Lecture 3 Dividend Policy Theory.doc

Lecture 3 Dividend Policy Theory
Lecture 3 Dividend Policy Theory
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Lecture 3 Dividend Policy Theory

Reading list:
Financial Theory and Corporate Policy Ch16

Miller and Modigliani, Dividend Policy, Growth and the Value of Shares, Journal of Business, 34, 1961, pp 411-433
Frank and Jagannathan, Why do Stock prices drop by Less than the value of the Dividend? Evidence from a Country without Taxes, Journal of Financial economics, Vol47, 1998, 161-1881>.
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No Taxes
MM 1961
Assume two identical firms in all respects except for their current dividend payout (. identical stream of future cash flows, planned investments outlays, and all future dividend payments )
Notational:
EBIT1(t) = EBIT2(t) t = 0, 1, …., ∞
I1(t) = I2(t) t = 0, 1, …., ∞
Div1(t) = Div2(t) t = 1, …., ∞
Div1(0) ≠ Div2(0)


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No td.
Assumption:
The market-required rate of return (Ku(t+1)) for firms in the same risk class are identical
dIVi(t+1) = dividends per share paid end of period t
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No td.
Cntd from pp4:
Multiply by current number of shares outstanding, ni(t), and rearrange:
Divi(t+1) = Total dividend paid = ni(t)divi(t+1)
Vi(t) = Firm’s market value =ni(t)Pi(t)
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No td.

Hence the value of the firm is the sum of two cash flows: dividends paid out Divi(t+1), and the end-of-period value of the firm.

To show that present value of the firm is independent of dividend payout, we examine the sources and uses of funds for firms.
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Sources and Uses of Funds
Consider an all-equity firm:
Sources of funds:
Cash from operations …. EBITt(t+1)
Issue new shares …. Mi(t+1)Pi(t+1)
Where Mi(t+1) = the number of new shares.
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Sources and Uses of Funds
Major uses of funds:
Dividends paid out …. DIVi(t+1)
Investment …. Ii(t+1)
Sources = uses
NOIt(t+1) + Mi(t+1)Pi(t+1) = Ii(t+1) + DIVi(t+1)
Money return to share holders = Ri(t+1)
=
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Sources and Uses of Funds
ni(t+1) = ni(t) + mi(t+1)
ni(t) = ni(t+1) - mi(t+1)
Hence,
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Sources and Uses of