Relevance of Dividend Policies
The critical questions is whether dividends have an influence upon the value of the firm, given its investment decisions. There are two school of thought one argues for the irrelevance of dividends while the other believes that dividends are relevant as they do affect the shareholders. wealth, Let us examine in brief, both the arguments.
If the dividends are irrelevant, as Modigliani and Miller believe, the firm should retain earning only in keeping with its investment opportunities. If there are not sufficient investment opportunities to provide expected returns in excess of costs of capital. the unused funds (profits) should be paid out as dividends (Van Horne). If there are ample investment opportunities whose returns exceed its cost of capital i.e., r>k), the firm will use retained earnings and there would be no dividends. In such a situations the dividend policy is reduced to merely a financing decision. And : when we treat dividend policy strictly as a financing decision the payment of cash dividends is a “passive residual’ (Ezra Solomon). This implies that dividends are irrelevant; the investors are indifferent between current dividends are capital gains.