Dividends refer to that portion of a firm’s net earnings which are paid out to the shareholders. Our focus here is on dividends paid to the ordinary shareholders because holders of preference shares are entitled to a stipulated rate of dividend. Moreover, the discussion is relevant to widely held public limited companies as the dividend issue does not pose a major problem for closely held private limited companies. Since dividends are distributed out of the profits, the alternative to the payment of dividends is the retention of earnings profits. The retained earnings constitute an easily accessible important source of financing the investment requirements of firms. There is, thus, a type of inverse relationship between retained earnings and cash dividends, forger retention, lesser dividends; smaller retention, forger dividends. Thus, the alternative uses of the net earnings dividends and retained earnings are competitive and conflicting.

A major decision of financial management is the dividend decision in the sense that the firm has to choose between distributing the profits to the shareholders and sloughing them back into the business. The choice would obviously hinge on the effect of the decision on the maximization of shareholders wealth. Given the objective of financial management of maximizing present values, the firm should be guided by the consideration as to which alternative use is consistent with the goal of wealth maximization. That is, the firm would be well advised to use the net profits for paying dividends to the shareholders if the payment will lead to the maximization of wealth of the owners. If not, the firm should rather retain them to finance investment programmed. The relationship between dividends and value of the firm should, therefore, be the decision criterion.

There are, however, conflicting opinions regarding the impact of dividends on the valuation of a firm. According to one school of thought, dividends are irrelevant so that the amount of dividends paid has no effect on the valuation of a firm. On the other hand, certain theories consider the dividend decision as relevant to the value of the firm measured in terms of the market price of the shares.

The purpose of the present Chapter is, therefore, to present a critical analysis of some important theories representing these two schools of thought with a view to illustrating the relationship between dividend policy and the valuation of a firm. While Section 1 focuses on the theory(ies) relating to the irrelevance of dividends to valuation, the theories which support the relevance hypothesis are examined in Section 2. The main points are summarized in the last Section.

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