Save 30% on all 2023 Study Packages with Code: BLACKFRIDAY30. Valid until Nov. 28th.

Theories of Dividend Policy

Theories of Dividend Policy

Dividend policy dictates the amount and timing of dividend payments. Two groups of financial theorists have different opinions on the dividend policy, with one group claiming that the dividend policy is irrelevant to shareholders. In contrast, another group claims that dividend policy does matter to a company’s shareholders. Normally, the significance of dividends is associated with the belief that investors value a unit of dividend more than an equal amount of uncertain capital gain.

Dividend Policy Does Not Matter

Modigliani and Miller argued that under perfect market assumptions, a company’s dividend policy should have no impact on shareholder wealth or its cost of capital. The dividend decision is independent of a company’s financing and investment decisions. According to the MM assumptions, there is no difference between share repurchases and dividends as they are all ways a company returns cash to shareholders. A company would distribute more cash in the form of dividends to its shareholders if its current cash flows were more than what they need for positive NPV projects. In a world with no transaction costs or taxes, if shareholders need income, they could construct their dividend policy by selling enough shares to create the desired cash flows. This concept is known as the ‘homemade dividend.’

The irrelevance argument does not argue that dividends are not relevant to share value, but that the actual dividend policy is irrelevant. Due to market imperfections, however, MM’s dividend policy irrelevance propositions have some problems, namely:

  • Both the individual and the company incur transaction costs.
  • If the share price declines, shareholders will be forced to sell more shares to create the same income stream of dividends.

Dividend Policy Matters: Bird in the Hand Argument

Financial theorists such as Myron Gordons have argued that due to the low level of risk that dividends have, shareholders will prefer a dollar of dividends to a dollar of potential capital gain from reinvesting earnings. Assuming that capital gains are riskier than the same amount of dividends, the argument is that a company that pays dividends will have a lower cost of capital, which translates to a higher share price. However, MM contends with this argument because increasing dividend payouts do not affect the risk of future cash flows.

Dividend Policy Matters: The Tax Argument

In most countries, income from dividends is taxed at higher rates than capital gains. An argument can be made that in countries with a high tax rate on dividend income than capital gains, investors will prefer companies that pay low dividends and reinvest earnings in more profitable opportunities. Growth in earnings that is more than the opportunity cost of funds would lead to higher share prices. A company lacks growth opportunities that would use retained earnings; it could distribute its funds through share repurchases. Some countries have laws that require companies to distribute excess earnings as dividends making it complicated to have a zero-payout ratio.


The ‘bird in the hand theory’ implies that:

  1. Dividend policy matters.
  2. Dividend policy is irrelevant.
  3. High tax rates matter.


The correct answer is A.

The theory suggests that dividend policy matters.

B is incorrect. The bird-in-hand theory suggests that dividend policy is relevant.

C is incorrect. Taxes are not covered in the bird in the hand theory.

Reading 16: Analysis of dividends and Share Repurchases

LOS 16 (b) Compare theories of dividend policy and explain implications of each for share value given a description of a corporate dividend action.

Shop CFA® Exam Prep

Offered by AnalystPrep

Featured Shop FRM® Exam Prep Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Shop Actuarial Exams Prep Shop GMAT® Exam Prep

    Daniel Glyn
    Daniel Glyn
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.
    Nyka Smith
    Nyka Smith
    Every concept is very well explained by Nilay Arun. kudos to you man!
    Badr Moubile
    Badr Moubile
    Very helpfull!
    Agustin Olcese
    Agustin Olcese
    Excellent explantions, very clear!
    Jaak Jay
    Jaak Jay
    Awesome content, kudos to Prof.James Frojan
    sindhushree reddy
    sindhushree reddy
    Crisp and short ppt of Frm chapters and great explanation with examples.