The residual theory of dividends is a school of thought that suggests that the dividend paid by a firm should be viewed as a residual, that is, the amount left over after all acceptable investment opportunities have been undertaken. Using this approach, the firm would treat the dividend decision in three steps as follows:

residual theory of dividends

A school of thought that suggests that the dividend paid by a firm should be viewed as a residual,the amount left over after all acceptable investment opportunities have been undertaken.

  • Step 1 Determine its optimal level of capital expenditures, which would be the level that exploits all a firm’s positive NPV projects.
  • Step 2 Using the optimal capital structure proportions (see Chapter 13), estimate the total amount of equity financing needed to support the expenditures generated in Step 1.
  • Step 3 Because the cost of retained earnings, rr, is less than the cost of new common stock, rn, use retained earnings to meet the equity requirement determined in Step 2. If retained earnings are inadequate to meet this need, sell new common stock. If the available retained earnings are in excess of this need, distribute the surplus amount—the residual—as dividends.

According to this approach, as long as the firm’s equity need exceeds the amount of retained earnings, no cash dividend is paid. The argument for this approach is that it is sound management to be certain that the company has the money it needs to compete effectively. This view of dividends suggests that the required return of investors, rs, is not influenced by the firm’s dividend policy, a premise that in turn implies that dividend policy is irrelevant in the sense that it does not affect firm value.


The residual theory of dividends implies that if the firm cannot invest its earnings to earn a return that exceeds the cost of capital, it should distribute the earnings by paying dividends to stockholders. This approach suggests that dividends represent an earnings residual rather than an active decision variable that affects the firm’s value. Such a view is consistent with the dividend irrelevance theory put forth by Merton H. Miller and Franco Modigliani (M and M).2 They argue that the firm’s value is determined solely by the earning power and risk of its assets (investments) and that the manner in which it splits its earnings stream between dividends and internally retained (and reinvested) funds does not affect this value. M and M’s theory suggests that in a perfect world (certainty, no taxes, no transactions costs, and no other market imperfections), the value of the firm is unaffected by the distribution of dividends.

dividend irrelevance theory

Miller and Modigliani’s theory that, in a perfect world, the firm’s value is determined solely by the earning power and risk of its assets (investments) and that the manner in which it splits its earnings stream between dividends and internally retained (and reinvested) funds does not affect this value.

Of course, real markets do not satisfy the “perfect markets” assumptions of Modigliani and Miller’s original theory. One market imperfection that may be important is taxation. Historically, dividends have usually been taxed at higher rates than capital gains. A firm that pays out its earnings as dividends may trigger higher tax liabilities for its investors than a firm that retains earnings. As a firm retains earnings, its share price should rise, and investors enjoy capital gains. Investors can defer paying taxes on these gains indefinitely simply by not selling their shares. Even if they do sell their shares, they may pay a relatively low tax rate on the capital gains. In contrast, when a firm pays dividends, investors receive cash immediately and pay taxes at the rates dictated by then-current tax laws.

Even though this discussion makes it seem that retaining profits rather than paying them out as dividends may be better for shareholders on an after-tax basis, Modigliani and Miller argue that this assumption may not be the case. They observe that not all investors are subject to income taxation. Some institutional investors, such as pension funds, do not pay taxes on the dividends and capital gains that they earn. For these investors, the payout policies of different firms have no impact on the taxes that investors have to pay. Therefore, Modigliani and Miller argue, there can be a clientele effect in which different types of investors are attracted to firms with different payout policies due to tax effects. Tax-exempt investors may invest more heavily in firms that pay dividends because they are not affected by the typically higher tax rates on dividends. Investors who would have to pay higher taxes on dividends may prefer to invest in firms that retain more earnings rather than paying dividends. If a firm changes its payout policy, the value of the firm will not change; instead, what will change is the type of investor who holds the firm’s shares. According to this argument, tax clienteles mean that payout policies cannot affect firm value, but they can affect the ownership base of the company.

clientele effect

The argument that different payout policies attract different types of investors but still do not change the value of the firm.

In summary, M and M and other proponents of dividend irrelevance argue that, all else being equal, an investor’s required return—and therefore the value of the firm—is unaffected by dividend policy. In other words, there is no “optimal” dividend policy for a particular firm.


2. Merton H. Miller and Franco Modigliani, “Dividend Policy, Growth and the Valuation of Shares,” Journal of Business34 (October 1961), pp. 411–433.

Modigliani and Miller’s assertion that dividend policy was irrelevant was a radical idea when it was first proposed. The prevailing wisdom at the time was that payout policy could improve the value of the firm and therefore was relevant. The key argument in support of dividend relevance theoryis attributed to Myron J. Gordon and John Lintner,3 who suggest that there is, in fact, a direct relationship between the firm’s dividend policy and its market value. Fundamental to this proposition is their bird-in-the-hand argument, which suggests that investors see current dividends as less risky than future dividends or capital gains: “A bird in the hand is worth two in the bush.” Gordon and Lintner argue that current dividend payments reduce investor uncertainty, causing investors to discount the firm’s earnings at a lower rate and, all else being equal, to place a higher value on the firm’s stock. Conversely, if dividends are reduced or are not paid, investor uncertainty will increase, raising the required return and lowering the stock’s value.

dividend relevance theory

The theory, advanced by Gordon and Lintner, that there is a direct relationship between a firm’s dividend policy and its market value.

bird-in-the-hand argument

The belief, in support of dividend relevance theory, that investors see current dividends as less risky than future dividends or capital gains.

Modigliani and Miller argued that the bird-in-the-hand theory was a fallacy. They said that investors who want immediate cash flow from a firm that did not pay dividends could simply sell off a portion of their shares. Remember that the stock price of a firm that retains earnings should rise over time as cash builds up inside the firm. By selling a few shares every quarter or every year, investors could, according to Modigliani and Miller, replicate the same cash flow stream that they would have received if the firm had paid dividends rather than retaining earnings.

Studies have shown that large changes in dividends do affect share price. Increases in dividends result in increased share price, and decreases in dividends result in decreased share price. One interpretation of this evidence is that it is not the dividends per se that matter but rather theinformational content of dividends with respect to future earnings. In other words, investors view a change in dividends, up or down, as a signal that management expects future earnings to change in the same direction. Investors view an increase in dividends as a positive signal, and they bid up the share price. They view a decrease in dividends as a negative signal that causes investors to sell their shares, resulting in the share price decreasing.

informational content

The information provided by the dividends of a firm with respect to future earnings, which causes owners to bid up or down the price of the firm’s stock.

Another argument in support of the idea that dividends can affect the value of the firm is theagency cost theory. Recall that agency costs are costs that arise due to the separation between the firm’s owners and its managers. Managers sometimes have different interests than owners. Managers may want to retain earnings simply to increase the size of the firm’s asset base. There is greater prestige and perhaps higher compensation associated with running a larger firm. Shareholders are aware of the temptations that managers face, and they worry that retained earnings may not be invested wisely. The agency cost theory says that a firm that commits to paying dividends is reassuring shareholders that managers will not waste their money. Given this reassurance, investors will pay higher prices for firms that promise regular dividend payments.

Although many other arguments related to dividend relevance have been put forward, empirical studies have not provided evidence that conclusively settles the debate about whether and how payout policy affects firm value. As we have already said, even if dividend policy really matters, it is almost certainly less important than other decisions that financial mangers make, such as the decision to invest in a large new project or the decision about what combination of debt and equity the firm should use to finance its operations. Still, most financial managers today, especially those running large corporations, believe that payout policy can affect the value of the firm.

3. Myron J. Gordon, “Optimal Investment and Financing Policy,” Journal of Finance 18 (May 1963), pp. 264–272; and John Lintner, “Dividends, Earnings, Leverage, Stock Prices, and the Supply of Capital to Corporations,” Review of Economics and Statistics 44 (August 1962), pp. 243–269.


14–7Does following the residual theory of dividends lead to a stable dividend? Is this approach consistent with dividend relevance?

14–8Contrast the basic arguments about dividend policy advanced by Miller and Modigliani (M and M) and by Gordon and Lintner.

14.4 Factors Affecting Dividend Policy

LG 3

The firm’s dividend policy represents a plan of action to be followed whenever it makes a dividend decision. Firms develop policies consistent with their goals. Before we review some of the popular types of dividend policies, we discuss five factors that firms consider in establishing a dividend policy. They are legal constraints, contractual constraints, the firm’s growth prospects, owner considerations, and market considerations.

dividend policy

The firm’s plan of action to be followed whenever it makes a dividend decision.


Most states prohibit corporations from paying out as cash dividends any portion of the firm’s “legal capital,” which is typically measured by the par value of common stock. Other states define legal capital to include not only the par value of the common stock but also any paid-in capital in excess of par. These capital impairment restrictions are generally established to provide a sufficient equity base to protect creditors’ claims. An example will clarify the differing definitions of capital.

Example 14.4

The stockholders’ equity account of Miller Flour Company, a large grain processor, is presented in the following table.

Miller Flour Company Stockholders’ Equity
Common stock at par $100,000
Paid-in capital in excess of par  200,000
Retained earnings  140,000
  Total stockholders’ equity $440,000

In states where the firm’s legal capital is defined as the par value of its common stock, the firm could pay out $340,000 ($200,000 + $140,000) in cash dividends without impairing its capital. In states where the firm’s legal capital includes all paid-in capital, the firm could pay out only $140,000 in cash dividends.

Firms sometimes impose an earnings requirement limiting the amount of dividends. With this restriction, the firm cannot pay more in cash dividends than the sum of its most recent and past retained earnings. However, the firm is not prohibited from paying more in dividends than its current earnings.4

4. A firm that has an operating loss in the current period can still pay cash dividends as long as sufficient retained earnings against which to charge the dividend are available and, of course, as long as it has the cash with which to make the payments.

Example 14.5

Assume that Miller Flour Company, from the preceding example, in the year just ended has $30,000 in earnings available for common stock dividends. As the table in Example 14.4 indicates, the firm has past retained earnings of $140,000. Thus, it can legally pay dividends of up to $170,000.

If a firm has overdue liabilities or is legally insolvent or bankrupt, most states prohibit its payment of cash dividends. In addition, the Internal Revenue Service prohibits firms from accumulating earnings to reduce the owners’ taxes. If the IRS can determine that a firm has accumulated an excess of earnings to allow owners to delay paying ordinary income taxes on dividends received, it may levy an excess earnings accumulation tax on any retained earnings above $250,000 for most businesses.

excess earnings accumulation tax

The tax the IRS levies on retained earnings above $250,000 for most businesses when it determines that the firm has accumulated an excess of earnings to allow owners to delay paying ordinary income taxes on dividends received.

During the recent financial crisis, a number of financial institutions received federal financial assistance. Those firms had to agree to restrictions on dividend payments to shareholders until they repaid the money that they received from the government. Bank of America, for example, had more than 30 years of consecutive dividend increases before accepting federal bailout money. As part of its bailout, Bank of America had to cut dividends to $0.01 per share.


Often, the firm’s ability to pay cash dividends is constrained by restrictive provisions in a loan agreement. Generally, these constraints prohibit the payment of cash dividends until the firm achieves a certain level of earnings, or they may limit dividends to a certain dollar amount or percentage of earnings. Constraints on dividends help to protect creditors from losses due to the firm’s insolvency.


The firm’s financial requirements are directly related to how much it expects to grow and what assets it will need to acquire. It must evaluate its profitability and risk to develop insight into its ability to raise capital externally. In addition, the firm must determine the cost and speed with which it can obtain financing. Generally, a large, mature firm has adequate access to new capital, whereas a rapidly growing firm may not have sufficient funds available to support its acceptable projects. A growth firm is likely to have to depend heavily on internal financing through retained earnings, so it is likely to pay out only a very small percentage of its earnings as dividends. A more established firm is in a better position to pay out a large proportion of its earnings, particularly if it has ready sources of financing.


The firm must establish a policy that has a favorable effect on the wealth of the majority of owners. One consideration is the tax status of a firm’s owners. If a firm has a large percentage of wealthy stockholders who have sizable incomes, it may decide to pay out a lower percentage of its earnings to allow the owners to delay the payment of taxes until they sell the stock. Because cash dividends are taxed at the same rate as capital gains (as a result of the 2003 and 2012 Tax Acts), this strategy benefits owners through the tax deferral rather than as a result of a lower tax rate. Lower-income shareholders, however, who need dividend income, will prefer a higher payout of earnings.

A second consideration is the owners’ investment opportunities. A firm should not retain funds for investment in projects yielding lower returns than the owners could obtain from external investments of equal risk. If it appears that the owners have better opportunities externally, the firm should pay out a higher percentage of its earnings. If the firm’s investment opportunities are at least as good as similar-risk external investments, a lower payout is justifiable.

A final consideration is the potential dilution of ownership. If a firm pays out a high percentage of earnings, new equity capital will have to be raised with common stock. The result of a new stock issue may be dilution of both control and earnings for the existing owners. By paying out a low percentage of its earnings, the firm can minimize the possibility of such dilution.