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Modigliani and Miller on dividends

Clearly it would be to the shareholder’s advantage for the business to make the

investment and so it should be made. If White plc wanted both to pay the dividend

(using up all available cash) and to make the investment, it would need to raise new

finance. Assuming that it wished to retain its all-equity status it would need to issue new

shares to the value of the dividend. Since the value of the business after paying the

dividend and making the investment would be £5 million, this would engender an issue

price of the new shares of £5 each (200,000 of them to make up the £1 million required).

This means that the original shareholders would gain £1 per share by way of divi-

dend and lose £1 per share, as each share would have a value of £5 instead of the £6

make the investment? Alternatively, should the business pay a dividend and raise

the necessary finance for the investment opportunity by issuing additional shares to

the investing public, perhaps including any of the existing shareholders who wish

to be involved?

Even where the business cannot see any particularly advantageous investment

opportunities, should it be cautious and pay less than the full amount of dividend that

the law allows?

Just what should the business’s dividend policy be, and does it really matter any-

way? We shall consider these questions in this chapter.

12.2 Modigliani and Miller on dividends

In 1961, Modigliani and Miller (MM) published an important article dealing with

dividends and their effect on shareholders’ wealth (Miller and Modigliani 1961). Their

theme further developed the principle, Fisher separation, which we discussed in

Chapter 2. There we looked at a very simple example that suggested that directors

need not concern themselves with the payment of dividends. Provided that the busi-

ness takes on all available investment projects that have positive NPVs, when dis-

counted at the cost of capital, shareholders’ wealth will be maximised. Any funds left

over should be paid to shareholders as dividends.

MM took this slightly further by asserting that the value of a share will be unaf-

fected by the pattern of dividends expected from it. If shareholders want dividends

they can create them by selling part of their shareholding. If dividends are paid to

shareholders who would rather leave the funds in the business, they can cancel these

dividends by using the cash received to buy additional shares in the business, in the

capital market.

Let us use an example to illustrate the MM proposition.

White plc has net assets whose net present value is £5 million. This includes cash of £1 mil-

lion, and the directors have identified a possibility that this could be invested in a project

whose anticipated inflows have a present value of £2 million. Assuming that White plc is

financed by 1 million ordinary shares (no gearing) and that the investment is undertaken and

no dividend paid, the value of each share should be £(5 + 2 −1) million/1 million =£6. If,

instead of making the investment, the £1 million cash were used to pay a dividend, each

share would be worth £(5 −1) million/1 million =£4 and the holder of one share would have

£1 (the dividend) in cash.

Example 12.1