What is Dividend Irrelevance Theory?

The dividend irrelevance theory was developed by Franco Modigliani and Merton Miller in 1961. This theory maintains that dividend policy does not have an impact on stock's cost of capital or stock price. The dividend irrelevance theory also argued that the dividend policy of a company is irrelevant and investors need not pay any attention to it. Since investors also have the option of selling part of their shares if they want not cash, the dividend policy has no effect.

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How Does Dividend Irrelevance Theory Work?

Franco Modigliani and Merton Miller developed the dividend irrelevance theory is a famous seminal paper in 1961. According to these authors, the announcement and payment of dividends by a company have no impact on the stock price neither does it affect the company's capital structure. Modigliani and Miller are of the opinion that if an investor is paid a dividend higher than what he expected, he has the option of reinvesting the stock with the excess cash flow received. On the other hand, if a company pays less dividend than what the investor expects, he can sell part of his shares to get the amount he wants.

Dividend Irrelevance Theory and Portfolio Strategies

Although, Modigliani and Miller holds that the dividend policy of a company does not matter to investors, in reality, many investors pay attention to dividends structure when selecting and managing their portfolios. In many portfolio strategies, dividend is vital. Given that investors have varying needs and investment goals, the premium they place on dividends differ. When investors use the income strategy for instance, they seek to distinguish investments that offer dividends above the average from those that pay dividends below the average. Also, payment of steady dividends is crucial to investors in this category, this is why they often go for blue chip companies that are known for payment of stay dividends.