Introductory Corporate Finance: Dividend Policy - Dividend Irrelevance Theory, MillerModigliani Assumptions

What This Is

The Dividend Irrelevance Theory, also known as the Miller-Modigliani (M-M) Theorem, states that a company's capital structure does not affect its value. This theory assumes that investors can borrow and lend at the same rate as the company, and that there are no taxes or transaction costs. For example, consider a company with a market value of $100 million, 50% debt, and 50% equity. If the company pays a dividend of $5 million, the value of the company remains $100 million, regardless of its capital structure.

Key Formulas & Models

• WACC = wd × rd(1-T) + wps × rps + we × re: Weighted average cost of capital; used as discount rate.
• wd: weight of debt (proportion of debt in capital structure)
• rd: cost of debt (interest rate on debt)
• T: corporate tax rate
• wps: weight of preferred stock
• rps: cost of preferred stock
• we: weight of equity
• re: cost of equity (required rate of return on equity)
• DOL = Q(P-V) / (Q(P-V)-F): Degree of operating leverage; measures EBIT sensitivity to sales.
• Q: sales
• P: price per unit
• V: variable costs per unit
• F: fixed costs
• Earnings Per Share (EPS) = Net Income / Number of Shares Outstanding: Measures profitability per share.
• Dividend Yield = Annual Dividend / Stock Price: Measures the return on investment from dividends.
• Cost of Equity (re) = Rf +-× (Rm - Rf): Measures the required rate of return on equity.
• Rf: risk-free rate
• ?: beta coefficient (measure of systematic risk)
• Rm: market return
• Sustainable Growth Rate = Retention Ratio × ROE: Measures the long-term growth rate of a company.
• Retention Ratio: proportion of earnings retained
• ROE: return on equity
• Free Cash Flow (FCF) = EBIT - Capital Expenditures - Change in Working Capital: Measures the cash flow available for investment or debt repayment.
• Debt-to-Equity Ratio = Total Debt / Total Equity: Measures the proportion of debt in the capital structure.

Step-by-Step Calculation

1. Calculate the weighted average cost of capital (WACC) using the formula WACC = wd × rd(1-T) + wps × rps + we × re.
2. Calculate the degree of operating leverage (DOL) using the formula DOL = Q(P-V) / (Q(P-V)-F).
3. Calculate the earnings per share (EPS) using the formula EPS = Net Income / Number of Shares Outstanding.
4. Calculate the dividend yield using the formula Dividend Yield = Annual Dividend / Stock Price.
5. Calculate the cost of equity (re) using the formula re = Rf +-× (Rm - Rf).
6. Calculate the sustainable growth rate using the formula Sustainable Growth Rate = Retention Ratio × ROE.

Common Mistakes

1. Mistake: Using book value instead of market value for WACC.
2. Correction: Use market value to reflect the current market price of the company's securities.
3. Counterexample: A company with a book value of $50 million and a market value of $100 million has a WACC of 10% using market value, but 5% using book value.
4. Mistake: Ignoring flotation costs when calculating WACC.
5. Correction: Include flotation costs in the WACC calculation to reflect the true cost of capital.
6. Counterexample: A company with a WACC of 10% without flotation costs has a WACC of 12% with flotation costs.
7. Mistake: Confusing sunk cost with opportunity cost.
8. Correction: Sunk costs are costs that have already been incurred and cannot be changed, while opportunity costs are the benefits that could have been obtained from alternative uses of resources.
9. Counterexample: A company that invested $10 million in a project that failed to generate returns should not include the $10 million as a sunk cost, but rather as an opportunity cost.

Exam / CFA Tips

1. Tip: Be careful when applying the M-M Theorem, as it assumes no taxes and no transaction costs.
2. Tip: When calculating WACC, use market value and include flotation costs.
3. Tip: When calculating sustainable growth rate, use the retention ratio and ROE.
4. Tip: Be aware of the difference between dividend irrelevance and bird-in-hand, as they are related but distinct concepts.

Quick Practice Problem

A company has EBIT of $10 million, interest of $2 million, and tax of 25%. Calculate the degree of financial leverage (DFL).

Answer: DFL = (EBIT - Interest) / EBIT = ($10 million - $2 million) / $10 million = 0.8

Explanation: The DFL measures the sensitivity of EBIT to changes in sales.

Last-Minute Cram Sheet

1. WACC = wd × rd(1-T) + wps × rps + we × re: Weighted average cost of capital.
2. DOL = Q(P-V) / (Q(P-V)-F): Degree of operating leverage.
3. EPS = Net Income / Number of Shares Outstanding: Earnings per share.
4. Dividend Yield = Annual Dividend / Stock Price: Return on investment from dividends.
5. re = Rf +-× (Rm - Rf): Cost of equity.
6. Sustainable Growth Rate = Retention Ratio × ROE: Long-term growth rate of a company.
7. FCF = EBIT - Capital Expenditures - Change in Working Capital: Free cash flow.
8. Debt-to-Equity Ratio = Total Debt / Total Equity: Proportion of debt in capital structure.
9. In M-M Proposition I (no taxes), firm value is independent of capital structure – but with taxes, value increases with debt due to the interest tax shield.
10. Sustainable growth rate is affected by retention ratio and ROE, but not by capital structure.