File: L13AMMDIV

L13A-Irrelevancy Of Dividend Payments (MM View)

MM viewed dividends as neutral (irrelevant). They assumed a world of perfect capital
markets and perfect certainty where all market participants were aware of the future
investment programme and profits of all companies. In these circumstances, companies
could be correctly valued on the basis of their future cash flows and these values reflected
in share price. If shareholders had different consumption requirements in any year they
could adjust their cash preferences by either selling or buying shares through the perfect
market assumed where there would be no taxes or transaction costs. Any cash dividend
payments made by companies would lead to a reduction in share price equal to the
dividend payment made reflecting the outflow of resources from the company to
shareholders.
Illustration of MM view on dividend policy
1.

We assume an all equity company with 10 million shares in issue, each having a
current market value of 840p per share. The company is currently valued at 84
million which reflects the present value of its business activities. It is further
assumed that the company's cash resources are committed to investment in
business activities and it has no spare cash resources to pay a dividend.

2.

The company has always paid a dividend and the directors wish to maintain this
record by paying a dividend of 40p per share which will require cash of 10M x 40p
= 4M

3.

If the company is to maintain its investment programme then the 4M required to

pay the dividend will have to be obtained by issuing new shares to outside
investors.

4.

After payment of the dividend the company and individual share value will be

Before dividend
Less : Cash dividend
After dividend

Company

Per Share

84,000,000
4,000,000
80,000,000

840p
40p
800p

5.

The company will have to issue shares to the value of 4M and will issue
4,000,000
8

= 500,000 shares

The issue of 500,000 shares at 800 p will bring in 4M cash thus replacing the cash
used to pay dividend to the 'old shareholders'. The latter will have received
dividend of 40p per share and have a share now valued at 800p; before payment of
the dividend they hold shares valued at 840p. There has thus been no change in the
wealth of the original shareholders, only in the form it takes.
6.

Why could the new shares not be sold at the old price of 840p? Because markets are
assumed to be perfect and therefore investors will know that the dividend payment
is being made to existing shareholders, thus reducing the assets of the company and
the value of the equity.
Company assets
84M

Dividend of 4M
cash paid & replaced
with new issue proceeds
of same amount

Shareholders
Before dividend After dividend
10M shares
at 84p
= 84M

Old shareholders
10M shares at
(840 - 40) p
= 80M
New shareholders
0.5M shares at 800p
= 4M

This emphasizes that share value is determined by company value which itself is
determined by the present value of its future business activities. To emphasize this
point consider the following example.
Example
An all equity company has in issue five million shares with a current market value of 12
per share valuing the company at 60M. The company has 5M in cash which can either
be used to pay a dividend of 1 per share or invested in a project which has an NPV or
5M. Should the company pay the dividend or invest in the project?

Solution
If the company pays a dividend then total value falls by 5M to 55M. Shareholders will
receive a dividend of 1 per share and will hold shares valued at 11 each (55M/5M).
Their total wealth will remain unchanged at 12 per share originally held.
On the other hand, if the company does not pay a dividend but invests instead in the new
project the value of the company increases by the NPV of the project to 65M (60M + NPV
of 5M). Shareholders' wealth will be increased by this strategy as they will now hold
shares valued at 13 each (65M/5M).