SSRN-id680855 - The Irrelevance of the MM Dividend...

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The Irrelevance of the MM Dividend Irrelevance Theorem by Harry DeAngelo* Linda DeAngelo* July 2004 Revised March 2005 Abstract Contrary to Miller and Modigliani (1961), payout policy is not irrelevant and investment policy is not the sole determinant of value, even in frictionless markets. MM ask “Do companies with generous distribution policies consistently sell at a premium above those with niggardly payouts?” But MM’s analysis does not address this question because the joint effect of their assumptions is to mandate 100% free cash flow payout in every period, thereby rendering “niggardly payouts” infeasible and forcing distributions to a global optimum. Irrelevance obtains, but in an economically vacuous sense because the firm’s opportunity set is artificially constrained to payout policies that fully distribute free cash flow. When MM’s assumptions are relaxed to allow retention, payout policy matters in exactly the same sense that investment policy does. Moreover (i) the standard Fisherian model is empirically refutable, predicting that firms will make large payouts in present value terms, (ii) only when payout policy is optimized will the present value of distributions equal the PV of project cash flows, (iii) the NPV rule for investments is not sufficient to ensure value maximization, rather an analogous rule for payout policy is also necessary, and (iv) Fischer Black’s (1976) “dividend puzzle” is a non-puzzle because it is rooted in the mistaken idea that MM’s irrelevance theorem applies to payout/retention decisions, which it does not. hdeangelo@marshall.usc.edu or ldeangelo@marshall.usc.edu *Marshall School of Business, University of Southern California. This research was supported by the Charles E. Cook/Community Bank and Kenneth King Stonier chairs at USC. For their useful comments on earlier drafts of this paper, we thank Michael Brennan, Kenneth French, Jonathan Karpoff, Ronald Masulis, David Mayers, Edward Rice, Jay Ritter, René Stulz, and especially Eugene Fama and Clifford Smith. We also gratefully acknowledge the constructive comments of three referees. We would particularly like to thank Michael Jensen for his invaluable suggestions and advice on this project.
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The Irrelevance of the MM Dividend Irrelevance Theorem Miller and Modigliani’s (1958, 1961) irrelevance theorems form the foundational bedrock of modern corporate finance theory. The MM theorems indicate that, in frictionless markets with investment policy fixed, all feasible capital structure and dividend policies are optimal because all imply identical stockholder wealth, and so the choice among them is irrelevant. The central lesson commonly drawn from MM is that investment policy alone determines stockholder wealth in frictionless markets, and that leverage and payout decisions have no impact on firm value, given a value-maximizing investment program (see, e.g., Allen and Michaely (2003, p. 339)). Specifically, when a firm considers different
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SSRN-id680855 - The Irrelevance of the MM Dividend...

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