Dividend Decision theories.undeestand irrelevance theory.MM Approach
In this video I will discuss Dividend Decisions. Residual and MM approach with example.
The dividend theories relates with the impact of dividend on the value of the firm. According to one school of thought the dividends are irrelevant and the amount of dividends paid does not affect the value of the firm while the other theory considers that the dividend decision is relevant to the value of the firm.
Thus there are conflicting theories on dividends.
Irrelevance Theory of Dividend
Relevance Theory of Dividend
Residuals theory of Dividends
The theory is based upon the assumptions that since the external financing has excessive costs and may not be available to the firm. The firm finances its investment by retained earnings or by retaining earnings. The retaining earnings are that portion of profits that is not distributed to the investors.
The residual theory of dividend policy is that the firm will only pay dividends from residual earnings, that is, from earnings left over after all suitable (positive NPV) investment opportunities have been financed. With the residual dividend policy, the primary focus of the firm’s management is indeed on investment, not dividends.
Thus the firm’s decision to pay the dividends is influenced by:
The investment opportunities available to the business
The availability of the internal funds. If the internal funds are excessive and all the investments are finances the residual is paid as dividends.
Thus, the divided policy is totally passive in nature and has no influence on the market price of the firm.
Modigliani and Miller (MM) Approach
Modigliani and Miller (MM) expressed their opinion in a more comprehensive way. The authors argue that a company’s share price is determined by its earning potential and investment policy, not by the pattern of income distribution.
Under the condition of a perfect capital market, rational investors, absence of tax discrimination between dividend income and capital appreciation given in the company’s investment policy. If dividends have no influence on share price.
The logic given by the above school of thought is that whatever increase in shareholder wealth results from dividend payments, it will be exactly offset by the effect of raising additional capital.
Example
If a company with investment opportunities distributes its earnings to shareholders, it will need to raise capital externally. This will increase the number of shares, leading to a decline in share price.
Therefore, whatever a shareholder receives due to the higher dividend payment will be counterbalanced and neutralized with the falling share price and declining expected earnings per share.
Assumptions of MM Hypothesis
The MM hypothesis is based on the following assumptions:
Capital markets are perfect.
Investors behave rationally. Information is freely available to them and there are no floatation and transaction costs.
There are no taxes and no differences in the tax rates applicable to capital gains and dividends.
The firm has a fixed investment policy.
Risk or uncertainty does not exist. Investors can forecast future prices and dividends with certainty. One discount rate can be used for all securities at all times.
Please watch my videos on following links and subscribe my channel
• What is petty cash book? What is Imprest s...
• How to prepare for any interview? What to ...
• Topic-3 Basic Accounting Conventions.
• What is TRIPLE Column cash book? Part II. ...