Definition: The Dividend Policy is a financial decision that refers to the proportion of the firm’s earnings to be paid out to the shareholders. Here, a firm decides on the portion of revenue that is to be distributed to the shareholders as dividends or to be ploughed back into the firm.
The amount of earnings to be retained back within the firm depends upon the availability of investment opportunities. To evaluate the efficiency of an opportunity, the firm assesses a relationship between the rate of return on investments “r” and the cost of capital “K.”
As per the dividend models, some practitioners believe that the shareholders are not concerned with the firm’s dividend policy and can realize cash by selling their shares if required. While the others believed that, dividends are relevant and have a bearing on the share prices of the firm. This gave rise to the following models:
- Miller and Modigliani Hypothesis- Dividend Irrelevance Theory
- Walter’s Model – Dividend Relevance Theory
- Gordon’s Model- Dividend Relevance Theory
As long as returns are more than the cost, a firm will retain the earnings to finance the projects, and the shareholders will be paid the residual dividends i.e. the earnings left after financing all the potential investments. Thus, the dividend payout fluctuates from year to year, depending on the availability of investment opportunities.