# Relevance and Irrelevance Theory

### Relevance and Irrelevance Theories of Dividend

Dividend is that portion of net profits which is distributed among the shareholders. The dividend decision of the firm is of crucial importance for the finance manager since it determines the amount to be distributed among shareholders and the amount of profit to be retained in the business. Retained earnings are very important for the growth of the firm. Shareholders may also expect the company to pay more dividends. So both the growth of company and higher dividend distribution are in conflict. So the dividend decision has to be taken in the light of wealth maximization objective. This requires a very good balance between dividends and retention of earnings.

A financial manager may treat the dividend decision in the following two ways:

**(i) As a long term financing decision:** When dividend is treated as a source of finance, the firm will pay dividend only when it does not have profitable investment opportunities. But the firm can also pay dividends and raise an equal amount by the issue of shares. But this does not make any sense.

**(ii) As a wealth maximization decision:** Payment of current dividend has a positive impact on the share price. So to maximize the price per share, the firm must pay more and more dividends.

**Dividend and Valuation**

There are conflicting opinions as far as the impact of dividend decision on the value of the firm. According to one school of thought, dividends are relevant to the valuation of the firm. Others opine that dividends does not affect the value of the firm and market price per share of the company.

**Relevant Theory**

If the choice of the dividend policy affects the value of a firm, it is considered as relevant. In that case a change in the dividend payout ratio will be followed by a change in the market value of the firm. If the dividend is relevant, there must be an optimum payout ratio. Optimum payout ratio is that ratio which gives highest market value per share.

**Walter’s Model (Relevant Theory)**

Prof. James E Walter argues that the choice of dividend payout ratio almost always affects the value of the firm. Prof. J. E. Walter has very scholarly studied the significance of the relationship between internal rate of return (R) and cost of capital (K) in determining optimum dividend policy which maximizes the wealth of shareholders.

Walter’s model is based on the following assumptions:

(i) The firm finances its entire investments by means of retained earnings only.

(ii) Internal rate of return (R) and cost of capital (K) of the firm remains constant.

(iii) The firms’ earnings are either distributed as dividends or reinvested internally.

(iv) The earnings and dividends of the firm will never change.

(v) The firm has a very long or infinite life.

Walter’s formula to determine the price per share is as follows:

P = market price per share.

D = dividend per share.

E = earnings per share.

R = internal rate of return.

K = cost of capital.

According to the theory, the optimum dividend policy depends on the relationship between the firm’s internal rate of return and cost of capital. If R>K, the firm should retain the entire earnings, whereas it should distribute the earnings to the shareholders in case the R<K. The rationale of R>K is that the firm is able to produce more return than the shareholders from the retained earnings.

Walter’s view on optimum dividend payout ratio can be summarized as below:

(a) Growth Firms (R>K):- The firms having R>K may be referred to as growth firms. The growth firms are assumed to have ample profitable investment opportunities. These firms naturally can earn a return which is more than what shareholders could earn on their own. So optimum payout ratio for growth firm is 0%.

(b) Normal Firms (R=K):- If R is equal to K, the firm is known as normal firm. These firms earn a rate of return which is equal to that of shareholders. In this case dividend policy will not have any influence on the price per share. So there is nothing like optimum payout ratio for a normal firm. All the payout ratios are optimum.

(c) Declining Firm (R<K):- If the company earns a return which is less than what shareholders can earn on their investments, it is known as declining firm. Here it will not make any sense to retain the earnings. So entire earnings should be distributed to the shareholders to maximize price per share. Optimum payout ratio for a declining firm is 100%.

So according to Walter, the optimum payout ratio is either 0% (when R>K) or 100% (when R<K).

**Gordon’s Model**

Another theory, which contends that dividends are relevant, is the Gordon’s model. This model which opines that dividend policy of a firm affects its value is based on the following assumptions-

(a) The firm is an all equity firm (no debt).

(b) There is no outside financing and all investments are financed exclusively by retained earnings.

(c) Internal rate of return (R) of the firm remains constant.

(d) Cost of capital (K) of the firm also remains same regardless of the change in the risk complexion of the firm.

(e) The firm derives its earnings in perpetuity.

(f) The retention ratio (b) once decided upon is constant. Thus the growth rate (g) is also constant (g=br).

(g) K>g.

(h) A corporate tax does not exist.

Gordon used the following formula to find out price per share

P = price per share

K = cost of capital

E1 = earnings per share

b = retention ratio

(1-b) = payout ratio

g = br growth rate (r = internal rate of return)

According to Gordon, when R>K the price per share increases as the dividend payout ratio decreases.

When R<K the price per share increases as the dividend payout ratio increases.

When R=K the price per share remains unchanged in response to the change in the payout ratio.

Thus Gordon’s view on the optimum dividend payout ratio can be summarized as below-

(i) The optimum payout ratio for a growth firm (R>K) is zero.

(ii) There no optimum ratio for a normal firm (R=K).

(iii) Optimum payout ratio for a declining firm R<K is 100%.

Thus the Gordon’s Model’s is conclusions about dividend policy are similar to that of Walter. This similarity is due to the similarities of assumptions of both the models.

**Bird in Hand Argument**

**(Dividends and Uncertainty)**

Gordon revised this basic model later to consider risk and uncertainty. Gordon’s model, like Walter’s model, contends that dividend policy is relevant. According to Walter, dividend policy will not affect the price of the share when R = K. But Gordon goes one step ahead and argues that dividend policy affects the value of shares even when R=K. The crux of Gordon’s argument is based on the following 2 assumptions.

(i) Investors are risk averse and

(ii) They put a premium on a certain return and discount (penalise) uncertain return.

The investors are rational. Accordingly they want to avoid risk. The term risk refers to the possibility of not getting the return on investment. The payment of dividends now completely removes any chance of risk. But if the firm retains the earnings the investors can expect to get a dividend in the future. But the future dividend is uncertain both with respect to the amount as well as the timing. The rational investors, therefore prefer current dividend to future dividend. Retained earnings are considered as risky by the investors. In case earnings are retained, therefore the price per share would be adversely affected. This behaviour of investor is described as “Bird in Hand Argument”. A bird in hand is worth two in bush. What is available today is more important than what may be available in the future. So the rational investors are willing to pay a higher price for shares on which more current dividends are paid. Therefore the discount rate (K) increases with retention rate. This is shown below.

**Modigliani-Miller Model**

**(Irrelevance Theory)**

According to MM, the dividend policy of a firm is irrelevant, as it does not affect the wealth of shareholders. The model which is based on certain assumptions, sidelined the importance of the dividend policy and its effect thereof on the share price of the firm. According to the theory the value of a firm depends solely on its earnings power resulting from the investment policy and not influenced by the manner in which its earnings are split between dividends and retained earnings.

**Assumptions:**

(i) Capital markets are perfect:- Investors are rational information is freely available, transaction cost are nil, securities are divisible and no investor can influence the market price of the share.

(ii) There are no taxes:- No difference between tax rates on dividends and capital gains.

(iii) The firm has a fixed investment policy which will not change. So if the retained earnings are reinvested, there will not be any change in the risk of the firm. So K remains same.

(iv) Floatation cost does not exist.

The substance of MM arguments may be stated as below:

If the company retains the earnings instead of giving it out as dividends, the shareholders enjoy capital appreciation, which is equal to the earnings, retained.

If the company distributes the earnings by the way of dividends instead of retention, the shareholders enjoy the dividend, which is equal to the amount by which his capital would have been appreciated had the company chosen to retain the earnings.

Hence, the division of earnings between dividends and retained earnings is irrelevant from the point of view of shareholders.

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