under certain conditions, dividend policy is irrelevant. What is it that they ar

Question

under certain conditions, dividend policy is irrelevant. What is it that they are specifically claiming to be irrelevant? Explain with the following example. Assume that a firm has $100,000 in assets at market value, no debt, and 100 shares outstanding. $10,000of the assets are in cash, which represents the recent net income of the firm. Now the firm can choose whether to pay out a 50% dividend that will require the issuance of $5,000 in new shares, or to pay no dividend and plow back all $10,000 of earnings into a project with an attractive NPV.

Explanation / Answer

Answer: MM are proclaiming that, regardless of dividend policy—that is, the decision of what portion of the firm's earnings to pay as dividends—the value of the firm is unaffected. Assume that the investment will be undertaken regardless of dividend policy. The firm's shares should currently be worth $1,000 each. If 50% of the firm's earnings are paid as dividends, shareholders will receive $50 per share and have shares that are now worth $950 each. The value of the old equity is now $95,000, but $5,000 has been raised (through the issue of 5.26 shares at $950 each). Thus, the value of the firm remains at $100,000. The key to this example is to realize that the new shares cannot be sold at the previous value of $1,000 each. Efficient markets will reduce the value of each new share to the value of the previous shares.

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