Question 6

Miller and Modigliani argue that payout policy is irrelevant in determining the value of a
company. However, many models used to value a company’s shares express the
current share price as the present value of future dividends.

Can these two opinions be reconciled?

(20 marks)

Ans:
• Dividend Irrelevancy Theory (M&M)

In an efficient market, dividend irrelevancy theory suggests that, retained

earnings are invested in positive NPV projects, existing shareholders will be
indifferent about the pattern of dividend payouts. However, practical
influences, including market imperfections, mean that changes in dividend
policy, particularly reductions in dividends paid, can have an adverse effect on
shareholder wealth:

● Reductions in dividend can convey bad news' to shareholders

(dividend signalling)
● Changes in dividend policy, particularly reductions, may conflict
with investor liquidity requirements (selling shares to
"manufacture dividends" is not a costless alternative
to being paid the dividend).
● Changes in dividend policy may upset investor tax planning

(e.g. income v capital gain if shares are sold).

• More details on Modigliani and Miller's theory

The classic view of the irrelevance of the source of equity finance

 • Their argument is that the source of equity finance is in itself

irrelevant.

● Since ultimately it represents a sacrifice of consumption (or other

investment opportunities) by the investor at identical risk levels, it makes no
difference whether dividends are paid to the investor, or equity is raised as
new issues, or profits are simply retained
● The only differences would arise due to institutional frictional
factors, such as issue costs, taxation and so on.

● If both new equity and retained earnings have the same cost
then it should be irrelevant, in terms of shareholders wealth, where
equity funds come from.

Argument for irrelevancy dividend model

● It was shown above that in theory the level of dividend

is irrelevant

● In a perfect capital market it is difficult to challenge the dividend

irrelevance position. However, once these assumptions are relaxed, certain
practical influences emerge and the arguments need further review.
Dividend signalling

Dividends can be used to convey good (or bad) information. A firm that
increases its dividend payout ratio may be signalling that it expects future
cash flows to increase, as this ratio tends to remain steady over time. Bad
firms can also increase dividends to try to convince the markets that they
too are expecting increased future cash flows. However, this increase may
be unsustainable if the promised increases do not occur and the
inevitable reduction in dividend payout ratio will mean heavy penalties
from the market.

Preference on current income

 ● Many investors require cash dividends to finance current
consumption. This does not only apply to individual investors needing cash
to live on but also to institutional investors, such as pension funds and
insurance companies, who require regular cash outflows to meet day to day
outgoings such as pension payments and insurance claims.

Resolution of uncertainty

● One argument often put forward for high dividend payout is that
income in the form of dividend is more secure than income in the form of
capital gain. This, therefore, leads investors to place more value on high
payout shares (sometimes referred to as the "Bird in the Hand" theory).

​Practical influences on dividend policy

Before developing a particular dividend policy, a company must
consider the following:

● Legal position

● Levels of profitability and free cash flow

● expectations of shareholders

● optimal gearing position- paying a large dividend reduces the

value of equity in the firm, so can help a firm move towards its optimal
gearing position.

inflation

● control

● tax

● liquidity/cash management in the short and long term

● other sources of finance and the necessary servicing costs.

These factors limit the "dividend capacity" of the firm

​Dividend capacity
• This can be simply defined as the ability at an given time of a

firm's ability to pay dividends to its shareholders. This will clearly

have a direct impact on a company's ability to implement its
dividend policy (i.e. can the company actually pay the dividend it
would like to)

• Legally, the firm's dividend capacity is determined by the

amount of accumulated distributable profits.

• However, more practically, the dividend capacity can be calculated as

the Free Cash Flow to Equity (after reinvestment), since in practice, the level of
cash available will be the main driver of how much the firm can afford to pay
out.

​In practice, there are a number of commonly adopted dividend policies:

• stable dividend policy

• constant payout ratio

• zero dividend policy

• residual approach to dividends

Dividends and taxes

A final theory explaining dividend payments is based on the presence of different corporate and
personal taxes on one hand and of different income and capital gains taxes on the other.
Modigliani and Miller assume that there are no personal taxes. Taxes on dividends (ordinary
income) are higher than taxes on capital gains. Thus, under the presence of personal taxes,
companies should not pay dividends because investors require a higher return to companies
that pay dividends. If payments are to be made to shareholders, the company should opt for
other alternatives, such as share repurchases. This is true if taxes on dividend income are higher
than taxes on capital gains. However, different investors have different tax rates. High tax-rate
individuals will prefer the firm to invest more, whereas low tax individuals may prefer that the
firm does not invest and instead pays dividends. Investors try to select companies with dividend
policies that approximate their requirements