A firm which pays dividends will have to raise funds externally in order to finance its investment plans. When a firm pays dividend, its advantage is offset by external financing. This means that the terminal value of the share declines when dividends are paid. Thus the wealth of the shareholders – dividends plus the terminal share price – remains unchanged. Consequently the present value per share after dividends and external financing is equal to the present value per share before the payment of dividends. Thus the shareholders are indifferent between the payment of dividends and retention of earnings.

1. Merton H. Miller; Franco Modigliani, “Dividend Policy,
Growth, and the Valuation of Shares”, The Journal of
Business, Vol. 34, No. 4. (Oct., 1961), pp. 411-433

2. Sections
•the effects of differences in dividend policy on the current price of shares in an ideal
economy characterized by perfect capital markets, rational behavior, and perfect
certainty.
Section
I
•what investors "really" capitalize when they buy shares;
Section
II
•relations between price, the rate of growth of profits, and the rate of growth of
dividends per share
Section
III
•drops the assumption of certainty to see the extent to which the earlier conclusions
about dividend policy must be modified.
Section
IV
•the implications for the dividend policy problem of certain kinds of market
imperfections.
Section
V

3. Perfect Capital Market
• Conditions that face a firm operating in a
perfect capital market, either;
1. The firm has sufficient funds to pay dividend
2. The firm does not have sufficient funds to
pay dividend therefore it issues stocks in
order to finance payment of dividends
3. The firm does not pay dividends but the
shareholders need cash

4. Assumptions
Perfect capital markets:
• No income taxes.
• No flotation or transaction costs.
• Leverage does not affect cost of capital
• Both managers and investors have access to the same information concerning
firm's future prospects.
• Firm's cost of equity is not affected by distribution of income between dividend
and retained earnings.
• Dividend policy has no impact on firm's capital budgeting
Rational behavior:
• Investors prefer more wealth to less.
• Investors indifferent between cash payment or increment in market value of
shares.
Perfect certainty:
• Future dividends and CFs are known.

5. Section I: Effects of dividend policy
• dj(t) = dividends per share paid by firm
• pj(t) = share price (ex any dividend in t -1)
independent of t
equivalent
)(
)(
)()1()(
t
tpj
tpjtpjtdj


)2()]1()([
)(1
1
)( 

 tpjtdj
t
tpj


6. Cont.
• Fundamental principle:
– The share price must make shares in every market
have same rate of return (dividend plus capital
gain)
– This process tend to drive down the prices of the
low-return shares and drive up the prices of high-
return shares until any difference in rates of return
had been eliminated by arbitraging or switching.

7. The effect of dividend policy
• n(t) = the number of shares of record at the start
of t
• m(t + 1) = the number of new shares (if any) sold
during t at the ex dividend closing price p(t + I),
so that
• n(t + 1) = n(t) +m(t + 1)
• V(t) = n(t) p(t) = total value of the enterprise
• D(t) = n(t) d(t) = total dividends paid during t to
holders of record at the start of t

8. Cont.
• we can rewrite (2)
• To
• Dividend policy problem; dividend decision effects price in
two conflicting ways:
– directly via D(t) and
– inversely via -m(t) p(t +1)
• Dilemma:
– To reduce dividend and rely on retained earnings, or
– To raise dividends but float more new shares?
• For the higher the dividend payout in any period, the more
new capital must be raised from external sources to
maintain any desired level of investment.
• The two effects must always cancel out so that the dividend
policy will have no effect on the price.
)3()]1()1()1()([
)(1
1
)( 

 tptmtVtD
t
tV


9. Cont.
– I(t) = level of the firm's investment
– X(t) = firm's total net profit for the period
• The amount of outside capital required:
• The D(t) cancel.
• Since D(t) does not appear directly among the
arguments and since X(t), I(t), V(t + 1) and p(t) are all
independent of D(t); the current value of the firm must
be independent of the current dividend decision.
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)(1
1
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(3)into(4)expressionngSubstituti
)4()]()([)()1()1(



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

tVtItX
t
tptn
tDtXtItptm


10. Result
• Thus, we may conclude that given a firm's
investment policy, the dividend payout policy it
chooses to follow will affect neither the current
price of its shares nor the total return to its
shareholders.
• Values there are determined solely by "real"
considerations:
– the earning power of the firm's assets and
– its investment policy
– and not by how the fruits of the earning power are
"packaged" for distribution

11. Cont.
• Miller and Modigliani showed that dividend
policy didn’t matter:
– They showed that as long as the firm was realizing
the returns expected by the market, it didn’t
matter whether that return came back to the
shareholder as dividends now, or reinvested.
• They would see it in dividend or price appreciation.
– The shareholder can create their own dividend by
selling the stock when cash is needed.

12. Section II: Valuation (What the
market really capitalize)
• The amount of dividends to be paid is not
relevant, since the new owner can make the
future dividend stream whatever he pleases.
• For investors, the value of firm depends on:
– market rate of return;
– earning power of assets held by the firm;
– the opportunities that the firm offers for making
additional investments in real assets that will yield
more than the "normal" (market) rate of return.

13. Cont.
1. The discounted cash flow approach
– We discount at the market rate of interest, the stream
of cash receipts minus the cash outlays in the firm’s
projects.
2. The investment opportunities approach
(12)
– The essence of "growth“, is not expansion, but the
existence of opportunities to invest funds at higher
than "normal" rates of return.
– p*(t) > p
– p is the cost of capital or cutoff rate – p*must exceed
p in order to grow.

14. Cont.
3. The stream of dividends approach.
– The current value of a share is the discounted value of the stream of
dividends to be paid on the share in perpetuity.
– An increase in current dividends, given the firm's investment policy,
will reduce the terminal value of existing shares
– because part of the future dividend stream must be diverted to attract
the outside capital from which the higher current dividends are paid,
– the reduction in terminal value must always be precisely the same as
the increase in current dividends.  dividend policy is irrelevant.
4. The stream of earnings approach
– Value of the firm is the discounted sum of future total earnings
• it overlooks the fact that the corporation is a separate entity and
that these profits cannot freely be withdrawn by the shareholders
• It does not depend on any assumptions about the time shape of the
stream of total profits or dividends per share (which are actually
closely related via financial policy).

15. Result
• Dividend Irrelevance Theory:
– Miller/Modigliani argued that dividend policy
should be irrelevant to stock price.
– If dividends don’t matter, this chapter is irrelevant
as well (which is what most of you are thinking
anyway).

16. Section III: earnings, dividends and
growth rates
1. The convenient case of constant growth rates.
– value of the firm is a function of its current earnings, growth rate of
earnings, internal rate of return, and market rate of return.
– Note that (23) holds not just for period 0, but for every t. Hence if X(t) is
growing at the rate kp*, it follows that the value of the enterprise, V(t), also
grows at that rate.
2. The growth of dividends and total profits.
– what is the rate of growth of dividends and of share price?
– vary depending on whether or not the firm is paying out a high percentage of its
earnings and thus relying heavily on outside financing
– The higher the payout policy, the higher the starting position and the slower the
growth
– Growth rate falls when more external financing is used. Use internal financing 
pecking order theory.
)23(
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
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k
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
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17. Cont.
3. The special case of exclusively internal financing
– The growth rate of dividends per share is the same as
the growth rate of the firm only when all financing is
internal.
4. Corporate earnings and investor returns
– The relation between the investors' return and the
corporation's profits (Xt) depends on the relation
between p* and p.
– p* = p  no growth, investors’ return = firm profit.
– p* < p  return is less than corporate profit
– p* > p  investors’ return is more than corporate profit.

18. Section IV: Effects of dividend policy
under uncertainty
• Drops perfect market assumption.
1. Uncertainty and the general theory of valuation:
– dividend policy does not determine market value of firms.
– “Imputed rationality” and “symmetric market rationality”
2. The irrelevance of dividend policy despite uncertainty:
– There is no need to modify the conclusion.
3. Dividend policy and leverage:
– Borrow to pay dividend. Leverage involves interest.
– The net result is that both the dividend and interest component of
total earnings will cancel out making the relevant (total) return, [Xi(O)
- Ii(0) + Vi(1)] which is clearly independent of the current dividend.
– So, firm’s value is also independent of dividend policy.

19. Cont.
4. The informational content of dividends
– the fact that in the real world a change in the dividend
rate is often followed by a change in the market price
(sometimes spectacularly so).
– This would not be incompatible with ‘irrelevanc’e
because it was merely a reflection of the
"informational content“ of dividend.
– Investors tends to interpret dividend rate as
management’s view of future prospects. The dividend
change provides the occasion for the price change
– But, the price is still being solely a reflection of future
earnings and growth opportunities

20. Section V: Dividend policy and market
imperfections
• Considers imperfection that might lead an
investor to have a systematic preference as
between a dollar of current dividends and a
dollar of current capital gains (irrational).
• Imperfections that bias individual preferences
– such as the existence of brokerage fees which tend to
make Young “accumulators” prefer low-payout shares
and retired persons lean toward “income stocks“
– “Clientele effect”
• a company's stock price will move according to the demands
and goals of investors in reaction to a tax, a dividend or
other policy changes.

21. Conclusions
• A firm which pays dividends will have to raise funds
externally in order to finance its investment plans.
• When a firm pays dividend, its advantage is offset by
external financing.
• This means that the terminal value of the share declines
when dividends are paid. Thus the wealth of the
shareholders – dividends plus the terminal share price –
remains unchanged.
• Consequently the present value per share after dividends
and external financing is equal to the present value per
share before the payment of dividends.
• Thus the shareholders are indifferent between the payment
of dividends and retention of earnings.