Dividend Policy

Dividend policy theories

From the above influences on dividend payment levels have arisen a number of theories regarding dividend payments that might help to classify them into different categories.

The residual theory

This theory states that only when a company can no longer identify any investment opportunities with a positive net present value should it pay a dividend. In other words, a company should not pay dividends if it can positively identify investments in new projects with a positive NPV.

The traditional view

This theory assumes that a market share price depends upon the mix of dividends expected by shareholders, and that dividend policy should reflect this.

The irrelevancy theory

This theory concludes that the value of a company is based upon the earning power of its assets and investments and that, in a tax-free world, a company’s shareholders have no preference between dividends and capital gains. Accordingly, dividend policy is irrelevant. This theory was the view of Modigliani and Miller. There are arguments for and against this theory and, rather than list these here I will let you form your own opinion, which I am sure is as good as any others. The Modigliani and Miller theory is well referenced on the web if you have an academic interest in their work.

The optimal dividend policy theory

This theory argues that there exists an optimal dividend policy that will strike a balance between dividend payments and growth that will maximize a company’s share price on the market.

The dividend relevancy theory

This theory assumes that the value of a company is affected by dividend policy and that an optimal dividend policy may be reached that will maximize a company’s value There is much debate regarding the effect of dividend policy on share valuation, and for the purpose of this text it is sufficient for you to be aware of the various theories.