The Irrelevance of the MM Dividend Irrelevance Theorem

Abstract

Contrary to Miller and Modigliani (1961), payout policy is not irrelevant and investment policy is not the sole determinant of value, even in frictionless markets. MM ask Do companies with generous distribution policies consistently sell at a premium above those with payouts? But MM's analysis does not address this question because the joint effect of their assumptions is to mandate 100% free cash flow payout in every period, thereby rendering niggardly infeasible and forcing distributions to a global optimum. Irrelevance obtains, but in an economically vacuous sense because the firm's opportunity set is artificially constrained to payout policies that fully distribute free cash flow. When MM's assumptions are relaxed to allow retention, payout policy matters in exactly the same sense that investment policy does. Moreover, (i) the standard Fisherian model is empirically refutable, predicting that firms will make large payouts in present value terms, (ii) only when payout policy is optimized will the present value of distributions equal the PV of project cash flows, (iii) the NPV rule for investments is not sufficient to ensure value maximization, rather an analogous rule for payout policy is also necessary, and (iv) Fischer Black's (1976) dividend puzzle is a non-puzzle because it is rooted in the mistaken idea that MM's irrelevance theorem applies to payout/retention decisions, which it does not.