How can it be said that dividend policy is irrelevant

A number of strong implications emerge from this proposition. Among them, the value of equity in a firm should not change as its dividend policy changes. This does not imply that the price per share will be unaffected, however, since larger dividends should result in lower stock prices and more shares outstanding. In addition, in the long term, there should be no correlation between dividend policy and stock returns. Later in this chapter, we will examine some studies that have attempted to examine whether dividend policy is in fact irrelevant in practice.

The assumptions needed to arrive at the dividend irrelevance proposition may seem so onerous that many reject it without testing it.

That would be a mistake, however, because the argument does contain a valuable message: Namely, a firm that has invested in bad projects cannot hope to resurrect its image with stockholders by offering them higher dividends. In fact, the correlation between dividend policy and total stock returns is weak, as we will see later in this chapter. When Are Dividends Irrelevant? Financial Ratios.

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Your Money. Personal Finance. Your Practice. Popular Courses. Financial Analysis How to Value a Company. What Is the Dividend Irrelevance Theory Dividend irrelevance theory holds the belief that dividends don't have any effect on a company's stock price. The dividend irrelevance theory also argues that dividends hurt a company since the money would be better reinvested in the company.

The theory has merits when companies take on debt to honor their dividend payments instead of paying down debt to improve their balance sheet.

Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Note the following carefully: P 0 is the ex div market value. The formula can be usefully rewritten as. The Gordon growth model This model examines the cause of dividend growth. If the company retains earnings and uses those to produce higher returns than demanded by investors and that could be through expanding current operations to become more efficient and cost effective then dividends should be cut as that will increase shareholder value.

If the company retains earnings and uses those to produce lower returns than demanded by investors and that could be through keeping excess cash in the bank, earning very little then dividends should be increased to avoid the share price falling. If the company can think of no good use for its earnings, it should distribute them to shareholders who can then decide for themselves what to do with them.

Practical considerations As so often occurs, theoretical outcomes do not always match practical considerations. The practical matters are: Signalling. The announcement of a dividend is the release of a piece of publically available information. The semi-strong form of the efficient market hypothesis says that the share price will react to this information. The problem is: what signal does a change in dividend give out and therefore how should share prices move? For example, does a cut in dividend mean that the company is conserving cash because it expects hard times or does it mean that the company sees a great investment opportunity?

There is inevitably information asymmetry as the directors will almost certainly be in possession of information that is not in the public domain. Almost always shareholders will be unsettled by abrupt changes in dividend policy.

Really, this point follows on from above. Here, it is argued that a current dividend means that investors have safely received cash. Whereas, if the dividend were deferred they are at the mercy of future events and risks.

This argument is very persuasive, but it is incorrect. Market forces should mean that a share price has been correctly set for the level of risk and returns made. If more cash is paid out as dividend the investor has to decide how to invest that cash. It could be spent on another investment which has higher returns and higher risk or on one where both returns and risks are lower.

In either case, diversified investors should be happy with the deal because the capital asset pricing model states that extra risk is correctly compensated for by extra returns. The clientele effect.

Under the constant dividend policy, a company pays a percentage of its earnings as dividends every year. In this way, investors experience the full volatility of company earnings.

If earnings are up, investors get a larger dividend ; if earnings are down, investors may not receive a dividend. The primary drawback to the method is the volatility of earnings and dividends. It is difficult to plan financially when dividend income is highly volatile. Residual dividend policy is also highly volatile, but some investors see it as the only acceptable dividend policy. With a residual dividend policy, the company pays out what dividends remain after the company has paid for capital expenditures CAPEX and working capital.

This approach is volatile, but it makes the most sense in terms of business operations. Investors do not want to invest in a company that justifies its increased debt with the need to pay dividends.

However, many investors found the company on solid footing and making sound financial decisions for their future. Kinder Morgan. Stock Price. Dividend Stocks. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page.

These choices will be signaled globally to our partners and will not affect browsing data. We and our partners process data to: Actively scan device characteristics for identification.