Dividend Irrevance Theory

Topics: Dividend, Stock, Stock market Pages: 26 (7017 words) Published: October 17, 2011


The term dividend refers to that part of profits of a company 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. The investors are interested in earning the maximum return on their investments and to maximize their wealth. A company, on the other hand, needs to provide funds to finance its long-term growth. If a company pays out as dividend most of what it earns, then for business requirements and further expansion it will have to depend upon outside resources such as issue of debt or new shares.

The term ‘dividend policy’ refers to “the practice that management follows in making dividend payout decisions or, in other words, the size and pattern of cash distributions over time to shareholders” (Lease et al., 2000, p.29). Dividend policy of a firm affects both the long-term financing and the wealth of shareholders. This issue of dividend policy is one that has engaged managers since the birth of the modern commercial corporation. Surprisingly then dividend policy remains one of the most contested issues in finance. The study of dividend policy has captured the attention of finance scholars since the middle of the last century. They have attempted to solve several issues pertaining to dividends and formulate theories and models to explain corporate dividend behaviour.


The issue of corporate dividends has a long history and, as Frankfurter and Wood (1997) observed, is bound up with the development of the corporate form itself. Corporate dividends date back at least to the early sixteenth century in Holland and Great Britain when the captains of sixteenth century sailing ships started selling financial claims to investors, which entitled them to share in the proceeds, if any, of the voyages. At the end of each voyage, the profits and the capital were distributed to investors, liquidating and ending the venture’s life. By the end of the sixteenth century, these financial claims began to be traded on open markets in Amsterdam and were gradually replaced by shares of ownership.

It is worth mentioning that even then many investors would buy shares from more than one captain to diversify the risk associated with this type of business.

At the end of each voyage, the enterprise liquidation of the venture ensured a distribution of the profits to owners and helped to reduce the possibilities of fraudulent practice by captains (Baskin,1988). However, as the profitability of these ventures was established and became more regular, the process of liquidation of the assets at the conclusion of each voyage became increasingly inconvenient and costly. The successes of the ventures increased their credibility and shareholders became more confident in their management (captains), and this was accomplished by, among other things, the payment of “generous dividends” (Baskin, 1988).

As a result, these companies began trading as going concern entities, and distributing only the profits rather than the entire invested capital. The emergence of firms as a “going concern” initiated the fundamental practice of firms to decide what proportion of the firms’ income (rather than assets) to return to investors and produced the first dividend payment regulations (Frankfurter and Wood, 1997). Gradually, corporate charters began to restrict the payments of dividends to the profits only. The ownership structure of shipping firms gradually evolved into a joint stock company form of business. But it was chartered trading firms more generally that adopted the joint stock form. In 1613, the British East India Company issued its first joint stock shares with a nominal value. “No distinction was made, however, between capital and profit” (Walker, 1931, p.102).

In the seventeenth century, the success of this type of trading company seemed poised to allow the spread of this form of...
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