Topic 7 – Dividend Policy Copeland, Weston, Shastri –Chapter 16

The foundational paper in dividend policy is Miller and Modigliani, "Dividend Policy, Growth and the

Valuation of Shares," Journal of Business 4 (1961) 411-433. As with Modigliani and Miller’s (1958) capital

structure irrelevance paper, Miller and Modigliani (1961) show that dividend policy is irrelevant under perfect

capital market conditions.

Assumptions:

1) Perfect capital markets: price takers, equal and costless access to relevant information, no transaction costs, no tax

differences between dividends and capital gains.

2) Investors prefer more wealth to less and are indifferent between cash payments (i.e., cash dividends) and equal

increases in the value of their stock.

3) Certainty (no need to distinguish between stocks and bonds). This assumption is relaxed later.

4) Given investment policy

With certainty, two stocks offering the same rate of return (either with dividends or capital gains), must have the

same price. Define the return for period t as:

d j (t ) + p j (t + 1) - p j (t )
ρ(t ) =
p j (t )

(1)

Notice that ρ (t) is independent of j. The time t price per share is:

p j (t ) =
1
1 + ρ(t )
(
d j (t ) + p j (t + 1) ) (2)

Notation:

ρ (t) = the one period risk free interest rate for period t

d(t) = dividends paid during period t (assume at the end of the period)

p(t) and p(t+1) are the beginning of the period stock prices for periods t and t+1.

Time line:

Beginning of period t (e.g., January 1, 2009): pj(t)

End of period t (e.g., December 31, 2009): dj(t), the dividend is ex-dividend at the beginning of period t+1
 Beginning of period t+1 (e.g., January 1, 2010): pj(t+1)

In terms of total firm value (and dropping the j subscript):

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V (t ) = [ D(t ) + n(t ) p(t + 1) ] (3)
1 + ρ(t )

More notation:

n(t) is the number of shares outstanding at the start of time t

m(t+1) = new shares sold at the end of period t (at the ex-dividend stock price at the beginning of period

t+1)

n(t+1) = n(t) + m(t+1)

V(t) = n(t)p(t)

V(t+1) = n(t+1)p(t+1)

D(t) = n(t)d(t)

Therefore:

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V (t ) = [ D(t ) + V (t + 1) - m(t + 1) p (t + 1) ]
1 + ρ(t )

(4)

Now, to isolate the affect of dividend policy at time t on the current value of the firm, assume that dividend

policy for time t + 1 and future periods is fixed (therefore V(t+1) is independent of D(t)).

The remaining two terms will have equal and opposite effects. That is, if D(t) is increased, then for a given level

of investment (see assumption (4)), more new shares must be sold. To see, consider the following:

Even more notation:

I(t) = the given level of investment in period t (assume end of period)

X(t) = the net operating cash flow during period t (assume end of period).

The amount of cash needed from new security sales at time t + 1:

m(t + 1) p (t + 1) = I (t ) - [ X (t ) - D (t )]

(5)

Substituting into equation (4)

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 1
V (t ) = [ X (t ) - I (t ) + V (t + 1) ]
1 + ρ(t )

(6)

Notice that D(t) is no longer in the equation, so the firm value at the beginning of time t cannot depend on

dividends during the year. That is, if dividend policy is fixed in all future periods, the amount of dividends paid

during period t has no effect on current stock price.

Now relax the assumption that dividend policy is fixed for future time periods. We know from the previous

discussion that V(t) is unaffected by D(t). Now go one period into the future, and we can use a similar argument to

show that V(t+1) is unaffected by D(t+1), … , and so on. Therefore, the value of the firm depends on the cash flow

generating power of the firm and its investment policy that creates those cash flows, and not how the firm decides to

distribute those cash flows.

We can skip the middle section of the paper which discusses the equivalence of various valuation formulas and

proceed to the discussion of the effects of uncertainty (section IV). Assume an individual trader assumes (a) every

other trader in the market is rational (preferring more wealth to less, indifferent to the form of the payment -

dividend vs. capital gain) and (b) that these other traders impute rationality on all other traders. Also assume that

every trader behaves rationally and imputes rationality on the market. (These assumptions preclude the possibility of

market prices deviating from fundamental values - no speculative bubbles.)

Assume that we have two identical firms in terms of operating cash flows and investment policy (as in the

M&M (1958) capital structure paper). These firms have a different dividend policy for t = 0, but the same dividend

policy for future time periods.

The random return (cash flow) to current stockholders of firm 1 during period 0 is:

~
R1, 0 = D1, 0 +V 1,1 - m1,1 p1,1
~ ~ ~ ~

(7)

The random cash flow is made up of dividends taken in during the period plus the total value of the firm at the end

of the period, less the portion sold to outsiders. Using the accounting identity, equation (5), again:

R1, 0 = X 1, 0 − I 1, 0 + V 1,1
~ ~ ~ ~
(8)

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The same can be said for firm two. Again, the current dividend drops out. Because of the rationality assumptions

discussed above, then with the same dividend policy starting at t = 1, the two firms must have the same value at the

beginning of time 1. Therefore, from the previous equation, the returns are the same (since the firms are identical in

terms of operating cash flows and investment policy). With the same returns, the firms must have the same value at

time 0. Therefore dividend policy during period 0 doesn’t matter. Using the same argument as before, dividend

policy in future time periods do not matter.

Why do dividends appear to matter? When firms increase dividends, stock prices increase. This is still

consistent with M&M’s (1961) story if an increase in dividends signals that future cash flows are expected to

increase. This might be true if firms utilize a targeted payout ratio or if firms are reluctant to decrease dividends.

Their final section discusses the impact of market imperfections. To the extent these imperfections do not bias

investors to one type of payment, then it does not cause a change in the analysis, it just adds randomness. If it does,

it still might not cause dividend relevance. For instance, assume young investors prefer non-dividend paying stocks

and older investors income stocks (you need transaction costs to tell this story). However, it is likely that two types

of firms will emerge to service the two clienteles. Since one clientele is as good as the other, then there is no

incentive to switch.

The various theories as to why corporations and investor's pay attention to dividends are nicely summarized by

Black, Fisher. “The dividend puzzle.” Journal of Portfolio Management 2 (1976), 5-8.

a) The paper starts with the dividend irrelevance theorem presented by M&M (1961). The essence of the M&M

(1961) argument is that a higher dividend gives you more money today, but lowers the capital gain you would

receive later (because a portion of the firm must be sold to finance the increased dividend). These effects exactly

offset each other in the perfect capital market world presented by M&M (1961).

b) Different tax rates on capital gains and dividends changes the analysis. The M&M (1961) paper depends on

no taxes, or having the same tax rate apply to dividend and capital gains. What if capital gains are taxed at a lower

rate? (Historically, the tax rate on capital gains was less than on dividends for individuals. Currently, the tax rates

are the same for both types of income for individuals. With the same tax rate, can we say that capital gain income

still receives preferential tax treatment?)

Logically, if dividends are taxed more heavily than capital gains, you would expect a higher price for non-

dividend paying stocks, and firms that pay dividends will cut, or eliminate dividends. However, firms still pay

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dividends. Why? Are there taxpayers (“clienteles”) that are not subject to the higher tax rate on dividends? (Yes –

corporations and tax exempt taxpayers.)

However, is this group large enough to explain corporate dividend policy?

Side note - Miller and Scholes (1982) describe a way for individuals to eliminate the tax on dividends. See page

653 of the textbook, but note that the effectiveness of this method was reduced or eliminated when Congress

reduced the ability of individuals to deduct interest expense.

c) Transaction costs. Assume you can either own a non-dividend paying stock or a stock that pays dividends.

Both stocks have the same risk. With no transaction costs, you can replicate the dividend stream of the dividend

paying stock by selling shares in the non-dividend paying stock.

What if there are transaction costs? (What are these costs?). Can dividends be a cheaper way to pull cash out of

the corporation? If transaction costs are large, maybe that is why companies pay dividends.

This argument doesn’t seem to explain corporate dividend policy. First, compare the size of the tax

disadvantage of dividends to the amount of the transaction costs. Second, you could always borrow money on

margin to meet your cash flow needs. (What about the tax deduction in this example?) Third, trustees could sell

large blocks of shares in the open market (drawing on economies of scale) and distribute the proceeds, pro-rata, to

the stockholders.

d) Information. Perhaps dividends reveal information about the firm that cannot be disseminated in other ways.

This argument assumes that managers are reluctant to decrease dividends, therefore will only increase dividends

when future prospects are better than expected and are almost guaranteed not to fall to such a point that they would

need to decrease dividends. Therefore, an increase in dividend gives a strong signal as to the future earning power of

the firm. However: (1) How easy is it for a “bad” firm to imitate a “good” firm by increasing its dividends, and if it

is easy to imitate, how effective is the signal? (2) Eventually the stock price will reflect the information that is

revealed by the firm through the dividend. Given that, why pay dividends? Impatience?

e) Wealth redistribution can occur from bondholders to stockholders with a large dividend. However,

bondholders should be able to anticipate this and pay a price (receive an interest rate) which assumes the wealth

redistribution. Therefore, it would seem to be better for firms to restrict their ability to pay dividends and therefore

get a lower interest rate on debt.

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 f) Dividend payments prevent managers from taking negative NPV investments, at least for the funds

distributed (Jensen, 1986). When managers have good projects, they could simply cut dividends and prevent the

adverse consequences of a security sale. However, what if dividend payments are small in relation to the planned

investment? Plus, Myers and Majluf (1984) would argue that it is better to pay no dividends and store up slack, then

to have to go to the capital markets to raise cash. (Plus, dividend cuts cause a significant decline in stock prices.)

g) Perhaps investors (irrationally) demand dividends. Going back to argument (b), this would only seem to

increase the size of the dividend preferring clientele and would not give firms the incentive to change dividends

once the new equilibrium is met. (One problem from the investor’s perspective is that a portfolio of low (or high)

dividend stocks is probably not well diversified.)

In the end, Black concludes that we don’t know have a good understanding about corporate dividend policy.