The traditional view on dividends
What they did notsay is that it does not matter whether dividends are paid or not
as far as the value of the business is concerned. If shareholders are never to receive a
dividend or any other cash payment in respect of their shares, the value of those shares
must be zero. What MM said is that the patternof dividends is irrelevant to valuation.
Provided that the business invests in all projects that have a positive NPV when dis-
counted at the shareholders’ opportunity cost of capital (and none with a negative
NPV), and provided that eventually all of the fruits of the investment are paid in cash
to shareholders, it does not matter when payment is made. ‘Eventually’ may be a very
long time, but this in principle does not matter. Even if no cash is expected to be forth-
coming until the business is liquidated, this should not, of itself, cause the shares to be
less valuable than were there to be a regular dividend until that time. Thus MM do not
cast doubt on the validity of the dividend model for valuing equities, which we dis-
cussed in Chapter 10 (page 279).
In principle, the timing of a particular dividend does not matter to the shareholders,
provided that the later dividend is (1 +r)ntimes the earlier alternative, where ris the
shareholders’ expected return (that is, their opportunity cost of capital) and nis the
time lapse between the earlier and later dividends.
Suppose that a business could pay a dividend now of amount D. Alternatively, it
could invest that amount now in a project that will produce one cash inflow after n
years, which will be paid as a dividend at that time. The shareholders would be indif-
ferent as to whether the dividend is paid now or in nyears, provided that the later divi-
dend is D(1 +r)n. This is because D(1 +r)nhas the present value D[that is, D(1 +r)n
/(1 +r)n]. Thus dividend Dnow, or D(1 +r)nin nyears, should have equal effect on
the value of the shares and on the wealth of the shareholders. If the business were able
to invest in a project that yields an inflow of amount greater than D(1 +r)n(that is, a
project with a positive NPV), then the value of the shares would be enhanced.
Of course, as MM pointed out, it is always open to individual shareholders to cre-
ate dividends by selling part of their shareholding if the delay in the dividend does not
suit their personal spending plans.
The key point here is that the business has funds that belong to the shareholders. If
it is able to invest those funds more effectively, on the shareholders’ behalf, than the
shareholders can do for themselves, then it should do so. If it cannot do this, it should
return the funds to the shareholders and let them do the investing. This is, of course,
why businesses should use the shareholders’ opportunity cost of capital as the dis-
count rate in investment appraisal. If the business’s potential investments cannot
achieve that rate, the funds should be passed to the shareholders, who can achieve it.
12.3 The traditional view on dividends
Before MM made their assertion and presented a plausible proof of it, the view had
been taken not only that dividends are the paramount determinant of share values but
also that £1 in cash is worth more than £1 of investment.
The traditionalists would value the shares differently depending on whether or not
a dividend was to be paid. Greater value would be placed on the share where a divi-
dend was to be paid (and, for example, a share issue undertaken) than where this was
not the case. This is a view based on ‘a bird in the hand is worth two in the bush’
approach, that is, the notion that a guaranteed receipt enhances the value of the asset
from which it derives.
