In 1961, Miller and Modigliani (abbreviated MM) contrived that the distribution policy of a company is, under certain circumstances, not able to influence its share value, i.e. that the dividend policy is irrelevant. As long as a company distributes the full present value of its cash flow, it is not relevant how or in which period it does this in detail. Linda and Harry DeAngelo (D&D) on the other hand found that Miller and Modigliani were wrong. They say that the model of MM is unnecessary restrictive. In such a way that it even produces false and warped results. After relaxing some assumptions of MMs model, they get a contrary result. In their opinion payout policy is not irrelevant. They say that when retention is allowed it is very well important and relevant which dividend policy a company chooses.
Both points of view got a certain amount of support in the aftermath of their publishing. Prominent authors supporting MM were for example Joseph Stiglitz and Mark Rubinstein, while Myron Gordon and James Walter argued against it. But which is the right position? Is it afterall possible to answer this with certainty?
Probably not. Maybe it will last years to get a definite answer; if there will ever be one. None-theless this term paper will try to get some clarity onto that matter. Therefore the expose will start in chapter 2 with a review of Miller and Modigliani’s proof of irrelevancy. After this, in chapter 3 there will be a presentation of the contrasting thesis, most recently emphasized by DeAngelo and DeAngelo, who relax the critical assumption of no retention. In chapter 4 there will be a discussion of the consequences for the market participants if retention is allowed, brought forward alongside with its consequences for payout relevancy.
This paper will conclude by weighing the most important arguments of both sides. As it will not succeed in letting the scale tip, so gives an outlook on possible extensions of the MM valuation model. This will at least show the angles where both points of view gainsay the reality up to now.
Table of Contents
1. Introduction
2. Scale A - Irrelevance
2.1 Key assumptions of the model
2.1.1 Perfect capital markets
2.1.2 Rationality
2.1.3 Perfect certainty
2.2 Miller/Modigliani share valuation
3. Scale B - Relevance
3.1 Gordon and Walter
3.2 DeAngelo/DeAngelo's full payout
4. Consequences of retention
5. A scale in balance - Conclusion
Objectives and Topics
This seminar paper examines the controversial debate regarding the relevance of corporate dividend policy on a company's market value, contrasting the traditional Miller-Modigliani irrelevance proposition with newer, relevance-oriented theories.
- Evaluation of the Miller-Modigliani (MM) irrelevance theorem and its underlying assumptions.
- Analysis of the criticisms raised by Gordon, Walter, and the DeAngelo/DeAngelo school of thought.
- Examination of the role of retention, investment policy, and market imperfections.
- Synthesis of the debate to determine if dividend policy impacts shareholder value.
Excerpt from the Book
1. Introduction
“Do companies with generous distribution policies consistently sell at a premium over those with niggardly payouts?” Merton Miller and Franco Modigliani, 1961
The excerpt above, from the introduction of Merton Miller and Franco Modigliani’s article “Dividend Policy, Growth, and the Valuation of Shares” shows very perspicuously what this expose will be about: the influence of distributions on the value of a company.
In 1961, Miller and Modigliani (abbreviated MM) contrived that the distribution policy of a company is, under certain circumstances, not able to influence its share value, i.e. that the dividend policy is irrelevant. As long as a company distributes the full present value of its cash flow, it is not relevant how or in which period it does this in detail.
Linda and Harry DeAngelo (D&D) on the other hand found that Miller and Modigliani were wrong. They say that the model of MM is unnecessary restrictive. In such a way that it even produces false and warped results. After relaxing some assumptions of MMs model, they get a contrary result. In their opinion payout policy is not irrelevant. They say that when retention is allowed it is very well important and relevant which dividend policy a company chooses.
Summary of Chapters
1. Introduction: Outlines the fundamental debate between the Miller-Modigliani irrelevance theorem and subsequent critics who argue for the relevance of dividend policy.
2. Scale A - Irrelevance: Details the theoretical foundation of the MM model, specifically focusing on the assumptions of perfect capital markets, investor rationality, and perfect certainty.
3. Scale B - Relevance: Reviews the alternative perspectives provided by Gordon, Walter, and DeAngelo, who argue that relaxing MM's rigid assumptions demonstrates the significance of payout decisions.
4. Consequences of retention: Explores the market impacts of retained earnings and how different theoretical models view the substitution of dividends with stock repurchases or capital gains.
5. A scale in balance - Conclusion: Summarizes the findings and concludes that while the debate remains complex, the assumptions regarding market conditions and rationality are critical determinants of the validity of these dividend theories.
Keywords
Dividend Policy, Miller-Modigliani, Corporate Finance, Share Valuation, Payout Policy, Market Imperfections, Capital Markets, Rationality, Retention, DeAngelo, Investment Policy, Shareholder Value, Cash Flow, Financial Theory, Arbitrage
Frequently Asked Questions
What is the primary subject of this paper?
The paper examines the long-standing economic debate regarding whether a company's dividend payout policy affects its market value, focusing on the tension between the "irrelevance" proposition and the "relevance" perspective.
What are the central thematic areas discussed?
The core themes include capital market efficiency, the influence of dividend payouts versus earnings retention, the impact of investment decisions on shareholder value, and the validity of theoretical assumptions in financial modeling.
What is the primary objective of this study?
The goal is to weigh the arguments of both sides—the Miller-Modigliani school and their critics (such as DeAngelo)—to determine the current standing of dividend theory in corporate finance.
Which scientific method is utilized?
The paper employs a comparative literature review and a theoretical analysis of mathematical valuation models, focusing on how shifting assumptions (like allowing retention) changes the predicted impact of dividend policy.
What topics are covered in the main body?
The main body breaks down the MM irrelevance proof, contrasts it with DeAngelo’s critique of the model's restrictions, and discusses the consequences of retention in the context of market participants and life cycle theory.
Which keywords best characterize this work?
The most relevant keywords include Dividend Policy, Miller-Modigliani, Share Valuation, Capital Markets, and Corporate Finance.
How does the author interpret the MM assumption of "perfect certainty"?
The author highlights "perfect certainty" as a critical, albeit unrealistic, assumption that allows MM to exclude risk and external influences, thereby creating a model that simplifies future investment and profit outcomes.
What is the "trapezoid" concept mentioned in relation to DeAngelo and DeAngelo?
The trapezoid represents the set of all feasible payout policies available to a manager, including those that are suboptimal; this model illustrates why, in reality, managers might face choices where dividend policy is no longer irrelevant.
Why do critics argue that dividend policy is relevant?
Critics argue that when the restrictive assumptions of the MM model (like the absence of retention or the assumption of perfect capital markets) are relaxed, companies have real choices that affect shareholder utility and firm value.
What is the final verdict regarding the irrelevance of dividend policy?
The paper concludes that there is no single definitive answer, but emphasizes that the validity of the irrelevance proposition depends entirely on the underlying assumptions about market conditions and investor behavior.
- Quote paper
- Diplom Volkswirt Jonas Böhmer (Author), 2007, Irrelevanz der Ausschüttungspolitik?, Munich, GRIN Verlag, https://www.grin.com/document/135690
