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M and m further argue that a clientele effect exists

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Unformatted text preview: es a decrease in share price as investors sell their shares. M and M further argue that a clientele effect exists: A firm attracts shareholders whose preferences for the payment and stability of dividends correspond to the payment pattern and stability of the firm itself. Investors who desire stable dividends as a source of income hold the stock of firms that pay about the same 1. Merton H. Miller and Franco Modigliani, “Dividend Policy, Growth and the Valuation of Shares,” Journal of Business 34 (October 1961), pp. 411–433. CHAPTER 13 Dividend Policy 565 dividend amount each period. Investors who prefer to earn capital gains are more attracted to growing firms that reinvest a large portion of their earnings, favoring growth over a stable pattern of dividends. Because the shareholders get what they expect, M and M argue, the value of their firm’s stock is unaffected by dividend policy. In summary, M and M and other proponents of dividend irrelevance argue that, all else being equal, an investor’s required return—and therefore the value of the firm—is unaffected by dividend policy for three reasons: 1. The firm’s value is determined solely by the earning power and risk of its assets. 2. If dividends do affect value, they do so solely because of their informational content, which signals management’s earnings expectations. 3. A clientele effect exists that causes a firm’s shareholders to receive the dividends they expect. These views of M and M with respect to dividend irrelevance are consistent with the residual theory, which focuses on making the best investment decisions to maximize share value. The proponents of dividend irrelevance conclude that because dividends are irrelevant to a firm’s value, the firm does not need to have a dividend policy. Although many research studies have been performed to validate or refute the dividend irrelevance theory, none has been successful in providing irrefutable evidence. Arguments for Dividend Relevance dividend relevance theory The theory, advanced by Gordon and Lintner, that there is a direct relationship between a firm’s dividend policy and its market value. bird-in-the-hand argument The belief, in support of dividend relevance theory, that investors see current dividends as less risky than future dividends or capital gains. The key argument in support of dividend relevance theory is attributed to Myron J. Gordon and John Lintner,2 who suggest that there is, in fact, a direct relationship between the firm’s dividend policy and its market value. Fundamental to this proposition is their bird-in-the-hand argument, which suggests that investors see current dividends as less risky than future dividends or capital gains. “A bird in the hand is worth two in the bush.” Gordon and Lintner argue that current dividend payments reduce investor uncertainty, causing investors to discount the firm’s earnings at a lower rate and, all else being equal, to place a higher value on the firm’s stock. Conversely, if dividends are reduced or are...
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