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