Dividends are payments made to stockholders from a firm's earnings, whether those earnings were generated in the current period or in previous periods.
Dividends may affect capital structure.
- Retaining earnings increases common equity relative to debt.
- Financing with retained earnings is cheaper than issuing new common equity.
Dividend Policy and Stock Value
There are various theories that try to explain the relationship of a firm's dividend policy and common stock value.
Dividend Irrelevance Theory
This theory purports that a firm's dividend policy has no effect on either its value or its cost of capital. Investors value dividends and capital gains equally.
Optimal Dividend Policy
Proponents believe that there is a dividend policy that strikes a balance between current dividends and future growth that maximizes the firm's stock price.
Dividend Relevance Theory
The value of a firm is affected by its dividend policy. The optimal dividend policy is the one that maximizes the firm's value.