Dividend policy of a firm determines what proportion of earnings is paid to holders by way of dividends and what proportion is ploughed back in the firm for investment purposes.
If a firm’s capital budgeting decision is independent of its dividend policy, a higher dividend payment will entail a greater dependence on external financing. Thus the dividend policy has a bearing on the choice of financing. On the other hand, if a firm’s Capital budgeting decision is dependent on its dividend decision, a higher payment will shrink its capital budget and vice versa. In such a case, the dividend policy has a bearing on capital budgeting decision.
Discussions on dividend policy and firm value assumes that the investment decision of a firm is independent of it dividend decision. However, there are some models which assume that investment and dividend decisions are related. Two such models are and the Walter model Gordon model.