Chapter 12 • The dividend decision
that would apply if no dividend were paid. In other words, the dividend would make
no difference to the wealth of the shareholders. On the other hand, making the invest-
ment makes a significant difference to their wealth.Creating homemade dividends
Note that, provided the new investment is undertaken, the worth of the original
shares would be £6 each. This value is in some combination of share price and divi-
dend. Irrespective of the amount of dividend paid, the individual shareholder can
choose how much dividend to take. Suppose that no dividend is paid on the White plc
shares, but a particular shareholder owning 100 of the shares wants cash of, say, £60.
The shareholder can create a ‘homemade’ dividend by selling 10 shares (at £6 each,
their current value).Cancelling dividends
Conversely, assuming that the business pays a dividend of £1 per share (and creates
an additional 200,000 shares to finance it), shareholders who do not want a dividend
but prefer to keep their investment intact could negate the effect of the dividend pay-
ment by using the whole of the dividend receipt in buying new shares. Let us again
consider the holder of 100 shares who receives a £100 dividend. This cash could be
used to buy 20 new shares (at £5 each), increasing the investment to 120 shares in total.
These will be worth £600, the same as the 100 shares would have been worth had no
dividend been paid. Using the whole of the dividend to buy new shares will ensure
that our shareholder retains the same proportion of the ownership (120 of the 1.2 mil-
lion) as was held before the dividend and the new issue (100 of the 1.0 million shares).Dividends as a residual
Example 12.1 illustrates MM’s central point, which is that the primary decision is the
investment one. The business should make all investments that yield a positive NPV
when discounted at the shareholders’ opportunity cost of capital. Any funds remain-
ing should be paid to the shareholders, enabling them to pursue other opportunities.
Thus dividends are a residual. MM contended that it would be illogical for the capital
market to value two, otherwise identical, businesses differently just because of their
dividend policy. If the business wants to pay a dividend it can do so and raise any nec-
essary finance by issuing new equity. Also, individual shareholders who do not like
the business’s dividend policy can alter it to suit their taste through ‘homemade’ crea-
tion or negation of dividends.
MM’s assertion does, however, rely on several assumptions of dubious validity in
the real world. We shall consider the limitations of these assumptions later in the
chapter. A formal derivation of the MM proposition is contained in the appendix to
this chapter.What MM did not say
Before we go on to assess what MM said about dividends against the traditional view
and against the evidence of what actually seems to happen in real life, it might be
worth clarifying exactly what they said.