Question

If you invest for your retirement solely through tax-advantaged accounts like IRAs or 401(k) plans, do you care about a firm's payout policy? If so, under what circumstances or assumptions? Imagine a very simple firm with the following balance sheet: Assets: Cash= 10, PP&E= 90, Total Assets=100; Liabilities: Debt=30, Retained Earnings=35, Paid-in Capital= 35, Total Liabilities and Equity=100. Suppose the firm conducts a $5 share repurchase. What would the firm's balance sheet look like? Now suppose that instead of a repurchase, the firm pays out $5 in dividends. What would the balance sheet look like then? If you were an investor, would you care about the difference? Explain the difference between the two phrases "Dividend policy is irrelevant" and "Dividends are irrelevant". It may help you to think about a hypothetical case where a firm guarantees that it will never pay a dividend or any other form of payout, and ask yourself what shares of that firm would be worth.

Answer 1

Hello Student

Whether a dividend is relevant or irrelevant for the investors, but it always creates a positive attitude of investors towards the company image. Those companies who pays dividend are likely to build confidence amongst the investors.It is a investor only who always expect return on the money he invested in form of dividend .and if the company is not approached to give, the uncertainty is formed of firm performance in the minds of the investors. Without dividend his investment is meaningless .For the investors the dividend is the only medium to measure the firms growth.and Paying dividend enhanced companies goodwill.

Modigliani and Miller, famous for their capital structure theories, advanced the dividend irrelevance theory, which we’ll look at in greater detail below. If you are giving the CFA exam or any professional finance exam, this theory is one of the essential learning outcomes. Below we’ll analyze the theory, how investors deal with dividend cash flows and whether the theory stands true in real life.Modigliani and Miller suggested that in a perfect world with no taxes or bankruptcy cost, the dividend policy is irrelevant. They proposed that the dividend policy of a company has no effect on the stock price of a company or the company’s capital structure.

MM say that if an investor gets a dividend that’s more than he expected then he can re-invest in the company’s stock with the surplus cash flow. If the expected dividend is too small, then he can sell a part of his shares and replicate the same cash flow he would get if the dividend was what he expected. In both cases, investors are irrelevant to what the company’s dividend policy is because they can create their own cash flows.

I personally Feels that in business, everything is purchased with some purpose like Assets are purchased for production purpose instead of selling purpose similarly shares are purchased for expected return instead of a sale.Though sale creates the cash flow for the investor, but it is not their purpose to sell, Selling is always an alternative but not a fundamantel motive for investors. What if one is willng to sell but not able to sell shares because firm share price is too low for the purchase? and the reason behind the low price is low return. how would he sell it in the market? if the company do not generate enough returns, share price of company subsequently falls down. and hence no purchase, this perhaps creates a difficulty for the investor to sell. therfore dependency only on selling of shares is not good approach. I Personally not consider what MM model stated regarding with the sale of the shares for generating cash flows.

Higher returns are what investors care about. They can have that return through re-investing or selling a part of their shares. If the market conditions are perfect, then they don’t care if the return is from dividends or from stock price appreciation.

For this theory to work, investors need a certain frame of mind and this can be achieved only if we live in a perfect world.

Some of the assumptions for this theory are:

• Taxes do not exist: Personal income taxes or corporate income taxes
• When a company issues a stock, there are no flotation costs or transaction costs
• When a firm decides its capital budgeting, dividend policy has no impact on it
• Information is readily and freely available to all investors. Information about the firm’s future prospects is available to the company’s manager as well as investors
• Leverage has zero impact on the cost of capital of the company

In reality, none of these assumptions stand true. Taxes are a certainty for all of us. Companies have to deal with flotation costs while dealing with issuances. Information is readily available to everyone, but the tools and sophistication with which institutional investors analyze securities is far better than what a retail investor might use. The information that a company’s manager might have is still superior than what an institutional investor might have in spite of the sophisticated tools that they possess.

MM believe that it’s only the company’s ability to earn money—and how risky that activity is—that has an impact on the value of the company. MM’s conclusions might stand true theoretically but they do not stand true in the practical world.

While Millennials are saving for retirement at an earlier age than their parents, they are less savvy when it comes to investment. Stashing money away instead of investing it is a huge opportunity cost that will diminish their long-term results.

Long-term investing through dividends is one of the most reliable methods for building wealth. While anyone can benefit from dividends, Millennials have age on their side, and can theoretically generate much higher returns than those who begin later in life. The more years you can devote to growing your dividend portfolio, the wealthier you will become by the time you retire.

Not sure which dividend stock is right for you?

Dividend stocks provide a wealth of opportunity for young investors. For starters, they greatly enhance your stock-picking criteria by allowing you to focus on high-quality companies (after all, stocks that pay steady dividends have stronger fundamentals than their counterparts). The dividend yield usually sets the floor for the stock’s price, which provides a greater sense of certainty about the future of your portfolio.

Established dividend plays, like the kind you find on our 25-year dividend-increasing stocks list, also happen to be some of the world’s strongest companies. This is no coincidence. Building a long-term portfolio around consistent, high-yielding companies is one of the best strategies you can employ.

Strong dividend payers are only one side of the equation; to maximize their benefit, you must utilize the power of compounding. When it comes to investing, compounding is the process of generating higher returns on an asset by reinvesting its earnings. Simply put, by selecting high-yielding dividend stocks and reinvesting their earnings annually, you can become a millionaire before age 60.