This chapter addresses the issue of dividend policy. Dividend policy is among one of the most controversial issues of corporate finance. The controversy surrounds the question - do dividends increase the value of a firm? Three broad and divergent views have emerged in response to this question. The prevailing wisdom before the seminal work by Modigliani and Miller (MM) was that increased dividend payouts increase firm value. MM argued that a firm’s value is decided by the success of its investments and not by how it pays dividends. A more radical view suggests that in view of the differential taxation of dividends and capital gains, dividends will reduce the firm’s value as they are taxed at a higher rate. The dividend irrelevancy argument of MM assumes a world of perfect capital markets. MM's position was a direct challenge to the traditional view, which held that high payout ratios tend to increase the value of the firm. While there is still debate on the issue, it appears that the traditional position has weakened considerably and there is more acceptance of the general wisdom of MM’s argument.

Part of the controversy and confusion about dividends arises from the way the issue is framed. In order to decide whether dividends add value to the firm, one has to keep other variables like investment policy and debt policy constant. One has to isolate he dividend policy effects from those of capital budgeting and borrowing decisions. This means that the dividend policy trade-off is between retaining earnings for reinvestment on the one hand and paying dividends and financing the investments with newly issued stocks on the other. In other words, dividend policy issue is not about paying off any excess funds the company has; but whether a company should pay out earnings as dividends when it can profitably reinvest the same.

A financial manager needs to understand the issue and trade-off involved in order to be able to make the right decisions. It is also essential that she be familiar with the terms and terminology of dividends and the current practice of corporations in establishing dividends. The chapter helps you do this with descriptive material on the mechanics of dividend payments and corporate dividend practice. The chapter also includes a description of alternative tax systems and their implications for dividends.