MM Dividend Irrelevance Introduction

Does Dividend Policy Matter?

• Dividends matter
• The value of the stock is based on the present value of expected future dividends
• Dividend policy may not matter (M&M,1961)
• Dividend policy is the decision to pay dividends versus retaining funds to reinvest in the firm
• In theory, if the firm reinvests capital now, it will grow and can pay higher dividends in future

Assumptions of the Model

• Personal or corporate income taxes do not exist
• There are no stock flotation or transaction costs.
• Financial leverage does not affect the cost of capital
• Both managers and investors have access to same information concerning firm's future prospects.
• Firm's cost of equity is not affected in any way by distribution of income between dividend and retained earnings.
• Dividend policy has no impact on firm's capital budgeting

Dividend Irrelevance: example

• All equity firm with 100 shares outstanding
• Investors require a 10% return
• Expected CF = $10,000/Yr
• Plan to dissolve the firm in 2 yrs
• Firm can either:
• Pay out dividends of $10,000/Yr for each of the next 2 yrs, i.e $100/share
• Or it can pay $11000 this year, by raising other $1000 by issuing stocks (or bonds), then pay an amount in year 2, sufficient to provide new shareholders with a 10% return