Relevance of Dividend Policy
The critics of M-M agree that under the assumption made by M-M dividends are irrelevant. They, however, dispute the validity of the dividend irrelevance hypothesis by challenging the assumption used by M-M According to them dividends matter because of the uncertainty characterizing the future market imperfections in the capital market, existence of corporate taxes, existance of transaction and floation costs, information content of dividends and capital gains etc. Thus dividend policy does affect the perception of the investors and therefore, they do not remain indifferent between dividends and capital gains arising due to retained earnings.
- Resolution of uncertainty –Current dividends resolve uncertainty in the minds of investors. Therefore investors is no indifferent between dividends and capital gains. Investors are willing to pay more price for the share that offers the greater current dividend, all over things held constant.
- Information content of dividends – The dividends communicate information to the investors about the profitability of the firm. Where firm has a stable dividend payout ratio over time. and it increases this ratio, investors may believe and the future prospects of the company is better and promising.
- Soloman Stated – “In an uncertain world in which verbal statements can be ignored or misinterpreted, dividends action does provide a clear cut means of making a statement that speaks louder than a thousand word’s. Investors use dividend than a thousand word’s” Investors are dividend policy on a predictors of the firm’s future performance, hey-convey management’s expectatives to the future. The basic factor affecting the value is not dividends but expectations of future performance.
- Differential tax Rates – M-M assumed no corporate taxes, then current dividend income and capital gains will be same. Dividends are added in the ordinary income and are taxed, while the rates of capital gain tax are different and arises when one sells the stock. From the tax view point, capital gains are more attractive to the investors than dividend income because of lower tax rates on capital gains. Hence dividend policy matters.
- Floatation Costs – Investment plan can be financed from external and/ or internal financing External finance involve floatation costs whereas internal finance does not involve any floation cost Due to floation costs, external financing through retained earnings Hence, company is not indifferent between external and internal financing.