IRRELEVANCE OF DIVIDENDS
The crux of the argument supporting the irrelevance of dividends to valuation is that the dividend policy of a fum is a part of its financing decision. As a part of the financing decision, the dividend policy of the firm is a residual decision and dividends are a passive residual.
If dividend policy is strictly a financing decision, whether dividends are paid out of profits, or earnings are retained, will depend upon the available investment opportunities. It implies that when a fum has sufficient investment opportunities, it will retain the earnings to finance them. Conversely, if acceptable investment opportunities are inadequate, the implication is that the earnings would be distributed to the shareholders. The test of adequate acceptable investment opportunities is the relationship between the return on the investments (r) and the cost of capital. As long as r exceeds a firm has acceptable investment opportunities. In other words. If a firm can earn a return (r) higher than its cost of capital (k) it will retain the earnings to financial investment projects. If the retained earnings fall short of the total funds required it will raise external funds both equity and debt to make up the shortfall. If. however, the retained earning exceed the requirements of funds to finance acceptable investment opportunities. the ex earnings would he distributed to the shareholders in the form of cash dividends The amount dividend will fluctuate from year to year depending upon the availability of acceptable invest opportunities. With opportunists, the dividend payout ratio (D,P ratio, that is, the r of dividends to net earnings) would he zero. When there are no profitable opportunities, the P ratio will be 100, for situations between these extremes, the D,P ratio will range between zero and 100.
That dividends are irrelevant or are a passive residual, is based on the assumption that investors are indifferent between dividends and capital gains. So long as the firm is able to more than the equity capitalization rate (k) the investors would be content with the firm retains the earnings. In contrast if the return is less than the k investors would prefer to receive earnings (i.e. dividends).