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Thursday, May 5, 2016

Dividend Irrelevance Theory

 1. What is Dividend Irrelevance Theory?

Dividend irrelevance theory is one of the major theories concerning dividend poli cy of a company . It was first developed by Franco Modigliani and Merton Miller in a famous seminal paper in1961. The authors claimed that neither the price of a firm's stock nor its cost of capital is affected by its dividend policy . It broadly means that under perfect market conditions, stockholders would ultimately be indifferent be tween returns from dividends or returns from capital gains.

2. When are dividends irrelevant?

Put simply , firms that pay more dividends offer less stock price appreciation. The theory argues that what a firm pays in div idends is irrelevant and that investors or stockholders are indifferent about receiving dividends and capital appreciation when they buy stocks.

The assumption here is that firms that pay more dividends offer less price appreciation but must provide the same total return to stockholders.

This also means if dividends and capital gains are taxed at the same rate, investors should be in different to receiving their returns in dividends or price appreciation.

3. How does this theory matter to investors?

The argument in the theory has a valu able message for stock investors: A firm that has invested in bad projects cannot hope to resurrect its image with stockholders by offering them higher dividends. At the same time in the current context, with banks reporting huge losses, they may not be able to offer dividends to investors. Yet, it might not be fair to write them off completely as losses may reverse as economic environment improves and the banks have to make lesser provisioning.4. Does the theory have significance in our country?


The Reserve Bank of India, in its recent financial stability report noted that pub lic sector banks pay sizeable amounts of dividend to the government and other shareholders which are not linked to the balance sheet size and is not consistent with the dividend irrelevance theory . The central bank noted that the payout also reveals a cross-subsidisation by better banks at the system level.

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