Cuckee.com

One of the most comprehensive investment arguments for the irrelevance of dividends was provided by Modigliani and Miller in their research.

They asserted that given the investment decision of the firm, the dividend payout ratio is a mere detail and that it does not affect the invested wealth of the shareholders. The argument is that the investment value of the firm is determined solely by the earning power of the firm’s assets or its investments policy and that the manner in which the earnings stream is split between dividends and retained earnings do not affect this value.

The assumption being that the perfect capital markets exist and that there are no floatation and translation costs. The firm’s future revenues are also based of high certainties.

The crux is that the effect of dividend payments on shareholder wealth is exactly offset by other means of financing. Consider selling additional common stock to raise equity capital instead of simply retaining earnings. After the firm has made its investment decision, it must decide whether a) to retain earnings or b) to pay dividend and sell new stock in the amount of these dividends in order to finance the investments.

The sum of of the discounted value per share of common stock after financing plus current dividends paid is exactly equal to the market value per share of common stock before the payment of current dividends.

In other words the, the common stock’s decline in market price because of the dilution caused by external equity financing is exactly offset by the payment of the dividend. Thus the shareholder is supposed to be indifferent between receiving dividends and having earnings retained by the firm .