The residual theory of dividends implies that if the firm cannot invest its earnings to earn a return that exceeds the cost of capital, it should distribute the earnings by paying dividends to stockholders. This approach suggests that dividends represent an earnings residual rather than an active decision variable that affects the firm’s value. Such a view is consistent with the dividend irrelevance theory put forth by Merton H. Miller and Franco Modigliani (M and M).2 They argue that the firm’s value is determined solely by the earning power and risk of its assets (investments) and that the manner in which it splits its earnings stream between dividends and internally retained (and reinvested) funds does not affect this value. M and M’s theory suggests that in a perfect world (certainty, no taxes, no transactions costs, and no other market imperfections), the value of the firm is unaffected by the distribution of dividends.
dividend irrelevance theory
Miller and Modigliani’s theory that, in a perfect world, the firm’s value is determined solely by the earning power and risk of its assets (investments) and that the manner in which it splits its earnings stream between dividends and internally retained (and reinvested) funds does not affect this value.
Of course, real markets do not satisfy the “perfect markets” assumptions of Modigliani and Miller’s original theory. One market imperfection that may be important is taxation. Historically, dividends have usually been taxed at higher rates than capital gains. A firm that pays out its earnings as dividends may trigger higher tax liabilities for its investors than a firm that retains earnings. As a firm retains earnings, its share price should rise, and investors enjoy capital gains. Investors can defer paying taxes on these gains indefinitely simply by not selling their shares. Even if they do sell their shares, they may pay a relatively low tax rate on the capital gains. In contrast, when a firm pays dividends, investors receive cash immediately and pay taxes at the rates dictated by then-current tax laws.
Even though this discussion makes it seem that retaining profits rather than paying them out as dividends may be better for shareholders on an after-tax basis, Modigliani and Miller argue that this assumption may not be the case. They observe that not all investors are subject to income taxation. Some institutional investors, such as pension funds, do not pay taxes on the dividends and capital gains that they earn. For these investors, the payout policies of different firms have no impact on the taxes that investors have to pay. Therefore, Modigliani and Miller argue, there can be a clientele effect in which different types of investors are attracted to firms with different payout policies due to tax effects. Tax-exempt investors may invest more heavily in firms that pay dividends because they are not affected by the typically higher tax rates on dividends. Investors who would have to pay higher taxes on dividends may prefer to invest in firms that retain more earnings rather than paying dividends. If a firm changes its payout policy, the value of the firm will not change; instead, what will change is the type of investor who holds the firm’s shares. According to this argument, tax clienteles mean that payout policies cannot affect firm value, but they can affect the ownership base of the company.
The argument that different payout policies attract different types of investors but still do not change the value of the firm.
In summary, M and M and other proponents of dividend irrelevance argue that, all else being equal, an investor’s required return—and therefore the value of the firm—is unaffected by dividend policy. In other words, there is no “optimal” dividend policy for a particular firm.
2. Merton H. Miller and Franco Modigliani, “Dividend Policy, Growth and the Valuation of Shares,” Journal of Business34 (October 1961), pp. 411–433.
Modigliani and Miller’s assertion that dividend policy was irrelevant was a radical idea when it was first proposed. The prevailing wisdom at the time was that payout policy could improve the value of the firm and therefore was relevant. The key argument in support of dividend relevance theoryis attributed to Myron J. Gordon and John Lintner,3 who suggest that there is, in fact, a direct relationship between the firm’s dividend policy and its market value. Fundamental to this proposition is their bird-in-the-hand argument, which suggests that investors see current dividends as less risky than future dividends or capital gains: “A bird in the hand is worth two in the bush.” Gordon and Lintner argue that current dividend payments reduce investor uncertainty, causing investors to discount the firm’s earnings at a lower rate and, all else being equal, to place a higher value on the firm’s stock. Conversely, if dividends are reduced or are not paid, investor uncertainty will increase, raising the required return and lowering the stock’s value.
dividend relevance theory
The theory, advanced by Gordon and Lintner, that there is a direct relationship between a firm’s dividend policy and its market value.
The belief, in support of dividend relevance theory, that investors see current dividends as less risky than future dividends or capital gains.
Modigliani and Miller argued that the bird-in-the-hand theory was a fallacy. They said that investors who want immediate cash flow from a firm that did not pay dividends could simply sell off a portion of their shares. Remember that the stock price of a firm that retains earnings should rise over time as cash builds up inside the firm. By selling a few shares every quarter or every year, investors could, according to Modigliani and Miller, replicate the same cash flow stream that they would have received if the firm had paid dividends rather than retaining earnings.
Studies have shown that large changes in dividends do affect share price. Increases in dividends result in increased share price, and decreases in dividends result in decreased share price. One interpretation of this evidence is that it is not the dividends per se that matter but rather theinformational content of dividends with respect to future earnings. In other words, investors view a change in dividends, up or down, as a signal that management expects future earnings to change in the same direction. Investors view an increase in dividends as a positive signal, and they bid up the share price. They view a decrease in dividends as a negative signal that causes investors to sell their shares, resulting in the share price decreasing.
The information provided by the dividends of a firm with respect to future earnings, which causes owners to bid up or down the price of the firm’s stock.
Another argument in support of the idea that dividends can affect the value of the firm is theagency cost theory. Recall that agency costs are costs that arise due to the separation between the firm’s owners and its managers. Managers sometimes have different interests than owners. Managers may want to retain earnings simply to increase the size of the firm’s asset base. There is greater prestige and perhaps higher compensation associated with running a larger firm. Shareholders are aware of the temptations that managers face, and they worry that retained earnings may not be invested wisely. The agency cost theory says that a firm that commits to paying dividends is reassuring shareholders that managers will not waste their money. Given this reassurance, investors will pay higher prices for firms that promise regular dividend payments.
Although many other arguments related to dividend relevance have been put forward, empirical studies have not provided evidence that conclusively settles the debate about whether and how payout policy affects firm value. As we have already said, even if dividend policy really matters, it is almost certainly less important than other decisions that financial mangers make, such as the decision to invest in a large new project or the decision about what combination of debt and equity the firm should use to finance its operations. Still, most financial managers today, especially those running large corporations, believe that payout policy can affect the value of the firm.