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POLICY
DIVIDENDS
ARE
I R R E L E VA N T
Group 04
Khadiza Akter Lima 2022331011
10
a. At what price will the new shares be issued in year 1?
At
t=1, Price per share=
New Share issued = N
V1 = P1 (1,000,000 + N) = $21,000,000
10.c = $1,050,000
So, At t=2, Dividend per share = $1
Old share = 1,000,000
At t=2, Dividend paid to old shareholders= $1 1,000,000
= $1,000,000
PROBLEM
11
DIVIDEND POLICY IS IRRELEVANT:
THE MILLER-MODIGLIANI (MM) HYPOTHESIS
•In 1961 by Miller and Modigliani published a proof that dividend policy is irrelevant in a world
without taxes, transaction costs, or other market imperfections.
•For example, a firm wants to increase their total payout by increasing the dividend without changing
their investment and financing policy. The firm can finance the extra dividend by printing some
more shares and sell them.
•The firm can sell more shares while keeping its assets, earnings, investment opportunities, and,
therefore, market value unchanged through transfer of value from the old to the new stockholders.
•The new shareholders get the newly printed shares, each one worth less than before the dividend
change was announced, and the old shareholders bear a capital loss on their shares. The capital loss
borne by the old shareholders just offsets the extra cash dividend they receive.
•Now the old shareholders can also raise cash by selling their shares. So, investors do not need
dividends to earn cash, they will not pay higher prices for the shares of firms with high payouts. So,
the firm ought not to worry about dividend policy.
DIVIDEND POLICY IS IRRELEVANT:
THE MILLER-MODIGLIANI (MM) HYPOTHESIS
Before After
Dividend Dividend
New
shareholders
Total value of firm
Each share
Worth this …and worth
before.. this after
Old
shareholders
• As pointed out in the text, any increase in cash dividend must be offset by a stock
issue if the firm’s investment and borrowing policies are to be held constant.
PROBLEM • The old stockholders can also raise cash by their selling shares. Thus the old
shareholders can cash in either by persuading the management to pay a higher
11
dividend or by selling some of their shares. In either case there will be a transfer
of value from old to new shareholders. The only difference is that in the former
case this transfer is caused by a dilution in the value of each of the firm’s shares,
and in the latter case it is caused by a reduction in the number of shares held by
the old shareholders.
• Because investors do not need dividends to earn cash, they will not pay higher
prices for the shares of firms with high payouts. So, the firm ought not to worry
about dividend policy.
TRANSFER OF VALUE
Shares
Cash
Cash Shares
Firm
Cash
b) Assume that there are no taxes. By how much is the stock price likely
Answer
to fall?
Answer: The stock price will fall by $1.
c) Now assume that all investors pay tax of 30% on dividends and nothing on
capital gains. What is the likely fall in the stock price?
The stock price will fall by the after-tax dividend, i.e., by $1 (1-0.3) = $0.70,
so that the after-tax return on dividends and capital gains are the same. To see
this more clearly, suppose the stock price is 10 before the dividends is paid. If
you buy the stock right before the dividend is paid and sell it right after, your
Answer net profit should be essentially zero since you have held the stock for a small
amount of time. Here are your cash flows:
buy now: -10.00
dividend: + 1.00
tax on dividend: -0.30
sell after dividend: S (to be found)
So, the sum of all these cash flows should be zero:
-10+1-3.30+S=0
S= 9.30
The stock price fell by $10.00-$9.30= $0.70.
d) Suppose, finally, that everything is the same as in part (c), except that security
dealers pay tax on both dividends and capital gains. How would you expect your
answer to (c) to change? Explain.
In this case, there should be no tax effects, i.e., the stock price will fall
by $1. To better see this, suppose you buy the stock (for $10, say) right
before the dividend is paid, and sell it right after the dividend is paid.
Answer Because you hold the stock for a small amount of time (a second, say),
your net profit should be zero. You pay $10 for the stock; you receive
$1 as a dividend which is taxed at 30%; then you sell it for S (To be
found) and pay taxes of 30%*(S-10) on your capital gains (which are
going to be negative here).
So, your net profit is,
-10+ (1-0.30) +S-0.30 (S-10) =0
Solving for S, we find S=9. So, the change in S is $10-$9=$1
THANK
YOU