M&M said dividend policy is not important because:
(dividend irrelevance theory)
- There is no tax: when receiving a dividend you don’t need to pay income tax and when you sell a share you don’t need to pay capital gains tax.
- There is no transaction cost: this means shareholders can sell a share freely incurring no costs.
- Perfect market: this means if company cuts dividend for the year then shareholders know exactly why they are doing this, ie, retain profit and invest in profitable projects to generate a higher return.
But the actual world suggests this matters because:
- There is tax: when receiving a dividend you need to pay income tax and when you sell a share you need to pay capital gains tax.
- There is transaction cost: this means when shareholders sell a share then it incurring costs.
- Imperfect market: this means if company cuts dividend for the year then shareholders don’t know exactly why they are doing this and this would make shareholders not happy.
Signaling effect: if company cuts dividend and it suggests company is having cash flow problems.
Clientele effect: some shareholders would prefer dividend and hence they buy the shares.
There would be other ways besides giving shareholder dividend:
- Give them something: for Free, like free flights/free shares.
- Given them cash: by repurchasing shares from the market.