15.2Distribution Policy in Frictionless Markets

As we discuss later in this chapter, the dividend choice is closely related to the capi-

tal structure choice and, like the capital structure choice, is strongly influenced by mar-

ket frictions like taxes and transaction costs. Before considering how market frictions

affect dividend policy, we examine a simple case where there are no transaction costs

and no taxes, and where the dividend choice conveys no information to investors.³The

analysis of this case serves as a useful benchmark for understanding the more realistic

settings examined later. We will start with the case in which the firm knows how much

cash it would like to distribute, but has not decided whether to distribute the cash by

paying a dividend or by repurchasing shares.

³Chapter 19 examines how information considerations affect dividend policy.

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EXHIBIT15.2Selected Dividend Yields and Payout Ratios, 1993 and 1999

1993

1999

	Dividend Yield	Payout Ratio	Dividend Yield	Payout Ratio
Company	(%)	(%)	(%)	(%)

AT&T	2.51%	44.92%	1.73%	49.72%
Apple Computer	1.64	64.39	0	0
Boeing	2.31	27.34	1.35	22.22
Deere	2.70	92.74	2.43	85.44
Disney	0.54	18.35	0.20	8.25
Dow Chemical	4.58	110.82	2.60	57.81
General Motors	1.46	23.36	2.75	22.99
Hewlett-Packard	1.14	19.32	0.86	20.78
McDonald’s	0.74	13.82	0.48	13.54
Microsoft	0	0	0	0
Minnesota Mining & Mfg.	3.05	56.45	2.29	51.03
Philip Morris	4.67	63.91	8.00	57.32
Safeway	0	0	0	0
Texaco	4.94	65.84	3.31	84.11
Wal-Mart	0.52	12.81	0.37	16.00

Note: These ratios were calculated with data taken from COMPUSTAT.

The Miller-Modigliani Dividend Irrelevancy Theorem

In their classic article, Miller and Modigliani (1961) examined a firm that wanted to

distribute a fixed amount of cash to its shareholders either by repurchasing shares or

by paying a cash dividend. The authors assumed that the choice between these two

alternatives would affect neither the firm’s investment decisions nor its operations.

Given these assumptions, they demonstrated that, in the absence of personal taxes and

transaction costs, the choice between paying a dividend and repurchasing shares is a

matter of indifference. Shareholders are indifferent and firm values are unaffected by

which of the two methods is used. Result 15.1 summarizes the Miller-Modigliani div-

idend irrelevancy theorem.

Result 15.1

(The Miller-Modigliani dividend irrelevancy theorem.)Consider the choice between payinga dividend and using an equivalent amount of money to repurchase shares. Assume:

•	There are no tax considerations.
•	There are no transaction costs.
•	The investment, financing, and operating policies of the firm are held fixed.

Then the choice between paying dividends and repurchasing shares is a matter of indiffer-

ence to shareholders.

AProof of the Miller-Modigliani Theorem.To understand Result 15.1, consider

twosimilar equity-financed biotech firms with different dividend policies:

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536	Part IVCapital Structure

•	One firm, Signetics, has announced that it will pay a $10 million dividend nextyear.
••	The other firm, Comgen, has announced that it will repurchase $10 million in outstanding shares. ˜At the end of the year, the firms will each be worth the same amount, X(afterpaying dividends or repurchasing shares),which lies somewhere between $100million and $200 million, depending on industry conditions.
•	Each firm initially has 1 million shares outstanding.

These assumptions imply that a share of Signetics stock will sell for one millionth

˜˜

of Xat the end of the year; hence, if Xis $150 million, each share will be worth $150.

Calculating the year-end value of Comgen stock is slightly more complicated. Comgen

will repurchase Nshares for $10 million, implying:

Share price N $10 million

(15.1)

˜,its share price must satisfy:

Since the year-end value of Comgen equals X

˜
X
Share price	(15.2)
1 millionN

˜

For example, if Xis $150 million, then equations (15.1) and (15.2), two equa-

tions with two unknown variables, can be solved for both Nand the share price. With

˜

Xequal to $150 million, Comgen will repurchase 62,500 shares at a price of $160

per share. In this case, a tax-exempt investor who holds 100 shares of Signetics stock

receives a dividend of $1,000 ($10 dividend per share) and holds shares worth

$15,000 ($150 per share). If this same investor holds 100 shares of Comgen stock,

he receives no dividends at the end of the year. However, his shares will be worth

$16,000. In both cases, the value of the shares plus the cash dividend (for Signetics)

is the same.

Although the above example assumes that the year-end value was $150 million for

both Signetics and Comgen, the equivalence between dividends and share repurchases

holds regardless of the firms’year-end values, as long as it is the same for the two

firms. The future values of these two corporations are assumed to perfectly track each

other regardless of their dividend policies. Thus, the two firms, which differ only in

their dividend policies, should sell for the same initial price. If Signetics and Comgen

shares sell for different prices, there will be an arbitrage opportunity, as Example 15.1

illustrates.

Example 15.1:Arbitrage Opportunities That Arise When the Miller-Modigliani

Theorem Does Not Hold

Suppose that Signetics stock is currently selling at $130 a share and Comgen is selling at

$128 a share.What can an investor do to realize an arbitrage gain?

Answer:An investor who buys 100 shares of Comgen for $128 a share and sells short

100 shares of Signetics at $130 a share will realize an initial $200 cash inflow.This $200 is

free money;there will be no net cash outflow at the end of the year.

For example, assume that both companies are going to be worth either $100 million or

$200 million next year.The Comgen shares will then be worth either $200 per share or $100

per share, depending on industry conditions.The Signetics shares will be worth either $90

per share or $190 per share, depending on the state of the economy, plus a dividend of $10

per share.Hence, the year-end value of this arbitrage portfolio is zero, regardless of the state

of the economy.

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Example 15.1 shows that if two firms are equivalent except for their dividend poli-

cies, their values should be the same in the absence of taxes and transaction costs. If

the values are not the same, smart investors can realize arbitrage profits.

Kerkorian and Chrysler

Consider the Kerkorian and Chrysler situation examined in the opening vignette to this

chapter. Exhibit 15.3 compares the effects on Kerkorian’s position under the following

alternatives:

•	Chrysler pays out $1 billion as a special dividend.
•	Chrysler repurchases $1 billion of its own stock.

To simplify the numbers, assume that Chrysler stock is selling at $50 per share, that the

company has 350 million shares outstanding, and that Kerkorian wishes to maintain 10 per-

cent control of the firm.

If Chrysler pays a dividend, Kerkorian receives a $100 million dividend and ends up

with shares worth $1.65 billion. If Chrysler repurchases shares, Kerkorian will sell 2 mil-

lion shares to bring his stake back to 10 percent. At a selling price of $50 per share, the

stock sale will bring Kerkorian $100 million, and his stock position will be worth $1.65

billion. Ignoring taxes and transaction costs, Kerkorian is indifferent between the two alter-

natives.⁴

Optimal Payout Policy in the Absence of Taxes and Transaction Costs

Let’s now consider the trade-off between distributing earnings to shareholders, either

by paying a dividend or repurchasing shares, and retaining the earnings to increase

internal investment. The previous subsections indicated that, in the absence of taxes

EXHIBIT15.3Chrysler’s Choice: Dividends orShare Repurchase

Before	Pay $1 Billion in	Repurchase $1 Billion
Transaction	Dividends	of Stock
(in $ millions)	(in $ millions)	(in $ millions)

Total assets (other than	cash)	$ 9,800	$ 9,800	$ 9,800
Cash		7,700	6,700	6,700
Equity value		$17,500	$16,500	$16,500
Dividends			$1,000
Shares outstanding		350	350	330
Stock value per share		$ 50.00	$47.14	$ 50.00
Dividends per share			$2.86

Kerkorian stock value
(in $ millions)	$ 1,750	$1,650	$ 1,650

Kerkorian dividends
(in $ millions)	$	100

Kerkorian’s proceeds from
selling shares	$100 ($50 2)

⁴Accounting considerations also may lead firms to prefer share repurchases over dividends. Compared

with dividends, share repurchases generally increase both earnings per share and return on shareholder’s

equity.

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538Part IVCapital Structure

and transaction costs, dividends and share repurchases are equivalent. Therefore, a

distinction between the two methods of distribution at this point is unnecessary.

Result 15.2 specifies the assumptions made up to this point, along with their impli-

cations for the corporation’s choice between distributing or retaining the earnings.

Result 15.2

Consider the choice between paying out earnings to shareholders versus retaining the earn-ings for investment. Assume:

•	There are no tax considerations.
•	There are no transaction costs.
•	The choice between paying a dividend and retaining the earnings for reinvestment within the firm does not convey any information to shareholders.

Then a dividend payout will either increase or decrease firm value, depending on whether

there are positive net present value (NPV) investments that could be funded by retaining

the money within the firm. If there are no positive NPVinvestments, the money should be

paid out.

Result 15.2 restates the more fundamental point discussed in Part III of this text.

With frictionless capital markets, firms should accept all positive NPVprojects and

reject all negative ones. However, as we see below, this will not necessarily be the case

when taxes and transaction costs are present.