416 Part Five Payout Policy and Capital Structure
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Announcements of dividends and repurchases can convey information about management’s
confidence and so affect the stock price. But eventually the stock price change would happen
anyway as information seeps out through other channels. Does payout policy affect value in
the long run?
Suppose you are CFO of a successful, profitable public company. The company is matur-
ing. Growth is slowing down, and you plan to distribute free cash flow to stockholders. Does
it matter whether you initiate dividends or a repurchase program? Does the choice affect the
market value of your firm in any fundamental way?
One of the endearing features of economics is its ability to accommodate not just two,
but three opposing points of view. And so it is with the choice between dividends and repur-
chases. On the right are conservatives who argue that investors pay more for firms with gener-
ous, stable dividends. On the left, another group argues that repurchases are better because
repurchases mean higher stock prices, and capital gains have been taxed at lower effective
rates than dividends. And in the center, a middle-of-the-road party claims that the choice
between dividends and repurchases has no effect on value.Payout Policy Is Irrelevant in Perfect Capital Markets
The middle-of-the-road party was founded in 1961 by Miller and Modigliani (always referred
to as “MM”), when they published a proof that dividend policy is value-irrelevant in a world
without taxes, transaction costs, and other market imperfections.^13
MM insisted that one must consider dividend policy only after holding the firm’s assets,
investments, and borrowing policy fixed. Suppose they were not fixed. For example, suppose
that the firm decides to reduce capital investment and to pay out the cash saved as a dividend.
In this case the effect of the dividend on shareholder value is tangled up with the profitability
of the foregone investment. Or suppose that the firm decides to borrow more aggressively
and to pay out the debt proceeds as dividends. In this case the effect of the dividend can’t be
separated from the effect of the additional borrowing.
Think what happens if you want to up the dividend without changing the investment policy
or capital structure. The extra cash for the dividend must come from somewhere. If the firm
fixes its borrowing, the only way it can finance the extra dividend is to sell more shares.
Alternatively, rather than increasing dividends and selling new shares, the firm can pay lower
dividends. With investment policy and borrowing fixed, the cash that is saved can only be
used to buy back some of the firm’s existing shares. Thus any change in dividend payout must
be offset by the sale or repurchase of shares.
Repurchases were rare when MM wrote in 1961, but we can easily apply their reasoning
to the choice between dividends and repurchases. A simple example is enough to show MM’s
irrelevance result in this case. Then we will show that value is also unaffected if the company
increases the dividend and finances the increase with an issue of shares.Dividends or Repurchases? An Example
Rational Demiconductor has at this moment one million shares outstanding and the following
market-value balance sheet:(^13) M. H. Miller and F. Modigliani, “Dividend Policy, Growth and the Valuation of Shares,” Journal of Business 34 (October 1961),
pp. 411–433. MM’s results were anticipated by J. B. Williams, The Theory of Investment Value (Cambridge, MA: Harvard University
Press, 1938). Also a proof similar to MM’s was developed in J. Lintner, “Dividends, Earnings, Leverage and Stock Prices and the
Supply of Capital to Corporations,” Review of Economics and Statistics (August 1962), pp. 243–269. MM recognized that dividends
could convey information, but their proofs focused on value, not information about value. The examples in this section put aside the
information content of dividends.
16-3 Dividends or Repurchases? The Payout Controversy