American Finance Association

A Note on Dividend Irrelevance and the Gordon Valuation Model Author(s): Michael Brennan Reviewed work(s): Source: The Journal of Finance, Vol. 26, No. 5 (Dec., 1971), pp. 1115-1121 Published by: Blackwell Publishing for the American Finance Association Stable URL: http://www.jstor.org/stable/2326087 . Accessed: 09/03/2012 05:14
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A NOTE ON DIVIDEND IRRELEVANCE AND THE GORDON VALUATION MODEL*

MICHAEL BRENNAN$

finance justlycelebrated:'indeedmanyauthorities are woulddate thedevelopment modern of analytical financial theory their to path-breaking 1958 article. Yet, whilethepointsof disagreement betweenthe theory capital structure of in expressed their earlier articles thetraditional and theory have been narrowed downto differing empirical assumptions, same cannotbe said of their the later articleon dividend policy: "Dividend Policy, Growth, and the Valuationof Nine years after the publication this latter article there continueto of co-existamongfinancial theorists two opposingviews on the importance of dividend policyin perfect markets. The first and olderview,originally articulated by Myron Gordon,3 and still commanding widespreadassent,can be paraphrasedby the statement that even in perfectcapital markets,4 the existence uncertainty of about the future suffices make thepriceof a share to dependent upon thedividend policywhichis followed: and thatin particular, the moregenerous the dividend is policy,the higher will be the price of the share. Miller and Modiglianion the otherhand, have arguedthat once the investment policyof a firm given,the priceof its sharesis invariant is with respect thesize of thedividend to paid.' The issue betweenthese opposingviews cannot be settledby resortto for experience, thefundamental reasonthattheabove hypotheses relateto the of effects dividend policyin perfect whereasof courseactual capitalmarkets, fromseveral imperfections, most important securities markets suffer the of from pointof view of dividend the which, of policy,are the existence transtaxes on incomefromdividendsand capital actionscosts and of differential gains."Despitethis,thereis a paucityof articles thetheoretical on differences
* The author grateful a referee helpful to is for comments.

THE CONTRIBUTIONS of Modiglianiand Miller to the theoryof corporate

Shares."2

The University British of Columbia.

and 1. See Modigliani Miller[8, 9, 10]. 2. Modigliani Miller[8]. and 3. Gordon 3, 4]. [2, of 4. The perfection capitalmarkets thissenseis usuallytakento excludesuch factors in as taxesand transactions costs.It is further assumed that all market participants have accessto the of sameinformation, the though course existence uncertainty of precludes possession perfect the of information aboutthefuture. 5. Exceptinsofar current as dividends may carryinformation about the future prospects of thefirm. factors to 6. Bothof these maycauseinvestors have specific preferences between two income the of For difficultiesempirical in forms. a summary other testsof investor attitudes towards dividends see Friend Puckett and [1]. 1115

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between Gordon and M-M,7 and thetextbook treatment thetwoconflicting of theories in mostcases highly is unsatisfactory.8 student finance thus The of is leftin a quandary: bothauthorsdevelopplausibletheoriesfromreasonable assumptions, mystifyingly opposing but reach conclusions. This paperdoes notaim to breaknewground rather clarify main but to the pointsat issue betweenthe two theories;first, showing by thatthe Gordon argument in factrestupona confounding theeffects dividend does of of policy and investment policy; and secondly,by showingthat the M-M dividend irrelevance theorem be derived can from somewhat a weakerassumption than thatofsymmetric market rationality. Gordon's discussion dividend of policydevelops from stockprice directly his valuationmodel,whichassertsthat the price of a share is equal to the discountedvalue of expectedfuturedividends.9 dividendsare expectedto If growat the constant rate,g, in perpetuity, the discountrate is k, this and principle leads to thefamiliar valuation formula: p -D k- g (1)

whereP is thecurrent stockprice,and D is the current amountof dividends pershare. If thefirm retains constant a fraction, of its earnings share,and earns b, per a constant averagerate of return, on its investment, no r, employing outside financing, then
g= br

and D= (1 -b)Y for amountof earnings share. Substitution g and whereY is the current, per D in (1) yields P (I -b)Y
k - br

(2)

of be retention Equation (2) maythen used to evaluatetheeffect alternative if on thevalue of a share.In particular, ratios(and therefore payoutratios) on investment, are inthe discount rate,k, and the averagerate of return r, of of retention dependent the retention ratio,b, then the effect alternative withrespect b: to ratiosmaybe examined differentiating partially by (2)
7. However, Walter see [14]. conclusion reachthe rather "thatall and Brigham 8. Weston [15, P482] forexample surprising thoseof Gordonand M-M) resultin the same policy to the approaches dividends (including the Van as implications the Walterformulation." Horne [13, P185] summarizes arguments of in of on and M-M, before but Gordon passing to questions imperfections capitalmarkets, offers them. Mao [6, P484] leavesthe question no thereader guideas to how to choosebetween open, the between dividend that"The cause of thisconflict stating (Gordon) and the earnings theorists the of (M-M) can be tracedto theirdiffering assumptions concerning effect dividend policyon therateofreturn required investors." by of modelrelies on 9. Thispresentation Gordon's mainly Gordon[3].

Note on Dividend Irrelevance OP (r- k)Y

1117

Ob

(k-br)2

It follows withrespect thatthecondition thesharepriceto be invariant for is to the fraction earnings of retainedand re-invested just that the average of on investment rateof return, whichis also therateof return themarginal r, that rate,k. It shouldbe observed retained earnings, equal to the discount be in thiscase themarginal has value,so thatGordon investment a zeronetpresent the policyare neutralized setting by has shown thatif theeffects investment of policy equal to zero,thendividend net present value of marginal investment is irrelevant. The similarity this resultto that obtainedby M-M may be of of policy by holdingthe noted:10M-M neutralized the effects investment amountof investment under alternative dividendpolicies,whereas constant value of inGordonhas achievedthe same resultby holding net present the vestment constant. Gordon to However, goeson to arguethat,contrary whathas been assumed of so far,it is notin general case thatthe discount the rate,k, is independent the retention ratio,b. The rationalefor this is that dividendsexpectedat will be subjectto different different dates in the future risks,and thatthererate at shouldbe discounted a different to foreeach expectedfuture dividend for risk." Thus the valuationformula a share should reflect differential this as: be written explicitly D(1)
(1 + ki)

D(2)
(1 + k2)2

D(t)
(1+ kt)t(

where: in D (t) = theexpected dividend sharet periods thefuture, per to rate appropriate the risk of a dividendexkt= the discount ahead. pectedt periods value of a share,whichis As M-M pointout,'2since (4) givesthe market of of determined the interactions the supply and demand functions all by be as the marketparticipants, kt's should strictly interpreted marketdediscountrates, ratherthan the subjectivediscountrates of any termined thesewill be equal in equilibrium. individual investor, although whether is an admitsthatit is not possiblea priorito determine Gordon kt "The important function t. But, he observes, of or point increasing decreasing is is to thatktis a constant for to note,however, thatthere nothing guarantee all valuesoft."'3
thatM-M's proofof dividend be it irrelevance underuncertainty 10. However, should observed no whichrequires assumptions in about the way in proceeds a muchmoregeneral framework, whereasGordonexplicitly evaluate futuredividends, assumesthat they are which investors discounted. 11. Robichekand Myers [121 have arguedfor the use of certainty equivalents rather than whena different rateto accountforrisk; however, to adjustments the discount discount rateis are the to assigned each dividend payment, two approaches equivalent. 19. 12. M-M [8, P4241footnote 13. Gordon[3, P431.

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thatk in the of Once it is admitted thatktis a function t, thenit follows average of the individualkt, whose valuationformula(1) is a generalized In of are weights not independent the timepath of expecteddividends."4 the here,k is a function considered growth dividend case of exponential particular rate ofthegrowth g. i.e. Okd 0. thatif r is is rateof dividends givenby g = br,it follows Since thegrowth of independent b,
dk dk dg

ab

Og dg

ab
(5)

ak dk -r#0.

of of for Thus, allowing thisdependence k on b, the effect a changein the ratioon sharepriceis givenby: retention
dP _Y_ db

Y rk ~

dk '( b 1 b) ab-.(6)
(k -br)2

Then,if r

k
dP

-Y(1
ab____

b) dk
__

db

(k-br)2

r, investment, is set equal to on So, even if the rateof return the marginal of the averagediscountrate,k, the price of a share is not independent the retention ratio,unless ? 0.= Gordonconcludesfromthis that,in general, policy.", stockpriceand thecostof capitaldependon dividend of restson a confounding the M-M have assertedthatGordon'sargument has rejected of effects dividendand investment policy;"' Gordon,however, mean? It of What does this confounding the two effects this argument.'7 whichaccomthat meanspresumably thechangein theamountof investment policyin Gordon'smodelwould of itselfhave panies the changein dividend and that of a effected changein shareprice,regardless how it was financed,
to see of description thisdependence the Appendix Gordon[31written 14. For a m'athematical by Gangolli. of cost that the 15. "Therefore statement a corporation's of capitalis independent its dividend of thatk is independent br." on has implies policy no influence shareprice, rate,or thatdividend [6, P87] in foundation uncertainty, argument and its seeming the 16. "For all its ingenuity, however, of from policywith investment suffers fundamentally the typicalconfounding dividend clearly model."[11,P425] use financing accompanies of theinternal thatso frequently policy on is that 17. "It is well-known whenthe rate of return investment set equal to the discount on has the rate,changing level of investment no effect shareprice.By thismeansI neutralized clearthatI did not confound It of investment theprofitabilityinvestment. seemsto me perfectly rate."[t, P265] the and dividend policy:I changed discount

Irrelevance Note on Dividend

1119

in of the policy effect thechange to attributingdividend is Gordon mistakenly that M-M are disputing thenetpresent words, policy:in other investment r is investmentzero,evenwhen is setequalto k. The valueof themarginal the by examined considering net is of validity the M-M argument readily in by implied a change theretention investment valueofthemarginal present model. in ratio Gordon's not ratio in b, Observe that change theretention from to b2involves first a in but and invested earned, a change earnin change theamount justa single policy. in or periods, a change investment in and ings investmentall subsequent be must which policy in valueofthischange investment thenetpresent It is evaluated. in by implied a change t in Denoteby AItthechange period investment investment thatthemarginal Then,given ratio theretention from to b2.18 b, ahead t expectedperiods cashflows r, rate a earns perpetual ofreturn,andthat in valueof thechange investthe at arediscounted theratekt,'9 netpresent by: is policy given ment
00 00

NPV=~~E

+kt)t

(-l

+r

kt+,r)T )

in r setting= k willnotequatetheexpression (7) to zero, Now,ingeneral, in all unless thektare equal,and equal to k-the onlycircumstance which to policy be irrelevantl finds Gordon dividend in by has Gordon beenmisled thefactthat thespecial that Thusit appears of the r all casewhen thektare equal,setting = k doesneutralize effect the the neutralized that into of investment, believing thisprocedure profitability when ofinvestment thektareunequal.0 profitability of of proof therelevance is M-M's argument upheld:Gordon's Therefore policy and of on a confoundinginvestment dividend doesrest dividend policy will policy change dividend the of that effects. is true course changing firm's It formula This is notto say, (1). rate discount in thevaluation theaverage be for cost the that however, it changes corporation's of capital, as should cost of has the clearby now,if thekt are unequal, corporation no unique will to project rateapplicable an investment discount capital:theaverage k in the returns.21 Thus upontheexacttimepathof theproject's depend
18. AItis given by: AIt= Y[b2(1 + b2r)t - bl(I + b,r)tl.

whichare disfor that cash outflows investment, in 19. Thereis some awkwardness assuming whichare not. cash inflows, at cretionary, shouldbe discounted the same rate as the resulting for thatthe withGordon's to practice, he assumes this appears be compatible However, assumption of and to onlyon its futurity not on the magnitude rateapplicable a dividend depends discount in inherent a discounted in and retentions that period.This is one of the difficulties earnings under to uncertainty. cashflow approach valuation if of thatthe kt will be unequaleven underconditions certainty, the 20. It is worthnoting if relevance, it were ratesis not flat.Thus Gordon's proofof dividend of term structure interest of conditions certainty! valid,wouldapplyevenunder value approachto to 21. For thisreasonit would appearpreferable employthe net present rate. of for specification a singlediscount investment decisions, thisdoes notrequire

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cost beingthe corporation's of capital,is but formula valuation (1), farfrom for and as such shouldbe irrelevant decision-making an algebraicartefact, purposes. by proceeds way of underuncertainty irrelevance M-M's proofof dividend policy is held Assumingthat investment the familiararbitrageargument. that budgetconstraint the the from firm's M-M showthatit follows constant, holdingthe sharesof the i, in to return shareholders firm Ri(0), 22 from total for firm one periodis:
RI(0) Xi(0)
-

I(0) + V(1)

(8)

and investment incomestream operating where Xi(0) and Ii(0) are thefirm's budgetforthe period,and Vi(1) is its value at the end of the period.M-M (i posit two firms = 1, 2) identicalin all respectsexcept theirfirstperiod and arguethat: dividend,
(1)

are valuesof thefirms identical. (2) theinitial period are (1) Since the two firms assumedidenticalexcept for theirfirst (0) = X2(0) and I, (0) thatX1 by it dividend policies, follows assumption will thatall investors expectthatV1(1) = V2(1). I2(0). They arguemoreover marketrationof theirassumption symmetric This argument derivesfrom behaves rationally that everymarketparticipant ality,whichrequiresfirst to morewealthto less and being indifferent the in the sense of preferring that,in forming is his form which wealthincrement received;and secondly in bothbehaves participant he his expectations, believesthateveryothermarket Thus this asand believesthat all othersalso behave rationally. rationally will be will impliesthatall participants believethat the two firms sumption at valued rationally theend of theperiodso thatV1(1) and V2(1) willdepend of and investment the two dividends future earnings, onlyon the prospective that it firms period 1. Since theseare identicalby assumption, follows from will all investors expectV1( 1) a V2( 1), so thatRL(0) = R2(0) . mightbe leadingto the same conclusion A moredirectset of assumptions that: whichrequires information" of called the"independence irrelevant in are (a) investors rational theabove sense,and and future prospects, (b) sharesare valuedonlyon thebasis of their thatthisis so. knowfrom experience (c) at leastsomeinvestors of thatsince the prospects from thisset of assumptions It follows directly as to thetwo firms known be indentical of theend of the period,at least are will expectV1(1) =-V2 (1). Assumption (a) is the standard some investors to of (b), behavior;assumption in addition beingplausible, assumption rational of for assumption all stock has the advantageof familiarity, it is an implicit (c) would appear valuationmodels (includingGordon's),while assumption valid. to be empirically will all marketrationality, investors of (2) On the assumption symmetric
-

1R(0) = R2(0), and therefore,

of but refers here,not to the rate of return, to the total cash receipts 22. Note that"return" investment. initial their investors including

Note on Dividend Irrelevance

1121

perceive Rk(O) R2(0), and therefore theassumption individual that by of will equally, thatthevalueof thefirm so is rationality valuethetwofirms independentitsfirst of period dividend policy. On theweaker assumption theindependence irrelevant of of information, at leastsometraders realize who thatR1(0) _R2(0) willarbitrage awayany inthe difference initial valuation thetwofirms, of leading thesameresult. to Having shown that first period dividend policy irrelevant, proceed is M-M to showthatV1(2) and henceV1(1) and Vi(O) are independent second of period dividend policy, thence induction thevalueof thefirm and by that is independent itsdividend of policy all subsequent in periods, onceinvestment Thus any denialof the irrelevance dividend of policymustrelyupona rejection theprinciple symmetric of of market and rationality, theassumption oftheindependenceirrelevant -To of information. reject latter the assumption requires ofthefollowing assertions: one three either that: (a) investors notrational, are or (b) stock as prices depend pastevents wellas on their on future expected prospects, or valuation the (c) there no exist investors understand security who process.
REFERENCES Review American Economic Puckett. "Dividends StockPrices," and 1. IrwinFriend and Marshall Vol. 54,No. 5 (Sept.,1964),656-682. Reviewof Economics and Statistics Earnings and StockPrices," 2. MyronGordon. "Dividends, Vol. 41, No. 2, Part I (May, 1959),99-105. . "The Savings, Review of EcoInvestment Valuationof a Corporation," and 3. Vol. and nomics Statistics 45,No. 1 (Feb., 1962),37-51. . The Investment, and Valuationof the Corporation. Homewood, 4. Financing Illinois:Richard Irwin,1962. D. . "Optimal Journal FinanceVol. 18, No. 2 5. Investment Financing and of Policy," (May, 1963),264-272. and EugeneF. Brigham. and the Cost of Capital," Dividend 6. "Leverage, Policy, Journal Finance of Vol. 23,No. 1 (Mar., 1968),85-103. Decisions, Toronto:MacMillan, 1969. Analysis Financial of 7. James T. Mao. Quantitative C. "DividendPolicy,Growth and the Valuationof 8. MertonH. Millerand FrancoModigliani. Journal Business Vol. 34, No. 4 (Oct.,1961),411-433. Shares," of and MertonH. Miller."The Cost of Capital,Corporation Finance,and 9. FrancoModigliani Economic ReviewVol.48,No. 3 (June,1958),261-297. American theTheory Investment," of . "The Cost of Capital,Corporation Financeand the Theoryof Investment: 10. Economic ReviewVol. 49,No. 4 (Sept.,1959),655-669. American Reply." Incometaxes and the Cost of Capital: A Correction," American 11. --. "Corporate ReviewVol. 53,No. 3 (June,1963),433-444. Economic and C. Cliffs, Financing Decisions, Englewood A. Optimal 12. Alexander Robichek Stewart Meyers. 1965. N.J.: Prentice-Hall, and Englewood Cliffs, N.J.: Prentice-Hall, C. Management Policy, 13. James van Horne.Financial 1968. on Journalof 14. JamesE. Walter."DividendPolicy: Its Influence the Value of Enterprise," Finance Vol. 18,No. 2 (May, 1963),280-291. and EugeneF. Brigham. and Finance, New York. Holt,Rinehart Managerial 1S. J. FredWeston 1966. Winston,

poclcyis given.