For and Against the Irrelevance of Dividend Policy Essay

For and Against the Irrelevance of Dividend Policy - Essay Example When earnings are dispensed as dividends, the company is deprived of funds which are needed for augmentation and development, and this might result in the company looking for supplementary capital from external sources. Firms are not legally required to pay dividends to stockholders. Similarly, the stockholders cannot officially compel the Board of Directors to declare dividends. In addition to that, even courts cannot meddle in this affair (Kapil, 2011). Arguments For Dividend Irrelevance In the year 1961, two senior professors, Franco Modigliani and Merton Miller (M&M) stated that a firm’s value has no correlation with its dividend policy. According to them, the market value of a company is decided only by the actions pertaining to investment and operations that result in cash flows. The structure of capital and policies related to dividends are simply financing actions or in other words, purely the ways in which cash flows from operations are allocated among the investors. Modigliani and Miller were awarded Nobel Prizes for this exclusive effort concerning Accounting and Financing. The M&M proposal gave birth to scholarly analysis in the field of finance and accounting. Since their attempt, numerous researchers in economics, finance and accounting have come up with various models and theories to explain the irrelevance and relevance of dividends to the market value of the company. Besides the M&M Theory proponents known as Middle of the Roaders; there exist Rightist and Radical Left groups with their own viewpoints (Brealey, 2007). Residual Theory states that if a company is not capable of investing further to earn in surplus of its capital expenditure, then it should apportion the earnings among the stockholders. Over the years, the evolution of M&M Theory has propagated the notion that a company’s dividend policy is irrelevant to its market value. The major argument stated by the M&M theorists is that the investment strategy is the most impor tant determinant of a company’s market value, while the division between the dividends and the reinvestments does not have an effect on this value. However, this explicit suggestion has been made under certain assumptions (Baker et al, 2005). These assumptions largely entail capital markets which are perfect with no taxes and a steady interest rate in the market with limitless borrowing. The clients or potential investors who come with money are varied in terms of preferences for low disbursement and high disbursement demand for dividends. The proponents of dividend irrelevance emphasize on this point, elucidating that policy changes with regard to high or low disbursements of dividends, affects the clientele or the investors that the company will influence, not its value. Though research illustrates that major alterations in dividends somehow affect stockholder prices. However, the response of the proponents of dividend irrelevance is that the influence on the prices is asso ciated with the informational substance of dividends in relation to potential earnings instead of the dividend itself. It is the inclination in the preferences of the investors that results in modifications of prices. Another argument in the support of dividend irrelevance is the fact that most investors are little affected whether or not dividends are paid as they know that if dividends are not paid, then the earnings are reinvested which ultimately