Modigliani & Miller show that dividend policy can also be considered irrelevant.

Question

Modigliani & Miller show that dividend policy can also be considered irrelevant. Yet, unexpected increases in dividends are often closely followed by price increases, why?

To clarify, when a firm pays a dividend the stock price should drop by the amount of the dividend on the ex-dividend date. Let's say a firm has 5 stockholders, each holding 1 share. The firm owns $2,000 in cash and $3,000 in other assets. So the firm is worth $5,000 (it owes no debt). Each stockholder's claim is worth:

$5,000/5 = $1000.

Now the firm declares a dividend of $100/share. They must pay out a total of: $100 x 5shares = $500. So after the dividend is paid the firm now has $1,500 in cash and $3,000 in other assets, for a total of $4,500. Dividing this by 5 stockholders, we find that each stockholders claim is $900. The same as if we take $1,000 less $100 dividend to get $900. The stockholder hasn't lost anything, he still has $1,000 in value, just $900 in the firm and $100 in cash now.

But what we actually often see in practice is:

Let’s say the firm was expected to pay a $100/share dividend, but instead pays a dividend of $110. Like the example above, we would expect to see the stockholder's value fall to $890 ($1,000 - $110 = $890). Again, the stockholder still has $1,000; $890 in the firm and $110 in cash. In practice though, we see that instead of the stock dropping to $890, it falls to say, only $895. Thus the stockholder's value is now; $110 + $895 = $1,005.

Why did they gain $5 in value, just by issuing the dividend?

Explanation / Answer

Any company's share price after Dividend issuance will go up because of the share holders centiments. People always have perception that only that company will issue dividends which is going good, so that company's share demand goes high making it more expensive.

Related Questions

Navigate

• Browse (All)
• Browse M
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.