Dividend Decisions^331
finds itself in a declining industry, they want to retain more funds for the business
operations and pay out less so as to conserve the funds. Something that is not beneficial
for the shareholders. They also try to retain more to fund other more profitable investments
so the continuity of the corporation can be maintained.
The important issue is to decide the portion of profit to declare for dividend pay out and
for retaining in business. The dividend policy decision involves two questions:
l What fraction of earnings should be paid out, on average, over time? and
l Should the firm maintain a steady, stable dividend growth rate?
Before we try and answer these questions, let us look at the theories related to dividend
decisions. After that we will look at the empirical evidence of the same.
Theories of Dividends
Traditional Position: MM Model
Dividend Irrelevance: Miller and Modigliani
Miller and Modigliani developed the dividend irrelevance theory, which holds that a
firm's dividend policy has no effect either on the value of the firm or on its cost of
capital (Do you remember the capital structure theories?). MM used the same five
assumptions as they used in the debt policy:
- There are no personal or corporate income taxes.
- There are no share floatation or transaction costs.
- Investors are indifferent between a rupee of dividends and a rupee of capital
gains. - The firm's capital investment policy is independent of its dividend policy.
- Investors and managers have the same set of information (symmetric information)
regarding future investment opportunities.
The above assumptions that give us MM1 actually yield a far more powerful result than
just the irrelevancy of debt policy. They imply that the entire financial policy followed
by the organisation is irrelevant for its valuation; all that matters is the organisation's
portfolio of investment projects. Hence, capital structure, dividend policy and risk
management activities (among other things) are all ineffectual in altering organisation's
value.
Consider a firm that has fixed its investment policy. In each period, it is left with a net
cash flow, which is simply the difference between operating income and investment
costs. A straightforward corporate dividend policy would just be to pay out this net