Chapter 12 • The dividend decision
Going back to White plc in Example 12.1, if the shares are priced at £6 before a £1
per share dividend, the price of the share will not fall to £5 ex dividend, according to
traditionalists, but perhaps to, say, £5.50. Thus the wealth of a shareholder will be
enhanced by £0.50 per share as a result of the dividend.
The traditional view implies that the payment of dividends reduces the capital mar-
ket’s perceptions of the level of risk attaching to future dividends. This means that the
discount rate to be applied to expected future dividends will be lower and the market
price will increase as a result.12.4 Who is right about dividends?
The traditional view on dividends seems to suffer from a fundamental lack of logic.
The only circumstances where shareholders should logically value £1 in cash more
highly than £1 in investment is where they feel that the business is using retained cash
to make disadvantageous investments (that is, those that have negative NPVs when
discounted at a rate that takes account of the level of risk attaching to the particular
project). Since, ultimately, the shareholders must receive all of the fruits of the invest-
ments, provided businesses invest only in projects with positive NPVs then invest-
ment is to be preferred to present dividends.
MM seem to have logic on their side, yet many businesses appear to behave as if the
pattern of dividends does matter. Directors seem to devote quite a lot of thought to
fixing the levels of dividends. Most businesses seem to maintain pretty stable levels of
dividends, implying that they set aside a similar amount for dividends each year. Yet
it would be a remarkable coincidence if each year there were a similar amount of cash
for which profitable investment opportunities could not be found. We shall look at the
dividend policies of some well-known businesses later, in section 12.6.
MM’s assertion that the pattern of dividends does not matter is based, as we have
seen, on several assumptions. The extent to which these weaken their analysis might
explain why the logic of the MM proposition does not seem to be fully accepted in
practice. We shall now review these assumptions.l There are frictionless capital markets, which implies that there are neither transaction costs
nor any other impediments to investors behaving in practice as they might be expected to do
in theory. Obviously this is invalid and probably sufficiently so to call the MM view
into question. MM rely on the ability of individual shareholders to sell their shares
to create dividends or to buy shares to eliminate dividends. The fact that dealing in
the capital market involves significant cost (brokers’ fees and so on) means, for
example, that receiving a dividend, on the one hand, and liquidating part of an
investment in the shares concerned, on the other, are not perfect substitutes for one
another.
l Securities are efficiently priced in the capital market. The evidence (reviewed in Chapter
9) tends to support the validity of this assumption. The assumption is necessary,
otherwise (in Example 12.1, above). White plc undertaking the investment will not
necessarily increase the share price by £1, nor the payment of the dividend neces-
sarily reduce the share price by £1.
l Shares may be issued by businesses without any legal or administrative costs being
incurred. This assumption is not valid, and this is probably significant in the present
context. MM see paying no dividend on the one hand, and paying a dividend and