Home Accounting Corporate Valuation and Takeover: Exercises

## Dividend Irrelevancy## IntroductionIn a world of Because rational, risk-averse investors prefer their returns in the form of dividends now, rather than later (a "bird in the hand" philosophy), the but a function of the constant and timing of the dividend payout ratio. Expressed mathematically:size Consequently, share price is a As we explained in Chapter Three, Gordon and others who tested his model empirically were unable to prove this proposition categorically, even for all-equity firms, because of the statistical problem of Fortunately, two of Gordon's American academic contemporaries, Franco Modigliani and Merton H. Miller (MM henceforth) provided the investment community with a lifeline. According to MM (1961 onwards) the equity capitalisation rate (Ke) conforms to the company's class of business risk, so that under conditions of However, under conditions of because it confuses dividend policy with investment policy.inconclusive - Any increase in the dividend payout ratio, without any additional finance, reduces a firm's operating capability and - Because uncertainty is future stream of dividends, where K < K < K ...multi-period according to the investors' perception of the unknown.etc. MM therefore define a current model:one period where Ke equals the shareholders' desired rate of return (yield) and managerial cut-off rate for investment, which correspond to the "quality" of a company's periodic earnings (class of business risk). The greater their variability, the higher the risk, the higher Ke , the lower the price and MM then proceed to prove that because dividends and earnings are For a business risk, a change in dividend (D1) cannot alter a company's current ex-div share price (P0) because Ke remains constant.equivalent The next ex-div price (P1) increases by any corresponding reduction in dividend (D1) and ## Exercise 4.1: Dividend IrrelevancyBefore we rehearse the MM (op cit).Suppose the Winehouse Company, an all equity firm generates a net annual cash flow of £100 million to be paid out as dividends in perpetuity. The yield and corporate cut-off (discount rate) correspond to a 10 per cent market rate of interest commensurate with the degree of business risk. Thus, the gives a total equity value (market capitalisation):level perpetuity Now assume that the company intends to finance a new project of equivalent risk by retaining the next dividend to generate an dividend. Thereafter, a full distribution policy will still be adhered to.additional
1. Calculate the revised value for V E 2. Evaluate whether management is correct to retain earnings and whether shareholders should continue to invest in the company?
Our answer reviews the investment and financial criteria that underpin the normative objective of shareholder wealth maximisation, using NPV maximisation as a determinant of share price. 1. The Revised Equity Value (VE) The first question we must ask ourselves is how the incremental investment (a new project financed by the non-payment of a dividend) affects the shareholders' wealth? We can present the managerial retention decision in terms of the revised dividend stream: If we now compare total equity values using the £1,000 millionVE (revised) = £300 million / (1.1)2 + (£100 million / 0.10) / (1.1)2 = £1,074.4 million Thus, once the project is accepted the present value (PV) of the firm's equity capital will rise and the shareholders will be £74.4million better off. For those of you familiar with DCF analysis and the NPV concept, it is also worth noting that the same wealth maximisation decision can be determined from a The increase in total value is simply the new project's 2. An Evaluation of the Data In our example, management is correct to retain earnings for reinvestment. The shareholders relinquish their next dividend. However, they gain an increase in the current In perfect capital markets, where the firm's investment decisions can be made independently of the consumption decisions of shareholders: - NPV project maximisation produces shareholder wealth maximising behaviour. - It is a change in investment and |

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