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