This theory was proposed by two Noble Laureates, Merton H. Miller and Franco Modigliani, and is also commonly called the M and M theorem. The theory was proposed in their article “Dividend Policy, Growth, and the Valuation of Shares,” which was published in the Journal of Business in October of 1961, pp. 411-433.
The theory suggests that, in a perfect world, dividends are irrelevant when the value of the stock and, therefore, of the firm is determined.
The theory implies that retained earnings belong to the shareholders of the company and shareholders are not concerned whether money is used to pay out dividends or for investment purposes because they benefit either way by receiving dividends or via share price appreciation.
If investors will require cash, they can always sell a few of the shares which increased in value due to investments.
Miller and Modigliani also suggest that the clientele effect exists. This refers to the tendency for investors to hold stocks which are in line with their dividend payment preferences.
Investors who prefer regular dividends hold stocks of the companies which provide such dividends and investors who prefer for funds to be reinvested and to be reflected in the share appreciation hold those stocks that are aligned with such preferences.
The clientele effect further supports the proposition that the dividend policy does not affect the value of the stock because investors obtain income from the shares in their preferred way.
Miller and Modigliani also suggest that if dividends affect stock price than it is because of the informational content in changes in dividends. Investors see changes in dividends as signals. Increases in dividends are seen as a positive signal pointing out that management expects earnings of the firm to increase in the future. Decrease in dividends is seen as negative signal which points out that management expects earnings to decrease in the future.
Overall, the dividend irrelevance theory suggests that firm do not require a dividend policy because it does not affect the value of the firm.