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DIVIDEND THEORIES

There are several theories which try to look at the relevancy or irrelevancy of dividend payment. We shall discuss some of these theories:

1. M-M dividend irrelevancy theory

This theory was proposed by Franco Modgliani and Merton Miller in 1961 who argued that the value of the firm is determined by the basic earning power and the firm's risk and not by the distribution of earnings. The value of the firm therefore depends on the investment decisions but not the dividend decision. Their argument was however based on the following assumptions:

(a) No corporate or personal taxes

(b) No transaction costs associated with share floatation (The market is perfect and frictionless)

(c) The firm's investment policy is independent of the dividend policy

(d) The market is efficient and therefore investors and managers have the same set of information regarding future investment opportunities.

They were able to prove that dividend is irrelevant in the determination of the value of the firm using the dividend yield model.

(2) The Bird-in-hand theory

This theory was advanced by Myron Gordon and John Litner in 1963 who argued that a bird in hand is worth two in the bush and thus when a shareholder receives cash dividend he is better off than one receiving capital gain.

Investors therefore value dividend more than capital gains and a firm that pays dividend will have a higher market value.

They concluded that dividend decisions are relevant and a firm that pays higher dividend has higher value.

(3) Tax differential theory

This theory was advanced by Litzenberger and Ramaswamy in 1979 who noted that the tax rate on dividend is higher than the rate on capital gain (In Kenya Capital gain tax has been suspended). A firm that pays dividend will therefore have a lower value since shareholders will pay taxes on this dividend. Dividend decisions are relevant and a firm that pays no dividend has the highest value.

(4) Signalling theory

Stephen Ross in...