Dividend Irrelevance Theory
Dividend irrelevance theoryRelevance or irrelevance of retention for dividend policy irrelevance
Carlo Alberto Magni Department of Economics, University of Modena and Reggio Emilia viale Berengario 51, 41100 Modena, Italy Email: magni@unimo.it
Abstract. In an interesting recent paper, DeAngelo and DeAngelo (2006) highlight that Miller and Modigliani’s (1961) proof of dividend irrelevance is based on the assumption that the amount of dividends distributed to shareholders is equal or greater than the free cash flow generated by the fixed investment policy. They claim that, if retention is allowed, dividend policy is not irrelevant. This paper shows that the dividend irrelevance proposition holds even in case of retention. The key assumption has not to do with retention but with the NPV of the extra funds (either retained or raised): if NPV is zero, dividend irrelevance applies. Yet, the dichotomy retention/no-retention is useful, because if agency problems are present, managers tend to retain funds and invest them in negative-NPV projects, and therefore the zero-NPV assumption must be removed, so that dividend irrelevance does not apply any more. Keywords. Dividend policy, irrelevance, retention, zero-NPV, epistemology, modelling, agency theory. JEL codes. B41, G12, G30, G31, G35.
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Relevance or irrelevance of retention for dividend policy irrelevance
Introduction
A firm’s value is given by the sum of the present value of forecasted cash flows. Resting on Miller and Modigliani’s (1961) dividend irrelevance proposition, practitioners and some academics do not use actual cash flows; rather, they discount potential dividends, also known as free cash flows or free cash flows to firm (e.g. Damodaran, 2006a,b; Colepand, Koller and Murrin, 2000). Magni and Vélez-Pareja (2009) support the idea that only actual cash flows should be discounted, whereas potential dividends distort valuation in all cases where excess cash retained is not invested in NPV-neutral
Carlo Alberto Magni Department of Economics, University of Modena and Reggio Emilia viale Berengario 51, 41100 Modena, Italy Email: magni@unimo.it
Abstract. In an interesting recent paper, DeAngelo and DeAngelo (2006) highlight that Miller and Modigliani’s (1961) proof of dividend irrelevance is based on the assumption that the amount of dividends distributed to shareholders is equal or greater than the free cash flow generated by the fixed investment policy. They claim that, if retention is allowed, dividend policy is not irrelevant. This paper shows that the dividend irrelevance proposition holds even in case of retention. The key assumption has not to do with retention but with the NPV of the extra funds (either retained or raised): if NPV is zero, dividend irrelevance applies. Yet, the dichotomy retention/no-retention is useful, because if agency problems are present, managers tend to retain funds and invest them in negative-NPV projects, and therefore the zero-NPV assumption must be removed, so that dividend irrelevance does not apply any more. Keywords. Dividend policy, irrelevance, retention, zero-NPV, epistemology, modelling, agency theory. JEL codes. B41, G12, G30, G31, G35.
1
Relevance or irrelevance of retention for dividend policy irrelevance
Introduction
A firm’s value is given by the sum of the present value of forecasted cash flows. Resting on Miller and Modigliani’s (1961) dividend irrelevance proposition, practitioners and some academics do not use actual cash flows; rather, they discount potential dividends, also known as free cash flows or free cash flows to firm (e.g. Damodaran, 2006a,b; Colepand, Koller and Murrin, 2000). Magni and Vélez-Pareja (2009) support the idea that only actual cash flows should be discounted, whereas potential dividends distort valuation in all cases where excess cash retained is not invested in NPV-neutral
References: Copeland, T.E., Koller, T. and Murrin, J. (2000) Valuation: Measuring and Managing the Value of Companies, 3rd Edition Damodaran, A. (2006a) Damodaran on Valuation. Security Analysis for Investment and Corporate Finance, second edition Jensen, M. (1986). Agency costs of free cash flow, corporate finance, and takeovers.