Dividend Irrelevance Theory Explained

Dividend Irrelevance Theory Explained

Dividend irrelevance theory is a concept that suggests an investor is not concerned with the dividend policy of an organization. This lack of concern is because they can sell a portion of their portfolio for equities if there is a desire to have cash. That is why the issuance of dividends should have little or zero impact on the price of a stock.

It was first developed in a seminal paper in 1961 by Franco Modigliani and Merton Miller. According to the theory, it is the ability of an organization to earn money and how risky their activities happen that will directly impact the stock price.

The theory can be stated based on a standard valuation model with this formula:
P1=P0 * (1+k) –D

P1 is the market price of the share at the end of a period.

P0 is the market price of the share at the beginning of a period.

K is the cost of capital in the equation.

D is representative of the dividends received at the end of a period.

What Are the Implications of the Dividend Irrelevance Theory?

Should dividends be irrelevant, then many organizations spend much of their time pondering an issue to which their shareholders are indifferent. If that happens to be true, then there are implications to consider where looking at future decisions to make. The goal would be to raise the price of the stock so equities could be sold for cash instead of offering dividends per every share owned.

That is because investors would consider a capital gain to be an equal return on their investment when compared to a dividend. If the capital gain were large enough, it could even be treated as a superior investment when compared to stocks that are purchased solely for their dividends.

For this to be true, however, the existence of a perfect capital market would be required to exist. The cost of debt would need to be equal to the cost of equity since the cost of capital wouldn’t be affected by the leverage that dividends could place on a stock price.

What Are the Assumptions Made by the Dividend Irrelevance Theory?

There are six specific assumptions which are made by the dividend irrelevance theory.

1. The income taxes do not exist. This includes corporate and personal income taxes.

2. There are no transaction costs or stock flotation.

3. Financial leverage is not going to affect the cost of capital.

4. Investors and managers have access to the same information regarding the future prospects of the organization.

5. The cost of equity for the firm is not affected by the distribution of income between the retained earnings and the dividend that was issued.

6. The dividend policy has no impact on the capital budgeting of the organization.

Because these assumptions are not realistic, critics of the dividend irrelevance theory suggest that it cannot hold in a realistic situation. Investors and organizations both pay income taxes. Transaction costs exists and can be extensive. Flotation costs can be significant, especially since external financing can be very different from internal financing, but the theory does not present a difference between the two.

Even the cost of equity can be affected by dividend policies because of the costs involved. To sell part of a portfolio will require a transaction fee to receive the needed cash access. Because of this fact, shareholders tend to prefer dividends because cash can be received without the same need to create a transaction.

The idea that uncertainty doesn’t exist is unrealistic. That means under specific conditions, a dividend can be relevant, which disrupts the thesis contained within this theory.

Then there’s the fact that investors rarely have access to the same information that managers do. That is why real-life scenarios are questioned.

The dividend irrelevance theory offers an interesting perspective to the approach an organization could take with share valuation. It is a model that is popular, but because there are limitations based on the idea that a perfect environment exists, the outcome plotted by using its equations can be somewhat unpredictable.