In the case of a normal firm where the return on equity (r) is equal to the cost of equity (k), the firm should follow the Dividend Irrelevance Theory, specifically referring to the Modigliani-Miller Dividend Policy Model. According to this theory, the firm’s value is unaffected by its dividend policy under certain assumptions.
Modigliani-Miller Dividend Policy Model
Key Assumptions:
- Perfect Capital Markets: There are no taxes, transaction costs, or bankruptcy costs, and all investors have access to the same information.
- Investment Policy is Fixed: The firm has a specific investment policy and does not change it based on dividend decisions.
- No External Financing: The model assumes that the firm can only finance through retained earnings or dividends, avoiding external financing complexities.
Implications of the Model:
- Dividend Policy is Irrelevant: The model asserts that a firm’s dividend policy does not affect its overall value or the wealth of its shareholders. Investors can create their own dividends by selling shares if they want cash, regardless of how much the firm pays in dividends.
- Firm Value Determined by Earnings: The value of the firm is determined by its ability to generate earnings and invest in profitable projects rather than how earnings are distributed as dividends.
- Shareholder Wealth: Since investors can replicate the desired cash flows through personal trading, they are indifferent to whether the firm pays out high dividends or retains earnings for reinvestment.
Conclusion
In a scenario where a normal firm’s return on equity equals the cost of equity, following the Modigliani-Miller Dividend Policy Model indicates that the firm should focus on retaining earnings to finance profitable projects rather than distributing dividends, as it does not enhance shareholder wealth. The key takeaway is that, under ideal conditions, the choice between paying dividends and reinvesting earnings is irrelevant to the firm’s overall value.