Optimum dividend policy

Meaning. The optimum dividend policy is the payout ratio, the division of earnings between dividends and retained earnings, that maximises the market price of the share, and so the shareholders' wealth. Since the value of the firm is maximised when the shareholders' wealth is maximised, the dividend decision is judged by its effect on the share price.

What the theories say about the optimum

1. Walter's model compares the return on investment (r) with the cost of capital (k):
   • r > k (growth firm): retain all earnings; the optimum payout is zero;
   • r < k (declining firm): distribute all earnings; the optimum payout is 100%;
   • r = k (normal firm): the payout does not affect the price; there is no optimum payout.
2. Gordon's model reaches similar conclusions under certainty but, because investors value near dividends more than uncertain future gains ("bird in hand"), it adds the argument that investors value a certain dividend now more than an uncertain gain later.
3. Modigliani–Miller: in perfect markets dividend policy is irrelevant, so any payout is as good as another and there is no optimum; with investment policy fixed, a residual policy (pay what is left after funding profitable projects) is consistent with the theory, but it is not an optimum the theory derives.

In practice the optimum also reflects the firm's need for funds and its investment opportunities, its cost of capital and capital structure, the share price, the trend in the industry, shareholders' expectations and legal restrictions. Most firms aim for a target payout that is stable over time, balancing the shareholders' desire for current income against the firm's need to retain earnings for growth.