When Are Dividends Irrelevant? (The Miller Modigliani Proposition)

            There is a school of thought that argues that what a firm pays in dividends is irrelevant and that stockholders are indifferent about receiving dividends. Like the capital structure irrelevance proposition, the dividend irrelevance argument has its roots in a paper crafted by Miller and Modigliani.

The Underlying Assumptions

            The underlying intuition for the dividend irrelevance proposition is simple. Firms that pay more dividends offer less price appreciation but must provide the same total return to stockholders, given their risk characteristics and the cash flows from their investment decisions. Thus, there are no taxes, or if dividends and capital gains are taxed at the same rate, investors should be indifferent to receiving their returns in dividends or price appreciation.

            For this argument to work, in addition to assuming that there is no tax advantage or disadvantage associated with dividends, we also have to assume the following:

      There are no transactions costs associated with converting price appreciation into cash, by selling stock. If this were not true, investors who need cash urgently might prefer to receive dividends.

      Firms that pay too much in dividends can issue stock, again with no flotation or transactions costs, to take on good projects. There is also an implicit assumption that this stock is fairly priced.

      The investment decisions of the firm are unaffected by its dividend decisions, and the firms operating cash flows are the same no matter which dividend policy is adopted.

      Managers of firms that pay too little in dividends do not waste the cash pursuing their own interests (i.e., managers with large free cash flows do not use them to take on bad projects).

Under these assumptions, neither the firms paying the dividends nor the stockholders receiving them will be adversely affected by firms paying either too little or too much in dividends.

A Proof of Dividend Irrelevance

            To provide a formal proof of irrelevance, assume that an LongLast Corporation, an unlevered firm manufacturing furniture, has a net operating income after taxes of $ 100 million, growing at 5% a year, and a cost of capital of 10%. Further, assume that this firm has net capital expenditure needs (capital expenditures in excess of depreciation) of $ 50 million, also growing at 5% a year, and that there are 105 million shares outstanding. Finally, assume that this firm pays out residual cash flows as dividends each year. The value of LongLast Corporation can be estimated as follows:

Free Cash Flow to the Firm = EBIT (1- tax rate) - Net Capital Expenditures

                                                = $ 100 million  - $ 50 million = $ 50 million

Value of the Firm = Free Cash Flow to Firm (1+g) / (WACC - g)

                                    = $ 50 (1.05) / (.10 - .05) = $ 1050 million

Price per share = $ 1050 million / 105 million = $ 10.00

Based upon its cash flows, this firm could pay out $ 50 million in dividends.

Dividend per share = $ 50 million/105 million = $ 0.476

Total Value per Share = $ 10.00 + $ 0.48 = $10.476

            To examine how the dividend policy affects firm value, assume that LongLast Corporation is told by an investment consultant that its stockholders would gain if the firm paid out $ 100 million in dividends, instead of $ 50 million. It now has to raise $ 50 million in new financing to cover its net capital expenditure needs. Assume that LongLast Corporation can issue new stock with no flotation cost  and no adverse signaling implications to raise these funds. If it does so, the firm value will remain unchanged, since the value is determined not by the dividend paid but by the cash flows generated on the projects. The stock price will decrease, because there are more shares outstanding, but stockholders will find this loss offset by the increase in dividends per share. In order to estimate the price per share at which the new stock will be issued, note that after the dividend payment, the old stockholders in the firm will own only $1000 million of the total firm value of $ 1050 million.

Value of the Firm = $ 1050 million

Dividends per share = $ 100 million/105 million shares = $ 0.953

Value of the Firm for existing stockholders after dividend payment = $ 1000 million

Price per share = $ 1000 million / 105 million = $ 9.523

Value accruing to stockholder = $ 9.523 + $ 0.953 = $ 10.476

            Another way of seeing this is to divide the stockholders into existing and new stockholders. When dividends are increased by $ 50 million, and new stock is issued for an equivalent amount, the existing stockholders now own only $1000 million out of the firm value of $ 1050 million, but their loss in firm value is offset by their gain in dividends. In fact, if the operating cash flows are unaffected by dividend policy, we can show that the firm value will be unaffected by dividend policy and that the average stockholder will be indifferent to dividend policy since he or she receives the same total value (price + dividends) under any dividend payment.

            To consider an alternate scenario, assume that LongLast Corporation pays out no dividends and retains the residual $50 million as a cash balance. The value of the firm to existing stockholders can then be computed as follows:

Value of Firm = Present Value of After-tax Operating CF + Cash Balance

                        = $ 50 (1.05) / (.10 - .05) +  $ 50 million = $1100 million

Value per share = $ 1100 million / 105 million shares = $10.48

Note that the total value per share is unchanged from the previous two scenarios, as shown in Table 10.1, though all of the value comes from price appreciation.

Table 10.1: Value Per Share to Existing Stockholders from Different Dividend Policies

Value of Firm

Dividends

Value to Existing

Price

Dividends

Total Value

(Operating CF)

 

Stockholders

per share

per share

per share

$1,050

 $         -  

$1,100

 $ 10.48

 $         -  

 $     10.48

$1,050

 $   10.00

$1,090

 $ 10.38

 $     0.10

 $     10.48

$1,050

 $   20.00

$1,080

 $ 10.29

 $     0.19

 $     10.48

$1,050

 $   30.00

$1,070

 $ 10.19

 $     0.29

 $     10.48

$1,050

 $   40.00

$1,060

 $ 10.10

 $     0.38

 $     10.48

$1,050

 $   50.00

$1,050

 $ 10.00

 $     0.48

 $     10.48

$1,050

 $   60.00

$1,040

 $   9.90

 $     0.57

 $     10.48

$1,050

 $   70.00

$1,030

 $   9.81

 $     0.67

 $     10.48

$1,050

 $   80.00

$1,020

 $   9.71

 $     0.76

 $     10.48

$1,050

 $   90.00

$1,010

 $   9.62

 $     0.86

 $     10.48

$1,050

 $ 100.00

$1,000

 $   9.52

 $     0.95

 $     10.48

When LongLast Corporation pays less than $ 50 million in dividends, the cash accrues in the firm and adds to its value. The increase in the stock price again is offset by the loss of cash flows from dividends.

            It is important to note though that the irrelevance of dividend policy is grounded on the following assumptions.

      The issue of new stock is assumed to be costless and can therefore cover the cash shortfall created by paying excess dividends.

      It is assumed that firms that face a cash shortfall do not respond by cutting back on projects and thereby affecting future operating cash flows.

      Stockholders are assumed to be indifferent between receiving dividends and price appreciation.

      Any cash remaining in the firm is invested in projects that have zero net present value (such as financial investments) rather than used to take on poor projects.

Implications of Dividend Irrelevance

            If dividends are, in fact, irrelevant, firms are spending a great deal of time pondering an issue about which their stockholders are indifferent. A number of strong implications emerge from this proposition. Among them, the value of equity in a firm should not change as its dividend policy changes. This does not imply that the price per share will be unaffected, however, since larger dividends should result in lower stock prices and more shares outstanding. In addition, in the long term, there should be no correlation between dividend policy and stock returns. Later in this chapter, we will examine some studies that have attempted to examine whether dividend policy is in fact irrelevant in practice.

            The assumptions needed to arrive at the dividend irrelevance proposition may seem so onerous that many reject it without testing it. That would be a mistake, however, because the argument does contain a valuable message: Namely, a firm that has invested in bad projects cannot hope to resurrect its image with stockholders by offering them higher dividends. In fact, the correlation between dividend policy and total stock returns is weak, as we will see later in this chapter.