Dividend Decisions: Relevance/Irrelevance Theories, Dividend Policy Factors and Models (Overview)

Overview

Dividend decision is about how much of earnings should be distributed to shareholders as dividend and how much should be retained for reinvestment. It affects:

• shareholder expectations and market perception,
• availability of internal funds,
• growth and financing needs.

Exams often ask:

• “Is dividend policy relevant?” (Walter/Gordon vs MM),
• factors affecting dividend policy,
• short notes on stable dividend/residual dividend policy.

Learning objectives

You should be able to:

• Explain dividend decision and forms of dividends.
• Distinguish stable, constant payout and residual dividend policies.
• Explain dividend relevance and irrelevance theories (conceptually).
• Write factors affecting dividend policy using a clear table.
• Present answers with bold keywords, small flowcharts and comparison tables.

Meaning of dividend decision

Dividend decision refers to deciding:

• the payout ratio (portion of earnings distributed), and
• the retention ratio (portion retained).

Objective: balance shareholder return today with growth needs for tomorrow.

Key terms

• Dividend: distribution of profits to shareholders.
• Dividend policy: firm’s long-term approach for dividend payment.
• Payout ratio: dividend / earnings.
• Retention ratio: retained earnings / earnings.
• Stable dividend: relatively constant dividend per share.
• Residual dividend: dividends paid after funding acceptable investments.

Forms of dividends (brief)

• Cash dividend (most common)
• Stock/bonus shares (capitalisation of reserves)
• Interim dividend (during the year) (as per rules)

Dividend policy: stable vs residual vs constant payout

Stable dividend policy

Company pays a stable DPS (dividend per share), with gradual changes.
Benefit: reduces uncertainty; builds investor confidence.

Constant payout ratio

Pays a fixed % of earnings as dividend.
Issue: dividend fluctuates with profits.

Residual dividend policy

Dividends are paid only after financing all acceptable investments from retained earnings.

Dividend relevance theory (Walter & Gordon): idea

Dividend relevance says dividend policy affects share price/value because investors may prefer:

• certain dividends today (bird-in-hand), and/or
• signals about firm performance.

In these models, the relationship between:

• return on investment $r$, and
• cost of equity $k$ matters:
• if $r > k$, retention adds value (lower payout preferred).
• if $r < k$, dividends add value (higher payout preferred).

Dividend irrelevance theory (MM): idea

MM dividend irrelevance argues that under perfect market assumptions:

• dividend policy does not affect firm value,
• value depends on investment policy and earnings (cash flows), not on how earnings are split.

Assumptions (basic): no taxes, no transaction costs, perfect information, fixed investment policy.

Factors affecting dividend policy (exam table)

Walter model (concept + implication)

Walter’s model links dividend policy to firm value based on $r$ and $k$.

Implication:

• if r > k → retain earnings (low payout)
• if r < k → distribute dividends (high payout)
• if r = k → dividend policy is neutral

Gordon model (concept + implication)

Gordon’s model supports dividend relevance (bird-in-hand) and suggests investors value certain dividends.

Implication (basic):

• higher dividend payout can increase price if investors strongly prefer current dividends, subject to growth trade-off.

Residual dividend policy (basic flow)

Flow (write/draw): Earnings → fund equity portion of capital budget → remaining earnings = residual → pay dividend from residual

This policy aligns dividends with investment needs.

Quick comparison: relevance vs irrelevance (table)

Quick recap (1-minute revision)

• Dividend decision = payout vs retention.
• Stable dividend gives confidence; residual dividend pays after funding projects.
• Walter/Gordon: dividend policy relevant (r vs k matters).
• MM: dividend policy irrelevant under perfect market assumptions.
• Write factors in a table for easy marks.