Question

what do 3 theories indicate regarding the actions management should take with respect to dividend payouts.

Mini case 1 chap 14 Finance management question A-3

Answer 1

Firstly we need to understand the three theories

1. Dividend Irrelevance Theory

This theory was given by Modigliani and Miller. It states that dividend policy is irrelevant. In other words dividends have no effect on the share price.

This theory is based on certain assumptions which are as follows

a. Rational Investors

b. No Taxes

c. No Transaction cost

d. No flotation cost

e. No restrictions on short selling

f. Home made dividend and Corporate Dividend are perfect substitutes.

2. Bird in the hand theory

This theory states that dividends are relevant. This theory was given by Myron Gordon and John Linter.Return will be equal to Dividend Yeild and Capital Gains.According to this theory investors would value dividends more than capital gains when considering investiing in a stock.

3. Tax Preference Theory

Whenever an investor makes an investment in stocks he would consider the impact of taxes on such investment. The investors usually prefer lower payouts for tax reasons.The tax rate for dividends are usually higher than Capital gains tax and in such circumstances the investor would be more inclined towards capital gains.

Conclusion

• If the first theory i.e. Dividend Irrelevance Theory is followed then dividend policy will have no impact and management may follow any dividend policy.
• If the second theory i.e. Bird in the hand theory is followed then management will require the company to pay more dividends to maximise its stock price.
• If the third theory i.e. Tax Preference Theory is followed then management will require the company to pay less dividends to maximise its stock price.