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Summary and Conclusions

Once a company has issued ordinary shares (common stock) and received the proceeds, it is neither directly involved with their subsequent market transactions, nor the prices at which they are transacted. These are negotiable between existing shareholders and prospective investors, based on their perception of corporate performance measured by earnings, dividends, growth and capital gains. So, in mature mixed market economies where ownership is divorced from control, modern finance theory neatly resolves this dilemma by assuming (rightly or wrongly) that:

The normative objective of modern financial management is to maximise shareholder wealth, based on NPV maximisation techniques.

We therefore began our analysis of this objective by tracing the development of modern finance throughout the twentieth century, underpinned by the simplistic assumptions of reasonably efficient capital markets under conditions of certainty with few barriers to trade, characterized by freedom of information.

According to a significant body of independent academic work by Fisher (1930), MM (1961) and Gordon (1962), reinforced by the efficient market hypothesis (EMH) of Fama (1965) and agency theory formalized by Jensen and Meckling (1976)

Management can justify retained earnings to finance future investment, rather than pay a current dividend, if their marginal return on new projects at least equals the market rate of interest that shareholders could obtain by using dividends to finance alternative investments of equivalent business risk elsewhere.

Shareholders would support such behaviour, since it cannot detract from their wealth. What they lose through dividends foregone, they receive through increased equity values generated by internally financed projects discounted at their required opportunity rate of return.

Moving to a real world of uncertainty, however, this academic consensus falls apart.

Gordon believes that movements in share price relate to corporate dividend policy, rather than investment policy. Rational, risk-averse investors should prefer their returns in the form of dividends now, rather than later. So, share price is a positive function of the dividend payout ratio.

MM maintain that because dividends and retentions are perfect economic substitutes, shareholders who need to replace a missing dividend to satisfy their consumption preferences have a simple solution. They can create home-made dividends by either borrowing an equivalent amount at the same rate as the company, or sell shares at a price that reflects their earnings and reap the capital gain.

According to MM, the borrowing (discount) rate is defined by an investment's business risk (the variability of earnings) and not financial risk (the pattern of dividends). So, corporate distribution policy is trivial. Dividend decisions are concerned with what is done with earnings after the event, but do not determine the risk originally associated with the quality of investment that produces them.

Let us now translate these conflicting theories into twenty-first century practice.

Selected References

1. Gordon, M. J., The Investment, Financing and Valuation of a Corporation, Irwin, 1962.

2. Miller, M. H. and Modigliani, F., "Dividend policy, growth and the valuation of shares", The Journal of Business of the University of Chicago, Vol. XXXIV, No. 4 October 1961.

3. Fisher, I., The Theory of Interest, Macmillan (New York), 1930.

4. Fama, E.F., "The Behaviour of Stock Market Prices", Journal of Business, Vol. 38, 1965.

5. Jensen, M. C. and Meckling, W. H., "Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure", Journal of Financial Economics, 3, October 1976.

6. Hill, R.A., Corporate Valuation and Takeover: Parts One and Two (2011).

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