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(^332) Financial Management
cash flow to the holders of the equity. However, consider a firm that desires to pay a
dividend in excess its cash flow. In order to do this, the firm can raise funds by issuing
new equity. Alternatively, the firm could borrow money, which assuming perfect
capital markets is a transaction with the NPV of zero. Conversely, a firm wishing to
pay a smaller dividend might spend the balance of its net cash flow on repurchasing
equity. The key idea here is that a firm can choose whatever pay-out policy it
desires, funding the policy through share issues/ repurchases; hence; dividend policy is
irrelevant.
In other words, they reasoned that the value of a firm is determined by its basic
earning power and its risk class, and, therefore, that a firm's value depends on its asset
investment policy rather than on how earnings are split between dividends and
retained earnings. MM demonstrated, under the light of above mentioned assumptions,
that if a firm pays higher dividends, then it must sell more shares to new investors, and
the value of the shares given to the new investors is exactly equal to the dividends paid
out.
From the individual investor's point of view we can show that the dividend policy is
irrelevant too. To do this we can use a similar argument to that employed when we said
that shareholders are indifferent to capital structure changes; shareholders are indifferent
to dividend policy as, through appropriate purchases or sales of shares, they can replicate
any dividend policy they wish. Hence, investors will not value a firm paying a particular
dividend policy different to any other firm such that firm value does not depend on
dividends.
The MM assumptions are not realistic, and they obviously do not hold precisely. Firms
and investors do pay income taxes, firms do incur floatation costs, and investors do
incur transaction costs. Further, managers often have better information than outside
investors. Thus, MM's theoretical conclusions on dividend irrelevance may not be valid
under real-world conditions.
Radical Models
Bird-in-the-hand Theory: Gordon and Lintner
Gordon and Lintner argue that the cost of equity increases as the dividend payout is
reduced, because investors can be more sure of receiving dividends than the capital
gains that are expected to result from retained earnings. Therefore, the theory holds
that the value of the firm will be maximised by a high dividend payout ratio, because
investors regard actual dividends as being less risky than potential capital gains.
This means that this theory is in direct contrast with MM theory of dividend irrelevance.