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Chapter 2. High Dividend Stocks: Bonds w... > Theoretical Roots: Dividends and Val...

Theoretical Roots: Dividends and Value

Can paying more in dividends make a company a more attractive investment? There is a surprising degree of disagreement about the answer to this question in corporate financial theory. One of the most widely circulated propositions in corporate finance—the Miller-Modigliani theorem—states that dividends are neutral and cannot affect returns.[1] How, you might wonder, is this possible? When a company pays more in dividends every year, say, 4% of the stock price rather than the 2% it pays currently, does that not increase the total return? Not in a Miller-Modigliani world. In this world, the expected price appreciation on this stock will drop by exactly the same amount as the dividend increase, say, from 10% to 8%, leaving you with a total return of 12%. While there remain numerous adherents to this view, there are theorists who disagree by noting that a firm may signal its confidence in its future earnings by increasing dividends. Accordingly, stock prices will increase when dividends are increased and drop when dividends are cut. To complete the discussion, still others argue that dividends expose investors to higher taxes and thus should reduce value. Thus, dividends can increase, decrease or have no effect on value, depending upon which of these three arguments you subscribe to.

Dividends Do Not Matter: The Miller-Modigliani Theorem

The basis of the argument that dividends don't matter is simple. Firms that pay more dividends will offer less price appreciation and deliver the same total return to stockholders. This is because a firm's value comes from the investments it makes—plant, equipment and other real assets, for example—and whether these investments deliver high or low returns. If a firm that pays more in dividends can issue new shares in the market, raise equity, and take exactly the same investments it would have made if it had not paid the dividend, its overall value should be unaffected by its dividend policy. After all, the assets it owns and the earnings it generates are the same whether it pays a large dividend or not.


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