Definition
The dividend irrelevance theory was created by Modigliani and Miller in 1961. The authors concluded that dividend policy has no effect on the market value of a company or its capital structure. The idea behind the theory is that a company’s market value depends rather on its ability to generate earnings and business risk.
Assumptions
The dividend irrelevance policy assumes the following:
- The capital markets are perfect
- There are neither flotation nor transaction costs
- There are no taxes
- The capital structure does not affect cost, i.e., cost of capital is constant at any proportion of debt and equity
- Both management of companies and investors have equal access to all public and private information, i.e., there is no arbitrage opportunity
- The cost of equity is constant at any dividend payout rate
- The dividend policy does not affect capital budgeting
Breaking down the dividend irrelevance theory
The dividend irrelevance theory states that investors may affect cash flows regardless of a company’s dividend policy. If a particular investor considers the dividend is too high, the surplus will be used to buy additional company stock. If an investor considers the dividend is too low, it will sell some portion of its stock to replicate the expected dividends. Thus, the dividends are irrelevant to investors because they can control their own cash flows depending on their cash needs. This made it possible to conclude that the dividend policy of a company does not affect investor behavior.
It follows that the dividend payout rate does not affect the cost of capital or the stock price. In other words, the cost of capital and the price of stock is constant at any dividend payout rate.
Additional proof of the dividend irrelevance theory offered by its authors is the arbitrage. If capital markets are perfect, the dividend payout will result in a decrease in stock price for the amount of dividend per share. For example, if the stock price before the dividend was $15.65 and the company paid out a dividend per share of $1.20, the stock price would drop to $14.45. Thus, the total return for investors remains constant because any growth in the dividend is offset by capital loss. So, investors are irrelevant to a company’s dividend policy.
Criticism
Critics of the dividend irrelevance theory note that none of its assumptions are realistic. Both companies and investors are required to pay income tax. There are also flotation and transaction costs that affect investor behavior. This allows critics to claim that in reality a company’s dividend policy affects the value of the company, its capital structure, and investor behavior.
