Dividend Policy Theories

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Dividend Policy Theories

By | October 2008
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Question 1: There are a number of theories regarding the relevance of dividend policy-discuss these theories. In what situations might management decide to increase dividends?

Dividend Irrelevance Theory
Much like their work on the capital-structure irrelevance proposition, Modigliani and Miller also theorized that, with no taxes or bankruptcy costs, dividend policy is also irrelevant. This is known as the dividend-irrelevance theory, indicating that there is no effect from dividends on a company's capital structure or stock price.

Modigliani and Miller's dividend-irrelevance theory says that investors can affect their return on a stock regardless of the stock's dividend. For example, suppose, from an investor's perspective, that a company's dividend is too big. That investor could then buy more stock with the dividend that is over the investor's expectations. Likewise, if, from an investor's perspective, a company's dividend is too small, an investor could sell some of the company's stock to replicate the cash flow he or she expected. As such, the dividend is irrelevant to investors, meaning investors care little about a company's dividend policy since they can simulate their own.

Bird-in-the-Hand Theory
The bird-in-the-hand theory, however, states that dividends are relevant. Remember that total return (k) is equal to dividend yield plus capital gains. Myron Gordon and John Lintner took this equation and assumed that k would decrease as a company's payout increased. As such, as a company increases its payout ratio, investors become concerned that the company's future capital gains will dissipate since the retained earnings that the company reinvests into the business will be less.

Gordon and Lintner argued that investors value dividends more than capital gains when making decisions related to stocks. In this theory "the bird in the hand' is referring to dividends and "the bush" is referring to capital gains.

Tax-Preference Theory
Taxes are...