Dividend Policy Is Irrelevant in Perfect Capital Markets

In their classic 1961 article MM argued as follows: Suppose your firm has settled on its investment program. You have worked out how much of this program can be financed from borrowing, and you plan to meet the remaining funds requirement from retained earnings. Any surplus money is to be paid out as dividends.

Now think what happens if you want to increase the dividend payment without changing the investment and borrowing policy. The extra money must come from somewhere. If the firm fixes its borrowing, the only way it can finance the extra dividend is to print some more shares and sell them. The new stockholders are going to part with their money only if you can offer them shares that are worth as much as they cost. But how can the firm do this when its assets, earnings, investment opportunities, and, therefore, market value are all unchanged? The answer is that there must be a transfer of value from the old to the new stockholders. The new ones get the newly printed shares, each one worth less than before the dividend change was announced, and the old ones suffer a capital loss on their shares. The capital loss borne by the old shareholders just offsets the extra cash dividend they receive.

Figure 16.2 shows how this transfer of value occurs. Our hypothetical company pays out a third of its total value as a dividend and it raises the money to do so by selling new shares. The capital loss suffered by the old stockholders is represented by the reduction in the size of the burgundy boxes. But that capital loss is exactly offset by the fact that the new money raised (the blue boxes) is paid over to them as dividends.

Does it make any difference to the old stockholders that they receive an extra dividend payment plus an offsetting capital loss? It might if that were the only way they could get their hands on cash. But as long as there are efficient capital markets, they can raise the cash by selling shares. Thus the old shareholders can cash in either by persuading the management to pay a higher dividend or by selling some of their shares. In either case there will be a transfer of value from old to new shareholders. The only difference is that in the former case this transfer is caused

CHAPTER 16 The Dividend Controversy 443

Before After dividend dividend

Each share worth this before and worth this after

New stockholders

Old stockholders

Total number Total number of shares of shares

FIGURE 16.2

This firm pays out a third of its worth as a dividend and raises the money by selling new shares. The transfer of value to the new stockholders is equal to the dividend payment. The total value of the firm is unaffected.

Dividend financed by stock issue

No dividend, no stock issue

Cash

New stockholders ^H New stockholders

Cash

Cash

Old stockholders

Cash

Shares

Old stockholders

FIGURE 16.3

Two ways of raising cash for the firm's original shareholders. In each case the cash received is offset by a decline in the value of the old stockholders' claim on the firm. If the firm pays a dividend, each share is worth less because more shares have to be issued against the firm's assets. If the old stockholders sell some of their shares, each share is worth the same but the old stockholders have fewer shares.

by a dilution in the value of each of the firm's shares, and in the latter case it is caused by a reduction in the number of shares held by the old shareholders. The two alternatives are compared in Figure 16.3.

Because investors do not need dividends to get their hands on cash, they will not pay higher prices for the shares of firms with high payouts. Therefore firms ought not to worry about dividend policy. They should let dividends fluctuate as a by-product of their investment and financing decisions.

444 PART V Dividend Policy and Capital Structure

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