Modigliani & Miller show that dividend policy can also be considered irrelevant.

Question

Modigliani & Miller show that dividend policy can also be considered irrelevant. Yet, unexpected increases in dividends are often closely followed by price increases, why?

To clarify, when a firm pays a dividend the stock price should drop by the amount of the dividend on the ex-dividend date. Let's say a firm has 5 stockholders, each holding 1 share. The firm owns $2,000 in cash and $3,000 in other assets. So the firm is worth $5,000 (it owes no debt). Each stockholder's claim is worth:

$5,000/5 = $1000.

Now the firm declares a dividend of $100/share. They must pay out a total of: $100 x 5shares = $500. So after the dividend is paid the firm now has $1,500 in cash and $3,000 in other assets, for a total of $4,500. Dividing this by 5 stockholders, we find that each stockholders claim is $900. The same as if we take $1,000 less $100 dividend to get $900. The stockholder hasn't lost anything, he still has $1,000 in value, just $900 in the firm and $100 in cash now.

But what we actually often see in practice is:

Let’s say the firm was expected to pay a $100/share dividend, but instead pays a dividend of $110. Like the example above, we would expect to see the stockholder's value fall to $890 ($1,000 - $110 = $890). Again, the stockholder still has $1,000; $890 in the firm and $110 in cash. In practice though, we see that instead of the stock dropping to $890, it falls to say, only $895. Thus the stockholder's value is now; $110 + $895 = $1,005.

Why did they gain $5 in value, just by issuing the dividend?

Explanation / Answer

In perfect markets, assuming certainty, the stock's price sshould drop by the amount of the declared dividend on the ex-dividend date. In practice, uncertainty and other economic factors affect the behaviiour of those trading on the ex-dividend day. The ex-dividend day evidence is inconclusive as is the rationale for the behaviour. Thus, the expected ex-dividend day price drop and the dividend per share do not necessarily have to be equal.

According to M&M Thoery, the earning power and risk of its assets solely determine the value of the firm. M&M also argue that shareholders are indifferent to the payment of dividends because they can create any dividend policy they desire by buying or selling shares of the stocks. This controversial conclusion mean that dividend policy has no affect on shareholders wealth.

So we can conclude that though the value of the stock should drop to $ 890, in practice, due to the uncertainty and economic factors the value of the stock may increase or drop by a lesser amount than the amount to be droped as dividend paid. That is why they gain $ 5 in value.

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