Introduction to Corporate Finance

15: Payout Policy

the company reinvest earnings rather than issue new shares? We reinforce dividend policy irrelevance

by demonstrating in the following Example that investors can unwind companies’ dividend policy

decisions. In the end, what is true for the company as a whole is true for each investor: Dividend policy

is irrelevant when capital markets are perfect.

example

Consider two investors, Bert and Ernie. On 1 January

2016, Bert owns an 11% stake (110,000 shares) in

Retention, whereas Ernie holds an 11% stake (also

110,000 shares) in Payout. By the end of 2016, Bert

has received no dividend but he still owns 11% of

Retention’s outstanding shares, which are now worth

$22 each. In contrast, Ernie receives a $220,000

dividend during 2016 but, because Payout issues

100,000 shares to finance its investment opportunity,

the shares Ernie owns now represent only a 10% stake

in payout (110,000 ÷ 1,100,000).

If either Bert or Ernie is unhappy with the dividend

policy of the company in which he has invested, he can

unwind that policy. For example, suppose Bert wishes

to receive cash as he would from a dividend. At the end

of 2016, Bert can sell 10,000 of his shares for $22 each,

generating a cash inflow of $220,000, exactly equal

to the dividend that Ernie receives on his investment.

In selling some of his shares, Bert creates homemade

dividends. By the end of the year, Bert owns just 10%

of Retention’s equity, but that’s exactly equal to the

ownership stake that Ernie holds in Payout.

Conversely, suppose that Ernie prefers that

Payout did not pay dividends. The solution to

Ernie’s problem is simple. When he receives the

$220,000 dividend, he simply reinvests the money

by purchasing 11,000 new Payout shares. That would

bring his total ownership to 121,000, or 11%, of

Payout’s shares (121,000 ÷ 1,100,000). In other words,

Ernie’s position is just like Bert’s.

This may seem complex, but the essential points of these examples are simple. If there were no

frictions or imperfections in capital markets, then investors would not care whether the company: (1)

retains earnings to fund positive-NPV investments or (2) pays dividends and sells new shares to finance

investments. In either case, cash flows from the company’s investments – not dividend decisions –

determine shareholders’ returns.

15-3b MILLER AND MODIGLIANI MEET THE (IMPERFECT)

REAL WORLD

In the previous section, we saw that when capital markets are perfect and frictionless, payout decisions

do not affect company value. The core of the idea behind Miller and Modigliani’s argument is that

operational and investment decisions, not financial policies, are what create value. However, in Figure 15.3

we saw that corporate managers say that maintaining the existing dividend payment ranks ahead of

investment decisions at many companies. This is the starkest possible rejection of the Miller and

Modigliani irrelevance argument, because it implies that a financial decision (of maintaining dividends)

is more important than the investment decision.

How can this be the case? Here we discuss several academic theories that explain why payout

decisions do matter. Each of these theories describes why a certain market imperfection (such as taxes

or agency costs) affects payout decisions in general or the choice between dividends and repurchases.

LO15.4

See the concept explained

step by step on the

CourseMate website.

SMART

CONCEPTS