Introduction to Corporate Finance

15: Payout Policy

15-3 DIVIDENDS IN PERFECT AND

IMPERFECT WORLDS

Just as they did with capital structure, Miller and Modigliani demonstrated that – in a world of perfect

and frictionless capital markets – payout policy does not affect a company’s market value. Value derives

solely from the profitability of the company’s assets and the competence of its management team. If

payout policy does affect the company’s value, then it must be because markets are imperfect. In this

section, we examine these issues by first understanding Modigliani and Miller’s explanation of irrelevance

in a perfect world. We then expand this to examine the impact of the real world – in particular, the impact

of agency and signalling models.

15-3a PAYOUT POLICY IRRELEVANCE IN A WORLD WITH PERFECT

CAPITAL MARKETS

The notion that dividends are irrelevant appears to be a contradiction. After all, we argued in Chapter 5

that a share’s value equals the present value of all its future dividend payments. How, then, do we arrive

at a dividend ‘irrelevance’ result? As with capital structure, the answer emerges that a company’s value

derives solely from its current and expected future operating profits. As long as the company accepts

all positive-NPV investment projects and has costless access to capital markets, it can pay any level of

dividends it desires. But if a company pays out its earnings as a dividend, then it must issue new shares

to raise the cash required to finance its ongoing investments. So a company can either retain its profits

and finance its investments with internally generated cash flow, or pay out its earnings as dividends and

raise the cash needed for investment by selling new shares. This dividend irrelevance is best explained

with an example.

Consider two companies, Retention and Payout, which are the same size today (1 January 2016), are

in the same industry and have access to the same investment opportunities. Suppose both companies

have assets worth $20 million that will generate a net cash inflow of $2 million by 31 December 2016.

Each company thus earns a 10% return on investment. Furthermore, assume investors require a return,

r, of 10% per year and that, at the end of this year, each company will have the opportunity to invest $2

million in a positive-NPV project. Each company currently has 1 million shares outstanding, implying a

LO 15.3

4 Describe some of the key survey findings regarding dividend and share repurchase decisions. What

is the key advantage of share repurchases over dividend payouts?

5 Well-diversified investors are willing to tolerate great volatility in the prices of shares they own. Why

do you think they might value a constant dividend payment even though the underlying corporate

profits on which dividends are ultimately based are highly variable?

6 What appears to have happened to dividend payout ratios and the speed of dividend smoothing

during recent years? How has management’s use of share repurchases affected these behaviours?

CONCEPT REVIEW QUESTIONS 15-2