: The assumption that taxes do not exist is far from reality.
2. Floatation cost: A firm has to pay financing cost in the form of underwriting commission, brokerage, and so on. As a result, external financing is costlier than internal.
3. Transaction costs: In reality, shareholders need to pay brokerage fees and other fees when they sell shares. This is one reason why shareholders may prefer to have dividends.
4. Discount rate: The use of a single discount rate to discount cash inflow over different periods is incorrect. Uncertainty increases over time, which means that many investors prefer small dividends now over large dividends later.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.