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8.11.4. Does the firm's dividend policy affect firm value?

The objective of the firm is to maximize shareholder value. A central question regarding the firm's dividend policy is therefore whether the dividend policy changes firm value?

As the dividend policy is the trade-off between retained earnings and paying out cash, there exist three opposing views on its effect on firm value:

1. Dividend policy is irrelevant in a competitive market

2. High dividends increase value

3. Low dividends increase value

The first view is represented by the Miller and Modigliani dividend-irrelevance proposition.

Miller and Modigliani Dividend-Irrelevance Proposition

In a perfect capital market the dividend policy is irrelevant. Assumptions

- No market imperfections

• No taxes

• No transaction costs

The essence of the Miller and Modigliani (MM) argument is that investor do not need dividends to covert their shares into cash. Thus, as the effect of the dividend payment can be replicated by selling shares, investors will not pay higher prices for firms with higher dividend payouts.

To understand the intuition behind the MM-argument, suppose that the firm has settled its investment programme. Thus, any surplus from the financing decision will be paid out as dividend. As case in point, consider what happens to firm value if we decide to increase the dividends without changing the debt level. In this case the extra dividends must be financed by equity issue. New shareholders contribute with cash in exchange for the issued shares and the generated cash is subsequently paid out as dividends. However, as this is equivalent to letting the new shareholders buy existing shares (where cash is exchanged as payment for the shares), there is not effect on firm value. Figure 11 illustrates the argument:

Illustration of Miller and Modigliani's dividend irrelevance proposition

Figure 11: Illustration of Miller and Modigliani's dividend irrelevance proposition

The left part of Figure 11 illustrates the case where the firm finances the dividend with the new equity issue and where new shareholders buy the new shares for cash, whereas the right part illustrates the case where new shareholders buy shares from existing shareholders. As the net effect for both new and existing shareholders are identical in the two cases, firm value must be equal. Thus, in a world with a perfect capital market dividend policy is irrelevant.

8.11.5. Why dividend policy may increase firm value

The second view on the effect of the dividend policy on firm value argues that high dividends will increase firm value. The main argument is that there exists natural clienteles for dividend paying stocks, since many investors invest in stocks to maintain a steady source of cash. If paying out dividends is cheaper than letting investors realize the cash by selling stocks, then the natural clientele would be willing to pay a premium for the stock. Transaction costs might be one reason why its comparatively cheaper to payout dividends. However, it does not follow that any particular firm can benefit by increasing its dividends. The high dividend clientele already have plenty of high dividend stock to choose from.

8.11.6. Why dividend policy may decrease firm value

The third view on dividend policy states that low dividends will increase value. The main argument is that dividend income is often taxed, which is something MM-theory ignores. Companies can convert dividends into capital gains by shifting their dividend policies. Moreover, if dividends are taxed more heavily than capital gains, taxpaying investors should welcome such a move. As a result firm value will increase, since total cash flow retained by the firm and/or held by shareholders will be higher than if dividends are paid. Thus, if capital gains are taxed at a lower rate than dividend income, companies should pay the lowest dividend possible.

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