Dividend irrelevance. Miller and Modigliani (MM) maintain that dividend policy is irrelevant, as it has no effect on the price of a firm's stock or its cost of capital. MM's argument of dividend irrelevance is based on their concept of homemade dividends. Assume, for example, that you are a stockholder and you don't like the firm's dividend policy. If the firm's cash dividend is too big, you can just take the excess cash received and use it to buy more of the firm's stock. If the cash dividend you received was too small, you can just sell a little bit of your stock in the firm to get the cash flow you want. In either case, the combination of the value of your investment in the firm and your cash in hand will be the same. If investors don't care about the firm's dividend policy, the firm's dividend policy will not affect the firm's stock price and, consequently, dividend policy will not affect the firm's required rate of return on equity capital. Note: this theory holds only in a perfect world with no taxes, no brokerage costs, and infinitely divisible shares. This discussion applies to the firm's total payout policy (rather than just dividend policy).
Bird in hand argument for dividend policy. Myron Gordon and John Litner, however, argue that the firm's required rate of return on equity capital decreases as the dividend payout increases. Why? Because investors are less certain of receiving future capital gains from the reinvested retained earnings than they are of receiving current (and therefore certain) dividend payments. The main argument of Gordon and Lintner is that investors place a higher value on a dollar of dividends that they are certain to receive than on a dollar of expected capital gains. They base this argument on the fact that, when measuring total return, the dividend yield component, D(1)/P(0), has less risk than the growth component g.
Tax aversion. In many countries, dividends have historically been taxed at a higher rate than capital gains. Under such a situation, according to the tax aversion theory, investors will prefer to not receive dividends due to their higher tax rates. Taken to the extreme, the tax aversion theory implies that investors would want companies to have a zero dividend payout ratio so that they will not be burdened with higher tax rates.
Conclusions from the three theories. The results of empirical tests are unclear as to which of these theories best explains the empirical observations of dividend policy. Research suggests that higher tax rates do result in lower dividend payouts. In the United States, however, the change in tax law that put dividends and capital gains on common ground is likely to make the tax aversion theory irrelevant. There is empirical support for the "bird in the hand" theory as some companies that pay dividends are perceived as less risky and specific groups of investors do prefer dividend paying stocks. MM counter this argument by saying that different dividend policies appeal to different clienteles, and that since all types of clients are active in the marketplace, dividend policy has no effect on company value if all clienteles our satisfied.