BANGLADESH UNIVERSITY OF PROFESSIONALS

FINANCIAL STATEMENT ANALYSIS AND VALUATION

COURSE CODE: FIN4205

TERM PAPER ON INFLUENCE OF DIVIDEND IRREVELANCY THEORY ON

CAPITAL COST OF A CORPORATE FIRM

SUBMITTED TO

DR. MOHAMMAD MONZUR MORSHED BHUIYAN

PROFESSOR
DEPARTMENT OF BUSINESS ADMINISTRATION
IN
FINANCE AND BANKING
BANGLADESH UNIVERSITY OF PROFESSIONALS

SUBMITTED BY

AJMAIN FAHIM
ID: 2022151050
SECTION: B
DEPARTMENT OF BUSINESS ADMINISTRATION
IN
FINANCE AND BANKING
BATCH: 2020
BANGLADESH UNIVERSITY OF PROFESSIONALS

SUBMISSION DATE: 30.10.2023

 i. LETTER OF TRANSMITTAL

30th Oct 2023

Dr. Mohammad Monzur Morshed Bhuiyan

Bangladesh University of Professionals

Subject: Submission of Term Paper for the course FIN4205 Strategic Financial Management

Dear Sir,
Here is the Term Paper that has been assigned to us as a requirement of the course FIN4205
Strategic Financial Management on the topic- “Influence of dividend irrelevancy theory on
capital cost of a corporate firm”. This Term Paper details the impact of the theory and real-life
implications.

Finally, I would like to thank you for the opportunity this Term Paper gave us. This helped me to
learn better about how to do data analysis and conduct proper research. Hence overall, this term
paper was a vast learning experience for me.

Sincerely Yours,

___________
Ajmain Fahim

Course: Strategic Financial Management

Section: B
Department of Business Administration in Finance & Banking
Faculty of Business Studies
Bangladesh University of Professionals

I
 ii. ACKNOWLEDGEMENT
Firstly,
I would like to express our heartiest gratitude to the Almighty for whose kindness I have managed
to successfully complete this term paper with sound health. Throughout the entire period of time
of writing this paper, I have received support from some of our acquaintances who helped me to
complete our projections in time. Their support was of great value to me. I would like to express
my heartfelt gratitude to those individuals.

I would also like to thank Dr. Mohammad Monzur Morshed Bhuiyan, from Bangladesh University
of Professionals, for his guidance and support on how to prepare this paper. Without his guidance,
this paper would not have been complete. With his teachings, I was able to learn new things that
would help me in the future.

Lastly, I would like to thank my family for their all-time support and guidance. I will be forever
indebted to them.

ii
 TABLE OF CONTENTS

SERIAL PAGES

i LETTER OF TRANSMITTAL i

ii ACKNOWLEDGEMENT ii

1. THEORETICAL BACKGROUND 1

1.1 DIVIDEND 1

1.2 DIVIDEND POLICY 1

1.3 DIVIDEND IRREVELANCY THEORY 1

1.4 ASSUMPTIONS 2

2. DIVIDEND IRREVELANCY THEORY PROOF FROM THE 2

CORPORATE PERSPECTIVE

3. INFLUENCE OF DIVIDEND POLICY ON COST OF 4

CAPITAL

4. REAL LIFE IMPLICATIONS OF THE IMPACT OF 5

DIVIDEND IRREVELANCY THEORY ON CAPITAL
COSTS

5. RECOMMENDATIONS BASED ON STRATEGIC 7

DECISIONS

6. CONCLUSION 8

7. REFERENCES 9
 Influence of dividend irrelevancy on
capital costs of Corporate firms

1. Theoretical Background:

1.1. Dividend:
Dividend can be described as a distribution of profits/net income to shareholders for their
investment in shares of the company.

1.2. Dividend Policy:

Dividend policy can be defined as the methods, practices or regulations management follows in
making decisions of paying out dividends.

1.3. Dividend Irrelevance Theory:

This theory asserts that in a world with no taxes or bankruptcy costs, the dividend policy of a firm
does not matter. It has no effect on the stock price of a company or the company’s capital structure.

The value of the firm depends on the earnings generated from the assets the firm invested in. The
amount of dividends paid or earnings retained does not have any impact on the value of the firm
or the cost of capital. If the earnings are retained by the firm, it leads to capital appreciation equal
to the amount retained. On the other hand, if a dividend is distributed, the shareholders will receive
dividend income equal to the amount by which the capital would appreciate if the company would
have retained that amount.

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This theory states that the value of the firm & overall cost of capital is solely determined by its
investments policy; it is primarily responsible for the earnings generated by the firm. Dividend
payout has no effect on capital structure because it does not change the value of the firm.

1.4. Assumptions of the theory:

● Capital markets are perfect and investors are rational.

● Information is freely available in the market.

● No taxes exist.

● No floating costs exist in the market.

● No transaction costs are present.

● Investment and dividend decisions are independent of each other.

2. Dividend irrelevancy theory proof from the

corporate perspective:
Let us consider a firm that has a policy of full retention of earnings and constant investment
policy, whose shares are currently priced at BDT 5 and after one year it will rise to BDT 5.50.

Therefore, the equation will be: P0 = (D1 + P1) / (1 + Ke)

P0 = Current share price

P1 = Share price after 1 year
D1 = Dividend payment after 1 year
Ke = Cost of equity

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Here, P1 = 5.05, D1 = 0 & Ke = 0.10

There, P0 = (0 + 5.5) / (1 +0.10) = BDT 5

Let us assume the firm has 1 million shares from which we can derive its market value of equity.

n = 1 million

nP0 = (nD1 + nP1) / (1 + Ke) = (0 + 5.5 m) / (1 +0.10) = BDT 5 million.

The firm decides all its earnings are provided as dividends (BDT 0.5 per share on a million shares
issued) If investment projects are still to be implemented, the company must therefore raise new
equity capital equal to the proportion of investment that is no longer funded by retained earnings.
From the MM proof:

mP1 = nD1 = BDT 500,000

Based on all the shares outstanding at time period one, (n + m) P1, we can rewrite the equation
for the total market value of the original shares in issue as follows:

nP0 = [nD1 + (n + m)P1 - mP1] / 1 + Ke

And because mP1 = nD1, the equation now will be

nP0 = (n + m) P1 / 1 + Ke = (nP1 + BDT 500,000) / 1.1 = BDT 5 m

Since there is also only one unknown in the equation (P10, by dividing the number of shares
originally issued (n = one million).
P0 = (P1 + BD 0.5) / 1.10 = BDT 5.00

And rearranging terms and solving for P1:

P1 = BDT 5.00

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Thus, as based on dividend irrelevant theory by MM:

● The share price at the end of the period (P1) falls from its initial value of
BDT 5.5 to BDT 5.00, which is exactly the same as the BDT 0.5 dividend
payment resulting in the share price being completely unchanged.

● Because the dividend (D1) has completely disappeared from the equation, it
is impossible to conclude that share price is a function of dividend policy.

Since, dividend payout does not have any effect on the value of a firm there is no need to
consider it a capital cost for the firm.

3. Influence of dividend irrelevancy theory on

consideration as cost of capital:

Dividend irrelevance theory suggests managers of firms do not need to worry about providing
dividends to shareholders since they will receive that amount in the form of capital appreciation
of stocks any now.

This theory implies that dividend policy is kind of irrelevant in considering capital costs. It
suggests managers do need to worry about dividend policy. They can retain the entire earnings if
there are enough profitable opportunities for the firm to invest on as the stockholders will receive
the benefits.

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It suggests management of a firm mainly focuses on investment policy to generate as much
earnings as possible for the firm. Dividend payout does not affect the value of the firm. So, there
is no need to consider dividend payout as a cost of capital.

Retained earnings are merely considered another source of funds for the firm to use. Dividends are
considered as residuals to be given out to shareholders. It supports the idea that all the shareholders
are willing to invest in the firm even if they receive no dividends from time to time as they are
receiving their return in the form of capital appreciation of stocks.

It assumes that investors do not differentiate between dividend and retained earnings. It considers
investors will keep their stocks as long as they receive returns in the form of capital appreciation.

It considers dividends as residuals and kind of assumes that investors do not have other uses for
dividends rather than being used as investments.

4. Real life implications of dividend irrelevance theory’s

impact on capital costs:
In reality however, the situation is quite different. Taxes are a constant source of costs in the
market. Both investors and firm managers have to keep taxes in mind whenever they make a
decision.

Flotation costs are always present for firms. Whenever firms have to issue new stocks they have
to pay underwriting fees, registration fees, legal fees & audit fees. These fees scale up whenever
any firm has to issue new stocks.

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Transaction costs are also present in the market. Whenever any stock is traded in the market,
investors have to pay for brokers fee & spreads, as a result investors consider transaction costs
whenever they make investments in any security in the market.

All information is not freely available in the market. Investors are not able to get all the information
about a firm when they invest in it.

Investment policy & dividend policy are not quite as independent in reality as it was assumed in
the theory. Managers have to ensure constant dividend payments to shareholders otherwise it will
not end well for the firm in the long run.

The reason for this is that managers have to make sure their investments earn enough profits so
that the firm is able to keep paying dividends to shareholders. If any firm is unable to pay constant
dividends, it is considered as a sign that the firm is struggling financially. As a result, shareholders
will start selling their stocks which will end up bringing down the value of the company.

This will further limit the firm ability to generate funds through debt or equity as lower value for
stocks means firms will receive less funds from issuing new stocks and funds trustworthiness will
drop which will make it harder for firms to receive debt. Even if debt funding is possible, it will
have to be returned back in higher interest rates thus hindering firms ability to gather funds to
make profitable investments.

So, we can see that in reality the situation is quite different. The assumptions made by dividend
irrelevancy theory do not hold up at all in the market. This suggests this theory is not as useful in
practice in real life scenarios.

As a result, dividend irrelevancy theory is not something that managers should focus on whenever
a specific dividend policy & investment policy is being decided for the firm. When planning a
capital structure & costs of capital that will result from it, managers should always keep the current
dividend policy in mind. Without a proper dividend policy, the sources of funds will become
extremely limited for any firm.

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5. Recommendations based on strategic decisions:
● Managers, whenever they are planning to make investments, have to make sure that the
investment will at least generate enough return to pay constant dividends to the
shareholders of the firm.

● Even if investments made by the managers of the firm completely fail, they have to make
sure the firm has enough funds beforehand to pay dividends to shareholders.

● Managers should develop investment policy that has to be consistent with dividend policy.
● When planning capital structure & costs of capital that the firm will have to bear as a result,
managers should keep in mind how not being able to pay constant dividends will severely
hamper the firm's ability to gather funds.

● Managers must develop a proper dividend policy based on the interests of the shareholders
as well as based on what type of investors are the shareholders of the firm.

● Whenever managers decide on issuing new stock, they must keep in consideration flotation
costs for the firm and how it will reduce the amount of funds the firm is able to generate
by issuing stocks.

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6. Conclusions:
While dividend irrelevancy theory was a major breakthrough in corporate finance, its usage is
quite limited in real life applications. While it may suggest that dividend payout has no role in
determining the capital structure or cost of capital of a firm, the situation is quite different in reality.

Constant dividend payout is the only way that firm can ensure the most suitable capital structure
& cost of capital for it. Managers should always develop dividend policy in the best interests of
shareholders and always keep dividend policy in mind when planning any investments for the firm.

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7. References:
● Ang, J. S., & Ciccone, S. J. (2011). Dividend Irrelevance Theory. Dividends and

Dividend Policy, 95–113. https://doi.org/10.1002/9781118258408.ch6

● Chen, J. (2020, November 1). Dividend Irrelevance Theory. Investopedia.

https://www.investopedia.com/terms/d/dividendirrelevance.asp

● Deangelo, H., & Deangelo, L. (2006). The irrelevance of the MM dividend irrelevance

theorem�. Journal of Financial Economics, 79(2), 293–315.

https://doi.org/10.1016/j.jfineco.2005.03.003

● G, A. (n.d.). Dividend.com. Dividend.com. https://www.dividend.com/dividend-

education/dividend-irrelevance-theory/#:~:text=in%20real%20life.-

● Saraf, P., & Kaur, R. (2014). The Study of Dividend Policy: A Review of Irrelevance

Theory. International Journal of Innovative Research and Practices , 2(5).

https://forum4researchers.com/cw_admin/docs/IJIRP-MAY-14-01.pdf