Dividend Decisions: Relevance/Irrelevance Theories, Dividend Policy Factors and Models (Overview) Questions

Question 1

Define dividend policy.

Accepted Answer

Dividend policy is the firm’s long-term decision regarding **payout** of earnings as dividend versus **retention** for reinvestment.

Question 2

What is dividend payout ratio?

Accepted Answer

Dividend payout ratio is the proportion of earnings distributed as dividend: **Dividend / Earnings**.

Question 3

Name any one form of dividend.

Accepted Answer

Cash dividend is one form of dividend (another is stock/bonus dividend).

Question 4

What is residual dividend policy?

Accepted Answer

Residual dividend policy pays dividend from **residual earnings** left after financing acceptable investment projects.

Question 5

Which theory states that dividend policy is irrelevant under perfect markets?

Accepted Answer

Modigliani–Miller (MM) dividend **irrelevance** theory.

Question 6

Stable dividend policy reduces uncertainty for investors.

Accepted Answer

True. Stable dividends provide predictable income and can improve investor confidence.

Question 7

Differentiate between stable dividend policy and residual dividend policy (any three points) using a table.

Accepted Answer

Stable vs residual dividend policy:

| Basis | **Stable dividend** | **Residual dividend** |
|---|---|---|
| Approach | steady DPS | dividend from leftover earnings |
| Priority | dividend stability | **investment first** |
| Dividend pattern | smoother | fluctuates with investment needs |

Thus, stable policy focuses on predictability; residual focuses on funding projects.

Question 8

State any three factors affecting dividend policy.

Accepted Answer

Any three factors:

- **Earnings stability**
- **Liquidity/cash position**
- **Investment opportunities** (growth needs)
- legal/contractual restrictions, taxes, shareholder preference, cost of external finance

These factors determine the feasible and desirable payout level.

Question 9

Explain dividend relevance vs dividend irrelevance (MM) in a short comparison table.

Accepted Answer

Relevance vs irrelevance:

| Point | **Relevance (Walter/Gordon)** | **Irrelevance (MM)** |
|---|---|---|
| Effect on value | dividend affects share price | dividend policy does not affect value |
| Key idea | investor preference, r vs k | perfect markets + fixed investment |
| Implication | optimal payout may exist | focus on investment policy |

Hence, assumptions decide whether dividend policy matters.

Question 10

Explain Walter model implication using r and k (brief) with a small table.

Accepted Answer

Walter model says dividend policy depends on relationship between return on investment **r** and cost of equity **k**:

| Condition | Implication |
|---|---|
| **r > k** | retain more (low payout) |
| **r < k** | pay more dividend (high payout) |
| r = k | policy is neutral |

Thus, if reinvestment earns more than required return, retention adds value.

Question 11

State any three assumptions of MM dividend irrelevance theory.

Accepted Answer

Any three MM assumptions:

- **no taxes**
- **no transaction costs** (buy/sell shares costless)
- perfect information (no signalling)
- fixed investment policy

Under these conditions, dividend policy does not change firm value.

Question 12

Explain dividend payout ratio and retention ratio relationship with a small table/flow.

Accepted Answer

Payout ratio and retention ratio are complementary:

Retention ratio = 1 − **payout ratio** (in percentage terms).

Flow: Earnings → Dividend (payout) + Retained earnings (retention)

| Item | Formula |
|---|---|
| **Payout ratio** | Dividend / Earnings |
| **Retention ratio** | Retained earnings / Earnings = 1 − payout |

Thus, higher payout implies lower retention for growth funding.

Question 13

Explain dividend policy factors and how they shape payout decisions (exam-style) with a table and conclusion.

Accepted Answer

### Key factors
Dividend policy depends on both ability and willingness to pay dividend.

| Factor | Effect on dividend |
|---|---|
| **Liquidity** | low cash → dividend may reduce |
| **Earnings stability** | stable earnings → stable dividend possible |
| **Growth/investment needs** | more projects → higher retention |
| **Legal/contract** | restrictions may limit payout |
| **Shareholder preference** | income investors prefer payout |

### Conclusion
A good policy balances **shareholder expectations** with **financing needs** and maintains long-term value.

Question 14

Explain MM dividend irrelevance theory: assumptions and conclusion (exam-style) with a table/flow.

Accepted Answer

### MM irrelevance proposition
MM argues dividend policy does not affect firm value under **perfect market** assumptions.

### Assumptions (basic)
- no taxes and no transaction costs
- perfect information
- fixed investment policy
- investors can create homemade dividends (sell/buy shares)

Flow: Investment policy तय → Earnings/cash flows तय → **Firm value** तय (dividend split doesn’t change value)

| Item | MM view |
|---|---|
| Dividend policy | **irrelevant** |
| Driver of value | **investment policy + earnings** |

### Conclusion
Thus, in ideal conditions dividend is just a distribution decision; value comes from investment returns.

Question 15

Explain residual dividend policy and its advantages/limitations (exam-style) with a flow and table.

Accepted Answer

### Meaning
Residual dividend policy pays dividends only after financing all acceptable investments from retained earnings.

### Flow
Earnings → fund equity portion of capital budget → remaining earnings = **residual** → dividend from residual

### Pros/cons
| Aspect | Points |
|---|---|
| Advantages | aligns dividend with investment needs; reduces external financing |
| Limitations | dividend becomes **unstable**; may disappoint income investors |

### Conclusion
Residual policy supports growth funding but may not suit firms aiming for stable dividends.

Basis	Stable dividend	Residual dividend
Approach	steady DPS	dividend from leftover earnings
Priority	dividend stability	investment first
Dividend pattern	smoother	fluctuates with investment needs

Dividend Decisions: Relevance/Irrelevance Theories, Dividend Policy Factors and Models (Overview)

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