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What Is the Dividend Irrelevance Theory?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 17 November 2014
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The dividend irrelevance theory is a concept that is based on the premise that the dividend policy of a given company should not be considered particularly important by investors. Further, the terms of that dividend policy should not have any bearing on the price of the shares of stock issued by that company. With this particular financial theory, the idea is that investors can always sell a portion of their shares if they want to generate some amount of cash flow. As with most investment theories, the dividend irrelevance theory has its share of supporters and detractors.

Among those who find that the dividend irrelevance theory has merit, the usual stance is that many investors use dividend payments to purchase more shares, thus increasing the holdings that the investor has in the company. The same general effect could possibly be achieved if dividends are not issued, and those funds are invested in various projects and activities that ultimately increase the value of the shares already owned by investors. Since the investor stands to benefit from either scenario, he or she should not be concerned about the company’s dividend policy one way or the other. In the end, the impact will be the same.

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For investors who do not agree with the dividend irrelevance theory, one point of contention is that by not considering the type of dividend policy that a given company follows, the investor does not have the opportunity to make investment decisions that are in line with his or her financial goals. For example, if the investor wants to create steady cash flow from investments that can be used for day to day living expenses, buying securities where dividends are paid on some sort of consistent basis will go a long way toward establishing that desired cash flow. If the investor does not consider the dividend policy prior to buying the shares, there is a good chance that this goal will not be met, even though the value of the stock may increase as the company diverts resources into expanding the business.

Detractors also point out that investors normally look closely at the dividend policy associated with potential investments, simply because there are tax implications. This means that an investor must determine how the policy connected with a given investment will increase or decrease the taxes owed on investments when taxes become due. If the policy is likely to increase taxes without the opportunity to generate enough return to make the acquisition worthwhile, then the investor will want to look at another stock and determine if the dividend policy associated with that security would be more favorable. If the investor follows the idea behind the dividend irrelevance theory, there may be a large and rather unexpected tax burden that must be settled. Here again, proponents note this can be handled by selling shares of stock that have appreciated in value, effectively offsetting the additional taxes.

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