Question

Explain the “Dividend Irrelevance” theory and the “Dividend Preference” theory of dividends. Which of these is theoretically the most justified? Is there any real-world evidence that either one might be the most relevant? (7 pts.)

Answer 1

The “Dividend Irrelevance” theory says that there is little impact on a company’s stock price by its declaration and payment of dividends. In other words the theory states that dividends do not add value to a company’s stock price and investors do not need to concern themselves with the dividend policy of a company. On the other hand the “Dividend Preference” theory states that value of a company is affected by its dividend policy and investors do prefer dividends as it is a source of regular cash flow for them.

Of the two it is the “Dividend Irrelevance” theory that is theoretically the most justified. This is because theoretically the value of a company is more dependent on its ability to generate earnings and the quantum and nature of its business and operational risks.

Real world evidence suggests that “Dividend Preference” theory is the most relevant. We know that stocks of blue chip companies like Intel, Apple, Johnson and Johnson, P&G etc. are in high demand. One of the reasons for their high demand is that the stocks of these companies pay regular dividends and hence investors know that they will have regular cash inflows if they invest in these stocks. This is the reason why, in the real world, many investors prefer to invest primarily in the stocks of these blue chip companies.